A rabbi trust is a special type of grantor trust that is created by a company and provides a non-qualified employee benefit. Despite its name, it is not limited to use by rabbis. The name derives from the fact that the first known trust of this type was created by a congregation to benefit their rabbi. The trust has several tax benefits which can make it a useful tool for attracting and retaining high-performing employees.
Features of a Rabbi Trust
There are several key features of a rabbi trust that make it appealing to employers and employees.
- Flexible terms: The terms and distribution rights of the trust can be modified to suit the needs of the grantor company. For example, vesting schedules can be tailored to encourage employees to stay at the company for a longer period.
- Tax advantages for employees: Contributions made to the trust for the benefit of the employee do not count as part of the employee’s wages. Accordingly, the employee does not pay tax on the contributions made by the company and the funds grow tax-free in the trust just as they would in a traditional qualified retirement plan. Employees are only taxed when the money is paid out.
- Access to the assets: The grantor company cannot access the funds because the trust is irrevocable. However, the assets are not protected from creditors of the grantor company, which does pose a risk that the funds could be lost.
Advantages of a Rabbi Trust
One of the main reasons that companies would want to use a rabbi trust is for recruitment and retention. The tax benefits to employees can set a company apart from competitors in the battle for talent. As long as the basic requirements of the rabbi trust statute are followed, the actual terms of the trust can be tailored to meet the business’s needs.
In addition, by segregating sufficient funds in the rabbi trust, companies can avoid the possible financial strain of paying large deferred compensation amounts when they become due in the future. The funds are certain to be available since they are held in an irrevocable trust and the trustee can meet its obligation to pay out the money as required under rules for non-qualified deferred compensation plans.
Finally, the funds are protected for employees in the event of new ownership. If the company is taken over, the new management cannot change the terms of the trust as it is irrevocable. This is beneficial in helping to ensure some continuity for current employees. However, there is still a potential threat to the assets if the new management has problems with creditors or becomes insolvent.
Disadvantages of a Rabbi Trust
The tax advantages of a rabbi trust accrue to employees. There are no specific tax advantages for the company making the contributions. Further, since it is a grantor trust, the company is treated as the owner of the assets by the IRS for tax purposes. However, rabbi trust contributions can be deducted by the company in the year that the benefits under the plan are included in the employee’s gross income.
Choosing a Rabbi Trust
A rabbi trust can offer companies an extra tool to help them compete for top talent. Our lawyers work closely with clients to determine the best options for creating value in their businesses as well as for their families. Contact us to discuss your business and estate planning needs.