There are a variety of deferred compensation plans used by employers who attempt to lock in their employees as far into the future as possible. Under any of these plans, an employee’s tax objective is to only pay a tax when the compensation is actually received, while the employer wants to receive a full expense deduction for any amounts paid—and the sooner, the better. If a plan meets enough criteria to be classified as an exempt trust or qualified plan, then a company can immediately recognize the expense of payments made into it, even though the employees being compensated will not be paid until some future tax year. Also, the value of funds or stock in the trust can grow on a tax-deferred basis, while participants in the plan will not be taxed until they are paid from it. In addition, the funds paid from such a plan may be eligible for rollover into an IRA, which results in an additional delay in the recognition of taxable income. While the funds are held in trust, they are also beyond the reach of any company creditors.
In order to become a qualified plan, it must meet a number of IRS requirements, such as a minimum level of coverage across the company-wide pool of employees, the prohibition of benefits under the plan for highly compensated employees to the exclusion of other employees, and restrictions on the amount of benefits that can be issued under the plan.
Since many employers are only interested in creating deferred compensation plans in order to retain a small number of key employees, they will instead turn to a nonqualified plan, which avoids the requirement of having to offer the plan to a large number of employees.
If the plan is nonqualified, then the employer can only record the compensation expense at the same time that the employees are compensated. A company that only wants to extend deferred compensation agreements to a few select employees will tend to use this type of plan, since it does not require payments to a large number of employees, and it allows the company to increase the amount of per-person compensation well beyond the restricted levels required under a qualified plan.
What is Rabbi Trust and How to Make it Works
A useful variation on the nonqualified plan concept is the “rabbi trust“, which is an irrevocable trust that is used to fund deferred compensation for key employees. Under this approach, a company contributes stock to a third party trustee, such as a bank or trust company, with the stock being designated for eventual payment to a few key employees.
Employee vesting can take seven years or even longer in a few instances, which gives companies an excellent tool to lock in key employees over long periods of time with such plans. Employees can be paid from the trust either in stock or cash, and will recognize income at the time of receipt. The company can recognize an expense at the same time that the employee recognizes income; however, if the employee gradually vests in the plan, the expense can be proportionally recognized by the company at the time of vesting.
If the payments made into the trust are in the form of company stock, then the company must only record as an expense the value of the stock at the time of grant, and can ignore any subsequent changes in the stock’s value. A company that uses a rabbi trust does not have to make extensive reports to the government under ERISA rules; instead, it is only necessary to make a one-time disclosure of the plan within four months of its inception. It is also necessary to initiate the plan prior to the start of any services to which the payments apply, or at least include in the plan a forfeiture clause that is active throughout the term of the deferred compensation agreement.
The terms of a rabbi trust must also state that a key employee’s benefits from the plan cannot be shifted to a third party. It must also state that the trust be an unfunded one for the purposes of both taxes and Title I of ERISA. Further, the plan must define the timing of future payments, or the events that will trigger payments, as well as the amount of payments to be made to recipients.
A key consideration for any company contemplating the creation of a rabbi trust is that the plan assets must be unsecured, and cannot unconditionally vest in the employees who are beneficiaries of the plan. This requirement is founded on the economic benefit doctrine, which holds that the avoidance of taxation can only occur if the receipt of funds is subject to a substantial risk of forfeiture. To this end, the plan document must state that plan participants are classed with general unsecured creditors in terms of their right to receive funds from the plan. The contractual obligation to pay employees from the plan cannot be secured by any type of note, since this defeats the purpose of having the assets be available to general creditors. However, just because the funds can be claimed by general creditors does not mean that they are available for other company uses—payment obligations to targeted employees must be made before any funds may be extracted for other company uses.
The unsecured status of a rabbi trust can be a cause of great concern for the employees who are being paid under its terms. Not only are the funds contributed to the trust at risk of being claimed by general creditors, but so too are all salary deferrals made by the targeted employees into the trust. This is a particular problem in the event of corporate bankruptcy, since secured creditors will be paid in full before the key employees can claim any remaining funds from the trust, which may result in a small payment or none at all.
When a bankruptcy occurs or seems likely, the company is required to notify the trustee, which must halt all subsequent scheduled payments to plan participants and hold all remaining funds for distribution to secured creditors. Further, a change in control may result in a new management team that is not inclined to honor the terms of a deferred compensation agreement that require additional payments into the trust, in which case the recipients under the plan may sue the company for the missing benefits. There is some protection for key employees in this case, however, because the terms of the deferred compensation agreement will require the third party trustee to make payments to employees as they become due; the main problem is that the funds for these payments will only continue to be available if the company pays funds into the trust.
If the perceived risk to plan participants outweighs the advantages of having a rabbi trust, it is also possible to create a secular trust. Under this approach, plan participants will have their assets protected in the event of corporate insolvency, but the reduced level of risk is offset by current taxation of the deferred compensation, which defeats the purpose of having the plan. A combined version of the two plans, called a “rabbicular trust”, starts as a rabbi trust, but then converts to a secular trust if the company funding the plan approaches bankruptcy. However, this approach will still result in the immediate recognition of all income at the time of conversion to a secular trust.
Though the rabbi trust concept can result in substantial benefits to both an employer and key employees, it is not allowed in some states, or only in a modified form. Also, rabbicular trusts must be carefully written to comply with all deferred compensation laws at both the state and federal levels. Consequently, the assistance of a qualified taxation professional should be obtained before setting up either type of deferred compensation plan.