2.7 Rabbi Trusts

ASC 710-10 — Glossary

Rabbi Trusts

Rabbi trusts are grantor trusts generally set up to fund compensation for a select group of management or highly paid executives. To qualify as a rabbi trust for income tax purposes, the terms of the trust agreement must explicitly state that the assets of the trust are available to satisfy the claims of general creditors in the event of bankruptcy of the employer.

Many entities have arrangements that allow their employees to defer some or all of their earned compensation (i.e., salary or bonus). Sometimes the employer uses a “rabbi trust” to hold assets from which nonqualified deferred compensation payments will be made. A rabbi trust is a special type of irrevocable trust that companies may establish in connection with a nonqualified deferred compensation plan. Employees defer compensation by election under the plan to a future date, often upon retirement or separation from service.

Assets placed in a rabbi trust are used to fund employees’ deferred compensation arrangements and reduce the risk that employees will not be paid. To qualify as a rabbi trust, the trust agreement must explicitly state that the assets of the trust are available to satisfy the claims of general creditors in the event of the employer’s bankruptcy.

Once an employer contributes funds to a rabbi trust, those funds cannot be used for anything other than the payment of deferred compensation benefits to the employee (except in the event of bankruptcy). Similarly, the employee cannot transfer or assign the rights in the trust. Deferred compensation can include cash (e.g., bonuses and salary) or the deferral of share-based payment arrangements. ASC 710 provides guidance on deferred compensation arrangements in which assets equal to compensation amounts earned (i.e., vested) by employees are placed in a rabbi trust. Such arrangements often permit employees to diversify their accounts by investing in cash, the employer’s stock, nonemployer securities, or a combination of these options. Under a deferred compensation arrangement, an employer may, but is not required to, set aside assets, including by placing them in a rabbi trust. If so, such assets are typically owned and controlled by the employer.

In accordance with ASC 710-10-45-1, rabbi trusts that are not variable interest entities are included in the employer’s consolidated financial statements. If the rabbi trust is a variable interest entity, the employer should determine whether to consolidate it. Generally, an employer would always consolidate a rabbi trust. Since the assets of the rabbi trust remain those of the employer, they are reported on the employer’s balance sheet; however, the deferred compensation liability is presented separately and is not offset against the trust assets.

Assets placed in a rabbi trust are also subject to other GAAP (e.g., ASC 320 on investments in debt securities, or ASC 321 on investments in equity securities). Any changes in the fair value of the assets held by the rabbi trust should be recognized in the income statement. Further, any changes in the fair value of the related deferred compensation obligation are recognized in earnings and should be presented separately (i.e., netting is not allowed). In addition, employer stock held in the rabbi trust is classified as equity in a manner similar to treasury stock.

The guidance in ASC 710-10-25-15 refers to four types of deferred compensation arrangements involving rabbi trusts. These four arrangement types, known as plans A, B, C, and D, differ on the basis of whether the plan permits diversification, whether the employee has elected to diversify, and the allowable forms of settlement.

Plan	Diversification	Settlement Options Permitted Under Plan	Deferred Compensation Obligation Classification
A	Not permitted	Delivery of a fixed number of shares of employer stock	Equity
B	Not permitted	Delivery of cash or shares of employer stock	Liability
C	Permitted, but employee has not diversified	Delivery of cash, shares of employer stock, or diversified assets	Liability
D	Permitted, and employee has diversified	Delivery of cash, shares of employer stock, or diversified assets	Liability

Deferred compensation arrangements in which the amounts earned are indexed to, or can be settled in, an entity’s own stock before being placed into a rabbi trust are within the scope of ASC 718. When the amounts earned in a deferred compensation arrangement (1) are within the scope of ASC 718 before being placed into a rabbi trust and (2) can be settled only in the employer’s stock (i.e., Plan A), the arrangement would be accounted for as an equity award under ASC 718 before the amounts earned are placed into the trust (provided that all other criteria for equity classification have been met; see Section 5.1). In addition, the deferred compensation arrangement would remain classified in equity and would therefore not need to be remeasured under ASC 710 after the amounts earned are placed into the rabbi trust.

