This article is reprinted with permission
from the
edition of
New York Law Journal.
© 2003 NLP IP Company.
Recent Secular Trusts - Including That of
American Airlines
By Joseph
E. Bachelder
The use of a secular trust to fund executive pensions
received widespread attention recently when a secular trust established by
American Airlines Inc. drew criticism from unions and was one of the reasons
for the resignation in April of AMR Corp. Chairman and CEO Donald J. Carty.
This trust and other current examples of secular
trusts are discussed below after a brief discussion of how a secular trust
works.
Funding of nonqualified pension plans in a way that is
both tax favorable and secure for the employee has been a focus of attention
for many employers for a long time. A funding vehicle that has been used for
many years is a so-called "rabbi trust." The assets of a rabbi trust
are subject to claims of the employer's creditors and, because of that characteristic,
the IRS has ruled that funding a rabbi trust does not result in tax to the
employee participant until the assets are paid out to the participant.
Defining 'Secular Trust'
A "secular trust," like a rabbi trust, is
one established for the benefit of employee participants in a nonqualified
pension or other deferred compensation arrangement. Unlike a rabbi trust,
however, the assets of a secular trust are not subject to the claims of the
employer's creditors. The secular trust results in tax to the employee at the
time contributions are made to it by the employer. [Sometimes, payments are
made by the employer to the employee who contributes the amounts to the trust.
There are tax reasons -- making the trust an employee grantor trust -- and
sometimes ERISA reasons -- avoiding provisions of ERISA that might apply if the
employer made the contribution -- for having the employee make the
contributions to the trust.]
From the employee's standpoint, the ideal arrangement
is to have the secular trust accompanied by a "full tax gross-up." A
"full tax gross-up" means that for every dollar contributed to the
secular trust on behalf of the employee, the employee gets an additional amount
which, after payment of all taxes on such additional amount, leaves the employee
with an amount equal to the tax payable on the original contribution to the
trust. For example, assume the amount needed to fund the pension benefit is one
dollar. The employer contributes one dollar to the secular trust. Assume the
effective tax rate [taking into account federal and any state and local taxes]
is 45 percent. In addition to the one-dollar contribution to the trust, the
employer would pay the executive 82 cents as a "gross-up." After
payment of tax on the 82 cents, the employee would be left with 45 cents, which
would be sufficient to pay the tax on the one-dollar contribution to the trust.
In addition to the issues of tax and possible tax
gross-up on the original contribution by the employer to the secular trust,
consideration must be given to the ongoing tax characteristics of the secular
trust. These questions include:
§
What is the tax treatment
to the trust of the income and gains on the amounts contributed to it?
§
What are the tax
consequences to the employee participant of such income and gains?
§
How is the employee
participant taxed upon distribution of assets from the trust?
§
Does it make a difference
whether the employer contributes directly to the trust or, instead, makes a
payment to the employee, who then contributes to the trust?
These are some of the ongoing issues, beyond the scope
of this column, that must be addressed if an employer
decides to establish and fund a secular trust for the benefit of employees.
American Airlines' Secular
Trust
Following is a description of the establishment and
funding of a secular trust by American Airlines Inc. [The following discussion
will not distinguish between American Airlines Inc. and its parent, AMR Corp.,
the stock of which is publicly traded, and will refer to either or both of them
as "American."] On
In the first quarter of 2003, American, facing the
possibility of bankruptcy, began negotiating new labor contracts with the
unions representing its pilots, flight attendants and ground crews. American
obtained major concessions from the unions in its effort to avoid bankruptcy.
The newsworthiness of American's secular trust resulted from the timing of the
public disclosure of the trust's establishment, which occurred after its
negotiations with the three unions were virtually completed.
Under SEC rules, American's 10K report was required to
be filed with the SEC no later than 90 days after the end of the company's
fiscal year [which fiscal year ended on
Also on
On April 18, American announced that its senior
executives would give up their retention agreements but that the secular trust
created to secure executive pension benefits would remain in place because it
represents a benefit already earned. On April 24, Mr. Carty
resigned as chairman and CEO of American. The same day, American's pilots union
announced that it would sign its labor agreement and all three unions
ultimately signed their agreements.
From available information, it appears that the amount
contributed to the trust in October 2002 was approximately $24 million. Another
approximately $16 million was added by American to provide a tax gross-up,
meaning an amount sufficient to pay the taxes due on approximately $40 million
[the $24 million contributed to the trust plus the $16 million gross-up payment
itself].
