This article is reprinted with permission
New York Law Journal.
© 2003 NLP IP Company.
Recent Secular Trusts - Including That of
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
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
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.
. 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.
. 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 and 101 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.