For all other deferred compensation arrangements in which amounts earned are placed into a rabbi trust, the accounting depends on the terms of the arrangement and on whether the arrangement is viewed either as one plan or as substantively consisting of two plans.

Connecting the Dots

For all plans except Plan A, SEC registrants (or entities electing to apply SEC requirements) should consider ASR 268 and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E, under which presentation must occur outside of permanent equity (i.e., as temporary or mezzanine equity) when redemption is outside the control of the entity. See Section 5.10 for discussion on the SEC guidance on temporary equity.

2.7.1 Accounting for a Deferred Compensation Arrangement as Two Plans

For an arrangement to be viewed as substantively consisting of two plans, the following two criteria must be met:

Criterion 1: Six-month “risk and rewards” period — There must be a reasonable period within which the employee is required to be subjected to the risks and rewards of ownership (i.e., to all the price movements of the employer’s stock). ASC 718-10-25-9 defines this period as six months or more. Accordingly, once the share-based payment award is vested (or, in the case of an option, when the option is exercised) and placed into the rabbi trust, it would need to remain indexed to the employer’s stock for at least six months. The grantee would not have the option to convert the equity into cash or other diversified assets until after the six-month (or longer) period has ended.
Criterion 2: Deferral must be entirely elective — The option to defer the amounts earned under the share-based payment award must be entirely elective. If the employee is forced into a liability deferred compensation plan, the award would have to be classified as a liability because in accordance with ASC 710, the employee has no choice but to accept a liability in satisfaction of the share-based payment award. That is, if deferral is mandatory, the employee is forced into a deferred compensation arrangement that is within the scope of ASC 710 once the award vests. Accordingly, the entire arrangement would be accounted for as a liability from the grant date of the share-based payment award and not just from the beginning of the deferred compensation arrangement.

If the above two criteria are met, the arrangement is viewed as a share-based payment arrangement that is subsequently “converted” into a deferred compensation arrangement (i.e., two plans) when the grantee elects to diversify the entity’s equity awards by exchanging them for cash or other assets. Accordingly, the entity applies the guidance in ASC 718 until the employee elects to diversify such amounts earned and then applies the guidance in ASC 710 until the deferred amounts are received by the employee (the “deferred compensation arrangement”). In other words, when viewing the arrangement as two substantive plans, it would be acceptable for the entity to conclude that the deferred compensation arrangement does not begin until the shares are no longer within the scope of ASC 718, which is when the employee elects to convert the shares into cash or other diversified assets.

If the above two criteria are met and equity classification is achieved from the grant date of the share-based payment award until the employee elects to diversify his or her amounts earned, a public entity also must consider the guidance in ASR 268 and ASC 480-10-S99-3A. ASC 480-10-S99-3A addresses share-based payment arrangements with employees whose terms may permit redemption of the employer’s shares for cash or other assets. Since the distribution of the amounts earned under the share-based payment award into a deferred compensation liability is viewed as a settlement transaction (i.e., because the deferred compensation obligation must be classified as a liability in accordance with ASC 710 once the employee elects to diversify his or her amounts earned), the share-based payment award would be subject to the guidance in ASC 480-10-S99-3A. The guidance in ASC 480-10-S99-3A requires classification in temporary (mezzanine) equity from the grant date of the share-based payment award until the beginning of the deferred compensation arrangement. At the beginning of the deferred compensation arrangement, the amounts diversified would be classified as a liability under ASC 710.

2.7.2 Accounting for a Deferred Compensation Arrangement as One Plan

If the two criteria discussed in the previous section are not met, the deferred compensation arrangement is treated as one plan. Under the one-plan approach, the award is classified as a liability under ASC 718 from the grant date because the arrangement includes substantive terms that are inconsistent with equity classification (e.g., the award may be settled in cash or other assets before the shares mature, or it permits diversification so that the value is indexed to unrelated equity). (See Chapter 7 for detailed guidance on the accounting treatment of liability awards.) Accordingly, the deferred compensation arrangement would be classified as a share-based liability from the grant date. Once the amounts earned are placed into the rabbi trust, they would continue to be a liability in accordance with ASC 710 until the employee receives them.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.