Accumulated Earnings and Deferred Compensation

Vested trusts

A vested trust is an unfunded nonqualified deferred compensation trust in which the executive is paid benefits from employer contributions only when vesting occurs. Vesting is usually scheduled to occur in conjunction with a specific event such as termination, company takeover, or the employee reaching a certain age.

Taxes. The executive is generally not taxed on the benefits held in the trust until vesting occurs, assuming that the executive's rights are nontransferable and subject to a substantial risk of forfeiture (a fact which should be clearly stated in the trust's vesting provisions). As the grantor of the trust, the employer is currently taxed on all vested trust income. The ultimate payment of benefits by the employer, therefore, is includible in the executive's gross income, and the employer may generally take a corresponding deduction.

Rabbi trusts. Perhaps the most talked about method of deferring compensation for executives is the use of a rabbi trust (so named because it was first used to provide deferred compensation for a rabbi).

Rabbi trusts have to be unfunded. Assets are placed to an irrevocable trust to be held for the benefit of executive employees. The trust is designed to provide some assurance to the beneficiary that future benefit obligations will be satisfied. A problem with this type of plan from the employee's standpoint is that nothing is really promised in the event the company goes bankrupt. Contributions by the employer to a Rabbi trust may be made on a periodic or ongoing basis.

The IRS will find that a valid rabbi trust exists if the following 3 conditions are met:

1. The funds in the trust must be available to all of the employer’s general creditors if the employer files for bankruptcy.
2. There are no insolvency triggers that hasten payments to employees when the employer’s net worth falls below a certain point, thereby bypassing creditors before insolvency is declared.
3. There is a procedure to provide the trustee with notice of the employer’s bankruptcy or financial hardship.

Taxes: A rabbi trust is subject to the claims of the employer’s general creditors. So, the employer is considered the owner of the trust and is taxed on any earnings; the employee is not subject to tax on the deferred amounts until payments are actually received. When payments are actually received and the employee is taxed, the employer may take a corresponding deduction.

Springing trusts: A springing trust is a rabbi trust that is unfunded until some event occurs. A springing trust is typically funded at the time of an actual or impending change of control as part of a severance plan which may sometimes be referred to as a Golden Parachute depending on the dollar value of the benefit.

Assets: The following investments may be placed in a rabbi trust:

• taxable assets (such as company stock)
• tax-sheltered assets (such as insurance vehicles or municipal bonds)