3534 / What is a “secular trust” and how is it taxed?

Secular trusts have not been as popular as rabbi trusts, in part because of questions surrounding their taxation (see Q 3535 to Q 3537), but they have historically received more consideration during severe economic downturns when companies are more at risk to fail, or the future for success of an industry appears unclear or highly volatile (such as the airline industry during the first decade of the 21st century).

ERISA Implications

Use of a secular trust (at least other than an employee-grantor trust) probably will cause a deferred compensation plan subject to ERISA to be funded for ERISA purposes.¹ Funded plans generally are required to meet ERISA’s Title I requirements.

Section 409A Inapplicable

Section 409A generally is inapplicable to a secular trust arrangement because the contributions and earnings are made subject to current annual income taxation to a plan participant and thus the plan is eligible to claim the Section 409A short term deferral exception for current compensation ( Q 3541). In effect, the plan is an after-tax plan that involves current compensation, not Section 409A nonqualified deferred compensation. Whether this is entirely true as to a plan participant when a nontaxable investment vehicle is used inside the trust to shelter any earnings growth from taxation as to the plan sponsor is not entirely clear as of the date of this publication.

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Planning Point: Although essentially an “after-tax” technique, the secular trust technique is usually used when an employer wants to provide a supplemental retirement benefit that is protected against the claims of the employer’s creditors. In private companies, the Section 162 bonus life insurance or annuity technique is often used as an inexpensive substitute for a secular trust.

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