Rabbi Trust
A rabbi trust is an irrevocable grantor trust established by an employer to hold assets set aside to fund nonqualified deferred compensation obligations, providing employees with a measure of security against the employer's unwillingness to pay while remaining subject to the claims of the employer's creditors in insolvency.
The name derives from a 1980 IRS private letter ruling involving a synagogue's deferred compensation arrangement for its rabbi. The key legal characteristic of a rabbi trust is that although the assets are segregated and cannot be used by the employer for general business purposes, they remain available to satisfy the claims of the employer's general creditors in bankruptcy. This prevents the trust from crossing the line into a funded, secured arrangement that would trigger immediate taxation under constructive receipt or economic benefit doctrine.
By placing assets in a rabbi trust, an employer assures key employees that promised deferred compensation will be available at the time of payment, insulating them from the risk that management might change its mind. This security is partial: it protects against unwillingness to pay but not against bankruptcy, which is the most significant risk employees bear in nonqualified deferred compensation plans.
From a tax perspective, rabbi trust assets are taxed to the employer as a grantor trust; income earned on the trust's investments is reported on the employer's tax return. Employees are not taxed on trust assets until amounts are actually distributed to them, as long as the arrangement remains at risk to creditors.
A secular trust, by contrast, places assets beyond the reach of employer creditors through a fully secured structure, but doing so triggers immediate income inclusion to the employee under the economic benefit doctrine, making it generally unattractive except in narrow circumstances. Rabbi trusts thus represent the most common middle ground between unfunded promises and fully secured arrangements.