I. TYPES OF NONQUALIFIED DEFERRED COMPENSATION PLANS
A. Elective Deferral Compensation Plans.
1. Employer adopts deferral plan to provide retirement benefits to a select group of management or highly compensated employees.
2. Participants elect to defer regular and/or incentive compensation. Amounts deferred are subtracted from the participant's compensation when it becomes payable and are credited to the participant's deferral account. Interest will be credited on the deferrals at the rate provided in the plan.
3. The deferral plan balance is solely a bookkeeping entry. Participant is a general, unsecured creditor of the employer with respect to the amounts deferred under the plan.
4. The benefits payable under the plan are represented solely by the employer's unsecured promise to pay the benefits. To this extent, the participants and their beneficiaries will be general, unsecured creditors of the employer.
B. Supplemental Executive Retirement Plans (SERPs).
1. The employer promises to pay the employee a benefit equal to a specified dollar amount or a percentage of final compensation.
2. No salary reduction.
3. The promise to pay is unfunded and unsecured. An employee is a general, unsecured creditor of the employer.
4. Typically, the benefit is subject to a vesting schedule. In some cases, there is a 100% forfeiture of benefits if the employee terminates prior to a designated retirement age for reasons other than death, disability, or change in control.
C. ERISA Excess Plans.
A SERP may be designed as an ERISA Excess Plan as defined in ERISA Section 3(36). Such a plan provides benefits which would have been paid but for the limitations on contributions and benefits contained in Section 415.
II. TAX CONSEQUENCES
A. Employer Tax Consequences.
1. Pursuant to Code Section 404(a)(5), amounts accrued under a plan which defers the receipt of compensation are not deductible until the year in which the amounts are includible in the employee's gross income, and then only to the extent such amounts represent reasonable compensation.
2. The employer should be able to deduct death benefits paid to beneficiaries in the year of payment if the payments are reasonable in amount and in duration.
B. Employee Tax Consequences.
1. IRC §451(a) provides that a cash basis taxpayer will be taxed on income prior to actually receiving it if the income is constructively received or received under the economic benefit theory.
Therefore, by avoiding the constructive receipt and economic benefit theories, the participant will recognize income only upon actual receipt of the deferred plan benefit payments.
2. The election to defer compensation must be made before the compensation has been constructively received in order to also defer the income tax on the deferred amounts. Rev. Proc. 71-19, 1971-1 C.B. 698.
3. Income is constructively received when it is credited to an employee's account, set apart for him, or otherwise made available to be drawn upon at any time. See Treas. Reg. §1.451-2(a).
4. The opinions of early courts discussing constructive receipt as it applies to deferral arrangements look to when the compensation is earned, when it is calculable, and when it is payable.
5. In the Veit decisions, Mr. Veit agreed with his employer on January 2, 1939 to defer until July and October of 1941 the payment of incentive compensation earned during 1939 and 1940. On November 1, 1940, during the service period but before the compensation was calculable, the parties agreed to further defer payment from July and October of 1941 to quarterly installments payable in 1942. Finally, on December 26, 1941, after the incentive compensation was both earned and calculable, but before it became payable, the parties again agreed to defer payment. This final agreement was that the compensation would be paid in 5 equal installments over the years 1942 to 1946. The Tax Court addressed the November 1, 1940 and the December 26, 1941 agreements in separate opinions given that both years were not before the court in the initial case.
a. Veit I. Regarding the November 1, 1940 agreement, the Tax Court held that a deferral during the service period but prior to the time the compensation was calculable or payable was effective to defer the tax on such amounts. See Veit v. Commissioner, 8 T.C. 809, 818 (1947). The Service acquiesced in this Veit opinion. See 1947-2 C.B. 4.
b. Veit II. In Veit v. Commissioner, 8 T.C.M. 919 (1949), the Tax Court held that the December 26, 1941 deferral was also effective even though it occurred after the services were performed and after the amounts were calculable. The court noted that prior to the agreement "there was never a time when the compensation was unqualifiedly subject to petitioner's demand or withdrawal." 8 T.C.M. (CCH) at 992. The Service did not acquiesce in this Veit opinion.
