Would the formation of a Rabbi Trust be a "material modification"?

[Guest FAQ]

Amounts deferred prior to 2005 are "grandfathered" and are not subject to 409A, unless "the plan under which the deferral is made is materially modified after October 3, 2004." §409A(d)(2)(B). Notice 2005-1, Q/A-18(a) states that "a modification of a plan is a material modification if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added."

Is it possible that the IRS would view the formation of a Rabbi Trust to fund grandfathered deferrals as a material modification? (Assume the Rabbi Trust would not violate the new rules in 409A re: springing Rabbi Trusts and foreign trusts.)

Instinctively this does not appear to be a material modification for several reasons. The addition of a Rabbi Trust change does not affect the plan itself, but rather the plan's funding mechanism. Also, a Rabbi trust does not protect the participants' assets from creditors, although it does prevent the company from disposing of the assets, except to pay benefits.

The Conference report contains the following in the summary of present law on p. 293: "Arrangements have developed in an effort to provide employees with security for nonqualified deferred compensation, while still allowing deferral of income inclusion." Could this provision of security after 10/3/04 (by adding a Rabbi Trust) be viewed as the enhancement of a right (e.g. the right to receive the benefits)?

I can't help but think that if Rabbi Trusts could not be added to old deferrals without losing their grandfathered status, that the IRS would have said so in the guidance issued to date or informally in the seminars and teleconferences that their representatives have attended. However, I would be interested in hearing others' views on why it is still ok to add a Rabbi trust to pay grandfathered benefits.

Thanks in advance.

[mbozek]

Why does the client want to add a rabbi trust now? As you stated the purpose of a rabbi trust is to provide security to the employee that the funds will be used only for paying benefits and not for the general expenses of the employer. Why isnt this enhancing a benefit right in material way?

The fact that the IRS has not answered this queston does not mean it is permissible because very little guidance has been issued under 409A and there is much more regulatory guidance to come.

[Guest FAQ]

The Rabbi trust was under consideration at the time the Act was passed, and we are now trying to determine whether it is still a possibility (assuming they want to remain under the grandfather).

I agree with your point regarding the lack of guidance and reading anything into silence by IRS & Treasury. I suppose it's a question of how broadly they will view a "benefit" or "right." Perhaps it's a question of the degree of additional security that would be provided by a Rabbi Trust and whether that would be material.

I wonder whether this might depend on the facts of the individual situation and financial condition of the employer. For example, a promise to pay deferred comp benefits from Microsoft would not be strengthened materially if Microsoft were to set up a Rabbi trust, in light of their deep pockets.

[Alf]

If the plan has to be amended to provide for the trust, then I wouldn't do it. If the provisions of a grandfathered plan already contemplate a Rabbi Trust, the modification wouldn't bother me. Employers are permitted to continue to administer grandfathered plans as is, subject of course to the pre-409A rules.

[401 Chaos]

I cannot add anything to the prior discussions on your specific question but did want to buttress Alf's comments. In particular, please note that the Conference Report in discussing Triggers Upon Financial Health notes that "An amount is treated as restricted even if the assets are available to satisfy the claims of general creditors. For example, the provision applies in the case of a plan that provides that upon a change in financial health, assets will be transferred to a rabbi trust."

I read this to say that if you establish a rabbi trust for an existing plan and place all assets in the trust up front, then there isn't any specifc guidance but you are arguably ok. However, if you have an existing plan or try to amend a grandfathered plan to provide that assets automatically be transferred to a rabbi trust upon a change in financial health of the company, then the amounts will be treated as restricted amounts included in income and subject to an excise tax even if a shift to the rabbi trust is the only result of the financial trigger. Why is having a provision allowing for transfers to a rabbi trust only upon a financial health trigger any worse than transferring all assets to a rabbi trust up front? Does this differ if the company is experiencing financial problems at the time of the up-front rabbi trust funding? I appreciate that there may be a perception issue with having amounts automatically shift into a trust upon a downturn but as a practical matter an automatic trigger doesn't seem to result in any more potential harm to shareholders / creditors than an up-front transfer to a rabbi trust.

[Guest George Chimento]

I cannot add anything to the prior discussions on your specific question but did want to buttress Alf's comments. In particular, please note that the Conference Report in discussing Triggers Upon Financial Health notes that "An amount is treated as restricted even if the assets are available to satisfy the claims of general creditors. For example, the provision applies in the case of a plan that provides that upon a change in financial health, assets will be transferred to a rabbi trust."

I read this to say that if you establish a rabbi trust for an existing plan and place all assets in the trust up front, then there isn't any specifc guidance but you are arguably ok. However, if you have an existing plan or try to amend a grandfathered plan to provide that assets automatically be transferred to a rabbi trust upon a change in financial health of the company, then the amounts will be treated as restricted amounts included in income and subject to an excise tax even if a shift to the rabbi trust is the only result of the financial trigger. Why is having a provision allowing for transfers to a rabbi trust only upon a financial health trigger any worse than transferring all assets to a rabbi trust up front? Does this differ if the company is experiencing financial problems at the time of the up-front rabbi trust funding? I appreciate that there may be a perception issue with having amounts automatically shift into a trust upon a downturn but as a practical matter an automatic trigger doesn't seem to result in any more potential harm to shareholders / creditors than an up-front transfer to a rabbi trust.

At this stage, we are in the realm of good faith compliance. So if adverse guidance is issued, it will be possible to take money out of a newly formed rabbi trust and return to the previous arrangement.

What's at stake are (1) plan failure, if this is an impermissable "funding" due to a financial trigger, and (2) possible loss of granfather treatment, if the adoption of a rabbi trust is considered a material modification.

Assuming that the employer is in good financial health, I do not see adoption of a rabbi trust as a "plan failure." Nor do I see additional funding of a rabbi trust to be a "plan failure."

I am less sure about the impact on grandfathering. Ultimately, I do not think grandftahering will be impacted. What does a rabbi trust really do ? It simply assures an employee that an existing, unsecured contract will be observed. The rabbi trust, if designed according to the rev. proc., does not enhance benefits or vesting. It's certainly a good faith interpretation that it is not a material modification of a plan, so what's to lose ?

George Chimento