Rabbi Trust

Ravenhill Corp promises its chief operating officer a nonqualified deferred compensation benefit and wants to reassure her that a future board will not simply change its mind. Counsel proposes an irrevocable trust holding life insurance to informally fund the promise, but warns that the trust must be drafted so the assets remain reachable by the general creditors of Ravenhill. The officer asks why anyone would deliberately leave the money exposed to creditors. What is the answer?

1. A.Creditor exposure is what preserves the deferral; assets placed beyond creditor reach, as in a secular trust, would make the benefit currently taxable to her.Correct. The trade is deliberate: exposure to general creditors keeps the benefit deferred, while true security triggers current taxation.
2. B.Creditor exposure is required by federal labor law for any trust holding executive benefits.Wrong. No labor law imposes this. The constraint comes from the tax doctrines governing constructive receipt and economic benefit.
3. C.It is a drafting formality with no substantive effect, since employers of this size rarely become insolvent.Wrong. It is the substantive core of the arrangement, and the tax result does not depend on how likely insolvency happens to be.
4. D.Creditor exposure allows the employer to deduct its contributions to the trust in the year they are made.Wrong. The employer deduction is deferred until the benefit is actually includible in the executive income, regardless of when the trust is funded.

Why: A rabbi trust is irrevocable and protects the executive against the employer changing its mind or against a new board after a change of control, because the employer cannot take the assets back for its own use. But the assets must remain subject to the claims of the employer general creditors. That exposure is precisely what preserves the tax deferral: if the assets were beyond creditor reach, the executive would have received an economic benefit that is no longer subject to a substantial risk of forfeiture, and she would be taxed currently even though no cash was paid. A SECULAR trust, which does put assets out of creditor reach, achieves real security at the price of current taxation. So the choice is a genuine trade: creditor exposure buys deferral, and creditor protection costs deferral.

Ravenhill Corp promises its chief operating officer deferred compensation payable at retirement and buys a corporate-owned policy on his life to informally fund the promise. The correct tax and creditor analysis is:

1. A.The executive is taxed each year on the premiums, since the policy is bought specifically to fund his benefit.This treats informal funding as if the executive owned the asset. He has no rights in the policy, so nothing is currently includable in his income.
2. B.The policy is a corporate asset reachable by general creditors, the executive is taxed only when benefits are paid, and Ravenhill deducts them then.An unfunded, unsecured promise avoids constructive receipt, so taxation and deduction are both postponed until benefits are actually paid, and the policy stays exposed to the employer's creditors in the meantime.
3. C.Ravenhill deducts the premiums annually as compensation expense while the executive remains untaxed until retirement.This claims a deduction with no matching income, which the tax rules do not permit. The employer's deduction arrives only when the executive includes the payment in income.
4. D.The policy must be placed in a trust beyond the reach of Ravenhill's creditors in order to preserve the executive's deferral.This has the requirement backwards. Securing the benefit against the employer's creditors is what would trigger current taxation to the executive.

Why: Informal funding means the employer buys an asset it owns outright while the executive holds only an unsecured promise to pay. Because the policy remains subject to the claims of the employer's general creditors, the executive is not in constructive receipt and is taxed only when benefits are actually paid. The employer, correspondingly, gets no deduction while the promise is outstanding and deducts the payments when made. Setting the asset beyond creditors' reach is exactly what would destroy the deferral.

Bramwell Foundry promises four senior executives deferred compensation payable at retirement and funds the promise by contributing to an irrevocable RABBI TRUST. An executive asks his IAR whether the trust makes the benefit secure and whether it changes when he is taxed. Which statement is correct?

1. A.The trust protects the benefit against the employer changing its mind or being acquired, but the assets remain reachable by the employer general creditors, and that continuing exposure is what preserves deferral until benefits are paid.Correct. Creditor exposure is the feature, not the flaw: removing it would trigger current taxation on the amounts set aside.
2. B.Because the trust is irrevocable, the assets are beyond the reach of the employer creditors, and the executive is taxed only when benefits are actually paid.Incorrect. Rabbi trust assets remain subject to general creditor claims. Shielding them from creditors would accelerate taxation.
3. C.Funding the trust causes the executive to be taxed immediately on the amounts contributed, in the year of each contribution.Incorrect. That is the outcome for a SECULAR trust. The rabbi trust structure is designed specifically to avoid current taxation.
4. D.The trust converts the arrangement into a qualified plan, so the benefit is protected by ERISA fiduciary and vesting rules.Incorrect. A rabbi trust does not make a nonqualified plan qualified. Deferred compensation for a select group of senior executives remains nonqualified.

Why: A rabbi trust is an irrevocable trust that holds assets earmarked for a nonqualified deferred compensation promise. It solves one problem well: because the employer cannot take the assets back, it protects the executives against a later change of heart by management or by an acquirer following a change of control. It deliberately does NOT solve the other problem. The trust assets remain part of the employer general assets and stay subject to the claims of the employer general creditors in insolvency. That exposure is not an oversight; it is the essential feature. If the assets were shielded from creditors, the executive would be treated as having received an economic benefit and would be taxed currently on the amounts set aside. Because the risk of forfeiture to creditors persists, taxation is deferred until the benefit is actually paid, at which point it is ordinary compensation income. A SECULAR trust does protect against employer insolvency, and the price of that protection is exactly the current taxation a rabbi trust avoids.