What Are Employee Benefit Trusts and How Do They Work?

An employee benefit trust, or EBT, is a legal arrangement where a company, the grantor, transfers assets like cash or stock into a trust. Managed by a trustee, these assets are held for the exclusive benefit of employees. This structure legally separates the assets from the company’s operational funds, providing a secure source for employee compensation and benefits.

Core Purpose and Function of an EBT

An EBT allows a company to pre-fund future benefit liabilities, such as long-term incentive plans. This ensures funds are reserved to meet these obligations and are shielded from the company’s creditors in case of financial distress. This methodical funding helps manage cash flow by smoothing out the cost of benefits.

A trust can also facilitate the administration of complex plans by acting as a centralized vehicle for holding and managing company shares for employee stock programs. The trustee manages the complexities of warehousing these shares, tracking allocations, and handling transactions, which is useful for private companies seeking to create an internal market for their stock.

Common Types of Employee Benefit Trusts

Welfare Benefit Trusts

Welfare benefit trusts are established to provide benefits like health insurance, disability coverage, life insurance, and severance. An employer makes contributions to pre-fund these costs, and a trustee manages the assets and payments.

A prominent example is the Voluntary Employees’ Beneficiary Association (VEBA), a tax-exempt trust authorized under the Internal Revenue Code. To qualify, a VEBA must be used exclusively to provide life, sick, accident, or similar benefits to its members. Employer contributions to a properly structured VEBA are generally tax-deductible when made, within certain limits, and earnings on the assets are typically sheltered from income tax.

Retirement Plan Trusts

Federal law under the Employee Retirement Income Security Act of 1974 (ERISA) mandates that the assets of most private-sector retirement plans be held in a trust. This rule applies to both defined contribution plans, like 401(k)s, and defined benefit pension plans.

In a 401(k) plan, the trust holds the individual accounts of each participating employee, containing their contributions, any employer matching funds, and all investment gains or losses. For a pension plan, the trust holds a single, pooled fund of assets managed to meet the plan’s long-term pension obligations. The trust structure makes features like participant-directed investments in a 401(k) possible, as the trustee is responsible for holding and tracking the various investment options.

Equity Compensation Trusts

Equity compensation trusts administer employee benefits based on the company’s own stock, such as Employee Stock Ownership Plans (ESOPs) and stock option plans. The trust acts as a warehouse, holding company shares that are allocated to employees as they meet service or performance requirements.

An ESOP is a type of retirement plan that invests primarily in the employer’s stock, with the trust purchasing and allocating shares to individual employee accounts. These trusts also facilitate share-based plans in private companies by creating an internal market for shares. For public companies, the trust can purchase shares on the open market to satisfy future obligations under stock award programs.

Key Tax Treatment

Employer Tax Implications

An employer’s tax deduction for contributions depends on the trust type. For a qualified retirement plan trust, such as a 401(k), the employer can generally deduct contributions in the year they are made, subject to Internal Revenue Code limits.

For non-qualified deferred compensation plans and many welfare benefit trusts, the deduction is often deferred. The company typically cannot claim a deduction until the year the employee includes the benefit in their taxable income. For example, funds contributed for future severance benefits are not deductible until an employee is terminated and actually receives the severance pay.

Employee Tax Implications

For an employee, taxation is tied to when they receive or have an unrestricted right to the benefits; the employer’s act of funding the trust is not a taxable event. With retirement plans like a 401(k), the employee is not taxed on contributions or earnings until they take a distribution, which is then taxed as ordinary income.

In the context of equity compensation, taxation often occurs when the employee’s rights to the stock vest. For instance, an employee is taxed on the value of restricted stock units (RSUs) when the shares are delivered to them. For benefits from a welfare trust, such as employer-paid health insurance premiums, the value is generally excluded from income, but a cash severance payment is fully taxable as wages.

Establishing an Employee Benefit Trust

The Trust Agreement

Establishing an EBT begins with a formal trust agreement. This legal document outlines the trust’s operation, including its purpose and the specific benefits provided. It must detail employee eligibility requirements and the vesting schedule, which dictates when an employee gains a non-forfeitable right to accrued benefits.

The agreement also specifies the trustee’s powers, the contribution process, and rules for distributing benefits and managing assets. Because of the legal and tax complexities involved, companies engage legal counsel specializing in employee benefits to draft this document.

Selecting a Trustee

Selecting a trustee is a key step in the establishment process. The trustee is the fiduciary responsible for managing the trust’s assets and administering the plan according to the trust agreement and applicable law. This role carries significant legal responsibility.

The trustee can be an individual, a committee of company executives, or a corporate trustee such as a bank or trust company. Many companies opt for a professional corporate trustee for their expertise in administration, investment management, and regulatory compliance. A company must conduct due diligence on a potential trustee’s experience and fees before making a selection.

Defining Beneficiaries

The trust agreement must precisely define the class of individuals eligible to benefit from the trust. Beneficiaries are typically current and sometimes former employees of the company. The document may also extend beneficiary status to the dependents or designated heirs of employees, particularly for benefits like life insurance or retirement plan assets. This clear definition is necessary for the trustee to determine who is eligible to receive benefits.

Trust Administration and Compliance

Funding the Trust

After the trust agreement is executed, the company funds the trust by transferring assets into an account held in the trust’s name. These assets can be cash, company stock, or other property as specified in the document. The trustee is then responsible for setting up the necessary financial accounts to receive and hold these assets. Subsequent funding may occur on a regular schedule, such as with each payroll for 401(k) contributions, or on an ad hoc basis for other types of trusts.

Fiduciary Responsibilities

The administration of the trust is governed by strict fiduciary duties imposed on the trustee. The trustee has a legal obligation to manage the trust’s assets with prudence and care, making investment decisions that are appropriate for the goals of the trust.

The duty of loyalty requires the trustee to act exclusively in the best interests of the plan participants and beneficiaries, avoiding any conflicts of interest. They must follow the terms of the trust agreement meticulously, ensuring that benefits are calculated correctly and paid out in a timely manner. Failure to meet these fiduciary standards can result in personal liability for the trustee.

Reporting Requirements

Operating an EBT involves reporting to federal agencies like the Internal Revenue Service (IRS) and the Department of Labor (DOL). The primary requirement is the annual filing of Form 5500, which details the plan’s finances, operations, and funding status.

The filing requirements for Form 5500 depend on the size of the plan. Plans with 100 or more participants are “large plans” and must file a detailed annual report that includes a financial audit. This count is based on the number of participants with an account balance at the beginning of the plan year, which allows many employers to qualify as “small plans” and file the simpler, audit-free Form 5500-SF. Trustees must also provide disclosures to participants, including the Summary Plan Description (SPD), which explains the plan’s benefits and rules in understandable language.