A rabbi trust is an irrevocable trust used to fund benefits for employees under a non-qualified deferred compensation plan. It prevents employers from using the funds for other purposes and protects the balance in case of changes to pension plans. It can also be used in situations where an employer buys another business to defer payment of a portion of the purchase price. Disbursements can be structured to limit taxes owed and manage the tax burden more efficiently.
Also known as a grantor trust, a rabbi trust is a type of trust established for employees and is considered irrevocable. One of the primary functions of this type of trust is to fund benefits provided to employees under a non-qualified deferred compensation plan. The name of this type of trust arrangement comes from a ruling made by the Internal Revenue Service in the United States, in conjunction with a trust issue involving a Jewish synagogue.
With a non-qualified deferred compensation plan, a portion of the income is placed in a trust fund on behalf of the employee. That income is not subject to tax at the time it is earned. This means that the income placed in the trust does not count as part of the employee’s reported net income for the tax year. Taxes are not calculated until funds are actually released from the trust account, with such taxes due on any disbursements from the trust fund that occur within the same tax year.
The idea behind a rabbi trust is to create resources that the employee can draw upon in subsequent years, usually after retirement from active employment with the employer. The nature of this type of trust prevents the employer from using the proceeds deposited in the trust for other purposes. At the same time, the balance of the rabbi’s trust is protected in the event that the employer decides to change the structure of the pension plans offered to employees. While the employer may choose to stop making contributions to the rabbi trust, contributions made up to that point cannot be withdrawn. Those remain in the trust until they are disbursed to the employee according to the provisions put in place at the time of the establishment of the trust.
It is also possible to use a rabbi trust in situations where the employer chooses to buy another business. In this scenario, the acquiring firm may set aside a portion of that purchase price and defer payment of that amount for a period of time, subject to agreement by both parties on the terms of such deferment. Typically, this arrangement will require certain events to occur before disbursements from the trust actually occur. The use of a rabbinical trust in this case can work very well for the former owner of the acquired business, as disbursements can be structured to limit the amount of taxes owed at the time of the acquisition. Furthermore, this approach limits the tax burden to only those disbursements that occur within a given tax year, allowing the tax burden to be managed more efficiently.
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