IRS Notice 88-99: Rabbi Trust Creditor Rules and 409A Funding

To preserve the income tax deferral it’s designed to create, a rabbi trust has to satisfy two separate sets of IRS requirements: the model trust language in Revenue Procedure 92-64, and Section 409A of the Internal Revenue Code. The core rule under Rev. Proc. 92-64 is that trust assets must remain reachable by the employer’s general creditors if the company becomes insolvent. Section 409A adds funding restrictions on the trust and operational rules for the underlying nonqualified deferred compensation plan. Miss any of it and the executive faces immediate taxation of the entire deferred balance, a 20% additional tax, and interest running back to the year of deferral.

Why Creditor Access Is the Central Requirement

Two tax doctrines explain why the IRS insists on the creditor-exposure feature that defines a rabbi trust.

The first is constructive receipt. Income is taxable when it’s credited, set apart, or otherwise made available to you, even if you haven’t taken the cash. A deferral election without meaningful restrictions is treated as a receipt of the money.¹ So the plan and trust have to genuinely restrict the executive’s access to the funds.

The second is the economic benefit doctrine. Even if the executive can’t touch the money, irrevocably setting assets aside for the executive’s sole benefit and out of reach of the employer’s creditors is itself a taxable transfer of property under Section 83.² A fully protected “secular trust” fails on this ground.

A rabbi trust threads the needle. Assets are earmarked for the executive, but the trust document expressly subjects them to the claims of the employer’s general creditors on insolvency.³ Because the executive’s interest can be wiped out in a bankruptcy, no immediate economic benefit exists. The trust is treated as a grantor trust, meaning the employer, not the executive, is taxed on the trust’s investment income each year, and the executive pays income tax only on actual distributions.⁴

The Rev. Proc. 92-64 Model Trust Provisions

Revenue Procedure 92-64 publishes model rabbi trust language that operates as a safe harbor. Adopt it verbatim and the IRS will not argue that the trust itself creates constructive receipt or an economic benefit. If you want a private letter ruling on your arrangement, conforming to the model is a prerequisite.⁵

The provisions the model requires:

Trust principal and earnings must be available to the employer’s general creditors under federal and state law if the company is insolvent. Participants may hold no preferred claim or beneficial ownership interest, only unsecured contractual claims against the employer.
The trust must define the employer as insolvent if it either cannot pay its debts as they become due or is the subject of a pending bankruptcy proceeding.
The board and the highest-ranking officer must notify the trustee in writing of insolvency. If a purported creditor alleges insolvency in writing, the trustee must independently determine whether it has occurred.
The trustee must suspend all benefit payments the moment insolvency is known and hold the assets for general creditors.
The trust must state that it is a grantor trust with the employer as grantor.
The trustee must be an independent third party with corporate trustee powers under state law, such as a bank trust department.
The employer must deliver a payment schedule to the trustee specifying amounts, form, and start date for each participant, and the trustee handles required tax withholding.
Once the trust is irrevocable, the employer cannot direct the return of trust assets until all plan obligations are satisfied. Whatever remains after all benefits are paid reverts to the employer.

The trust must be valid and its creditor-access provisions enforceable under applicable state law; the IRS verifies this on any ruling request.⁵ The model allows some flexibility. A trust can be irrevocable from inception, or it can start revocable and become irrevocable on a defined trigger such as a change in control, as long as the creditor-access language governs throughout.

Section 409A Funding Restrictions

Rev. Proc. 92-64 governs what the trust document says. Section 409A(b) governs how the trust can be funded, and it identifies three funding arrangements that trigger immediate taxation under Section 83 regardless of how well-drafted the creditor-access clause is.

Offshore Assets

Trust assets located outside the United States are treated as a taxable property transfer at the time they were placed offshore. The only exception is when substantially all of the services related to the deferred compensation were performed in that foreign jurisdiction.⁶

Financial Health Triggers

The trust cannot contain any provision restricting assets to participants based on a decline in the employer’s financial health. This closes off “springing” rabbi trusts that attempt to convert into a secured arrangement when the employer weakens. Both the presence of the trigger in the plan and any actual restriction of assets in response to deteriorating finances produce the same immediate-tax result.⁶

Restricted Periods for Underfunded Pension Sponsors

An employer that sponsors a single-employer defined benefit pension plan cannot set aside or transfer assets to a rabbi trust during a “restricted period,” which includes bankruptcy and periods when the pension plan’s funded status falls below certain thresholds.⁷

All three funding violations produce the same penalty: the deferred amount is included in the executive’s gross income, plus a 20% additional tax, plus interest at the underpayment rate plus one percentage point running back to the year of deferral or vesting.⁶

Section 409A Rules for the Underlying Plan

The trust is only the funding vehicle. The nonqualified deferred compensation plan sitting behind it must independently satisfy Section 409A’s rules on elections and distributions. A plan-side failure destroys the tax deferral just as thoroughly as a trust-structure failure.

