Meaning
A trust vehicle is used by corporations to fund nonqualified deferred compensation benefits for key executives. In rabbi trusts, the assets remain within the trust and are protected from the employer’s change of control or change of heart, but not from bankruptcy. This instrument allows the executive to defer tax on the compensation until it is distributed.
Insolvency Risk
The defining feature of this arrangement is that the assets must be available to the general creditors of the employer in the event of insolvency. Under rabbi trusts, the founder or executive must accept the risk that they might lose their deferred compensation if the company goes bankrupt. This exposure is required to avoid immediate taxation under tax laws.
Tax Benefit
The deferral of income tax is achieved because the funds are not considered constructively received or an economic benefit. With rabbi trusts, the executive does not pay tax on the contributions when they are made to the trust. This allows the funds to accumulate on a pre-tax basis until distribution.
Executive Protection
The trust provides security against the risk that a new management team or acquirer might refuse to pay the deferred compensation. When rabbi trusts are established, the funds are held by an independent trustee who is legally bound to distribute them according to the plan terms, unless the company is insolvent. This protects the executive from arbitrary decisions by the employer, offering a high degree of security short of absolute bankruptcy protection.
