Page 93 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 3. Current versus Deferred Compensation 79

know who owns the funds. A secular trust is one where the assets are for the exclusive use of
paying the executive and therefore subject to taxes. A modification is when the executive is
given the right to receive the employer contribution directly or have it paid by the employ-
er to the trust. This changes the status to an employee-grantor secular trust. As such, the
employee is taxed directly, thereby avoiding the trust becoming a taxpayer.
Another approach is the SERP swap. This is the exchange by the executive of all or a
portion of nonqualified supplemental executive retirement plan (SERP) benefits for a split-
dollar insurance policy with the company paying all or a portion of the premium. In essence,
the executive gives up payments that would otherwise be made during his or her lifetime in
exchange for more favorable estate and income taxes at the time of death. This assumes pay-
ments are for a prescribed period of time. These arrangements must be carefully designed in
light of accounting and tax requirements, which, due to their complexity and changing
nature, are not discussed here.
There are four basic types of deferred compensation trusts: rabbi, secured, secular, and
rabbicular. A rabbi trust (so named for a tax decision dealing with a rabbi’s pension plan) may
be either an unsecured promise to pay or funded. It is also called a grantor trust. The funds
are available to the company’s creditors as well as the executive. The trust is established
by the employer entering into an irrevocable trust agreement with a trustee responsible
for ensuring that the terms of the trust agreement are executed. The trustee is often a bank
but could be a designated individual. The tax status of an irrevocable trust is shown in
Figure 3-1.

Available to Taxable to recipient when
Is it (c)
Yes general contribution is made and as
funded? No
creditors? income is earned

(a) No (b) Yes
Tax deferrred until benefits received
Figure 3-1. Tax status of an irrevocable trust

Example “A” is an unfunded or dry rabbi trust. Example “B” is a funded or wet rabbi (or
secured) trust, but since the funds are available to general creditors, there is no tax liability to
the individual until benefits are actually received. While a properly constructed rabbi trust
cannot protect the executive against the company’s later inability to pay the promised bene-
fits, it can and should be able to protect the executive against the company’s later unwilling-
ness to pay the promised amounts. Example “C” shows that trust benefits are set aside for the
beneficiary; therefore, payments made to the trust (when made) and income (when earned)
are taxable to the beneficiary. This is a secular trust and is defined in Section 402(b) of the
IRC. A common form of a “dry” rabbi trust going “wet” is a springing rabbi trust; namely, it
is funded at time of a change of control of the company. This is also called a trigger funded or
rabbicular trust. In such event, it is not uncommon for the company to gross up the individ-
ual’s pay to cover the tax liability. The IRS developed a model rabbi trust with guidance on
complying with IRS rulings in Revenue Procedure 92–64