Before going further, I'd be remiss if I did not mention that my motivation for posting this is a recent series on top-hat plan litigation in Mike Melbinger's blog.
So why should an employer or employee care if their plan is a top-hat plan or not? According to regulations under ERISA Section 104, top-hat plans are exempt from the participation, funding, vesting, and fiduciary rules under ERISA. As we shall see, this can be critically important, especially in the current statutory environment.
Backpedaling just a bit because this will help the less knowledgeable reader to understand why top-hat plans exist, let's consider what it could mean to be in a top-hat group. ERISA was enacted in 1974 to provide certain protections for employees in retirement and certain welfare benefit plans. When a plan is exempt from some of the key provisions of ERISA, it fails to provide those protections. So, being in a top-hat plan could alert a participant that he or she might not need those protections.
As some authors, mostly attorneys, have pointed out, the last year or two has seen more than the usual amount of litigation related to top-hat plans. In the typical situation, either an individual thinks that they were improperly excluded from a top-hat plan (in my completely non-legal view, this would be a tough claim to make) or because they were in a plan that was treated by their employer as being a top-hat plan, but they thought that it did not satisfy the criteria for being top-hat.
Depending on your viewpoint, the latter is either an easy claim or a difficult claim to make. Why is that? It's been more than 40 years since the passage of ERISA and we still don't have formal DOL guidance telling us what a top-hat group is. Some have argued that an individual may properly be in a top-hat group by being either management or highly compensated or both. Despite the current definition of highly compensated (Internal Revenue Code Section 414(q)) not existing until late 1986, some have argued that satisfying that criterion is sufficient. Many years ago, the DOL floated a concept that a person should be eligible for a top-hat group that a person would be eligible if their compensation was at least two times (three times in a separate informally floated concept) the Social Security Wage Base. And, finally, there is the concept that a person may rightfully be in a top-hat group if by the nature of their position, they have the ability to influence the design and amount of their compensation and benefits package.
So, knowing that we currently don't know what a top-hat group actually is, why do we care?
Suppose your company sponsors what it believes to be a top-hat plan and it turns out that it's not top-hat. Then, it's going to be subject to some fairly onerous provisions that could create massive current costs in some cases and unsolvable compliance issues in others.
Consider the following scenario.
Suppose you have a DB SERP with 20 participants. Further suppose that for whatever reason, this plan is found to not be a top-hat plan. Assuming that the company is large enough, then the plan will fail the minimum participation rules and it will necessarily (unless the company has only highly compensated employees) fail the minimum coverage tests. Full vesting must occur generally within 5 years of entry and that entry must occur not later than age 21 with 1 year of service. The plan must be funded according to ERISA's minimum funding rules. And, those plan assets must be invested according to ERISA's fiduciary standards. But, the plan will still not be a qualified plan as it doesn't meet all of the Internal Revenue Code's standards under Section 401(a).
If the plan is not qualified, it must be a nonqualified plan of deferred compensation. That makes the plan subject to Code Section 409A. So, let's throw in one more wrinkle. Let's suppose the company also sponsors a qualified DB plan and let's suppose that the qualified plan is less than 80% funded. Now, you are between a rock and a hard place. Setting aside assets (funding) for the nonqualified plan will violate Code Section 409A which will subject participants to a very large unplanned additional tax liability. (By the way, those participant will likely have to find a way to pay those taxes perhaps without having access to the deferred compensation assets in order to pay them.) Not funding the SERP will cause the plan to fail to meet minimum funding standards which will result in excise taxes under IRC 4971.
What should an employer do?
I've been told by more than one attorney that it is unlikely that you can get a formal legal opinion that your top-hat group is, in fact, a bona fide top hat group.
If you can't get a formal legal opinion, perhaps the best way to get comfort is to get an outsider with expertise in this area to assist with an independent analysis.
Looking at a history of case law and DOL opinion on the topic, one might consider these elements:
- The percentage of the workforce in the top-hat group
- The relative pay of the top-hat group as compared to the pay of those people not in the top-hat group
- Whether the top-hat group was selected by the Board as compared to being, for example, any employee with the title Vice President or higher
- Whether individuals in the top-hat group, especially those among the lower-paid in the group, have significant management responsibilities
- Whether individuals in the group need the protection of ERISA
Nobody really knows. But, having an independent analysis might show that an employer is acting in good faith in determining the group. Given the downside of getting it wrong, it may just be worth it to find out.
Finally, I want to reiterate that I am not an attorney and I have no qualifications to provide legal advice. As such, nothing in this post or anything else that I write should be construed as legal advice or as the practice of law.