Nonqualified deferred compensation plans (NQDCPs) are effective, flexible tools to help recruit, reward and retain top talent. However, these plans present potential risks to participant benefits that do not apply to qualified plans such as 401(k) programs. NQDCP benefits are essentially IOUs from the employer to the participant, unfunded promises to pay benefits in the future. Therefore, even if assets are put aside to informally finance a NQDCP, those assets are exposed to the employer’s creditors in the event of bankruptcy.
While creditor risk cannot be avoided, other important risks can be effectively managed by placing assets in a “rabbi trust.” (This term exists because of an IRS private letter involving a trust that a synagogue used to pay benefits to its rabbi.) A rabbi trust can protect participant benefits in the event of a change in control (CIC) or if company management has a change of heart regarding paying plan benefits. Employers cannot generally use trust assets to fund the business’s operating expenses; they must be used to pay plan benefits.
Rabbi trusts can provide important benefit protections for NQDCP plan participants. However, they do add somewhat to overall plan costs, as well as increase the administrative and tax reporting services required to manage the plan effectively. Plan sponsors will need to evaluate the value of a rabbi trust based on their individual circumstances. Wrightwood can help you determine whether implementing a rabbi trust makes sense for your organization based on its financial strength and stability, ownership structure, industry, and other key factors.
How Rabbi Trusts Work
The plan sponsor establishes the rabbi trust to hold assets used to pay plan benefits. Rabbi trusts are structured as grantor trusts, meaning the tax effects of trust assets flow through to the company itself. For example, if the trust is funded with mutual funds, any capital gain or dividend income associated with those funds directly increases the company’s taxable income. This is why many plan sponsors informally finance rabbi trusts with Corporate-Owned Life Insurance (COLI). COLI income is not subject to current taxation, and all COLI values are income tax-free if policies are never surrendered or allowed to lapse.
Rabbi Trust Regulations
- IRS Revenue Procedure 92-62 allows sponsors to establish “safe harbor” plan designs using model trust language.
- Sponsors should avoid offshore rabbi trusts because these trusts may result in immediate taxation to plan participation.
Rabbi Trusts: Key Items to Consider
Shown below are topics that could influence whether a rabbi trust makes sense for your organization’s NQDCP.
