3537 / If a secular trust is used to fund employer-provided deferred compensation, is the trust itself subject to taxation?
Proposed regulations have affirmed this position.2
Because the IRS generally would tax highly compensated employees each year on vested trust earnings (and generally would tax other employees on at least some trust earnings when a substantially nonvested interest becomes substantially vested), double taxation of trust earnings is a very real possibility. Funding secular trusts with life insurance may eliminate this by eliminating taxation of the trust. The IRS has not considered the use of life insurance in secular trusts, but under generally applicable tax rules, the inside build-up (or “earnings”) on life insurance should not be taxed to the trust while it holds the policies. The use of life insurance probably will not save employees from taxation on trust earnings, however.
It also is possible to avoid trust (and therefore double) taxation by using employee-funded secular trusts. Employee-funded trusts generally are treated as employee-grantor trusts, because the trust income generally is held solely for the employee’s benefit. As a result, the trust income generally is taxed to the employee only.3
1. Let. Ruls. 9502030, 9417013, 9302017, 9212024.