Implementing and Exiting Rabbi Trusts

By David B. Bruckman

In Brief

Minimizing estate and income taxes

In a typical rabbi trust, a type of nonqualified unfunded deferred compensation plan, an employer implements a trust in order to pay future compensation to employees or independent contractors. The trust is generally designed so the employer owns the trust pursuant to the grantor trust rules, thereby enabling any trust income to be taxed to the employer. An estate and tax planning strategy may arise for employees that are rabbi trust beneficiaries and do not require all of their deferred compensation and any accrued interest. The author explains the general rules and benefits of rabbi trusts, and reviews the role endorsement split-dollar life insurance arrangements may have in exiting these trusts.

Because rabbi trusts, named after a nonqualified plan implemented by a synagogue congregation for its rabbi, fall outside the ambit of IRC section 401, the interest income each year on the trust’s corpus is taxable. The timing of inclusion in the income of the employee of a contribution to a nonqualified plan depends upon whether the plan is funded or unfunded. If the assets of a plan are set aside exclusively for the benefit of the employee, such as in an escrow account owned by the employee, the plan is considered a funded plan. Under a funded plan, an employee must generally include contributions to the plan in gross income in the first year that her rights to the contributions are transferable or are not subject to a substantial risk of forfeiture.

Rabbi trusts allow employers to help certain employees defer a portion of their income and augment their qualified retirement plans. Employers must consider the cost of postponing the deduction and the payment of tax on trust income, and employees must consider the economic health of the employer. Employees that do not require the use of all or some of their deferred compensation or are averse to paying income tax on the prospective distribution should consider the merits of what is called a “rabbi rescue.”

IRC section 83, “Property transferred in connection with performance of services,” states that—if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of the fair market value of such property … at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over the amount paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of such person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable [emphasis added].

For the purposes of IRC section 83, the regulations define a substantial risk of forfeiture.

If contributions to a deferred compensation plan are not specifically set aside and the plan consists of the employer’s unsecured promise to pay compensation in the future, or if the assets are unprotected from the employer’s creditors, the plan is deemed unfunded. In an unfunded plan, the employee is taxed only on the deferred compensation when she receives payment or when the assets are made available to the employee under the theories of constructive receipt or economic benefit.

Constructive Receipt and the Doctrine of Economic Benefit

IRC section 451, “General rule for taxable year of inclusion,” states that “The amount of any item in gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.” Treasury Regulations section 1.451-1(a) provides that an item of gross income is includible in gross income in the taxable year in which it is actually or “constructively received” by the taxpayer. Under Treasury Regulations section 1.451-2(a), income is constructively received in the taxable year during which it is credited to a taxpayer’s account, set apart, or otherwise made available so that the taxpayer may draw on it at any time.

Substantial legal authority exists regarding how the doctrine of constructive receipt applies to deferred compensation arrangements. The plan that was the subject of Revenue Ruling 60-31 provided that a percentage of the corporation’s annual net earnings would be divided among the plan’s participants. The corporation set up a separate account on its books for each participant. Distributions from these accounts were to begin when the employee reached age 60 or was no longer employed by the corporation (including cessation of employment due to death or disablement), whichever occurred earlier. Under the terms of the plan, the corporation was “under a mere contractual obligation to make the payments when due, and the parties did not intend that the amounts in each account be held by the corporation in trust for the participants.”

The taxpayer requested advice regarding the taxable year of inclusion in income of the taxpayer for the payments by the corporation. The IRS first turned to Treasury Regulations section 1.451-1(a), citing the rule that income is included in gross income for the taxable year in which actually or constructively received by the taxpayer. Treasury Regulations section 1.446-1(c)(1)(i) provides that “Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received.”

The IRS noted that under Treasury Regulations section 1.451-2(a) income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Under the doctrine, a taxpayer may not turn her back on income and select the year in which to report it. The IRS added that—It is clear that the doctrine of constructive receipt is to be sparingly used; that amounts due from a corporation but unpaid, are not to be included in the income of an individual reporting his income on a cash receipts basis unless it appears that the money was available to him, that the corporation was able and ready to pay him, that his right to receive [the money] was not restricted, and that his failure to receive [the money] resulted from exercise of his own choice.

