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Recent events have greatly increased senior executives' interest in nonqualified deferred compensation arrangements. As this increase continues, the use of rabbi trusts to fund such arrangements will also grow.
Even as the tax increases under the Omnibus Budget Reconciliation Act of 1993 (OBRA '93) have elevated highly compensated executives' interest in deferring income through their qualified retirement plans, another provision of the act has reduced the amount they can shelter through such plans by reducing the amount of compensation that may be considered in determining contributions.(1) Nonqualified deferred compensation arrangements, often used to avoid such limitations, are receiving renewed attention as a result. This economic incentive is buttressed by a recent Internal Revenue Service (IRS) private letter ruling that executives may buy insurance guaranteeing their benefits from a rabbi trust without causing the arrangement to become immediately taxable.
This growing interest in nonqualified deferred compensation arrangements increases the likelihood that the trustees of qualified retirement plans will be asked to act as trustee of the employer's rabbi trust as well. But rabbi arrangements are not Internal Revenue Code (IRC) Section 401(a) trusts and present different issues concerning risk management, compliance and taxation from qualified plan trusts. This article highlights those differences and suggests ways to structure the trust to enable efficient ongoing administration once the trust is established.
The first part of this article addresses the general ERISA and tax issues that affect the administration of rabbi trusts. The second part analyzes the IRS' model rabbi trust and recommends which optional sections should be used, and which avoided, in establishing the trust.
Rabbi trusts are commonly used as funding vehicles for such deferred compensation plans as "top-hat" plans and excess benefit plans (these arrangements are also sometimes called supplemental executive retirement plans or SERPs). Because rabbi trusts are not IRC Section 401(a)qualified pension trusts, contributions to the trust are not deductible by the employer until participants' benefits under the plan become subject to income tax.
What drives interest in these arrangements is their flexibility. Deferred compensation plans are not subject to the qualified plan dollar limitations, can discriminate in favor of the highly compensated group and are exempt from many of the other requirements of ERISA.
Nonqualified arrangements can be coordinated with qualified retirement...