Executive Compensation Plans the Rabbi Trust Fund

Rabbi Trust . . . a term we may all become more familiar with as the financial woes of big companies begins to affect more and more people. Exactly what is a rabbi trust? I’m not a financier, but the more I read about the rabbi trust, the more interesting it becomes.

The trust received its name due to the fact that a rabbi’s congregation wanted to reward him for all the support he provided to them, so they set up a type of “retirement” fund that would not be taxed at the time it was deposited into the trust, but when it was withdrawn. There are usually specific terms set regarding when the trust can be accessed, such as death, becoming disabled, resignation (voluntary or involuntary) or retirement.

This benevolent gesture towards the rabbi did not go unnoticed in the financial world. Soon the rabbi trust funded much more than hardworking, devoted rabbis. Before long the rabbi trust was used by businesses to defer taxes on compensation to employees to be paid when the employee retired and would supposedly (hopefully?) be earning less money than currently, thus the income received would be in a lower tax bracket.

It was not long before businesses purchasing businesses began to implement the rabbi trust plan also. When there are additional stipulations to be met by the seller, a percentage of the purchasing cost may be put into a rabbi trust until the stipulations of the purchasing contract are met. Until the rabbi trust monies are withdrawn, all taxes and other liabilities are the responsibility of the selling business, not the purchasing business.

The three conditions that must be met to establish a rabbi trust, which must be sanctioned by the IRS are:

* The trust’s assets must be available to all the general creditors of the employer if the employer files for bankruptcy.

* There are no insolvency triggers that hasten payments to employees when the employer’s net worth falls below a certain point, thereby bypassing creditors before insolvency is declared.

* There is a procedure to provide notice to the trustee of the bankruptcy of the employer or financial hardship of the employer.

The non-qualified deferred compensation plan allows the employer to place monies into a trust for the employee’s future and for the employee to not have to pay taxes until the money is withdrawn. Because of the economic benefit theory doctrine, the IRS allowed by private letter ruling that the trust would not result in income according to Section 83(a) of the code if the assets of the trust were available to the reach of the employer’s general creditors. (Wikipedia)

This sounds like a “promise” to me. As long as the company is doing well, the rabbi trust will stay in the black. But what happens if the company fails? Do those same untaxed dollars then revert back to the company in order to pay their creditors? That is the way I read it.

Regarding bankruptcy, “Case law, including Goodman v. Resolution Trust Corporation [KTC 1993-174 (4th Cir. 1993)], shows that property held in a rabbi trust is subject to the employer’s creditors. When the bank that had set up rabbi trusts for certain employees later went into receivership and some of the employees that were beneficiaries of the trusts brought an action seeking a determination that they were entitled to the trusts assets, the District Court denied the employees motion for summary judgment and ruled that the receiver had the right under the terms of the trusts to recover the trusts assets in order to satisfy the bank’s creditors.” http://www.nysscpa.org/cpajournal/2003/0303/features/f033403.htm

While the phrasing above seems to indicate that the trust does not belong to the employee until certain conditions are met, rabbi funds are also used to:

“* offset IRS limits on qualified plans (as an excess benefit plan)

* provide a voluntary deferred compensation plan

* supplement an executive’s retirement plan

Though less frequent, rabbi trusts can be included in executive incentive plans, director retirement plans, golden parachute plans, and termination agreements.” http://www.rabbitrust.net/

Rabbi trusts seem to be restricted to a company’s top executives, “If they are ERISA plans, then one issue is whether the employee entitled to receive the gratuitous benefit is within the “top hat” group?” and “Diverting the assets of the existing rabbi trust to pay benefits that are not consistent with the exclusive purpose of the trust, raises state law fiduciary duty and breach of contract issues. . . . . Since rabbi trust agreements are designed to enhance the executive’s benefit security.” http://benefitslink.com/boards/lofiversion/index.php/t1578.html

Rabbi Trust.a term that leaves this “free spirit” (a Dave Ramsey plug here) with as many questions as answers. For many of us, financiers or not, the Rabbi Trust is a term of which we should take notice.