3567 / What is a “rabbi” trust?

A rabbi trust is a trust vehicle for accumulating assets to support an employer’s unfunded deferred compensation plan obligations. Under the IRC, this trust is considered an IRC Section 671 “grantor” trust. Established by the employer with an independent trustee, a rabbi trust is designed to provide employees with some assurance that their promised benefits will be paid while preserving the tax deferral that is at the heart of unfunded deferred compensation plans. To accomplish these ends, a rabbi trust is generally irrevocable.

The use of such trusts with nonqualified deferred compensation plans has been affirmed under Section 409A(b). However, plans must meet the funding rules contained in 409A(b) that include prohibitions against funding or distribution while in declining financial circumstances, placing them offshore,¹ and placing assets into one during the “restricted period” when a sponsor is underfunded on any qualified defined benefit plan.² There are currently no regulations covering these 409A(b) funding rules but they are expected to be released at some point in the future.

---

Planning Point: Planners need to watch for the proposed regulations covering these funding rules under Section 409A(b). Although Section 409A(b) now statutorily confirms use of rabbi trusts in connection with nonqualified plans, these regulations are likely to make substantive changes in the requirements for a 409A(b) compliant rabbi trust. They will likely revoke or replace the current rabbi trust model trust in Revenue Procedure 92-64³ ( Q 3569).

---

In addition to the new funding requirements of Section 409A(b),the key characteristic of a rabbi trust is that it must provide that its assets remain subject to the claims of the employer’s general creditors in the event of the employer’s insolvency or bankruptcy.⁴ This result has been affirmed even when there was a delay in making a distribution of account, based on a legitimate participant request under the plan, until a bankruptcy filing prevented any distribution.⁵

These trusts are called “rabbi” trusts because the first such trust approved by the IRS was set up by a synagogue for a rabbi.⁶ Historically, the combination of security (albeit imperfect; a rabbi trust can protect an employee against the employer’s future unwillingness to pay promised benefits, but it cannot protect an employee against the employer’s future inability to pay) and the tax deferral offered to participants in a nonqualified deferred compensation plan supported by a rabbi trust has made such trusts very popular, even though the new Section 409A(b) funding rules have reduced the ability to use the trust device to provide security for the payment of benefits (for example, placing it offshore).

---

1.   26 USC § 409A(b)(2) as amended by the Gulf Opportunity Zone Act of 2005 (“GOZA”).

2.   27 USC § 409A(b)(3) in the Pension Protection Act of 2006.