The IRS has issued a revenue ruling explaining the tax consequences of a "secular trust." An employer may establish a nonqualified deferred compensation plan to provide retirement benefits or other payments following termination of employment to its management or highly compensated employees. A secular trust is a funding vehicle for a nonqualified deferred compensation plan. The assets of a secular trust can only be used to pay benefits to employees who participate in the plan. The assets of a secular trust are not subject to claims of the employer's creditors if the employer becomes bankrupt.1 This article briefly summarizes the key guidance provided by Revenue Ruling 2007-48 concerning secular trusts.

1. Tax consequences for participant

The participant (who is a highly compensated employee within the meaning of Internal Revenue Code §414(q)) has no gross income on account of the participant's interest in the trust until his or her accrued benefit under the trust vests. For the participant's taxable year in which his or her accrued benefit under the trust initially vests and each later taxable year in which the participant participates in the plan, the participant includes in gross income his or her vested accrued benefit (other than the participant's "investment in the contract"), computed as follows:

  • The fair market value (FMV) of the participant's account in the trust as of the last day of the trust's taxable year, plus
  • Any amount distributed to the participant during the participant's taxable year (secular trust arrangements often provide for in-service distributions to satisfy a participant's taxes relating to the trust), less
  • For taxable years after the initial year of vesting, the FMV of the participant's account as of the end of the trust's prior taxable year (the participant's "investment in the contract")

Note that these rules result in the participant being taxed on unrealized income, as well as any tax-exempt income, of the trust.

2. Tax consequences for employer

If a separate trust account is maintained for the participant, to which the employer contributions under the plan, along with any income, are allocated, the employer may deduct contributions to the trust in its taxable year in which amounts attributable to those contributions are includable in gross income by the participant.2

3. Tax consequences for the trust

The income of a secular trust is taxed to the trust and not the employer. A secular trust may deduct trust income that is distributable to participants during the taxable year. The trust agreement typically should provide that taxable income of the trust will be distributed each year to prevent trust income from being taxed twice — to the trust when earned and to the participant under the rules described in (1) above.

4. Income tax withholding

Employers are required to withhold income taxes from wage payments. There are no income tax withholding obligations until the participant's accrued benefit under the trust initially vests. For the participant's taxable year of initial vesting and each later taxable year, the FMV of the participant's vested accrued benefit under the trust (other than the participant's investment in the contract), including distributions, computed as described in (1) above, is treated as a wage payment subject to income tax withholding on the last day of the trust's taxable year. The trust, not the employer, is liable for these income tax withholding obligations.

5. FICA taxes

FICA taxes are imposed on wages. The employer and the employee are each liable for one-half of these FICA taxes. The employee's share of FICA taxes is collected by the employer through wage withholding.

The participant's wages, for FICA purposes, attributable to the employer's contributions to the trust made in the participant's taxable years prior to the taxable year in which the participant's interest in the trust initially vests, are treated as paid on the date the participant's interest in the trust initially vests. The amount of these wages equals the FMV of the participant's interest in the trust on that date of initial vesting. The participant's wages, for FICA purposes, attributable to the employer's contributions to the trust made in taxable years during and after the taxable year in which the participant's interest in the trust vests, are treated as paid on the dates the contributions are made. The amount of wages equals the amount of the vested contribution.

The trust is considered the employer liable for satisfying FICA obligations for wages attributable to contributions made by the employer to the trust in years before the participant vests. By contrast, the actual employer is considered the employer liable for satisfying FICA obligations for wages attributable to contributions made by such employer to the trust in the year of vesting and later years.

Note that the amount and timing of wage payments for income tax withholding purposes and for FICA tax purposes are determined under different rules. To recap, generally, wages:

  • For income tax withholding purposes, are treated as paid on the last day of the trust's taxable year and are equal to the FMV of the participant's vested accrued benefit under the trust on that date
  • For FICA purposes, are treated as paid on the date the participant's interest in the trust initially vests and on the date each subsequent vested contribution is made and are equal to the FMV of the participant's interest in the trust on the date of initial vesting and the amount of each vested contribution, respectively.

Further note that the person responsible for complying with income tax withholding and FICA obligations varies as follows:

  • All income tax withholding obligations: trust
  • FICA obligations for years before vesting: trust
  • FICA obligations for vested contributions after vesting: the employer

As always, we would be happy to assist you in implementing and reviewing secular trust and other deferred compensation funding arrangements.