A rabbi trust is a type of non-qualified deferred compensation plan set up by an employer for the benefit of an employee. Rabbi trusts get their name from a 1980 IRS private letter ruling that approved the use of these trusts. In that case, a congregation wanted to set up a trust for the benefit of its rabbi, but did not want the rabbi to have taxable income when the contributions were made to the trust. The IRS ruled that the contributions to the trust would not be taxable to the rabbi until the actual distribution of trust assets upon the rabbi’s disability, termination of employment, retirement, or death.
A rabbi trust works like this: A company or organization establishes a trust for the benefit of an employee (called a “participant”). Although the trust can be set up to be revocable, generally rabbi trusts are set up as irrevocable. The company makes contributions to the trust and pays taxes on the interest income from the trust. The company cannot deduct the contributions to the trust for tax purposes. The trust agreement sets forth the circumstances under which the participant can withdraw the money. Generally, the participant cannot withdraw funds until he or she becomes disabled, no longer works for the company, or dies. The participant does not pay taxes as the contributions are made to the trust, but rather when he or she withdraws the money. The company can deduct the amount of the distributions when the funds are actually distributed to the participant or his or her estate.
IRS Revenue Procedure 92-64 clarifies the rules regarding rabbi trusts and sets forth a model rabbi trust. A key requirement is that the trust assets must be subject to claims of the company’s general creditors. Some of the additional requirements of a valid rabbi trust include:
- Trust assets cannot be subject to claims of the participant’s creditors.
- The trustee must be an independent third party such as a trust company or bank.
- The participant must be prohibited from assigning his or her benefits prior to distribution of the trust assets.
The main advantage of a rabbi trust for an employee participant is that the trust allows the employee to defer paying taxes until he or she actually withdraws money from the trust.
An advantage for the employer is that rabbi trusts can be a way to supplement the retirement benefits of highly compensated and valuable employees. Benefits such as deferred compensation in a rabbi trust can be an attractive way to retain key employees.
The risk that the trust assets will be seized by the company’s creditors in bankruptcy is the main disadvantage for participants. An employee who is considering entering into a deferred compensation arrangement in the form of a rabbi trust should consider the company’s financial health and likelihood of bankruptcy or insolvency in the future.
A rabbi trust that is improperly created or administered can have significant negative tax consequences. Anyone considering establishing a rabbi trust should consult with an attorney.
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