Rabbi trusts used with SERPs are designed to overcome the concern that a change in company management could jeopardise promised SERP benefits.
A Rabbi Trust is an irrevocable trust established by the employer and has an independent trustee. The rabbi trust is used with SERPs to accumulate assets to support the employer’s obligations under the SERP.
A rabbi trust, however, contains a provision that the trust assets would always be available to the employer’s general creditors in the event of bankruptcy. As a result of making trust assets available to general creditors, the IRS has held that, in the case of a SERP whose benefits are secured by a rabbi trust, the participant would have no current taxable income.
The use of a rabbi trusts used with SERPs effectively eliminates the risk that the benefit will not be paid except in the case of the employer’s bankruptcy or insolvency. So, the trust resolves the security issue in the event of a change in management and the refusal of the new management to pay the promised benefit. It represents an advance in protecting the promised benefits of a SERP without the loss of its tax advantages.
Thus, a rabbi trust used with SERPs protects the SERP benefits from being lost because of a change in management, but it does not protect them against being attached by the employer’s creditors.
IRC § 409A also impacts the use of a rabbi trust by imposing certain funding prohibitions. The prohibitions on the use of a rabbi trust in connection with a nonqualified deferred compensation plan, including a SERP, are as follows:
- Securing or distributing deferred compensation during a period when the employer’s net worth is falling in order to secure payment of the benefits—transferring funds from a rabbi trust to a secular trust, for example—is considered a violation of IRC § 409A and will cause deferred compensation to become immediately taxable and subject to an additional 20 percent tax plus interest on the underpayment of tax.
- Using an offshore trust to house assets to fund deferred compensation benefits is deemed to unacceptably secure the payment of the benefits and will cause the deferred compensation to become immediately taxable andsubject to an additional 20 percent tax plus interest on its underpayment.
- Making contributions or transferring assets to another trust during the period that the employer’s qualified defined benefit pension plan is considered “at risk” by being below the required percentage statutory funding levels is a violation of IRC § 409A.
In the next trust that we will consider—the secular trust—the guarantees of payment are greater, but the tax results are far less favorable.