Also known as a grantor trust, a rabbi trust is a type of trust that is established for employees and is considered irrevocable. One of the main functions of this type of trust is to fund benefits provided to employees as part of a non-qualified deferred compensation plan. The name for this type of trust arrangement is derived from a ruling made by the Internal Revenue Service in the United States, in conjunction with a trust issue related to a Jewish synagogue.
With a non-qualified deferred compensation plan, a portion of income is placed into a trust fund on behalf of the employee. That income is not subject to taxes at the time it is earned. This means that the income placed into the trust does not count as part of the employee’s reported net income for the tax year. Taxes are not assessed until the funds are actually issued from the trust account, with those taxes becoming due on any disbursements from the trust that occur within the same tax year.
The idea behind a rabbi trust is to create assets that the employee can draw upon in later years, usually after retirement from active employment with the employer. The nature of this type of trust prevents the employer from using the proceeds placed into the trust for other purposes. At the same time, the balance of the rabbi trust is protected in the event that the employer decides to change the structure of retirement plans offered to employees. While the employer may choose to stop making contributions to the rabbi trust, there is no opportunity to withdraw any contributions made up to that time. Those remain in the trust until they are disbursed to the employee in accordance with the provisions put in place when the trust was established.
It is also possible to utilize a rabbi trust in situations where the employer chooses to purchase another business. In this scenario, the acquiring business can set aside a portion of that purchase price and defer payment of that amount for a period of time, subject to the agreement of both parties on the terms of that deferral. Typically, this arrangement will require that certain events take place before disbursements from the trust actually occur. The use of a rabbi trust in this instance can work very well for the former owner of the acquired business, since the disbursements can be structured in a way that limits the amount of taxes due at the time the acquisition takes place. In addition, this approach limits tax liability to only those disbursements that occur within a given tax year, making it possible to manage the tax burden with greater efficiency.