article is reprinted with permission from the
October 29, 1990
New York Law Journal.
© 1990 NLP IP Company.
Secular Trusts: Recent Rulings
By Joseph E. Bachelder.
THIS COLUMN WILL discuss recent Internal Revenue Service rulings involving secular trusts. The rapidly growing values associated with non-qualified retirement programs have created increasing interest in the vehicles that are used to fund these arrangements. 1
Rabbi versus Secular Trusts
To understand the secular trust concept, it will be helpful to review the concept of a "rabbi trust," the much more widely used vehicle for funding non-qualified retirement arrangements and a progenitor of the secular trust. "Rabbi trust" is the term used to describe an irrevocable trust established by an employer to fund deferred benefits for its employees (and, occasionally, non-employees such as outside directors) that provides that the assets it holds are subject to the claims of the general creditors of the employer. This latter provision is one of the requirements for an irrevocable trust to qualify for an IRS ruling that contributions to the trust by the employer in respect of vested rights of participants are not taxable to the participants. Earnings thereon continue to be taxable to the employer because, for tax purposes, the trust's assets are treated as if they continue to be assets of the employer. The employee is not taxed until distributions out of the trust are made to the employee, at which time the employer claims a deduction for those distributions.
A secular trust, in contrast, contains no provision subjecting its assets to the claims of the employer's creditors. Amounts attributable to contributions by the employer to such a trust are taxable to participants at the time of contribution. 2 The employer obtains a deduction in respect of the contributions at the time (and generally to the extent) taxable to the participants. 3
Substantial Risk of Forfeiture
PLR 9036018 (June 11, 1990) introduces an interesting twist on who is taxable, and when, in the case of contributions to a secular trust. In the circumstances covered by the ruling, a trust held assets for the benefit of certain employees (and their beneficiaries) of a corporation. There were unusual features to the arrangement. The trustees had discretion over the amount and timing of distributions of trust principal or income. They also had discretion as to which participants would receive the distributions.
The establishment and funding of the trust was pursuant to a plan of reorganization of the employer following a filing in bankruptcy. At the demand of the overseers of the reorganization, stockholders of the employer turned over their stock to a trust. Certain employees of the company were the beneficiaries of the trust. The trustees of the trust were the overseers of the reorganization. Ultimately, the company's profitability was restored, and the trust sold the company stock to a third party for cash plus a note payable over 10 years. At issue in the ruling was the taxability of the employee beneficiaries on the assets in the trust and on future income of the trust.
The ruling holds that because the trustees have the discretion to determine the amount, if any, each participant is to receive from the trust, the participant's interest is subject to a substantial risk of forfeiture within the meaning of § 83(a) of the Internal Revenue Code of 1986. Once the trustees determine the amount a participant is entitled to receive, the value of that interest is taxable to the participant under the same code section. If the participant's interest is not distributed at the time it is determined by the trustees, and later there is income attributable to that interest as retained by the trust, the ruling holds that the participant is subject to taxation under the rules of Code § 72 governing annuities when his interest is distributed or made available.
The position taken in the ruling that the discretion of the trustees constitutes a substantial risk of forfeiture under Code § 83 so as to delay taxation until the discretion is exercised to grant a vested interest in the trust to a participant raises interesting questions:
(a) What degree of uncertainty must there be in respect of a trustee's allocation of an interest in a secular trust to a participant in order to preserve the position that, until that allocation occurs, there is no tax on the participant because a substantial risk of forfeiture exists as to that interest? For example, what if, at all times, the assets held in the trust equaled the amount necessary to fully fund a supplemental employees' retirement plan (SERP), but the trustee was given the discretion as to when and to whom to pay amounts from the trust?
(b) What if the trustee described in paragraph (a) had sole discretion as to what, when and to whom to distribute but the trust instrument contained suggestions as to circumstances the trustees should take into account in exercising that discretion? For example, what if the trust contained suggestions that the trustee take into account whether the employer was keeping current in its payments of benefits to each retired participant under a SERP?
