United States: Deferred Compensation Plans For US Persons - AKA Rabbi Trusts

US persons are amongst the most heavily taxed in the world. Unlike all other nationalities, US persons do not generally benefit if they go and live in lower taxed countries as they continue to be fully liable to US tax on their world-wide income and capital gains. However, contrary to popular belief, there are ways in which US persons can legally and legitimately mitigate their taxes.

The Rabbi Trust was so named because one of the first such arrangements approved by the IRS was developed by a synagogue for its Rabbi.
The Employer acts as the settlor of a trust and pays into that trust a proportion of  the Employee's agreed compensation. The Employer would, subject  to local legislation, get a deduction for the payment into trust but those monies would not be taxable in the U.S. on the Employee while they are held in trust and, as long as the trust is correctly structured and managed offshore, those monies could also be reinvested on behalf of the Employee and rolled up free of tax.

For example, if the Employee's total remuneration package was worth, in salary and benefits, US$250,000 per annum and if the Employee was U.S. resident this US$250,000 package would normally  be taxable at full American rates. If the Employee was non U.S. resident then he would enjoy an exemption from tax on the first US$97,600 so only US$152,400 per annum would be subject to U.S. tax.  If the Employer paid the Employee US$96,700 and paid the remaining US$152,400 into the trust the result would be zero US tax.

US$152,400 per annum could be held by the trustees, invested on behalf of the Employee and rolled up completely free of tax for as long as it remained within the trust structure. If part or all of the trust fund was removed from the trust structure and paid to the Employee  the distributed portion would be taxable in the hands of the Employee. The trustees would be able to invest in whatever the Employee desired so could, for example, purchase property, cars, boats and planes which could be used by the Employee. It may be that the Employee would be taxed on his usage of these assets at whatever the IRS considered to be the value of the benefit in  kind but this  would still represent an extremely tax efficient method of purchasing and making such assets available to the Employee.

In some high tax countries it would need to be ascertained whether or not the payment into trust by the employer satisfied the local requirements to give  the employer a tax deduction and that local tax would not be payable on the payment into trust until released from trust. That is unlikely to be uncomplicated. In lower or zero tax countries these problems do not arise. For example, in the  UAE there is no local tax so only US tax rules are relevant and the Rabbi trust works extremely well. In Hong Kong there is local tax at 16%. It may be possible to structure the trust so that payments into it escape local tax but the worst case scenario is that local tax remains payable on the amounts flowing into trust but there is still a substantial saving being the difference between the US tax payable and the local tax paid.

The tax saving is not limited to the saving on the salary paid into trust because investment returns generated on that money would also be tax free. The savings secured by using a Rabbi Trust structure are substantial and cumulative.

It is important to note that this form of tax deferment/avoidance structure has previously been challenged by the IRS in the U.S. courts but those challenges have failed at the Court of Appeal [See Minor v United States 772F.2d 1472 (9th Cir.  1985)]. After such unsuccessful challenges the IRS issued a Revenue Ruling outlining the criteria which had to be fulfilled for such schemes to be acceptable to the IRS. Therefore, as long as the trust is structured in accordance with the IRS guidelines and is administered accurately and correctly by the trustees the tax benefits will flow from that structure.

Following various cases involving the abuse of Rabbi trusts, most notably in the bankruptcy of Enron, the rules, practice and procedure on Rabbi trusts were altered by the IRS. Henceforth it became necessary for the employer, employee and the trustee all to be resident in the same jurisdiction to qualify for the privileged tax treatment.


ARE THERE ANY DISADVANTAGES?

There are no tax disadvantages. There are only tax advantages.

For insolvency purposes the assets held within the trust remain as the property of the Employer and not the Employee. Thus, if the Employer were to become insolvent and otherwise unable to pay his debts as they become due, any creditors of the Employer who had priority over the Employees (under laws of most jurisdictions to the Employee is a priority creditor ranking only after secured creditors) could seize the trust assets. This need not be a concern  where the Employer is a large, solvent company nor where the Employer is owned and run by the employee. This may be a concern where the Employer is a middle ranking business or has a less than perfect credit rating.

In these cases it is possible to manage the risk by having the employee contracted to a service company set up, owned and managed by Sovereign. The employee is then assigned by Sovereign to the employer. The employer pays Sovereign and Sovereign pays the employee. As the Sovereign company will not trade or incur any other liabilities other than in relation to these contracts there is very little to zero chance of the Sovereign company getting into financial difficulty and therefore virtually no chance of there being a clawback of the monies paid into trust. Thus the risks outlined above are substantially reduced or eliminated altogether.

Payments out of the trust must be made in accordance with a plan outlined within the trust deed. US tax is payable on all payments leaving the trust so that the greatest benefit is obtained by leaving monies within the trust structure for reinvestment for as long as possible. Any alteration to the payment plan must be made at least 12 months in advance of the payment date. With careful drafting it is possible to give the maximum flexibility allowing payments to be withdrawn to meet financial emergencies or desires. Typically, the trust deed will state that 20% of the trust fund will be released to the employee for each year commencing two years after inception of the trust. If a payment is not required notice can be served on the trustees delaying the first payment until two years after the last and so on. Thus every calendar year a decision can be made as to whether to take a payment during the next year or whether the financial circumstances of the employee will allow that payment to be delayed and rolled on to the end of the payment plan delaying the tax for a further two year period. In short, tax can be deferred indefinitely whilst still allowing the employee flexibility  to take payments if required. Additionally,  the trustees can distribute the entire trust fund in the case of certain specified trigger events such as disablement, death, a fixed date, a change in ownership of the employer (whether that be the Sovereign staffing provider or the end user employer) or the occurrence of an unforeseen emergency.


CONCLUSION

Trusts can be used by US persons working abroad to obtain substantial tax benefit. They are not uncomplicated and must be set up and administered carefully and in accordance with all relevant IRS legislation and codes of practice. In preparing these details Sovereign has sought advice from legal counsel within the US. When preparing documentation on behalf of a client Sovereign can, and strongly recommends that it does, obtain a short opinion from the US advisors stating that all documentation is in order and the tax effects described above would ordinarily follow.

The trustees are faced with some restrictions on the investments that can be made through the trust. These are minor and should not be of concern  to most clients. The trustees  can only make local investments.  In practice this means that trust monies must be lodged with a local wealth/asset management or private banking firm. Or, if it is wished to invest monies otherwise than through a local firm the account holder must be an underlying company incorporated in the same jurisdiction as the residence of the trustee, employer and employee and wholly owned by the trustee. That local company can then open accounts anywhere in the world. Sovereign is happy to recommend suitable arrangements for the investment.


Whilst every effort has been made to ensure that  the details contained herein are correct and up-to-date, this information does not constitute legal or other professional advice. We do not accept any responsibility, legal or otherwise, for any error or omission.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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