3568 / What is the impact of Section 409A(b) on a “rabbi” trust?
(1) The securing or distribution of deferred compensation during a period when the employer’s net worth is falling or during other financial events that unacceptably secure the payment of the promised benefits is treated as a violation of Section 409A.1 This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events indicating the employer’s financial difficulty. Under any such arrangement, otherwise deferred compensation is immediately taxable and subject to the 20 percent additional tax, plus premium interest on the underpayment of taxes (at the normal underpayment AFR rate plus 1 percent).2
(2) Also, under the Section 409A(b) funding rules, setting aside assets in an offshore trust (one outside the United States) to directly or indirectly fund deferred compensation also unacceptably secures the payment of the promised benefits.3 Under any such arrangement, the otherwise deferred compensation is immediately taxable and subject to the 20 percent additional tax, plus premium interest on the underpayment of taxes (at the normal underpayment AFR rate plus 1 percent).4
The Section 409A funding rules on both (a) prohibition on financial triggers and (b) offshore trusts apply even to deferrals of compensation earned and vested on or before December 31, 2004 (and thus not generally subject to the requirements of IRC Section 409A). The IRS provided transition relief through December 31, 2007, for amounts otherwise subject to IRC Section 409A(b), if those assets relate to compensation deferred on or before December 31, 2004, and if those assets were set aside, transferred, or restricted on or before March 21, 2006.5 Note: the IRS did not further extend the deadline for compliance on the funding rules to December 31, 2008, as it did for other documentary and operational compliance with Section 409A. December 31, 2007, was the deadline for compliance with the Section 409A(b) funding requirements. All existing trusts out of compliance with the Section 409A funding requirements should have been terminated and assets distributed or the trust amended as of December 31, 2007. A trust that has not done so is in violation of Section 409A.
(3) Finally, a trust is in violation of the funding requirements of Section 409A if it makes contributions or transfers assets to a trust during the period that any qualified defined benefit pension plan is “at risk” (below the required percentage statutory funding levels) under the qualified pension funding rules enacted in the Pension Reform Act of 2006, or during the period of any reorganizational bankruptcy.
Planning Point: IRC Section 409A has called into question many prior decisions and rulings in the deferred compensation arena, and there are no detailed regulations on the new funding rules of Section 409A(b), even though the law has been in effect for more than a decade. Moreover, during this time, there has been no IRS update on the model trust in light of the enactment of Section 409A. Employers and employees therefore should rely on their own legal counsel in structuring deferred compensation when using rabbi trusts and any other informal funding mechanisms. There currently are not even proposed regulations for Section 409A(b) requirements, so much detail for guidance in trust construction, especially in the absence of a revised model trust, is lacking. Using the model trust document modified to add the current three funding prohibitions of Section 409A(b) should be acceptable. The planner needs to continue watch for the release of Section 409A proposed regulations, even though there seems to be no IRS priority for it. These regulations will likely make substantive changes in the requirements under these new rules governing rabbi trusts that will impact documentation and operation. The fate of Revenue Procedure 92-64 governing the model rabbi trust document should also be part of this proposed regulation release. Ideally, a new prototype rabbi trust document will be part of the release. However, as of the date of this publication, no such revised revenue procedure or prototype grantor rabbi trust document exists.