6. The taxpayer in Oates v. Commissioner, 18 T.C. 570 (1952), aff'd. 207 F.2d 711 (7th Cir. 1953), was a life insurance agent. At retirement, the agent elected to have renewal commissions paid to him at the rate of $1,000 per month rather than as the carrier received the renewal premiums. The precise amount of the previously earned renewal commission was not calculable at the time of the deferral, but "it was well known that considerable amounts would be due [the agent] as commissions out of the renewal premiums." Nevertheless, the Tax Court held, and the Seventh Circuit agreed, that the agent's deferral at retirement was effective to defer the income tax on the commissions until they were actually paid to the agent. The Service later acquiesced in the Tax Court's decision.
7. In Martin v. Comr., 96 T.C. 814 (1991), Executives were allowed to choose between two non-qualified deferred compensation plans, the original plan which only provided installment payments and a new plan which permitted both lump sum payments and installment payments. The IRS contended that the Executives constructively received the full amount of benefits under the new plan because they had the choice to receive a lump sum payment. The Tax Court held for the Executives.
C. FICA Tax Consequences.
1. Section 3121(v)(2)(A) provides compensation deferred under a deferral plan is subject to FICA taxes at the later of when the services are performed, or when there is no substantial risk of forfeiture of the rights to such amount. Amounts deferred are typically always 100% vested and thus are subject to FICA taxes in the year the services are performed.
2. Deferred compensation and interest it earns is subject to FICA taxes only once. Therefore, deferred amounts paid to the participant will not again be subject to FICA taxes.
3. Section 1402(a) provides that for purposes of self employment tax and earnings for Social Security purposes, an outside director is deemed to have earned his or her fees in the year in which the services are performed regardless of when the fees are paid.
4. Final regulations on the employment tax treatment of deferred compensation have been issued recently. Key aspects of the final regulations include the following:
a. The grant of a stock option, stock appreciation right, or other stock value right is not a grant that is subject to Section 3121(v).
b. Special rules for early window programs.
c. Payments made under a non-qualified deferred compensation plan in the event of death are death benefits, but only to the extent the total benefits payable under the plan exceed the lifetime benefits under the plan. Similarly, payments made under a non-qualified deferred compensation plan in the event of disability are disability benefits, but only to the extent the disability benefits payable exceed the lifetime benefits payable under the plan.
III. ERISA REQUIREMENTS
A. Top Hat Exemption.
1. Plans that are "unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees" are excepted from the participation, vesting, benefit accrual, joint and survivor annuity, funding and fiduciary requirements of ERISA. However, such plans must comply with the reporting and disclosure requirements, and must also provide a claims and review procedure.
2. Although ERISA, its regulations and its legislative history are silent on the meaning of "unfunded" and "select group of management or highly compensated employees", 3 cases and several DOL opinion letters have provided some standards for determining which plans qualify under the exception.
3. In Dependahl v. Falstaff Brewing Corp., 491 F.Supp. 1188 (E.D. Mo. 1980), rev'd on other grounds, 653 F.2d 1208 (8th Cir.), Cert. denied, 454 U.S. 968 (1981), an employee claimed that a death benefit only plan was funded because the employer had purchased life insurance contracts on the lives of participants.
a. The district court found that the plan was funded because the benefits would "eventually be paid through the insurance contracts purchased and maintained by [the employer]." 491 F. Supp. at 1195.
b. The Eighth Circuit Court of Appeals agreed that the plan was funded because the life insurance policies constituted "a res separate from the corporation" to which the beneficiaries could look for payment. See 653 F.2d at 1214.
c. The Dependahl opinions appear to hold that a plan is funded if the employer purchases a life insurance policy on the life of a participant. However, the insurance policies in Dependahl were directly tied to the payment of plan benefits -- the insured key executives were named in the plan documents; letters to the executives explaining the plan benefits directly tied the policies to the computation and payment of benefits; and the plan was explicitly "secured" by the policies.
4. In Belka v. Rowe Furniture Corp., 571 F.Supp. 1249 (D.Md. 1983), an ex-employee claimed that a deferred compensation plan was funded because the employer had purchased life insurance policies on the lives of plan participants. The employer was the owner and beneficiary of the policies.
a. The court found that Dependahl was distinguishable because it involved a death benefit only plan for which "the insurance policies would certainly assist in paying, if not completely funding, the benefits due." Conversely, benefits under the Rowe plan were lifetime retirement benefits that would be paid from the employer's general assets rather than out of insurance proceeds.
b. The Dependahl plan allowed the employee's estate to look to the insurance proceeds directly if the employer was unable to pay the death benefits. The Rowe plan, on the other hand, expressly provided that neither the employee nor his beneficiary had any preferred claim to the insurance policy or its proceeds. Rather, the employee depended solely upon the employer's general financial soundness for benefit payments.
c. Because the insurance under the Rowe plan was not interwoven with the payment of plan benefits as was the insurance in Dependahl, the Rowe court found that the plan was unfunded for ERISA purposes.
