What is a Rabbi Trust, how can personal injury or other contingency type attorneys benefit from them as a wealth management / tax planning tool?
A Rabbi Trust is an irrevocable, employer-established trust used to fund non-qualified deferred compensation arrangements, with assets set aside for designated beneficiaries (often highly compensated employees or, in legal practice, attorneys) but remaining subject to the employer’s creditors in the event of insolvency. For personal injury or contingency fee attorneys, Rabbi Trusts can offer significant opportunities for wealth management and tax planning, although careful structuring and awareness of recent IRS scrutiny are essential.
Rabbi Trust: Definition and Key Features
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A Rabbi Trust is funded by an employer to pay non-qualified deferred compensation to select employees, shielding funds from company misuse but not from company creditors.
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It is irrevocable—once contributions are made, they cannot be withdrawn or reallocated by the employer, except in the case of bankruptcy, where the assets are available to general creditors.
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The trust qualifies for tax deferral because, under the doctrine of constructive receipt, the compensation is not taxable to the beneficiary (the attorney) until actually distributed.
Benefits for Personal Injury and Contingency Fee Attorneys
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Attorneys can use Rabbi Trusts to defer the receipt of large contingency fees, allowing these funds to be invested and grow tax-deferred until a predetermined date or event (e.g., retirement).
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This deferral can support managing tax brackets, spreading out income over lower-income years, and designing custom cash flows for long-range planning, including retirement, partner buyouts, or college funding.
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The deferred compensation is not subject to payroll taxes until distributions are made, providing some immediate tax savings and enhancing long-term wealth accumulation.
Tax and Planning Considerations
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The IRS has closely examined the use of Rabbi Trusts for attorney fee deferrals, referencing both the Childs v. Commissioner case (which supported deferred income treatment if the arrangement is correctly structured) and subsequent memoranda warning of potential challenges under doctrines like constructive receipt, economic benefit, and Section 409A.
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Distribution from a Rabbi Trust is taxed as ordinary income, not capital gains.
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Assets placed in a Rabbi Trust are not protected from the employer’s creditors in bankruptcy, meaning beneficiaries are essentially unsecured creditors in that scenario.
Practical Structure for Attorneys
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In a typical structure, the attorney assigns the right to receive their contingent fee to a third party, which places the fee in a Rabbi Trust and distributes funds to the attorney on a schedule.
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Some states, such as Nevada, offer favorable trust situs options for additional asset protection features, but the basic federal tax facts remain unchanged: assets are subject to employer creditors, and deferral is contingent on strict adherence to IRS and legal precedent.
Key Takeaways
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Rabbi Trusts provide a means for personal injury and contingency attorneys to defer large fees and manage tax exposure, but proper structuring is essential to withstand IRS scrutiny and creditor risks.
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Benefits include tax-deferred investment growth, flexibility in cash flow planning, and potential tax bracket management, balanced against the risk of loss in employer insolvency and ordinary income tax rates at distribution.
Attorneys considering Rabbi Trusts for fee deferral should consult closely with tax counsel and ensure all legal and tax requirements are strictly followed.
