article is reprinted with permission from the
June 07, 1995
New York Law Journal.
© 1995 NLP IP Company.
Employee Grantor Trusts
By Joseph E. Bachelder.
AS EXECUTIVE BECOME significantly more dependent on unfunded obligations of their employers to provide nonqualified retirement benefits, the search for appropriate funding arrangements continues. 1 There appears to be a growing interest in the employee grantor trust as a vehicle for funding such benefits.
For purposes of this column, "employee grantor trust" means a trust created to fund deferred compensation benefits and intended to qualify as a grantor trust as to the covered employees, subject to the rules of Subchapter J of the income tax provisions of the Internal Revenue Code of 1986. It is intended to avoid treatment as an employees' trust under the rules of §402 of the code.
Provided such a trust otherwise meets the Internal Revenue Service requirements for employee grantor trust treatment, it should make no difference for tax purposes whether the employee or the employer, in fact, establishes the trust. Subject to IRS requirements noted below, it should make no difference for tax purposes whether the contributions, in fact, are made by the employee or by the employer. In this latter respect, as discussed below, the arrangements must be carefully worked out to give the employee a bona fide choice whether to "cash out" or to contribute, or to have the employer contribute on his behalf, the amount involved.
The advantage of an employee grantor trust over a so-called rabbi trust is that its assets are not subject to the claims of the employer's creditors. The advantage of an employee grantor trust over a secular trust is that it avoids the rules of code §402. A secular trust is an irrevocable trust the assets of which are held for the exclusive benefit of an employee and are not subject to the claims of the employer's creditors (as are the assets of a rabbi trust). The IRS has ruled that under code §402 the income of a secular trust is subject to double taxation as well as to complex rules in determining the taxability of the employee beneficiaries. 2
The employee grantor trust does not solve all problems. The employee is taxed at the time of contribution to the trust. The funds intended for the trust must be paid, if the employee so chooses, directly to the employee. This latter feature means that the employer, which presumably wants the funds to be available to provide the employee with a retirement benefit, risks the employee's electing to be paid currently. If paid to the employee currently, the funds may be spent before retirement, leaving the employee without the intended retirement benefit. 3
In 1988 two private letter rulings (PLRs) addressed employee grantor trusts established by Abbott Laboratories. 4 These two rulings were discussed in this column on Oct. 29, 1990. Since June 1992 there have been at least nine PLRs dealing with employee grantor trusts. 5
All of the private letter rulings beginning in 1992 require that for a trust to be treated as an employee grantor trust subject to Subchapter J of the code, there must be actual or constructive receipt by the employee of the amount transferred into the trust. Thus the employee must be cashed out, or be given the opportunity to cash out, as an alternative to having the employer make the contribution to the trust.
The IRS reasoning behind this position is that the employee must make the contribution in order for the trust to be treated as a grantor trust as to the employee. If the employer, for tax purposes, is treated as making the contribution, the trust would be treated as an employees' trust under code §402. Even if the employer paid the amount to the employee who then contributed it to the trust, the IRS would not consider it to be an employee contribution if payment was conditioned on the employee making the contribution to the trust.
In PLR 9450004, the IRS stated that its requirement in this regard is satisfied if "the Participant receives a distribution on his own behalf as income under §61 of the code, and does not receive a distribution as the agent of X [the employer]."
From a practical standpoint, most employers would prefer not to pay directly to an employee currently an amount that is intended as a contribution to fund a future retirement arrangement. In many cases there would be administrative difficulties in the process of sending a payment to an employee and then arranging for the employee to contribute it to the trust. Accordingly, the most practical course for an employer is to make available to the employee the amount to be contributed, obtain the employee's consent to contribute it directly to the trust and then make the contribution on behalf of the employee.
Even if the employee is not actually given the amount before the contribution to the trust, it is considered to be "constructively received" by the employee if it is made available to the employee within the meaning of Treasury Regulation §1.451-2(a). That regulation provides that
[income] although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Thus there must not be any "substantial limitations or restrictions" on the availability to the employee of the cash (or other property) in lieu of the contribution to the trust. If such availability exists, the IRS considers the contribution to have been made by the employee even though the employer, in fact, makes the contribution
Are Amounts 'Made Available'?
As indicated in Treasury regulation §1.451-2(a) above, in order to be deemed constructively received, an amount not actually received by the employee must be available so that the employee "may draw upon it at any time, or so that the [employee] may draw upon it during the taxable year. . . . "
The "availability" of the cash-out alternative varies in the different cases covered by the PLRs noted above. For example, in some of the rulings the participant has the right to "cash out" at the time of the original contribution as well as at a later point if, before retirement, he decides he wants to "cash out." 6
In other rulings, once the decision is made to have the contribution put into the trust, the employee must wait until retirement or some other future event to become entitled to the amount put into the trust and cannot simply elect to "cash out." In PLR 9243034, for example, once the employee elects to have a contribution put into the trust, the ruling provides "[amounts] in the trust will be paid upon retirement or other termination of employment." An exception generally applicable is one that allows the employee access to amounts needed to pay taxes in respect of trust income.
The IRS is willing to permit the employer to attach certain penalties to an employee's decision to "cash out." For example, in PLR 9235044, if a participant elects to take out any amount that has been set aside for retirement (generally in trust form) the employer will make no further contributions (including tax gross-ups) to the funding arrangement.
In PLR 9328007 if a participant directs contributions be made to a trust, the participant will be eligible to receive continuation payments, representing the difference, determined each year once retirement benefits commence, between the benefit entitlement under the retirement plan and the amount available in the trust to fund the payment of the plan benefit for the year in question. If a participant chooses to cash out instead of having the contribution make to the trust, the participant forfeits the right to continuation payments.