5. In Belsky v. First National Life Insurance Company, 818 F.2d 661 (8th Cir 1987) following the bankruptcy of his employer, a bank, a nonqualified plan participant brought suit to obtain a life insurance policy owned by the bank. The participant claimed that the policy was a plan asset of the employer's funded employee benefit plan and that, therefore, the policy could not be transferred to the FDIC. The court followed the Rowe rationale, distinguishing Dependahl for the following reasons:
a. The Belsky plan provided for retirement and disability benefits in addition to a death benefit.
b. The plan did not require that the employer hold or acquire assets to finance the liabilities; and
c. The plan expressly provided that neither the employee nor his beneficiary had a preferred claim to the policy or its proceeds. Rather, it specifically provided that plan participants were general, unsecured creditors of the employer.
6. In DOL Op. Ltr. 81-11A, an advisory opinion was issued to Tandy Corporation regarding its death benefit only plan, the Department of Labor ("DOL") stated that the insurance would not cause the plan to be funded if certain conditions were met:
a. The insurance proceeds were payable only to the employer;
b. The employer had all the rights of ownership under the policy;
c. Neither the participants nor the beneficiaries had any preferred claim against the policies or any beneficial ownership in the policies;
d. No representations were made to the participants or the beneficiaries that the policies would be used to provide benefits or were security for benefits; and
e. Plan benefits were not limited or governed in any way by the life insurance policies.
B. ERISA Excess Plans.
1. An unfunded ERISA Excess Plan is exempt from all of the Title I ERISA requirements. ERISA §4(b)(5).
a. Reporting and disclosure (Part 1);
b. Eligibility, participation, and vesting (Part 2);
c. Minimum funding and benefit accrual requirements (Part 3);
d. Fiduciary rules (Part 4); and
e. Enforcement provisions (Part 5).
2. A funded ERISA Excess Plan is exempt from the following ERISA requirements:
a. Eligibility, participation, and vesting (Part 2). ERISA §201(7).
b. Minimum funding and benefit accrual (Part 3). ERISA §301(a)(9).
IV. INCENTIVE STOCK OPTIONS (ISOs)
A. ISOs Versus Nonqualified Options.
1. With an ISO, the employee does not recognize current compensation upon the exercise of the option. Any gain on the exercise is deferred until the stock is sold and all the gain is characterized as capital gain.
To qualify for capital gain treatment, the employee must hold the stock for at least 2 years after the date the ISO was granted and at least one year after it was exercised.
2. An employee does not receive tax-favored treatment on the exercise of a nonstatutory or "nonqualified" stock option. Under section 83(a), a nonqualified stock option results in ordinary income to the employee in the year of exercise on the spread between purchase price and fair market value at exercise and capital gain on the appreciation realized between exercise and sale.
3. The employer sponsoring the ISO never receives a tax deduction for the compensatory bargain element in the ISO. A nonqualified stock option is more favorable for the employer because it gets a deduction.
B. ISO Requirements.
1. The employer must have a written option plan that sets forth the maximum number of shares that may be issued under the plan, as well as the class of employees eligible to receive options.
The plan must be approved by a majority of the stockholders of the company within 12 months of its adoption by the board of directors.
The plan must provide that the aggregate value of the stock with respect to which ISOs are first exercisable by the optionee in any calendar year cannot exceed $100,000.
2. Assuming that the plan satisfies these requirements, the option grant must also conform to a number of statutory prerequisites under Section 422(b), including:
a. The option exercise price must be no less that the fair market value of the shares (as determined by the board of directors in good faith) on the date of the grant.
b. The option must be granted within 10 years of adoption of the plan.
c. The option, by its terms, cannot be exercisable for a period longer than 10 years after the date of the grant.
d. The option may be granted only to a person who is an employee of the company (or its parent or subsidiary) on the date of the grant.
e. The option must be exercised by the employee no later than 3 months after termination of employment (except in the case of death or disability, after which an ISO can be exercised for up to one year).
f. The option, by its terms, cannot be transferable (other then by will or laws of descent) and can only be exercised during the employee's lifetime by the employee.
g. If an option is granted to a more-than-10% shareholder of the company (or its parent or subsidiary), the exercise price can be no less that 110% of the fair market value at the date of grant and the option cannot be exercised for a period longer than 5 years after the date of the grant.
