Rabbi Trusts: Taxation Basics and Drafting Beyond the Model Language

Abstract

Tax Consequences of Rabbi Trusts Constructive Receipt Doctrine In the context of the employer-employee relationship, the constructive receipt doctrine provides that income is included in the gross income of an employee in the tax year in which it is actually or constructively received by the employee.2 Income is treated as "constructively" received in the tax year during which it is credited to the employee's account, set apart, or otherwise made available so the employee can draw upon it at any time.3 Economic Benefit Doctrine The economic benefit doctrine provides that, if in connection with the performance of services property is transferred to an employee, the employee will be taxed on the fair market value of the transferred property in the earlier of the tax year during which (i) the employee's rights in such property can be transferred, or (ii) the employee's rights in the property is no longer subject to a substantial risk of forfeiture, i.e., when the employee is vested in his or her rights to the property.4 Applying these tax doctrines, an employee will be subject to immediate taxation with respect to nonqualified deferred compensation5 if (i) the employee can assign or transfer his or her rights to the deferred compensation, or (ii) the deferred compensation is "funded," i.e., assets have been set aside for the exclusive benefit of the employee. [...]no deduction is allowed when the employer contributes funds to the trust and the employer is taxed currently on any earnings on trust assets. Reimbursement of Direct Benefit Payments by Employer The model rabbi trust requires an employer to deliver to the trustee a payment schedule and to make benefit payments to participants and beneficiaries in accordance with the payment schedule.8 Generally, the model rabbi trust provides that once a trust becomes irrevocable, an employer has no right to direct the trustee to return trust assets to it or divert to trust assets to others before all payments of benefits have been made to participants and beneficiaries pursuant to the terms of the plan.9 The model rabbi trust includes an exception to the general rule for the remittance of federal, state, and local taxes to the appropriate taxing authorities with respect to payments the trustee makes to participants or beneficiaries pursuant to the payment schedule under the plan.10 The model rabbi trust also permits payments to the employer's creditors if the employer becomes insolvent. Arguably, a rabbi trust for an account-based plan could be drafted so that, in the event of a forfeiture due to a participant's failure to satisfy the plan's vesting schedule, an employer can direct the trust to pay to it the "excess assets" in the rabbi trust, i.e., the amount by which the total value of the trust assets exceed the total dollar value of benefits payable to all remaining participants and beneficiaries as of a specified determination date. Because rabbi trust assets must remain subject to the creditors of an employer in the event of insolvency, application of a reversion provision should be prohibited if an employer is at or near insolvency.