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Rabbi Trust Explained
In the United States, the rabbi trust is a non-qualified, deferred compensation arrangement created by employers for their employees. The first Internal Revenue Service Letter ruling approved the use of this type of trust involved a Rabbi; thus, it is called the Rabbi Trust.
The amount contributed buy the employer into the rabbi trust is not considered to be a part of the employee’s wage and is tax-deferred. This means the employee does not not have to pay any tax for that amount until she actually receives the money from the trust.
For example, an employee gets $60,000 per year as a salary. The employer contributes $500 to the employee’s rabbi trust each month. The employee’s taxable income is $60,000 a year. The additional $6,000 is not considered to be a taxable income until the employee withdraws the money or gets an actual check from the trust. This allows the assets of the employee to grow tax-deferred inside the trust.
The trust is irrevocable and outside the control of the employers. Once an employer contributes to a rabbi trust, he or she is not allowed to get the money back.
A Little More on Rabbi Trusts
The Rabbi trust does not provide any tax deduction to the employer until the year in which the employee receives the benefits from the trust. At that time, the employer can take a deduction against taxable income for the amount of the distribution of trust funds to the employee. That makes its use limited in comparison to other types of trusts.
Most commonly, a rabbi trust is used by an employer to provide a source of funds to satisfy the employer’s obligation to executives under a non-qualified benefit plan.
Under the federal and state law, the general creditors of a company may claim the assets held by the rabbi trust on the occasion of insolvency. The law allows the creditors of a company to have access to the trust’s assets if the employer goes bankrupt or the company becomes insolvent.
Mergers or takeovers do not generally affect the assets of the trust. After a trust is set up, only the beneficiaries (or the trustee) have the power to change its details. An employer cannot change the structure and terms of the trust once it is created. The company that takes over does not have the power to change the terms of the trust.
Employers are not allowed to take out funds from the trust at any conditions. Thus, the funds held by a rabbi trust is protected and are dedicated to the serve the interests of the employee. Unless the company faces an insolvency, the funds are safe in the trust.
References for Rabbi Trust
Academic Research on Rabbi Trust
Deferred Compensation Arrangements-The Rabbi Trust, Fitzgerald Jr, R. E. (1992). J. Mo. B., 48, 547. This paper presents various rulings issued under which the trust assets were not subject to the claims of the creditors of the employers in general but only to the claims of its judgment creditors. This type of trust arrangement is what is known as a ‘rabbi trust.’ The name was adopted since one of the favorable rulings involved a trust that was established for the rabbi of a congregation.
Rabbi trust secured with insurance, Marcus, F. J., & Freeman, D. K. (1994). Journal of Financial Service Professionals, 48(1), 26. This article provides a potential method of achieving security for a deferred compensation arrangement without a serious immediate income tax impact. The paper also shows how the rabbi trust technique has grown to become a popular planning device. However, it has a blind spot, and that is that the trust assets are subject to the employer’s creditors and thus might be failed to be paid to the employees.
Rabbi trust administration: An overview, Ritter, M. S. (1994). Benefits Quarterly, 10(3), 43. This paper analyzes the general ERISA as well as the tax issues that influence the administration of rabbi trusts. It also analyzes the rabbi trust of the IRS’ model and suggests the optional sections that should be used and those to be avoided when establishing the trust. It also presents various ways to structure the trust and ensure efficient ongoing administration after the trust is established.
Rabbi Trust: A Unique Way to Defer Compensation, The, Klueger, R. F. (1987). Colo. Law., 16, 614. This study examines the rabbi trust which is a deferred compensation arrangement that has been present since 1981. It states that when this trust is structured correctly, it gives the executive the ability to have a funded deferred compensation arrangement that is only taxed to the executive in the years in which the distributions are made.
Deferred Compensation Arrangements and the Rabbi Trust/Awards to Employees; Non-Taxability of Employee Awards, Fitzgerald Jr, R. E. (1985). J. Mo. B., 41, 331. This paper presents a proposal on how to finance the future payment of the deferred bonus or incentive award to a future date without having the funded amount presently includible in the executive’s income. The paper also suggests the review of various methods for financing deferred compensation such as the reserve account, life insurance, and revocable trust, among others.
RABBI TRUST MODIFICATION, ANAND, V. (1996). PENSIONS & INVESTMENTS, 24(11), 38. This article explains a rabbi trust which is developed to support the non-qualified benefits requirements of employers to their employees. It is used since it creates security for the employees since employers cannot control the assets in the trust. After an employer contributes to a rabbi trust, he/she cannot retrieve them.
… planning: Using an international employee-leasing program combined with a nonqualified deferred compensation plan and a transnational rabbi trust, Chatzky, M. G., & Scholz, H. K. (2000). Journal of Asset Protection, 5(5), 24-24. This study briefly discusses various qualified and nonqualified deferred compensation plans as well as other executive compensation plan that can be custom made into nearly any situation that requires a creative compensation solution. It also introduces various creative solutions that are used to solve crucial recurring employee compensation.
A Theorem for Compensation Deferral: Doubling Your Blessing by Taking Your Rabbi Abroad, Ordower, H. (1993). Tax Law., 47, 301. This paper creates a mathematical model that determines whether or not to defer compensation income. It combines the increased the rates on ordinary income, a reduced compensation ceiling for contributions to qualified pension and profit sharing plans, and a skewing of rates in favor of the corporation and as a result, OBRA’93 sets the ground for accelerating the use of alternative tax deferral techniques.
The New Congressional Attack on Offshore Rabbi Trusts, Cantley, B. G. (2003). Or. Rev. Int’l L., 5, 5. This article explains that offshore rabbi trusts have become popular methods for US persons employed abroad by foreign companies to set aside retirement funds. Also, many offshore hedge fund managers have used offshore rabbi trusts as a way to defer income from current taxation. The article explains the prior proposed legislation, its possibility of passing in the next Congress and the legal doctrines that are utilized in making such a change in tax policy.
An Overview Concerning Certain Recent Changes for Foreign Compensatory Trusts: 402 (b) Trusts, Grantor Trusts and Rabbi Trusts, Rabitz, S. W. (1998). Fla. Tax Rev., 4, 429. This study explains the various issues that surround the foreign deferred compensatory trust world after the recent changes of the Internal Revenue Code and the regulatory authority under it. It also discusses the issues that affect inbound and outbound compensatory arrangements that involve trusts.
The Regulation of Private Equity, Hedge Funds, and State Funds, Ordower, H. (2010). The American Journal of Comparative Law, 58(suppl_1), 295-322. The research presents a project that describes the United States law features of hedge funds, private equity funds, and sovereign wealth funds and also determines the critical current issues in the regulation and governance. It presents the discussion of recent US legislation on financial services that affect the pooled investment vehicles.