C. Sequential Exercise Rule.
Prior to the 1986 Tax Reform Act, pursuant to the sequential exercise rule, an ISO could not be exercisable before any prior ISO granted to the same optionee by the same company had been exercised in full or had expired (by lapse of time) under the terms of the grant.
This rule was repealed by the 1986 Tax Reform Act.
D. Grant Limitation Rule.
Prior to the 1986 Tax Reform Act, the grant limitation rule required that the terms of the ISO plan provide that no employee could be granted ISOs for more that $100,000 worth of stock in any calendar year.
This rule was repealed by the 1986 Tax Reform Act. Post-1986 ISOs are subject to a $100,000 exercise limitation rule rather than a grant limitation rule.
E. Alternative Minimum Tax.
The spread on exercise of an ISO is a tax preference for alternative minimum tax purposes.
F. Third-Party Stock Options.
These programs consist of plans whereby employees receive options to purchase third-party (i.e. non-employer) stock or mutual funds. Generally, a bargain purchase price on the date of grant is part of these programs.
The use of this type of program would allow a tax-exempt employer to provide deferred compensation to its executive in an amount in excess of the annual limitation imposed under Section 457.
V. ESTATE PLANNING WITH STOCK OPTIONS
A. General Rules
In general, there are two types of stock options. They are Incentive Stock Options and nonqualified stock options.
The key with Incentive Stock Options is that an employee does not recognize gain on the grant or exercise of the option, but only on the sale of the underlying security. The gain at that time will be characterized as capital gain if the employee holds the security for two years from date of grant and one year from date of exercise. Incentive Stock Options are not transferable by the employee during his or her lifetime, therefore, they do not offer estate planning opportunities.
Nonqualified stock options provide greater flexibility in estate planning. There is no statutory provision limiting transferability.
If an option does not have a readily ascertainable FMV at the date of grant, income will be recognized at the date of exercise. Gain will be characterized as ordinary income.
B. Disposition of Option
In an arm's length disposition or sale of an option, compensation is realized at the time of the transaction pursuant to 1.83-1(b).
In a non-arm's length disposition or sale of an option, compensation is realized by the transferor at the time of exercise by the transferee pursuant to 1.83-1(c).
1. These rules were recently confirmed in PLR 200005006. The IRS addressed the issue of whether a husband is taxed under Section 83 when stock options are transferred to his former wife pursuant to a divorce decree. The IRS concluded that this was an arm's length transaction and that the husband had to recognize compensation income at the time of the transfer.
2. In PLR 199952012, a stock option agreement was amended to provide that options were transferable to immediate family members. The taxpayer wanted to make a gift of options. The plan stated that options were exercisable only after the optionee had been continuously employed for at least one year. Since the taxpayer had satisfied this service requirement, the IRS ruled that the proposed transaction was a completed gift on the date of transfer. There was a discussion of Rev. Rul. 98-21 in the ruling. In that instance the IRS ruled that a gift of a stock option from a mother to her child was not a completed gift because the exercise of the option was conditioned on the employee's performance of services.
Rev. Proc. 98-34 sets forth how to value a stock option for gift and estate tax purposes. It establishes a safe harbor if certain conditions are met, otherwise the taxpayer may obtain an independent appraisal. One of the conditions necessary to qualify for the safe harbor is that the company must be subject to Statement of Financial Accounting Standard No. 123 (Accounting for Stock-Based Compensation).
VI. SPLIT DOLLAR LIFE INSURANCE PLANS
A. Definition of Split Dollar.
1. "Split dollar" refers to an arrangement between parties, typically an employer and an employee, for the purchase of a life insurance policy. The benefits payable under the policy are "split", and the premiums paid for it may be split, by the parties.
2. The cost sharing at the heart of a split dollar plan enables the flow of benefits from, for example, an employer to an employee. In the employment context, this "nonqualified" plan can channel current and future benefits to key employees.
3. A hallmark of split dollar life insurance is flexibility. The costs and benefits may be split in any number of ways, with different tax consequences. An employee's share of the premiums may even be zero. While the plan must use a life insurance policy with a cash surrender value, the policy may take the form of whole life, universal life, or variable life insurance.