(c) What if the discretion as to triggering a payment under the trust lay not with the trustee but with the employer? Assume a secular trust the terms of which provide that so long as the employer pays the pensions due under a SERP, the trustee is not permitted to make any distributions under the SERP. If, however, the employer does not pay pensions when due (whether due to financial inability or otherwise) then the trustee is instructed, under the trust instrument, to make the payments. Is the entitlement to the trust assets subject to any less substantial a risk of forfeiture in this case than in that covered by the ruling? The IRS might take the position that since the employee is assured of the pension payments from either the employer or the trust, the employee should be taxed as if he had a vested interest in the trust. This, however, would seem to be very unfair since the employee would have no entitlement to the trust assets unless and until the employer failed to make a retirement payment at some time in the future, a circumstance that might never occur. 4
Taxability and Deductibility
Another recent private letter ruling dealing with secular trusts is PLR 9031031 (May 8, 1990). That ruling deals with the taxability and deductibility of contributions to two trusts established pursuant to employment agreements and death benefit agreements with certain senior executives of a company. The trusts were secular trusts created by the employer for the benefit of the employees involved. The ruling holds that the contributions are taxable in the year contributed under Code §§ 83(a) and 451(a). Contributions are held deductible by the company in the year contributed subject to the provisions of §§ 83 and 162(a) of the code.
The ruling states that the question whether the company, the trust or the executives are treated as the (owners) of the trusts under § 677 of the code is an issue currently under study by the IRS and upon which no ruling can be made, in such circumstances, the employer is to be treated as the grantor and owner of the trust because (a) the trust is established by the employer and (b) income of the trust will be used to satisfy obligations of the employer to the employee beneficiaries. 5 If the IRS so ruled, it would mean that the income of the trust would be taxable to the employer. 6 Since the income of the trust is being retained by the trust, rather than distributed to the employer, the employer presumably would claim an offsetting deduction on the theory that the earnings of the trust represented a constructive contribution by the employer to the trust and thus could offset the earnings, leaving the employer with no taxable income. 7
The concern on this issue is that, the employee ultimately will pay a tax on the distributions from the trust in accordance with Code § 402(b) and the annuity rules of Code § 72. In the meantime, if the employer is taxed without an offsetting deduction, (or if, on some other theory, the IRS concluded the trust was taxed without an offsetting deduction) the same income, in effect, would be taxed twice. 8
The current proxy for Abbott Laboratories describes an interesting variant on the secular trust concept. Under the Abbott management incentive plan, participants are given a choice of receiving their incentive awards in cash currently or having them contributed to a trust established by each participant electing such contribution. (Participants are also given the right to defer their incentive awards on an unfunded basis.) In addition to management incentive plan participants, non-employee directors of Abbott, according to the proxy, also may choose to have the company contribute their directors' fees to individual trusts that each director may establish.
In 1988, two private letter rulings were issued under circumstances remarkably similar to the Abbott proxy descriptions. PLR 8843021 (July 29, 1988) describes the election that the employer proposes to make available to participants in a management incentive plan as follows:
X proposes to amend the Plan to allow participants to elect the payment of benefits in one of the following methods:
(a) current payment of cash to the participant,
(b) current payment of a portion of the benefit to a trust (as described below), with the balance payable to the participant in cash,
(c) deferral of payment and payout in a manner selected by the participant.
The ruling goes on to describe the type of trust involved as follows:
The trust will be an irrevocable trust established by the Plan participant. The participant will be entitled to the entire corpus and income of the trust. Neither X nor its creditors shall have any interest in trust assets. Amounts in the trust will be paid in installments after retirement or termination of employment.
The ruling holds that the individual participants in the plan will be subject to tax under Code § 451(a) at the time the election is made by the participant to have the contribution made to the trust. The ruling also holds that amounts contributed by the employer to the trust will be deductible in accordance with § 162(a)(1) of the code.
The ruling concludes that the trust will be classified as a trust for federal income tax purposes and includes the following statements as part of its holding:
Each participant will be treated as the grantor of his respective trust. Because all income will be distributed to the grantor or accumulated for future distribution to the grantor, each participant, as the grantor, shall be treated as the owner of the entire trust under § 677 of the Code. Therefore, pursuant to § 671, each participant shall include all income, deductions and credits of the trust in computing his taxable income.
In PLR 8841023 (July 9, 1988) the IRS reached the same conclusions in respect of a similar program provided by an employer to its non-employee directors in respect of their directors' fees. It is understood that ruling requests were submitted in 1988 to the IRS in respect of secular trusts as to which the employer intended to be the owner under Code § 677. After reviewing the requests, the IRS apparently gave a preliminary indication of its uncertainty as to whether the employer would be treated as the owner under the grantor trust rules. The taxpayer (or taxpayers) involved apparently modified the arrangements to provide for trusts established by employees and non-employee directors to which the employer would then make contributions after offering the participants the opportunity of taking the amounts in cash. Thus the issue of the status of the employer as an owner under the grantor trust rules as to a trust established by an employer for its employees remains subject to study by the IRS without any ruling having been issued to date.
