Providing Additional Guarantees through Trusts
As executive compensation has grown while the level of benefits that can be provided these participants under qualified plans has generally decreased, executives and their employers have frequently turned to nonqualified deferred compensation plans to provide increasing amounts of retirement income. By some estimates, many executives can expect to receive as much as 50 percent of their retirement income from nonqualified deferred compensation plans. At the same time that this has been occurring, the business environment has become increasingly unstable and marked by leveraged buyouts and hostile takeovers.
We don't need to look very far to see the effects of this vicissitude in the economic and business environment. In 2003 Bethlehem Steel Company, once the backbone of the American economy, effectively ceased all operations and left the economic stage. A company that had employed several hundred thousand workers had been relegated to economic history.
It is the uncertainty of business that renders many nonqualified plans -- particularly deferred compensation plans -- somewhat risky. What happens if the employer that has promised deferred compensation benefits is bought out by another company that chooses not to honor the plan commitment or declares bankruptcy? The simple fact is that the deferred compensation participant becomes an unsecured creditor of the employer. However, ensuring that the funds intended to support plan benefits remain available to the employer's creditors has been key to the plan's ability to defer income taxation.
Because of the unenviable position in which the executive is thrust in such a case coupled with the increasing importance of these plans, interest in securing the benefits promised by a deferred compensation plan is also increasing. A trust can help provide some of that security.
Trusts that have been used to help secure the deferred compensation plan benefit are the following:
Rabbi trusts, and
Let's briefly examine how they work.
A rabbi trust is designed to overcome the concern that a change in company management could place the promised deferred compensation plan benefits in jeopardy. A rabbi trust, however, contains a provision that the trust assets would always be available to the employer's general creditors in the event of bankruptcy. As a result of that provision, the IRS has held that, in the case of a deferred compensation plan whose benefits are secured by a rabbi trust, the participant would have no current taxable income.
The use of a rabbi trust effectively eliminates the risk that the benefit will not be paid except in the case of the employer's bankruptcy or insolvency. So, the trust resolves the security issue in the event of a change in management and the refusal of the new management to pay the promised benefit. It represents an advance in protecting the promised benefits of a deferred compensation plan without the loss of its tax advantages. In the next trust that we will consider -- the secular trust -- the results are different.
Secular trusts provide the protection afforded by a rabbi trust (protection against the employer's unwillingness to make promised payments) plus protection against the risk that the employer will declare bankruptcy or become insolvent and be unable to make payments. As a result of the protection of the secular trust's assets from the claims of the employer's creditors, the executive is currently taxed on the deferred compensation benefits; that is to say that, while the compensation may be deferred under the plan, its taxation is not-generally, a poor combination. In some cases, however, the secular trust and its disadvantageous tax treatment are preferable to exposing the deferred compensation benefits to the risk that the employer will not survive.
Certain companies and industries -- because of their exploitation of new technology, or for some other reason -- are characterized by significant risk that can't easily be transferred through insurance. The dot.com companies that were the fuel behind the high-tech market run-up of the 1990s are a good example. Many of these companies produced a lot of "paper" millionaires. However, when the dot.com bubble burst early in the 21st century, the majority of those companies were gone. If a key executive had a deferred compensation plan with one of them and did not use a secular trust, the benefits were probably lost when the company folded. In such a case, the secular trust would have been a far more desirable approach despite the income tax issue.