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A rabbi trust is a grantor trust that an employer sets up to informally fund a nonqualified deferred compensation plan. It holds assets apart from the company's general operating accounts so employees have assurance those funds are reserved for their future benefit. The name comes from the first such trust the Internal Revenue Service approved in 1980, which was established by a congregation to pay its rabbi deferred compensation. The crucial distinction is that a rabbi trust does not protect employees from the employer's creditors: if the company goes bankrupt, those assets are available to general unsecured creditors just like any other company asset.
Nonqualified deferred compensation plans are promises by employers to pay executives and key employees future compensation in exchange for deferring current pay. Those plans must remain unfunded and unsecured to preserve the tax deferral. If assets were fully secured and beyond the reach of creditors, the Internal Revenue Service would treat them as immediately taxable to the employee.
A rabbi trust threads this needle. It holds and segregates assets away from the company's general accounts, protecting employees from a change of heart or management change. The company cannot simply decide to stop paying because the assets sit in an independently managed trust. But because the assets remain technically accessible to creditors in bankruptcy, the plan stays legally unfunded, and employees remain untaxed until they receive payments.
Companies establish rabbi trusts primarily to protect against two scenarios. The first is a hostile takeover or change of control, where new management might try to cancel or renegotiate deferred compensation commitments made by the prior team. Once assets are in the trust, the trustee controls them under the terms of the trust document rather than current management's preferences.
The second is a simple change of heart. A company facing cash pressure might be tempted to delay or reduce payments it had promised years earlier. The trust prevents this: unless the trust document expressly permits it, the employer cannot claw back or redirect assets that have already been contributed.
A rabbi trust cannot protect employees from employer insolvency or bankruptcy. If the company files for bankruptcy protection, the trust assets are part of the bankruptcy estate and available to satisfy creditor claims. Executives covered by rabbi trusts rank as general unsecured creditors, far below secured lenders in the distribution hierarchy.
This limitation is fundamental and intentional under federal tax law. If the trust fully protected assets from creditors, the deferred compensation would be currently taxable, defeating the entire purpose.
A secular trust is the alternative that provides complete asset protection: assets in a secular trust are beyond the reach of both the employer and its creditors. The tradeoff is immediate taxation. Assets contributed to a secular trust are taxable to the employee when they vest, not when distributed, triggering an upfront tax bill that eliminates most of the deferral benefit. Secular trusts are rare precisely because the tax disadvantage makes them unattractive in most situations.
In 1992, the Internal Revenue Service published Revenue Procedure 92-64, which provided a model rabbi trust document and specified the features required to achieve tax-deferred treatment. Employers do not have to follow the model exactly, but doing so provides a strong legal safe harbor against the Internal Revenue Service challenging the trust's unfunded status. The model allows for "springing" rabbi trusts, where assets are only contributed after a triggering event such as a change of control, rather than funded in advance.
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