The Abbott approach in respect of the secular trusts created by employees (and non-employee directors) reaches one important objective of secular trusts: It puts the funds into trusts for the irrevocable benefit of the participants, and the assets of the trusts are beyond the reach of general creditors of the employer.
On the other hand, there are important differences between an "Abbott" trust and a secular trust created by the employer. During the pre-retirement years, the participants will be subject to tax on the earnings of the trust under the trust rules of sub-chapter J of the Code (although this should not be a financial burden on them, because the earnings will be available to be paid out to the extent necessary to pay the taxes). Presumably, retirement payments also will be taxed under the trust rules of sub-chapter J, rather than the annuity rules of § 72. The trusts, while not subject to the claims of the creditors of the employer, may be subject to the claims of creditors of the individual participants. Finally, there is at least a question whether the trusts will enjoy the protections furnished certain employee trusts and their beneficiaries under the fiduciary rules of ERISA, the Employee Retirement Income Security Act.
The "Abbott" trust is an interesting interim solution pending a determination by the IRS of the issues involved in a secular trust established by an employer. Planners in this area, however, would very much appreciate a resolution of the IRS position as promptly as possible.
1 For a recent discussion of the general interest in this subject, see The New York Times, Business Section, Sunday, Oct. 7, 1990, page. 16. For prior discussions of methods of securing non-qualified deferred compensation arrangements, see this column in the following issues of the New York Law Journal: April 29, 1985 (rabbi trusts and surety bonds), June 29, 1987 (rabbi trusts and secular trusts), Aug. 29, 1988 (rabbi trusts), May 2, 1989 (agency agreements) and June 30, 1990 (third-party guarantees).
2 A beneficiary of a non-qualified employer trust is subject to tax on contributions to such a trust under §§ 402(b) and 83 (cross-referenced in § 402([b]) of the Internal Revenue Code. Distributions from such a trust are taxable in accordance with the rules applicable to annuities under Code § 72. Section 402(b)(1) expressly provides that such a beneficiary is not to be treated as the owner of any portion of such a trust under sub-part E of part I of subchapter J of the code (relating to grantors and others treated as owners). Section 402(b)(2) provides that "highly compensated employees" (within the meaning of Code § 414[q]) are to be taxed on the buildup of their vested accrued benefits (instead of being taxed on the amount of the employer contributions) if one of the reasons the trust is not an exempt trust is a failure of the plan to meet the requirements of Code §§ 401(a)(26) or 410(b) (sections containing participation and coverage requirements).
3 Code § 404(a)(5) provides for deduction "in the taxable year in which an amount attributable to the contributions is includible in the gross income of employees participating in the plan, but, in the case of a plan in which more than one employee participates only if separate accounts are maintained for each employee."
4 In the event the trust became over-funded because of the employer's payment of pensions to pensioners on a timely basis, the trust might provide for pay-over of excess amounts to fund employee benefits under other employee benefit programs. For a discussion of an analogous concept, see the discussion of "Megatrusts" in Moore & Tilton, "Non-Qualified Deferred Compensation: The Quest for Benefit Security," Non-Qualified Deferred Compensation Plans 1989 (Practicing Law Institute 1989) 205, at 335-359, 361-381.
5 Code § 677; Treas. Reg. § 1.677(a)-1(d).
6 Code § 671.
7 It is not certain that, if the IRS held that the employer is to be treated as the owner of the trust under Code § 677, it would also rule that the employer is entitled to a deduction for the earnings of the trust held by the trust to fund the deferred benefits for participants. The claim to a deduction for such amounts would not be based on a grantor trust theory (it would not be a deduction "passed through" by the trust to the employer pursuant to Code § 671). Presumably the claim, as noted in the text, would be based on a constructive distribution from the trust to the grantor and a construction contribution back to the trust by the employer.
8 If the grantor trust rules do not apply so as to tax the earnings to the employer, the earnings would be taxed to the trust. This would put the trust in a dilemma. If it were to claim a deduction, it presumably would do so under the trust rules of subchapter J of the code providing for the trust to claim a deduction on account of its distributions of distributable net income. However, in the pre-retirement years of participants, the trust will be receiving earnings which it will not be distributing currently to the participants. Thus, it could go for a number of years with taxable earnings in respect of accounts maintained for active employees without obtaining offsetting deductions. The effect of this would be virtually the equivalent of losing the offsetting deduction assuming an average of several years or more between the time contributions are made for a participant and the time the participant starts receiving distributions following retirement.