Retirement Plans

A federal appeals court ruled that a pastor whose “rabbi trust” retirement fund was substantially lost could not sue the investment company.

Key point. A rabbi trust is an arrangement that can provide attractive, tax sheltered retirement income for ministers and church workers. Employers that use the model rabbi trust published by the IRS in 1992 are assured that an employer's contributions to the trust will not be presently included in the employee's taxable income, and that income generated by the trust will be tax deferred.

* A federal appeals court ruled that a pastor whose "rabbi trust" retirement fund was substantially lost by an investment company due to securities law violations could not sue the investment company since he had no present interest in the trust assets. A pastor (Pastor Aaron) wished to save for his retirement. As a result, he entered into a "rabbi trust" arrangement with his church. A rabbi trust is a nonqualified deferred compensation arrangement that allows employers to set aside tax-deferred funds for an employee. The funds are taxable only upon distribution upon the employee's retirement or death. The trust funds, however, being the property of the employer until they are distributed, remain subject to the employer's general creditors. The church funded Pastor Aaron's rabbi trust by diverting a portion of his salary into the trust (salary reduction). The church contracted with a company (Charterhouse) that provided trustee services for rabbi trusts. In this agreement, Charterhouse agreed to act as trustee over the funds that the church contributed to the trust. Pastor Aaron claimed that a broker induced Charterhouse to purchase "viatical insurance contracts" as investments for the trusts it administered, promising above-market returns. Viatical insurance contracts are made when a terminally ill person (the viator) agrees to assign irrevocably the benefits of a life insurance policy to a third party for a discounted amount.

Charterhouse apparently invested more than one million dollars of trust funds in these viatical contracts, including more than $34,000 from Pastor Aaron's rabbi trust. It purchased the viatical contracts from another entity (Financial Federated Title & Trust). Pastor Aaron later received written notice that the entire investment from his trust in the viatical contracts was lost. All in all, of the 115 million dollars nationwide that was given to Financial Federal Title & Trust for the purpose of purchasing viaticals, only about six million dollars was actually so used. Charterhouse invested another $52,000 of Pastor Aaron's rabbi trust in notes issued by a company that purportedly made loans to "well-known companies." Pastor Aaron claimed that Charterhouse persuaded numerous other ministers to invest in these notes. The company declared bankruptcy, and refused Pastor Aaron's requests for repayment of the note to his rabbi trust.

Pastor Aaron filed a lawsuit against Charterhouse in federal court, alleging several violations of federal securities laws. The court dismissed the lawsuit, however, on the ground that he had no current legal interest in the assets of his rabbi trust, and therefore could not be considered the "person purchasing" the alleged securities, as is required to maintain his federal securities claim. The court also denied Pastor Aaron's request to bring a class action because he could not adequately represent a class of actual purchasers of the securities.

A federal appeals court affirmed the trial court's ruling. It noted that the IRS does not consider contributions to a rabbi trust to represent taxable income to the beneficiary in the year the contributions are made because the contributions are deemed to be an asset of the employer due to the following two characteristics: (1) the beneficiary has absolutely no right to access the trust funds until death or retirement, and (2) the trust fund remains subject to the employer's creditors. The court noted,

The trust agreement explicitly disavows any beneficial interest in the trust by Pastor Aaron. The trust agreement specifies that "Plan participants [i.e., Pastor Aaron] and their beneficiaries shall have no preferred claim on, or any beneficial ownership interest in, any assets of the trust." If that were not clear enough, the agreement goes on to define the rights Pastor Aaron retains under both the trust agreement and the deferred compensation plan as follows: "Any rights created under the Plan(s) and this Trust Agreement shall be mere unsecured contractual rights of Plan participants against the Congregation." That the trust proceeds were to be paid directly to Pastor Aaron rather than to the church appears to be, in light of the above, no more than a matter of expediency, and does not enlarge Pastor Aaron's rights beyond these limitations.

The court further noted that "the money used to make these investments was not Pastor Aaron's, but instead belonged to the trust and was subject in its entirety to the claims of the church's creditors." It also quoted from another section of the rabbi trust that prohibited Pastor Aaron from participating in any investment decisions. The court concluded, "Although the lack of investment authority may not be dispositive in the determination of who is a 'person purchasing,' we must conclude that Pastor Aaron, a person who did not actually make the relevant purchases, who did not own the funds used for the purchases, who was not a beneficiary of the trust for which the purchases were made, and who lacked any authority to control the purchasing decisions, is not a 'person purchasing' under [federal securities law]."

The court conceded that Pastor Aaron could have filed a motion with the trial court to "substitute" his church (the real purchaser of the securities) as the real party in the case. However, he failed to do so in a timely manner, and so this opportunity was lost.

Application. This case is important for two reasons. First, it illustrates the risks associated with unconventional investments. The real tragedy of this case was that Pastor Aaron lost most of his retirement funds. The same could happen to any minister whose funds are invested in questionable programs. Ministers are advised to carefully read the feature article entitled "Investment Fraud" that appeared in the March-April 2004 issue of Church Law & Tax Report. It provides ministers and other church leaders with vital information that will assist in avoiding such tragedies.

Second, this case highlights an important feature of rabbi trusts. Rabbi trusts are commonly used by secular corporations, and are increasingly being used by churches. A rabbi trust is a trust established by an employer to pay benefits to an employee upon retirement or some other event. The trust is generally irrevocable and does not permit the employer to use the assets for purposes other than payments to the employee. A rabbi trust is not taxable to the employee until the assets are distributed, so long as the trust is subject to a "substantial risk of forfeiture" which generally means that the trust is subject to the claims of the employer's general creditors. The IRS has published a "model" rabbi trust agreement that will provide the benefit of tax deferral if adopted. This model agreement was used by Pastor Aaron's church. It contains language necessary to avoid having contributions taxed to the employee in the year they are made. However, as this case illustrates, such language, to achieve the benefit of tax deferral, deprives the employee of all rights in the trust fund. This can have consequences in addition to tax deferral. It also means that the employee will not be allowed to sue investment companies in the event that their trust fund is lost or depleted due to securities law violations. Smith v. Partington, 352 F.3d 884 (4th Cir. 2003).

Resource. Rabbi trusts are addressed fully in chapter 10 of Richard Hammar's 2004 Church & Clergy Tax Guide.

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