When Deferral Elections Must Be Made

A deferral election must generally be made before the calendar year in which the services creating the compensation are performed. A newly eligible participant can elect within 30 days of becoming eligible, but only for compensation earned after the election date. Performance-based compensation covering a service period of at least 12 months can be deferred up to six months before the end of the performance period, provided the outcome is still uncertain when the election is made.

Permissible Distribution Events

Distributions can occur only on one of six triggering events: separation from service; disability as defined in the regulations; death; a specified time or fixed schedule set out in the plan; a change in ownership or effective control of the company or of a substantial portion of its assets; or an unforeseeable emergency involving severe financial hardship beyond the executive’s control.⁸ Any payment outside these categories violates Section 409A.

Six-Month Delay for Public-Company Specified Employees

If the executive is a “specified employee” of a publicly traded company, any distribution triggered by separation from service must be delayed at least six months after departure. Death during the wait ends the delay. The accumulated amount can be paid as a lump sum on the first day of the seventh month, or each scheduled payment can be pushed back six months.⁸

What a Failure Costs the Executive

Section 409A puts the consequences on the executive, not the employer. When a plan fails on design or operation, all compensation deferred under the plan for the current and all prior taxable years becomes immediately includible in the executive’s gross income, to the extent vested and not previously taxed.⁶

On top of that, the executive owes an additional 20% tax on the amount pulled into income, plus interest at the underpayment rate plus one percentage point calculated as though the compensation had been taxable in the year first deferred or, if later, the year it vested. For an executive who has been deferring for a decade, back-taxes, the 20% penalty, and compounding interest can be substantial. The same penalty structure applies to plan-operation failures under Section 409A(a) and to funding failures under Section 409A(b).⁶

The ERISA Top Hat Filing

A rabbi trust arrangement almost always sits inside a “top hat plan” for ERISA purposes. A plan is exempt from ERISA’s participation, vesting, funding, and fiduciary rules if it is unfunded and maintained primarily to provide deferred compensation for a select group of management or highly compensated employees.⁹

“Unfunded” is the hinge. A plan qualifies as unfunded for ERISA purposes as long as participants have no greater rights to plan assets than the employer’s general creditors. Because a properly structured rabbi trust maintains exactly that exposure, the plan remains unfunded under ERISA even though assets sit in a trust account.

The employer must electronically file a top hat plan statement with the Department of Labor within 120 days after the plan first becomes subject to ERISA. The statement includes the employer’s name and address, EIN, a declaration that the plan is maintained primarily for a select group of management or highly compensated employees, and the number of plans and employees covered.¹⁰ Each new top hat plan requires its own filing. Amending an existing plan to add participants does not.¹¹

If a participant falls outside the “select group” definition, the exemption can be jeopardized. Courts have generally read the exemption to require that the plan primarily benefit management or highly compensated employees, so a small number of borderline participants may not destroy it, but the safer practice is to limit participation strictly to executives and senior management.

Employment Taxes Follow a Different Timeline

Income tax deferral is the point of the arrangement, but FICA taxes don’t wait. Under the special timing rule for nonqualified deferred compensation, the employer must withhold the employee share of FICA and pay its own matching share as of the later of the date the executive performs the services creating the right to the deferred amount, or the date the amount is no longer subject to a substantial risk of forfeiture. Immediately vested compensation is subject to FICA in the year of the services; compensation on a vesting schedule is subject to FICA when it vests.¹²

The acceleration often helps rather than hurts. The Social Security wage base is $184,500 in 2026, and executives receiving nonqualified deferred compensation typically earn well above it.¹³ If the base is already maxed out on regular salary, the deferred amount may owe only the 1.45% Medicare tax plus the 0.9% additional Medicare tax on earnings above $200,000, rather than the full FICA rate.

A nonduplication rule protects amounts already taxed. Once FICA is paid under the special timing rule, neither that amount nor any investment earnings on it are subject to FICA again at distribution. If FICA was never paid under the special timing rule, the full distribution is subject to FICA at payout, which is often worse after years of accumulated earnings.¹²

1
eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income
2
Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services
3
U.S. Department of Labor. Advisory Opinion 1992-13A
4
Office of the Law Revision Counsel. 26 U.S. Code 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners
5
BenefitsLink. Revenue Procedure 92-64
6
Office of the Law Revision Counsel. 26 U.S. Code 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
7
Internal Revenue Service. Nonqualified Deferred Compensation Audit Technique Guide
8
eCFR. 26 CFR 1.409A-3 – Permissible Payments
9
Office of the Law Revision Counsel. 29 U.S. Code 1051 – Coverage
10
eCFR. 29 CFR 2520.104-23 – Alternative Method of Compliance for Pension Plans for Certain Select Employees
11
U.S. Department of Labor. Top Hat Plan Statement
12
eCFR. 26 CFR 31.3121(v)(2)-1 – Treatment of Amounts Deferred Under Certain Nonqualified Deferred Compensation Plans
13
Social Security Administration. What Is the Current Maximum Amount of Taxable Earnings for Social Security