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

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

In at least one older pre-409A letter ruling, the IRS held that the use of a third party guarantee as an additional security measure did not undermine the tax-effectiveness of a rabbi trust.⁶

Under the pre-409A process, the board of directors and the highest ranking officer of the employer were required to notify the trustee of the employer’s insolvency or bankruptcy, and the trustee must be required to cease benefit payments on the company’s insolvency or bankruptcy.⁷

Under pre-409A process, if the model trust was used properly, it should not cause a plan to lose its status as “unfunded.” In other words, contributions to a rabbi trust should not cause immediate taxation to employees; employees should not have income until the deferred benefits are received or otherwise made available.⁸ Contributions to a rabbi trust for the benefit of a corporation’s directors have been treated similarly.⁹ Likewise, contributions to a rabbi trust should not be considered “wages” subject to income tax withholding until benefits are actually or constructively received.¹⁰

Pre-409A, a proper rabbi trust would not be considered an IRC Section 402(b) nonexempt employees’ trust. Contributions to a proper rabbi trust would not be subject to IRC Section 83.¹¹

Pre-409A, the employer would receive no deduction for amounts contributed to the trust, but would receive a deduction when benefit payments were includable in the employee’s income ( Q 3573). In pre-409A and premodel trust days, the employer generally was considered the owner of the trust under IRC Section 677 and was required to include the income, deductions, and credits generated by the trust in computing the employer’s taxable income.¹² This is normal grantor trust tax treatment.

Pre-409A, the IRS generally would issue advance rulings on the grantor trust status of trusts following the model trust.¹³ Those pre-409A model trust rulings seem entirely consistent with earlier rulings.¹⁴ In pre-409A and premodel trust rulings, the IRS generally conditioned favorable tax treatment upon the satisfaction of two additional requirements: that creation of the trust did not cause the plan to be other than unfunded for ERISA purposes, and that trust provisions requiring that the trust’s assets be available to satisfy the claims of general creditors in the event of insolvency or bankruptcy were enforceable under state and federal law.¹⁵ The same conditions were imposed in earlier model trust rulings.¹⁶

Pre-409A, the concern of the IRS with respect to ERISA seems to have been that if the DOL took the position that the use of a rabbi trust causes the underlying plan to be other than unfunded for ERISA purposes, then this would cause the plan to be funded for tax purposes and require the accelerated taxation of contributions to the rabbi trust. The DOL’s position has been that rabbi trusts maintained in connection with excess benefit or top hat plans will not cause the underlying plans to be funded for ERISA purposes so long as the IRS maintains they are not taxable because they are unsecured (hence not funded for tax purposes).¹⁷

Also, at least one court prior to the enactment of Section 409A noted that the use of a rabbi trust will not cause a top hat plan to lose its ERISA exemption as long as the trust assets remain subject to the claims of the employer’s creditors in the event of insolvency, and the participants’ interests are inalienable and unassignable.¹⁸ Nonetheless, pre-Section 409A rulings on plans using the model trust are supposed to state that the IRS expresses no opinion on the ERISA consequences of using a rabbi trust.¹⁹

In earlier pre-409A private letter rulings, the IRS had allowed the use of a rabbi trust in conjunction with a deferred compensation plan that permitted hardship withdrawals, ruling that the hardship withdrawal provision did not cause amounts deferred to be taxable before they are paid or made available. In these letter rulings, “hardship” generally was defined as an unforeseeable financial emergency caused by events beyond the participant’s control. The amount that could be withdrawn generally was limited to the amount needed to satisfy the emergency need.²⁰

Pre-409A IRS guidelines for giving advanced rulings on unfunded deferred compensation plans expressly permitted the use of certain hardship withdrawal provisions ( Q 3541).²¹ Therefore, pre-409A, it seemed that a rabbi trust conforming to the model trust could be used in conjunction with a deferred compensation plan permitting an acceptable hardship withdrawal.²² Pre-409A, an appropriate hardship withdrawal provision was not expected to trigger taxation before deferred amounts are paid or made available. Such a provision might have triggered constructive receipt; however, at the time a qualifying emergency arose.²³

Pre-409A, the trustee could be given the power to invest in the employer’s securities. If the trustee was given that power, the trust had to be revocable or include a provision that the employer could substitute assets of equal value for any assets held by the trust.²⁴

Where presumably model trusts separately serving a parent and affiliates could invest in the parent’s stock, it was ruled that:

(1)   dividends paid on the parent’s stock held by the parent’s trusts would not be includable in the parent’s income in the year paid;

(2)   no gain or loss would be recognized by the parent on transfer of its stock from its trusts to its participants or their beneficiaries; and

(3)   no gain or loss would be recognized by the affiliates on the direct transfer of the parent’s stock to the affiliates’ participants or their beneficiaries if that stock was transferred directly by the parent to the participants or beneficiaries and neither the affiliates nor their trusts were the legal or beneficial owners of parent’s stock.²⁵

Regulations under IRC Section 1032 ( Q 307) generally permit nonrecognition treatment for transfers of stock from an issuing corporation to an acquiring corporation if the acquiring corporation immediately disposes of such stock. A transfer of a parent corporation’s stock to a rabbi trust for the benefit of a subsidiary’s employee would not qualify for this nonrecognition treatment because the stock is not immediately distributed to the participant. The IRS has announced that nonrecognition treatment is available for such transfers, albeit under a different theory. The IRS treated the parent corporation, rather than the subsidiary corporation, as the grantor and owner of the rabbi trust, so long as the trust provided that stock not transferred to the subsidiary’s employees reverts to the parent and the parent’s creditors can reach the stock.²⁶ Pre-409A, the IRS had indicated that it would rule on model rabbi trusts that have been modified to comply with this notice.

Pre-409A, the trust had to provide that, if life insurance would be held by the trust, the trustee would have no power to name any entity other than the trust as beneficiary, assign the policy to any entity other than a successor trustee, or loan to any entity the proceeds of any borrowing against the policy (but an optional provision permits the loan of such borrowings to the employer).²⁷

Pre-409A, the IRS issued several private letter rulings addressing the deductibility of interest paid on life insurance policy loans after the policies were transferred to a rabbi trust ( Q 30).

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Planning Point: Until proposed regulations under Section 409A(b) are released, the model trust will need to be amended to comply with all the new Section 409A(b) funding requirements if it is to be used with a Section 409A plan and remain 409A compliant under Section 409A(b). These forthcoming regulations under Section 409A(b) will be important in determining what will happen to Revenue Procedure 94-64 and the model trust contained in it, as well as the details that may be required to draft such trust provisions and guide trust operations. Planners and sponsors need to continue to watch for these proposed regulations or action on Rev. Proc. 92-64. In the meantime, they need to rely on legal counsel’s expert guidance to integrate the 409A(b) requirements with those in the revenue procedure, especially in light of more than a decade of inaction by the IRS.

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