A rabbi trust is an irrevocable trust established for employees to finance nonqualified deferred compensation plans. The trust protects the employee’s assets and limits tax liability for disbursements made within a given tax year.
Also known as a grantor’s trust, a rabbi trust is a type of trust that is established for employees and is considered irrevocable. One of the primary functions of this type of trust is to finance benefits provided to employees as part of a nonqualified deferred compensation plan. The name of this type of trust arrangement derives from a ruling issued by the United States Internal Revenue Service, 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 taxable at the time it is earned. This means that the income deposited in the trust does not count as part of the employee’s net reported income for the tax year. Taxes are not assessed until funds are actually issued from the trust account, and such taxes are due on any disbursements from the trust that occur within the same fiscal year.
The idea behind a rabbi trust is to create assets that the employee can use in later years, usually after retirement from active employment with the employer. The nature of this type of trust prevents the employer from using the income deposited in the trust for other purposes. At the same time, the balance of the rabbi’s trust is protected in case the employer decides to change the structure of the retirement plans offered to employees. While the employer may choose to stop making contributions to the Rabbi’s trust, there is no opportunity to withdraw contributions made up to that point. Those remain in the trust until they are disbursed to the employee in accordance with the provisions established when the trust was established.
It is also possible to use a rabbi trust in situations where the employer chooses to purchase another business. In this scenario, the acquiring business may reserve a portion of that purchase price and defer payment of that amount for a period of time, subject to both parties’ agreement to the terms of that deferral. Typically, this arrangement will require certain events to take place before disbursements are made from the trust. Using a rabbi trust in this case can work very well for the former owner of the acquired business, since the payouts can be structured in a way that limits the amount of taxes owed at the time of the acquisition. Additionally, this approach limits tax liability to only disbursements that occur within a given tax year, allowing for more efficient tax burden management.
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