article is reprinted with permission from the
August 31, 1992
New York Law Journal.
© 1992 NLP IP Company.
Deferred Compensation and Rabbi Trusts
By Joseph E. Bachelder.
THE INTERNAL Revenue Service has published two Revenue Procedures involving compensation arrangements, both effective July 28, 1992. In Revenue Procedures 1992-33 92-65, I.R.B. 16setting forth (Aug. 17, 1992) the IRS amplified Revenue Procedure 71-19, 1971-1 C.B. 698, the IRS requirements for obtaining a ruling that a deferred compensation program not result in does constructive receipt of the income being deferred.
In Revenue Procedure 92-64, 1992-33 I.R.B. 11 (Aug. 17, 1992) the IRS published for the first time model trust provisions setting forth the IRS requirements for obtaining a ruling that a trust constitutes a rabbi trust (and incidentally establishing a "safe harbor" test for trusts not actually submitted to the IRS for a ruling). 1
This Revenue Procedure amplifies in several respects the original procedural ruling in this area, Revenue Procedure 71-19. Most of these points of amplification have been addressed in earlier private letter rulings. It should be noted there are requirements in Revenue Procedure 71-19 that are not restated in Revenue Procedure 92-65 and that must also be met before a favorable ruling will be given.
Among the more substantive points covered in the Revenue Procedure are the following:
1. While the usual requirement for an elective deferral of compensation is that the election must be made prior to the period of service in respect of which the compensation is to be paid, there are two exceptions to this requirement:
(a) In the year the plan is first implemented the election may be made "to defer compensation for services to be performed subsequent to the election within 30 days after the date the plan is effective for eligible employees."
(b) In the first year a participant becomes eligible to participate the election may be made "to defer compensation for services to be performed subsequent to the election within 30 days after the date the employee becomes eligible."
Following are observations on these two points and the term "period of service" as used in the Revenue Procedure:
What determines the portion of an annual bonus that is "for services to be performed subsequent to the election"? Is it a simple pro rata allocation. What if the plan provides that for the first year of participation the bonus will be based only on performance subsequent to the commencement of participation?
The Procedure notes that, in accordance with Revenue Procedure 71-19, "for an election to defer payment of compensation, such election must be made before the beginning of the period of service for which the compensation is payable, regardless of the existence in the plan of forfeiture provisions."
The Revenue Procedure then states: "The period of service for purposes of this requirement generally has been regarded by the Service as the employee's taxable year for cash basis, calendar year taxpayers." This indicates that "period of service" is not necessarily synonymous with the period in respect of which the services in question are to be rendered -- such as a monthly or semi-monthly payroll period in the case of salary.
The Revenue Procedure appears to be saying that, at least for purposes of IRS ruling policy, election to defer salary would be required prior to the taxable year of the employee in which the services are to be rendered. 2
2. The plan must define the time and method for payment subsequent to each event, such as retirement, that triggers payment.
3. The plan may provide for payment in case of an "unforeseeable emergency" which must be defined as an unanticipated emergency that is beyond the control of the participant and would result in severe financial hardship if withdrawal is not permitted. Withdrawal can be permitted only to the extent required by the emergency.
4. Participants can have only the status of general unsecured creditors and any reference to a trust must be to a trust conforming to the terms for a model trust as described in Revenue Procedure 92-64, discussed below.
5. The plan must provide that a participant's rights may not be anticipated, assigned, alienated, etc.
A Model Rabbi Trust
The rabbi trust has been a popular finding vehicle for deferred compensation plans ever since the IRS ruled in the early 1980s that an irrevocable trust established by a congregation for its rabbi did not result in immediate federal income tax consequences because the trust's assets were subject to the claims of the congregation's general creditors. 3 The assets in the trust were treated as continuing to be part of the general assets of the congregation.
Since then, the IRS has been asked repeatedly to rule on whether specific trusts established in connection with unfunded deferred compensation arrangements qualified as rabbi trusts to that no immediate federal income tax consequences would be imposed.
In §3 of Revenue Procedure 92-64, the IRS details the scope and objective of the model rabbi trust. The IRS states that the model trust is intended to serve as a safe harbor for taxpayers that adopt and maintain grantor trusts in connection with unfunded deferred compensation arrangements.
Under the model rabbi trust, an employee will not be in constructive receipt of income or incur an economic benefit solely on account of the adoption or maintenance of the trust. 4
Henceforth the IRS ordinarily will rule on the federal income tax consequences to employer and employee of an unfunded deferred compensation plan only if it uses no funding vehicle or if the one it uses is the model rabbi trust. Only in "rare and unusual circumstances" will the IRS rule on a deferred compensation arrangement in this context if it uses a trust other than the model rabbi trust.