Applying these criteria to the situation presented, the IRS concluded that the plan participant would be required to include the deferred compensation concerned in his gross income only in the taxable years in which the taxpayer actually received installment payments in cash or other property previously credited to his account.

The doctrine of economic benefit originates in IRC section 61(a): “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including … (1) Compensation for services, including fees, commissions, fringe benefits, and similar items.” Treasury Regulations section 1.61-2 states that wages, salaries, and commissions paid to salesmen, as well as compensation for services on the basis of a percentage of profits, tips, and bonuses, are all income to the recipients unless excluded by law. The regulations further add, for compensation paid other than in cash, that “if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation.”

Tax and Nontax Considerations

As a grantor trust under IRC section 671, a rabbi trust’s income is taxed to the employer-settlor, not the employee. Although trust assets may be used only to pay benefits promised to the employees, generally the assets are not distributed until retirement, death, or termination of employment (without cause). The trust’s assets, however, remain available to creditors of the employer. Thus, the deposit of funds in a rabbi trust does not protect an employee from the employer’s bankruptcy. If a rabbi trust conditions payment of the deferred compensation upon future services or activities of the employee, the trust assets need not be subject to the claims of the employer’s creditors to preclude current inclusion. In that case, the trust’s assets revert to the employer if the employee fails to meet the condition or contingency. The risk of forfeiture prevents current inclusion in the employee’s income. Under Treasury Regulations and the IRC, the employer’s deduction is allowed for the taxable year in which the deferred compensation is included in the gross income of the individual who performed the services for the employer.

In the 1980 Private Letter Ruling which coined the term rabbi trust, the parties requested a ruling, for federal income tax purposes, about whether the employee, a rabbi, would be in receipt of income by virtue of the funding of a trust for his benefit by his employer. The congregation proposed to fund the trust and pay the net dividend each year, at least quarterly, to the rabbi. Upon the rabbi’s death, disability, retirement, or termination of his services, the trustees were to make distributions of corpus and income to the rabbi as provided for under the trust agreement. Although the congregation could not alter the trust, the assets of the trust were subject to its creditors. The rabbi could not assign, alienate, or pledge the trust’s assets. The IRS ruled that under the economic benefit doctrine, “the creation by an obligor of a fund in which the taxpayer has vested rights will result in immediate inclusion by the taxpayer of the amount funded. A ‘fund’ is created when an amount is irrevocably placed with a third party, and a taxpayer’s interest in the fund is ‘vested’ if it is nonforfeitable.” Turning to IRC section 451 and the related regulations in applying the doctrine of constructive receipt, the IRS concluded that—because the trust assets were subject to the claims of the congregation’s creditors and were not paid within the meaning of IRC section 451, the funding of the trust would not constitute a taxable event for the rabbi. Payments of principal and income to the rabbi would, however, be included in the rabbi’s gross income in the taxable year in which they are actually received or otherwise made available, whichever is earlier.

The IRS subsequently issued Revenue Procedure 92-64, which provided a model trust instrument as a safe harbor for taxpayers that would adopt and maintain grantor trusts in connection with unfunded deferred compensation arrangements. The desired tax effect will be achieved only if the plan effectively defers compensation, and no inference may be drawn concerning constructive receipt or economic benefit issues that may be present in the underlying nonqualified deferred compensation plan.

A rabbi trust is exempt from most of the Employee Retirement Income Security Act of 1974 (ERISA) as long as it is a “top hat” plan, which, according to section 201 of ERISA, is an unfunded plan maintained by an employer to provide deferred compensation to a select group of management or highly compensated employees. Generally, a plan that covers too great a percentage of employees will not be considered a select group. The Department of Labor has indicated that a top hat group consists of those individuals that have the ability to affect or substantially influence the design and operation of the deferred compensation plan.