PLR 9328007 contains the following comment on its conclusion that the foregoing condition does not constitute a substantial limitation or restriction on the "cash out" right:
A Participant who receives a lump sum distribution from X under Plan A receives the distribution in cash and has no obligation to contribute the amount of the distribution to a Trust. The possibility of eventually receiving Continuation Payments is an incentive to contribute to a Trust, since Continuation Payments are available only to a Participant who contributes to a Trust. We believe, however, that this incentive is to small to impose a substantial restriction on the Participant's use of the money. Accordingly we conclude that the Participant receives the lump sum distribution under a claim of right and that it is includable in his or her gross income in the year when it is received under §§61(a)(1) and 451.
In PLR 9322011, there is an interesting post-employment condition that relates, albeit only indirectly, to the funding of the trust. The condition is a no-compete requirement for two years following termination. The PLR, which ruled favorably on the employee grantor trust, describes this condition as follows:
Under the Plan, as a condition of participation each Participant must sign an agreement not to compete. The agreement will provide that for two years after the termination of employment with X, if the Participant engages directly or indirectly in any activity that competes with X's business, then the Participant must pay to X as liquidated damages the sum of all benefits awarded to the Participant under the Plan plus interest at a rate provided in the Plan. The amount of liquidated damages does not depend on whether the Participant elected to have his awards contributed to a Trust. The Participant's liability is not secured in any way, and X has no rights or access to the Trust in the event of a breach of the Participant' agreement not compete or otherwise.
An interesting feature of several cases covered by the rulings is a tax gross-up on the amounts contributed to the trust. In at least one case the tax gross-up applies whether or not the employee elects to cash out. 7 In another case the gross-up applies only in respect of a contribution to the trust. 8
Another noteworthy feature is that in several cases the employer retains exclusive control over the naming and removal of the trustee. 9 Thus, while the control over investments does not remain directly with the employer, the power to remove the trustee in those cases obviously leaves the power to influence investment decisions with the employer.
This column has not addressed a number of issues that might be associated with employee grantor trusts. For example, an "employee pension benefit plan," as that term is defined in §3(2) of the Employee Retirement Income Security Act of 1974 (ERISA), is subject to regulation under ERISA. An "unfunded" plan covering a select group of management or highly compensated individuals, known as a "top hat" plan, is exempted from most provisions of ERISA. However, a "funded" plan is subject to rules governing, among other things, vesting, funding and fiduciary duties.
The U.S. Department of Labor, which has jurisdiction to enforce Title I of ERISA, has issued a letter indicating it will generally defer to the IRS rulings on rabbi trusts. As a result, a plan that features a rabbi trust can qualify for the "top hat" exemption so long as it covers only "a select group of management or highly compensated employees." 10 However, the department has not ruled or issued an opinion as to whether a plan with an employee grantor trust is "funded" for this purpose. Where an employee has, for tax purposes, effectively set aside his own money, and where the employee has control over payment, a reasonable position would seem to be that the trust is not part of an employer sponsored plan. For now, the issue remains open.
Finally, as noted in a previous column, any deferred compensation arrangement may have implications under the registration requirements of the Securities Act of 1933. 11
1 For prior discussions of securing non-qualified deferred compensation benefits, see this column, New York Law Journal, Nov. 29, 1994; April 7, 1994; Aug. 31, 1992; Sept. 30, 1991; Oct. 29, 1990; July 30, 1990; April 30, 1990 and Dec. 28, 1989
2 For rulings on the subject of the tax treatment of secular trusts, see PLR 9212024 (Dec. 20, 1991); PLR 9212019 (Dec. 20, 1991); PLR 9212019 (Dec. 20, 1991); PLR 9207010 (Nov. 12, 1991) and PLR 9206009 (Nov. 11, 1991).
3 In the case of "Named Executive Officers" of a publicly traded company, there may be problems in determining how to report such amounts in the proxy statement. (Named executive officers for this purpose generally mean the chief executive officer and the four other most highly compensated executive officers.) It is not clear whether, in some cases, Item 402(b)(2)(v) of Regulation S-K under the Securities Exchange Act of 1934 might require such amounts to be treated as being in the category of "all other compensation," which would require them to be reported in the summary Compensation Table.
4 PLR 8843021 (July 29, 1988) and PLR 8841023 (July 9, 1988).
5 PLR 9450004 (Sept. 8, 1994); PLR 9437011 (June 14, 1994); PLR 9337016 (June 18, 1993); PLR 9328007 (April 15, 1993); PLR 9322011 (March 5, 1993); PLR 9316018 (Jan. 22, 1993); PLR 9316008 (Jan. 14, 1993); PLR 9243034 (July 24, 1992) and PLR 9235044 (June 2, 1992).
6 PLR 9450004 (Sept. 8, 1994); PLR 9337016 (June 18, 1993); PLR 9316018 (Jan. 22, 1993); PLR 9316008 (Jan. 14, 1993); and PLR 9235044 (June 2, 1992).
7 PLR 9243034 (July 24, 1992).
8 PLR 9316008 (Jan. 14, 1993).
9 PLR 9450004 (Sept. 8, 1994); PLR 9437011 (June 14, 1994); PLR 9337016 (June 18, 1993); PLR (9243034 (July 24, 1992); PLR 9235044 (June 2, 1994); PLR 8843021 (july 29, 1988) and PLR 8841023 (July 9, 1988).
10 ERISA §301(a)(3) 29 USC §1081(A)(3). See letter to Richard H. Manfreda, Chief, Individual Income Tax Branch, Internal Revenue Service from Elliot I. Daniel, Assistant Administrator for Regulations and Interpretations, Pension and Welfare Benefits Administration, Department of Labor dated Dec. 13, 1985.
11 See this column, NYLJ, Nov. 29, 1994.