B. Policy Ownership.
1. Either the employer or the employee may "own" the policy, subject to the rights of the other party.
2. If the employer owns the policy, the employee's right to a share of the benefits is secured by an endorsement to the policy. Hence, a split dollar arrangement structured in this manner is said to follow the "endorsement method". This approach may be used when it is intended that the employer retain control of the policy.
3. If the employee owns the policy, the employer's right to a share of the benefits is secured by a collateral assignment of the policy. Hence, a split dollar arrangement structured in this manner is said to follow the "collateral assignment method." This approach may be used when it is intended that the employee should eventually own the entire policy, or as part of an effort to provide the employee the benefit of the policy's "inside buildup."
C. Typical Structure.
1. The employer pays an annual premium not exceeding the anticipated increase in the policy's cash surrender value during the year.
2. The employee's premium is the balance of the annual premium due or scheduled.
3. The employer's share of the death benefit under the policy is the greater of the cash surrender value and the sum of the employer's premium payments. This "repays" the employer's contribution, with or without interest.
4. That balance is the employee's share of death benefit i.e., the amount that the employee may direct to be paid to his or her death beneficiary under the policy. This is the policy's "net amount at risk" or pure insurance element, more or less.
5. If the policy is surrendered, the employer receives all of the cash surrender value.
D. Employee Tax Consequences.
1. The longstanding foundation of split dollar plan taxation was Rev. Rul. 64-328, 1964-2 C.B. 11, holding that traditional split dollar plans involving employers and employees, whether following the endorsement method or the collateral assignment method, provide compensatory benefits to employees includible in their gross income.
2. Rev. Rul. 64-328 requires an employee who is party to a split dollar plan to include in income the value of current benefits received as a result of the employer's premium payments. This application of the economic benefit doctrine was held appropriate in Howard Johnson v. Commissioner, 74 T.C. 1316 (1980).
a. The value of the benefits is measured as the employer paid cost of the face amount of term life insurance equal to the coverage under the plan that the employee may direct to his or her death beneficiary.
b. For this purpose, the cost per unit of coverage is determined by applying the "P.S. 58" rates. See Rev. Rul. 55-747, 1955-2 C.B. 228. However, such cost may be based instead on actual 1-year term insurance rates of the insurer providing the coverage, if those rates are lower. Rev. Rul. 66-110, 1966-1 C.B.12. To be used for this purpose, the insurer's rates must be those generally available to standard risks and therefore cannot be as low as "fifth dividend" rates or other preferred rates. Rev. Rul. 67-154, 1967-1 C.B. 11; PLR 8547006.
c. Since Rev. Rul. 64-328 seeks to include in income only the employer-provided cost of coverage, any amount paid by the employee (or other owner) during the year for coverage received that year reduces the imputed income dollar-for-dollar. (There is no carry-over of "excess" payments, however.) Such payments are, of course, nondeductible by the employee.
3. According to Rev. Rul. 64-328, the death benefit received by the employee's beneficiary is excluded from the beneficiary's gross income under Section 101(a)(1). This assumes, of course, that the transfer-for-value rule of Section 101(a)(2) is not invoked and that the policy qualifies as life insurance under Section 7702.
E. Employer Tax Consequences.
1. According to Rev. Rul. 64-328, the death benefit received by the employer as beneficiary under the policy is excluded from gross income under Section 101(a)(1) (again assuming that Section 101(a)(2) is not invoked and that the policy qualifies under Section 7702).
2. The ruling also denies the employer a deduction for any part of the premium paid under the policy, pursuant to Section 264(a)(1), because of the employer's interest in the policy.
3. Under a split dollar plan, the employer may have the right to borrow against the policy's cash surrender value, such as to pay a premium.
a. Interest on the borrowing is deductible by the employer subject to rules of Section 264.
b. If the policy fails the "7-pay" test of Section 7702A and is therefore treated as a "modified endowment contract," such a loan or any other cash distribution from the policy (including a dividend) will be includible in the employer's gross income to the extent of the income on the contract under Section 72(e)(10), with application of the 10% penalty tax imposed by Section 72(v).
F. The Split Dollar "Rollout".
1. When an employee covered by a split dollar plan terminates employment, as by retirement, the plan itself may be terminated and the policy "rolled out" to the employee. The rollout may be accomplished by a sale of the employer's interest to the employee or by a "bonus" of such interest to the employee. The sale may be financed by borrowing from the policy's cash surrender value.