How was the $24 million trust fund determined? The
funding assumption may have worked as follows. Assume that, absent the secular
trust, each executive would have received a retirement benefit of exactly one
dollar paid directly by American or paid from a rabbi trust [either way, the
executive would be taxed on the one dollar at the time of payment]. Assume a
tax rate of 40 percent on the payment. That would leave the executive with 60
cents after taxes on the retirement payment from American [or a rabbi trust].
Under a secular trust, in contrast, all, or
substantially all, of the distributions will come out of the secular trust to
the retired executive free of any tax. Presumably, American contributed to the
secular trust based on a model that would provide the executive upon retirement
with a tax-free, or substantially tax-free, benefit of 60 cents [using the
example above]. The October 2002 deposit of $24 million into the secular trust
may be designed to provide future funds [taking into account future earnings on
the $24 million] sufficient to provide a 60-cent retirement payment [as here
described] on a tax-free [or substantially tax-free] basis. Thus the executive
is put in the same after-tax position as he would have been in with a direct
payment from American [or from a rabbi trust] that would have been taxed at a
40 percent rate on the full amount. [n1]
The primary purpose of a secular trust is, of course,
to secure the funds of the executives' pensions from the "reach" of a
third party. Obviously, this includes creditors in the event of an insolvency
of the employer. A problem may exist for American and its executives in the
event American declares bankruptcy. If such bankruptcy is declared within one
year of the transfer [presumably at about the same time the trust agreement was
executed,
More Secular Trusts
In addition to the American Airlines trust noted
above, secular trusts have been adopted by a number of other companies.
Following are four examples.
§
Delta Air Lines Inc. In
January 2002, Delta approved the funding of secular trusts to secure the
nonqualified retirement benefits of certain of its management personnel. The
trusts that were created in 2002 are described in Delta's proxy statement dated
§
Motorola Inc. According to
its proxy statement dated
Advanced Micro Devices
§
Advanced Micro Devices Inc.
According to its proxy statement dated March 14, 2003, Advanced Micro Devices
Inc. [AMD] contributed funds in 2001 and 2002 in the aggregate amount of
approximately $3.4 million to a trust for its chief executive officer, Hector
Ruiz, to replace the retirement benefit he forfeited by leaving his former
employer, Motorola, and AMD also paid Mr. Ruiz in 2001 and 2002 an amount
[approximately $2 million] to gross him up for taxes due on such contributions.
It is not clear whether the gross-up was a "full tax gross-up."
§
Altria Group Inc. [formerly Philip Morris Cos. Inc.] As reported in Altria's proxy statements filed in 2002 and 2003, Altria funded vested and accrued nonqualified supplemental
pension benefits for certain executive officers by depositing amounts, less
applicable tax withholdings, into individual trusts for such executives with
respect to the present value of the projected benefits expected to be earned by
the executive through a particular date. Altria also
reported reimbursing such executives for taxes on a portion of the earnings on
assets held in such trusts.
FOOTNOTES:
[1]. The
financial aspects of a secular trust raise interesting cost comparisons to an
employer's funding the retirement benefit through a rabbi trust. The tax-free
[or substantially tax-free] status of the payment to the retired executive from
the secular trust, together with the benefit of a current tax deduction for
contributions to the secular trust [payments through a rabbi trust are not
deductible until paid to the executive] mitigates [but probably does not
eliminate] the cost to the employer of giving the tax gross-up to the
executive. This observation on cost is made in the context of comparing funding
through a secular trust to funding through a rabbi trust.
[2].
Section 547[b] of the Bankruptcy Code [11 USC § [547[b]] generally
provides that the bankruptcy trustee may avoid any transfer of an interest of
the debtor in property [i] to or for the benefit of a
creditor [i.e., the executives in American's case]; [ii] for, or on account of,
an antecedent debt owed by the debtor before the transfer was made; [iii] made
while the debtor was "insolvent"; [iv] made either [a] on or within
90 days before the filing of the bankruptcy petition or [b] between 90 days and
one year before such filing if the creditor [i.e., the executive] at the time
of the transfer was an "insider" and [v] that enabled the creditor to
receive more than the creditor would have received if the bankrupt estate was
liquidated under Chapter 7 of the Bankruptcy Code. For definitions of
"insider" and "insolvent," see, respectively, § [§ [101[31]
and 101[32] of the Bankruptcy Code. Section 547[f] of the Bankruptcy Code
creates a rebuttable presumption that the debtor was
insolvent during the 90 days immediately preceding the date of the filing of
the bankruptcy petition.