3569 / What pre-409A issues were raised by the IRS model rabbi trust?

The rabbi trust has been so popular historically that the IRS released a model rabbi trust instrument in 1992 to aid taxpayers and to relieve the processing of requests on the IRS for advance rulings on these arrangements.¹ The IRS model trust was intended to serve as a safe harbor document for employers. Used properly, pre-409A, the model trust assured employers that plan participants either were not in constructive receipt of income or that they incurred no economic benefit because of the trust. Of course, whether an unfunded deferred compensation plan using the model rabbi trust effectively deferred taxation depended on whether the underlying plan effectively deferred compensation.

Pre-Section 409A, the IRS would issue advance rulings on the tax treatment of unfunded deferred compensation plans that did not use a trust and unfunded deferred compensation plans that used the model trust in Revenue Procedure 92-64. The IRS announced at that time that it would not issue advance rulings on unfunded nonqualified deferred compensation arrangements that use a trust other than the model trust.² With the enactment of Section 409A, the IRS announced that it would not issue any advance letter rulings on the income tax consequences of nonqualified deferred compensation plans, but would continue to advise on peripheral tax issues, such as gift tax issues. It also declined to issue prototype plans, although it did not indicate that this pronouncement also includes a revision of its model rabbi trust under the existing revenue procedure. The status of the model trust as provided in the revenue procedure has remained in limbo pending Section 409A regulations, and the funding portion of the law that include rules on trusts.³

The current model trust language contains all the pre-409A provisions necessary for operation of a trust separate from the underlying plan except provisions describing the trustee’s investment powers. The parties involved are still required to provide language describing the investment powers of the trustee, and those powers must include some investment discretion. Proper use of the model trust requires that its language be adopted verbatim, except where substitute language is expressly permitted. Although it is somewhat puzzling in light of the claim by the IRS that it will not rule on plans that do not use the model trust, the employer may add additional text to the model trust language, as long as such text is “not inconsistent with” the model trust language.⁴ The enactment of Section 409A, and specifically the new funding rules that impact trusts used in connection with such plans, places the use of the model rabbi trust requirements at issue, even if the grantor adds language incorporating the essential language contained in Section 409A(b), including all the amendments since the enactment of Section 409A.

Under the pre-409A model trust, the rights of plan participants to trust assets had to be merely the rights of unsecured creditors. Participants’ rights could not be alienable or assignable. The assets of the trust were required to remain subject to the claims of the employer’s general creditors in the event of insolvency or bankruptcy.⁵