2. The amount of the cash surrender value transferred to an employee in the rollout of a traditional split dollar plan, net of the employee's payment for the transfer, is includible in the employee's gross income pursuant to Section 83. See PLRs 7916029 and 8310027.
a. Although a policy used in a split dollar plan under the collateral assignment method is not itself transferred in the rollout (since the employee or some other party already owns it), the employer's interest in the cash value is transferred. See Treas. Reg. §1.83-3(a).
b. It appears that the employee may not count as part of his or her "payment" the previous premium payments made to reduce income imputation. See PLR 7916029.
c. If the policy is a modified endowment contract, amounts borrowed or withdrawn to effectuate the transfer may be includible in income and subjected to the 10% penalty tax.
3. The employer may deduct the amount transferred to the employee upon the rollout under Section 162 as provided in Section 83(h). However, any gain in the policy (i.e., any excess of the policy's cash surrender value over the employer's premium payments) will be includible in the employer's income under Treas. Reg. §1.83-6(b). See PLR 8310027.
4. The transfer-for-value rule of Section 101(a)(2), limiting the death beneficiary's exclusion for life insurance proceeds to the premium and other consideration paid therefor, should be take into account in structuring a rollout. Under that rule, e.g., a rollout of a policy to the insured thereunder would not trigger the limitation, but the policy's transfer to a third party owner may well do so.
New Interim Guidance
1. In 1996, the IRS released Technical Advice Memorandum 9604001, which set forth a new position regarding the income taxation of split dollar life insurance. Under this TAM, the IRS held that, in addition to the economic benefit, an employee has income under Section 83 each year as a policy's cash value exceeds the premiums recoverable by an employer.
In Notice 2001-10, 2001-5 IRB 459, the IRS announced a new interpretation of split dollar life insurance taxation. The Notice applies either Section 83 or Section 7872 to employer payments under split dollar plans. Taxpayers have a choice of characterizing employer payments as loans (subject to Section 7872), non-loans (subject to Section 83), or as payments of compensation (subject to Section 61).
The Notice makes several major changes to the term rates used to value the economic benefit of the life insurance protection.
VII. RABBI TRUSTS
A. General Definition.
1. In a nonqualified unfunded deferred compensation plan, the employee, generally, is an unsecured general creditor of the employer subject not only to the solvency and credit risks of the employer, but also to the employer's good faith payment of benefits. As a practical matter, delay and expenses associated with litigation to enforce a right to unfunded deferred compensation against a solvent employer can substantially reduce or eliminate the value to an executive of such benefits.
2. One method of securing the anticipated deferred compensation benefit is for the employer to establish a trust, to segregate the deferred compensation assets from its other assets and protect the employee's benefit. Although a trust can provide actual protection from loss of benefits (e.g., in the event of a hostile takeover), at best it may offer only psychological assurances in the event of employer insolvency or bankruptcy since the assets held in the trust must be available to the general creditors of the employer.
3. A rabbi trust is essentially an irrevocable grantor trust used to fund and secure nonqualified deferred compensation benefits for eligible employees. In order to establish a rabbi trust, the employer transfers assets to the trustee, either on a discretionary or actuarially determined basis (depending upon the form of the underlying deferred compensation program). Such funds may then be invested, and are generally available for the payment of benefits. As a form of grantor trust, its earnings are generally taxable to the employer and contributions deposited are not deductible until the employee receives the benefit and takes it into income.
4. In Private Letter Ruling 8113107, a congregation entered into a deferred compensation arrangement with its rabbi in order to provide benefits in the event of his death, disability, retirement, or separation from service. The congregation, as the plan sponsor, established an irrevocable trust to segregate the deferred amounts contributed by it. In accordance with its terms, the trust could not be amended or terminated; however, the trust corpus remained at all times subject to the claims of the congregation's general creditors. The IRS held that since the trust corpus was subject to the claims of general creditors, including the claims of the rabbi for his deferred benefits, and because of the anti-alienation provisions of the trust, there was no "funding." Therefore, the rabbi would not be currently taxed.