Additionally, if an employer seeks to obtain a ruling as to whether an unfunded deferred compensation plan which uses the model rabbi trust qualifies for rabbi trust treatment, there are three requirements that must be met:
* The request for a ruling must be accompanied by a representation that (1) the trust conforms to the model rabbi trust language, except where substitute or additional language is permitted, including the order in which the sections of the model trust language appear, and (2) the trust does not contain any inconsistent language, in substituted portions or elsewhere, that conflicts with the model trust language. While substituted or additional trust language is permitted if not inconsistent with the model trust language, the request must include a copy of the trust in which all substituted or additional language is either underlined or otherwise clearly marked.
* The request must contain a representation that the trust is a valid trust under state law and that all of the material terms and provisions of the trust, including the creditors' rights clause, are enforceable under the appropriate state law.
* The trustee must be an independent third party that may be granted corporate trust powers under state law, such as a bank trust department or other similar party.
The text of the model rabbi trust can be classified into three sets of language: (1) language that must be included in the trust document; (2) language as to which there is a choice of alternatives but one of which must be included in the trust document; and (3) language that is optional.
The mandatory language includes provisions that have been required in the past by the IRS to establish a rabbi trust. (The following is not a complete listing of the mandatory language.)
* it is intended that the trust shall constitute an unfunded arrangement.
* it is intended that the trust be a grantor trust of which the employer is the grantor within the meaning of §671-679 of the Internal Revenue Code of 1986, as amended (the Code)
* trust assets are subject to the claims of the employer's general creditors
* plan participants have no preferred claim on, or any beneficial ownership interest in, any trust asset
* the employer is required to pay benefits if the trust's principal and earnings thereon are insufficient to pay benefits
* the trustee must suspend any benefit payments in the event of insolvency
* the board of directors and the highest ranking officer of the employer must notify the trustee of the employer's insolvency (but the trustee is not under obligation to inquire as to solvency if it does not otherwise become aware of the problem)
* benefits payable to plan participants and the beneficiaries may not be anticipated, assigned, alienated, etc.
The provisions of the Revenue Procedure permitting alternative/optional language include those noted in the following paragraphs (this is not a complete listing of the alternatives and options).
Under §1(b) of the model trust, the employer is given the alternatives of providing that the trust is (1) revocable, (2) irrevocable, (3) irrevocable upon a change in control, (4) irrevocable after a specific number of days following the issuance of a favorable private letter ruling or (5) irrevocable upon approval of the board of directors.
Under §1(e) of the model trust the employer may provide that contributions to the trust will be at its sole discretion. Also, under §1(3) the employer may include a provision that triggers a mandatory contribution upon the occurrence of a change in control and/or upon the trust becoming irrevocable under the provisions of §1(b).
Section 5 of the model trust permits investment in securities of the employer. 5 If the trust instrument permits such investment the model trust provisions require that either the trust shall be revocable or that the employer may substitute assets of equal fair market value at any time and that the employer is authorized to so substitute assets in a nonfiduciary capacity and without the approval of any fiduciary.
Section 5 of the model trust also provides that the employer may retain voting and dividend rights as to assets of the trust and may retain the right to substitute assets of equal fair market value (which it must do, as just noted, if the trust instrument permits investment in employer securities).
In the introduction to the model provisions, §5.01 of the Revenue Procedure contains a somewhat unclear statement that "[the] trustee must be given some investment discretion, such as the authority to invest within broad guidelines established by the parties (e.g., invest in government securities, bonds with specific ratings, or stocks of Fortune 500 companies)." The model trust provisions clearly contemplate the employer can override the trustee's investment discretion at any time by substitution of assets of equal fair market value. 6 Section 5 of the model trust also permits a provision that all or part of the income of the trust hall be returned to the employer.
Under §12(c) of the model trust, upon written approval of participants and beneficiaries entitled to benefits under the plan, the employer may terminate the trust prior to the payment of all benefits due and all assets in the trust at termination shall be returned to the employer.
Under §13(d), the employer may provide its own definition of a change in control provided it is an "objective" definition. In its illustrations of "objective" provisions the model trust uses clauses quite typical to change in control definitions contained in employed agreements and other employment-related arrangements.
The implications of Revenue Procedure 92-64 are significant. Many rabbi trusts exist that have not been the subject of an IRS ruling. Many of them may contain provisions that are inconsistent with Revenue Procedure 92-64. If so, an employer is at peril in several respects if the trust fails to meet IRS requirements for a rabbi trust:
The plan administrator or sponsor may be required to file IRS Form 5500 and failure to have done so may result in penalties, owing to both the IRS and the Department of Labor (DOL). 7
The trust probably will be subject to the recently announced IRS position that the trust is taxable on its income, resulting in double taxation when the participants/beneficiaries are, in turn, subject to tax on distribution to them. 8
If the trust fails to meet IRS standards for a rabbi trust, the trust and the plan of which it is a part may become subject to all the requirements of Title I of ERISA, not just the reporting requirements. The DOL position has been that a trust that qualifies as a rabbi trust for IRS purposes does not, absent other circumstances, result in a "top hat" plan being deemed funded for DOL purposes. 9 It is for this reason that trusts constituting rabbi trusts are not subject to the participation, vesting, funding and fiduciary requirements of Title I of ERISA. If a trust maintained pursuant to a plan of deferred compensation for senior level employees fails to qualify as a rabbi trust the arrangement would, almost certainly, be in violation of Title I of ERISA.