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. The court felt that the term “bankruptcy” in the trust agreements must be read to include the receivership. The employees appealed, and the Court of Appeals noted that the controversy stemmed from the meaning of a provision in the trust agreements that stated that the trust’s assets “shall at all times be subject to the claims of creditors of Employer during both the operation period of the Employer or in the event of Employer’s insolvency or bankruptcy.” The employees argued that trust assets, under a strict interpretation of that provision, should be available for creditors only when the bank is operational, insolvent, or bankrupt. The employees contended that none of those three circumstances were present and that if the trusts’ assets were open to creditors “at all times” there would be no reason for the last part of the sentence. The receiver argued that the language of the agreements was clear that the assets remained available to creditors at all times and that the provision was added to the trusts to obtain the tax advantages. The Court of Appeals agreed with the receiver and affirmed the District Court decision.

Why Do Rabbi Trusts Exist?

Assuming an employer is amenable to creating and funding a rabbi trust, the crucial issue before the employee is whether the economic benefit of the tax deferral outweighs the risk of employer insolvency.

An employer, unless tax exempt, must postpone its deduction and also include the income earned by the rabbi trust in its income. Moreover, the employer cannot use the trust assets for its general business operations. A rabbi trust may, however, lure and retain employees, because it supplements other retirement savings.

The Rabbi Rescue

When a distribution of deferred compensation is due an employee from a rabbi trust, the potential exists that the employee is in a high tax bracket, does not require all of the deferred compensation, or prefers to reduce income tax on the distribution. An effective estate and tax planning technique, coined by the author as the “rabbi rescue,” is to have the rabbi trust purchase a universal life insurance policy in the employee’s account with some or all of the deferred compensation. Under the Treasury Regulations, “the value of an employee’s interest in a trust” means the amount of the employee’s beneficial interest in the net fair market value of all the assets in the trust as of any date on which some or all of the employee’s interest in the trust becomes substantially vested. The transfer of a life insurance policy owned by a rabbi trust to an employee beneficiary is, under IRC section 83, property transferred in connection with the performance of services. When a rabbi trust distributes a life insurance policy to the employee, the policy’s fair market value is its cash surrender value.

A rabbi rescue contemplates the purchase of a policy with a cash surrender value, in the early years of the contract, that is significantly less than the premium. Upon distribution of the policy to the employee, the employee would include in her income less than she would have if the distribution had been in cash in the amount used for the premium. The rabbi trust would pay the premiums over a short period of time (e.g., one to three years), after which the premiums would cease and the policy would be distributed to the employee under IRC section 83. While the employee does not have immediate access to the cash in the policy, she has saved considerably in income tax and has outright ownership of the policy. Obviously, for a rabbi rescue to be possible, the employer must be willing to forfeit taking all or part of its deduction upon distribution of the policy to the employee.

Whenever a life insurance policy is transferred from a rabbi trust for valuable consideration, the parties should be certain they comply with the rules under IRC section 101(a). Otherwise, the death benefit, to the extent it exceeds the premium paid, is subject to income tax. If a policy is transferred, the death benefit is income tax–free. A distribution of a policy to the employee will not constitute a violation of the transfer-for-value rule if the employee is the insured. If the employee wants to sell the policy to a trust, relative, or other third party, the transaction should be structured so that it is not a transfer for value.

By using a split-dollar arrangement (SDA), an employee can improve upon the tax consequences should she die while the policy is owned by the rabbi trust. An SDA is a vehicle for obtaining, maintaining, and, in some instances, transferring a life insurance policy. The split refers to the division of the benefits and costs of a life insurance policy.

A permanent life insurance policy owned pursuant to an SDA has a term life component and a cash value component. Generally, a substantial portion of the premium funds the cash value component. The employee may not wish to pay the income tax on the reportable economic benefit (or have the recipient, if other than a grantor trust, bear the cost), as the likelihood of the employee dying while the rabbi trust owns the policy is slim.

Under an endorsement SDA, the employer owns the policy and is typically responsible for the payment of the premiums. The employee generally reimburses the employer for the premiums through the endorsement of the policy wherein the employer grants the employee (or a trust implemented by the employee or other third party) the right to designate the beneficiary of the death benefit in excess of the amount, if any, that is to be repaid to the employer.

In a collateral assignment, or equity SDA, the employee or her trust owns the policy. The employer may advance the money to the employee to pay the premiums or a portion thereof. The employee, her trust, or another third party that owns the policy executes an assignment of the policy to the employer as security (collateral) for the money the employer advanced to the employee. Typically, the money the employer advanced for premiums can be repaid to the employer upon a triggering event, usually the termination of the employee’s employment, the surrender of the policy, or the death of the employee.

