Definition
A Rabbi Trust is an irrevocable trust established by an employer to provide deferred compensation benefits to key employees when no qualified plan or trust is available. The name originates from an IRS letter ruling involving a rabbi whose congregation had made contributions to such a trust for his benefit. Rabbi trusts are categorized as grantor trusts, meaning the income generated by the trust is taxable to the grantor, typically the employer. The employer cannot take a tax deduction for contributions to the trust but can do so when the trust disburses funds to the employee.
Rabbi trusts are designed to offer key employees some level of protection against company risks. However, they do not safeguard against insolvency or bankruptcy, potentially leaving employee benefits vulnerable in such scenarios.
Examples
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Tech Company Deferred Compensation: A technology company sets up a rabbi trust for its high-ranking executives. Every year, a portion of the executives’ bonuses is deferred and contributed to the trust. These funds are invested and will be distributed to the executives upon retirement or when they meet specific conditions.
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Law Firm Partner Benefits: A law firm uses a rabbi trust to provide deferred compensation to its senior partners. Contributions to the trust are based on a percentage of the firm’s profits each year, intended to secure the financial future of the partners.
Frequently Asked Questions (FAQs)
Q1: What is a Rabbi Trust? A1: A rabbi trust is an irrevocable trust used by employers to fund deferred compensation benefits for key employees when there is no qualified plan or trust available. It offers protection against some company risks but not against insolvency or bankruptcy.
Q2: Why is it called a Rabbi Trust? A2: The term “Rabbi Trust” stems from an IRS letter ruling concerning a rabbi whose congregation contributed to such a trust for his benefit, establishing a precedent for this type of deferred compensation arrangement.
Q3: How are Rabbi Trusts taxed? A3: Rabbi trusts are considered grantor trusts, meaning the income generated is taxable to the grantor (employer). The employer can only receive a tax deduction when the trust distributes funds to the employees, not when contributions are made to the trust.
Q4: Do Rabbi Trusts protect against company bankruptcy? A4: No, Rabbi Trusts do not protect the employee’s benefits from insolvency or bankruptcy, which means employee benefits could be at risk if the company faces financial difficulties.
Q5: How does a Rabbi Trust benefit employees? A5: A Rabbi Trust offers deferred compensation that can be beneficial for long-term financial planning, providing some protection against certain company risks like changes in management or ownership that could jeopardize employee benefits.
Related Terms
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Deferred Compensation: A portion of an employee’s income that is set aside to be paid at a later date, usually to take advantage of tax deferral and retirement planning benefits.
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Grantor Trust: A trust where the grantor retains control over the trust’s income and assets, and for tax purposes, the income generated is taxable to the grantor.
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Qualified Plan: A retirement plan that meets specific requirements set by the IRS and ERISA, offering tax advantages to both employers and employees.
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Secular Trust: An irrevocable trust used to fund non-qualified deferred compensation plans that offer more protection to employees than a Rabbi Trust, as assets in a secular trust are not subject to the employer’s creditors.
Online References
- Investopedia - Rabbi Trust Definition
- IRS Revenue Ruling 92-64
- Internal Revenue Service (IRS) - Deferred Compensation
Suggested Books for Further Studies
- “Qualified Retirement Plans” by Nicholas Kaster
- “Deferred Compensation: Taxation and Compliance” by Michael S. Melbinger
- “Federal Income Taxation of Retirement Plans” by Donald R. Levy
Fundamentals of Rabbi Trust: Employee Benefits Basics Quiz
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