A secular trust is a type of "top-hat" or supplemental executive retirement plan for management and highly compensated employees. It allows a company to provide non-qualified deferred compensation (NQDC) to such employees which exceeds the amount that the Employee Retirement Income Security Act (ERISA) permits under traditional "qualified" retirement plans.
The trust is called a "secular trust" to distinguish it from another type of NQDC called a "rabbi trust," so named because an important IRS ruling concerning such trusts was first issued in a case involving a rabbi. Both rabbi trusts and secular trusts have as a goal to provide deferred compensation to executives while avoiding some of the rules that otherwise would apply under ERISA.
How Secular Trusts Work
As an irrevocable trust, usually established by an employer, the secular trust's assets are set aside to provide for the future deferred compensation of the beneficiaries of the trust. Unlike the rabbi trust, assets in a secular trust are not subject to claims of the employer's general creditors. Thus, if the company suffers financial reversals, the deferred compensation should not be affected since the secular trust's assets are not part of the company's assets. This feature of the secular trust makes it more secure, from the employee's point of view, than the rabbi trust. However, secular trusts pay for this security by giving up a tax advantage that rabbi trusts have - deferral of tax. Simply put, there is immediate taxation to the employee upon vesting.
Tax Treatment of Secular Trusts
Part of the reason executives may want part of their compensation deferred is to defer the taxation of it. Because a rabbi trust is subject to claims of general creditors, there is a chance that the employee will not receive the benefits. This fact, plus the fact that the employee has no immediate right to the funds, means that the employee does not pay current income tax on the benefit. Instead, the employee pays income tax, and the employer takes a deduction, only when the employee actually receives funds from the rabbi trust.
The secular trust presents a different situation. Secular trusts vest either immediately or upon the happening of future specified events, such as retirement, death, disability, attaining a certain age, or termination of employment - depending on whether the funds are payable at the time of vesting. However, taxation is triggered by vesting, not payment, which means that the employee pays income tax, and the employer takes an income tax deduction, at the time that the benefits vest. In addition, private letter rulings by the IRS specify that earnings on assets held in a secular trust may be taxed to the beneficiaries as they are earned unless the trust is structured to include a substantial risk of forfeiture. Some employers "gross up," or provide employee bonuses timed to the vesting, so employees have funds to pay the income tax that falls due. However, the cost of "grossing up" for the employee adds to the expense of a secular trust. Another alternative is to provide for immediate distribution from the trust to the extent necessary to pay the employee's income tax liability.
Safety Versus Deferral of Taxation
Secular trusts provide more security for deferred compensation and a deduction for the employer upon vesting. The added security provides protection against a change of heart, a change of control, and insulation from the employer's creditors and bankruptcy. The downside of this added security is that the employee has to pay income tax at the time of vesting and the employer may need to provide bonuses to help the employee afford the cost of the tax, especially if the benefits are not immediately accessible. The pros and cons should be carefully weighed before deciding whether secular trusts are the appropriate vehicle to provide non-qualified deferred compensation to your company's top management.
In addition, unless otherwise approved within a bankruptcy court proceeding, a secular trust may be attacked under certain circumstances if the employer becomes insolvent too soon after the establishment of the secular trust. Federal bankruptcy laws permit the bankruptcy trustee to obtain a reversal of transfers made within 90 days of a bankruptcy. If the transfer is made to an "insider," as top management likely would be, transfers made during the 12 months prior to bankruptcy can be reversed. The deferred compensation recovered for the company by reversing those transactions would then be used by the bankruptcy trustee to pay creditors of the company. Therefore, secular trusts require very careful drafting to avoid these pitfalls.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.