In an equity SDA, a benefit of having a trust enter into the SDA with the employer and thus own the policy is the avoidance of estate tax on the death benefit. Unfortunately, that benefit may be outweighed by the negative tax consequences attached to equity SDAs by IRS Notice 2002-8.

IRS Notice 2001-10 (repealed by IRS Notice 2002-8), however, next set forth that “whether an [SDA] involves a transfer of property within the meaning of section 83 depends on the substance of the arrangement … If the employee is the beneficial owner of the life insurance contract from the inception of the arrangement, there is no transfer of property under section 83.” In which case, if the employer may receive repayment of its share of the premiums at a fixed or determinable future date, then the arrangement may be treated as the acquisition of a policy by the employee with the proceeds of an interest-free loan or a series of interest-free loans. In the case of compensation-related below-market loans, the imputed payments to the borrower are treated as compensation income.

The IRS acknowledged in Notice 2001-10 that without further guidance, taxpayers would have difficulty determining whether an SDA is subject to economic benefit treatment or loan treatment. Accordingly, the IRS stated that it would generally accept the parties’ characterization of the employer’s payments under an SDA. Ostensibly, each year that the SDA is in force and the employer has not yet been repaid, the parties must report and pay the tax on the income. In addition to the double income tax, if the policy is owned by a trust, the IRS could arguably assess gift tax to the employee based on the imputed interest each year that premiums are paid. The rationale is that the amount of the premium could be deemed a gift from the employee to the trust, which is the beneficial owner of the policy.

The IRS added that in “any case in which an employer’s payments under a [SDA] have not been consistently treated as loans, the parties will be treated as having adopted a non-loan characterization of the arrangement.” Under such a circumstance, the parties would be subject to economic benefit treatment.

IRS Notice 2001-10 also revoked Treasury Revenue Ruling 55-747, which was based on 1946 mortality tables. Notice 2001-10 provided an interim table (Table 2001) that had premium rates less than the PS rates (the value of the life insurance protection, i.e., term cost). Notice 2001-10 gives taxpayers the option of using the new rates or the insurer’s lower published premium rates that are available to all standard risks for term insurance. Notice 2001-10 added additional limitations that would likely compel the application of the Table 2001 rates.

IRS Notice 2002-8 states that the proposed regulations, as pertinent to rabbi rescues, will tax SDAs one of two ways, depending on who owns the life insurance policy. If the employer owns the policy (endorsement method), the taxpayer/employee (for SDAs entered into after the date of publication of final regulations) will be taxed on the benefits provided to the employee under IRC sections 61 and 83. If the employee owns the policy pursuant to an equity SDA, the premium paid by the employer is treated as a series of loans from the employer to the employee. If the employer is to be repaid by the employee or from the policy, the premiums paid by the employer will be subject to the tax rules in IRC sections 1271–1275 (original issue discount) and section 7872. If the employee is not obligated to repay the employer, the premium the employer paid will be treated as compensation to the employee at the time the premium is paid under section 61. Notice 2002-8 also provides interim guidance on revised standards for valuing the Reportable Economic Benefit (applying the rates set forth in IRS Notice 2001-10).

The promulgation of Notice 2002-8 reduces the efficacy of equity SDAs in rabbi rescues. By using an endorsement SDA, however, there is no transfer of the cash surrender value in the policy to the employee, as any equity in a policy belongs to the rabbi trust. Under the notice, a rabbi rescue will likely cost the parties less under the endorsement method, because the tax on the reportable economic benefit to the employee plus the cost at roll-out will ostensibly be less than the phantom income tax on the imputed interest under IRC section 7872 and the potential gift tax to the employee and additional taxable compensation to the employee if the premiums are not fully repaid to the employer.

Of course, each case should be independently evaluated to ascertain which method produces the optimal result.

David B. Bruckman, JD, MS Tax, is vice president of Professional Financial Services, LP, a national financial services firm based in Westchester County, N.Y. He can be reached at (914) 666-6556 and

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