1 The criteria set forth in Rev. Procs. 92-65 and 92-64 represent requirements established by the IRS for taxpayers seeking rulings on the subjects covered by the Rev. Procs. The safest course in such a case obviously is to conform to the position taken in the Rev. Proc. (and many taxpayers seek the further protection of a ruling on the particular facts of their cases). The Rev. Procs. do not necessarily reflect what the IRS will do in connection with an audit of a taxpayer on the same subject. Practitioners are frequently asked whether a particular provision that varies from what the IRS requires to obtain a favorable ruling will be challenged on audit. In connection with an audit the IRS must take into account a number of considerations including the likelihood that its position on a particular point, if challenged by the taxpayer, will be sustained (both within the IRS and, ultimately, in court).
2 On Jan. 12, 1987, the IRS released Announcement 87-3, 1987-2 I.R.B. 40, which stated that the Service would "scrutinize deferral agreements closely in order to determine whether income ostensibly received after 1986 was constructively received and thus taxable for 1986." See this column, New York Law Journal (March 30, 1987). There was no suggestion in that Announcement that an election to defer salary from 1986 had to be made prior to 1986. The Revenue Procedure does note that its statement of the rule is the one "generally" taken by the IRS, leaving open the possibility that salary deferrals might be permitted on a more proximate basis to the actual period of service. As explained in footnote 1 of the column, the fact that the IRS has established a requirement to obtain a ruling does not necessarily mean it is the IRS policy on audit.
3 PLR 8113107 (Dec. 31, 1980). For prior discussions of rabbi trusts, see this column, New York Law Journal (Aug. 29, 1988, June 29, 1987, Sept. 30, 1985 and April 29, 1985).
4 However, the Rev. Proc. contains the caveat that no inference may be drawn by reason of adoption of the model trust concerning constructive receipt or economic benefit issues that may be present in the underlying nonqualified compensation plans. In this regard, of course, examination should be made of Rev. Proc. 92-65 and Rev. Proc. 71-19 discussed in the first part of this column. For discussions concerning deferred compensation arrangements generally, see this column, New York Law Journal (March 30, 1987, April 29, 1985, June 1, 1982, Nov. 30, 1981 and July 31, 1978).
5 In May, the DOL had issued an advisory opinion that a rabbi trust that invests primarily in the employer's common stock will be considered "unfunded." Advisory Opinion 92-13A, Pension and Welfare Benefits Administration, Department of Labor (May 19, 1992). This opinion is based, in part, on an IRS private letter ruling issued last December but apparently not yet publicly available which ruled that an arrangement pursuant to which the assets of the trust were to be invested in employer stock did not result in current taxation to plan participants.
6 The introductory language just noted, however, raises questions. For example, what if the trust instrument mandates investment exclusively in employer securities? One answer to that particular question would be the substitution of "primarily" for "exclusively."
7 In April of this year the DOL announced an expanded program for assessing civil penalties against plan administrators who fail to file timely annual returns and reports. 57 Fed. Reg. 14,436 (April 20, 1992). As part of this program the DOL also announced that for a period ending Sept. 30, 1992 plan administrators who voluntarily file overdue annual reports in accordance with certain conditions set forth in the notice will be assessed $50 per day up to a maximum of $1,000 per filing (presumably much less than they otherwise would incur). In July the DOL announced that this "grace period" applies as well to the special statement described in 29 CFR 2520.104-23(b) for unfunded plans for a select group of management or highly compensated employees (so-called "top hat" plans, which include plans utilizing a rabbi trust). 57 Fed. Reg. 33,019 (July 24, 1992).
8 PLR 9212024 (Dec. 20, 1991); PLR 9212019 (Dec. 20, 1991); PLR 9207010 (Nov. 12, 1991); PLR 9206009 (Nov. 2, 1991).
9 See letter to Richard H. Manfreda, chief, Individual Income Tax Branch, Internal Revenue Service from Elliot I. Daniel, Assistant Administrator for Regulations and Interpretations, Pension and Welfare Benefits Administration, Department of Labor (Dec. 13, 1985). In §3 of Rev. Proc. 92-64 introducing the model rabbi trust provisions, the IRS states the DOL position to be that "top hat" and excess benefit plans will not lose their unfunded status under ERISA solely on account of their use of a trust conforming to the model trust provisions of Rev. Proc. 92-64.