B. DOL Requirements.
1. Section 4(b)(5) of ERISA exempts from the coverage of all of Title I of ERISA a plan which is both "unfunded" and an "excess benefit plan" as defined in Section 3(36) of ERISA. Section 3(36) defines an excess benefit plan as "a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations and contributions and benefits imposed by Section 415 of the Code on plans to which this Section applies, without regard to whether the plan is funded." Sections 201(2), 301(a)(3), and 401(a)(1) of ERISA exempt from the application of parts 2, 3 and 4 of Title I, respectively, "a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees."
Therefore, if a rabbi trust constitutes a "funded" deferred compensation plan for purposes of ERISA, such a plan would be subject to the ERISA rules requiring that benefits vest over prescribed periods of time and that assets be held in trust for the exclusive benefit of the participants and beyond the reach of the employer's creditors. Such plan would also be subject to the ERISA fiduciary, enforcement, reporting, disclosure and other rules.
2. In a letter to the IRS dated December 13, 1985, the DOL gave its opinion on the application of ERISA requirements to a rabbi trust. In its letter, the DOL limited its opinion to top-hat plans and excess benefit plans. The DOL stated that it would use a facts and circumstances test in order to determine whether a plan was "funded" for purposes of Title I of ERISA, including looking to relevant non-ERISA law (e.g., relevant Code provisions). The DOL further stated that it was "the working premise of the Department that a 'top-hat' plan or excess benefit plan would not fail to be 'unfunded' solely because there is maintained in connection with such a plan a 'rabbi trust,' and noted that it would accord significant weight to the IRS's position that a rabbi trust does not constitute a funded plan when the DOL makes its case-by-case determinations.
C. Employer Stock.
In PLR 9235006, the IRS issued a private letter ruling regarding the funding of rabbi trusts with employer stock. Under the facts of the ruling, the parent of an affiliated group of corporations, set up a trust to provide nonqualified deferred compensation benefits for the executives of the company and its affiliates. According to the trust, the trust assets were to be comprised principally of the company stock, purchased by the trustee on the open market. The IRS held:
1. The contribution of assets did not constitute a transfer of property within the meaning of Section 83;
2. The contribution of assets did not cause a participant to recognize, under either of the constructive receipt or economic benefit doctrines, income prior to the taxable year in which the assets are paid or made available;
3. The employer will be able to deduct the benefit payments in the year includible in the participant's income;
4. The employer will not be taxable on dividends to the trust as long as it remains the owner of the trust; and
5. The employer will not recognize any gain or loss on account of the receipt of money on other property by the trustee in exchange for the stock as long as it remains the owner of the stock.
In Private Letter Ruling 9344038, the IRS ruled that an employee's purchase of an insurance policy from an insurer to secure the future payment of nonqualified deferred compensation benefits from a rabbi trust conferred no economic benefit on the participant. Thus, the issuance of the policy did not cause the deferred compensation benefits to be includible in the participant's gross income prior to the time the benefits were paid or made available to the employee.
Under the economic benefit doctrine, employees must include in gross income any income from an economic or financial benefit received as compensation, including benefits not received in cash. An employee receives an economic benefit when assets are unconditionally and irrevocably paid into a fund or trust to be used for the employee's sole benefit.
When the employee independently purchased the policy, the IRS found the employer had not transferred property to the employee that was protected from the employer's creditors. Thus, no economic benefit was conferred on the employee by the employer. Under the policy, the employee paid all of the premiums and negotiated the terms of the policy without any involvement by the employer. In addition, the insurer issued the policy without entering into any collateral agreement with the employer and without obtaining any information about the employer other than publicly available information. The IRS noted, however, that if the employer reimbursed the employee for premiums paid, this amount would be includible in the employee's income at the time of reimbursement.
E. Model Rabbi Trust.
In Rev. Proc. 92-64, 1992-2 C.B. 422, the IRS designed a model rabbi trust. This Revenue Procedure provides that the IRS will not issue a private letter ruling for a nonqualified deferred compensation plan that uses a rabbi trust other than the model rabbi trust.
F. Offshore Rabbi Trusts.
There recently has been much commentary in compensation planning journals regarding the advantages of offshore rabbi trusts. As set forth above, a rabbi trust is a means to secure an Executive's deferred compensation. However, the assets within a rabbi trust are subject to the claims of the general creditors of an employer in the event of the employer's insolvency or bankruptcy. By placing the rabbi trust offshore, the various authors suggest that it will become more difficult for general creditors to go after these assets because of secrecy laws, etc. found in offshore jurisdictions and therefore the general creditors may not pursue collecting them.