Is Your Executive Plan Top-Hat?

Most larger companies and some smaller ones provide many of their higher paid employees the opportunity to participate in a nonqualified retirement plan often referred to as a Supplemental Executive Retirement Plan or SERP. The rationale for having such a plan is spelled out in ERISA. The regulations specifically grants "top-hat" status to plans that are limited to a select group of management or highly compensated employees. The plan must also be unfunded (and for those people who say that lots of top-hat plans have assets set aside, that is informal funding in a rabbi trust or through insurance products or some other means).

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.

Ouch!

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.

DOL Weighs in Again on Top-Hat Plans

ERISA contemplated so-called top-hat plans. In fact, it spelled out exactly what was contemplated in providing this opportunity for nonqualified deferred compensation so clearly that the legislative intent could never be misconstrued.

No, it didn't.

As is often the case when bills go from staffer to staffer and then to the floors of the houses of Congress, the bills tend to emerge with run-on sentences often punctuated by a myriad of commas making Congressional intent something upon which otherwise knowing people cannot agree.

Perhaps, some day they will learn.

No they won't, not in my lifetime anyway.

In any event, in a case (Bond v Marriott) concerning top-hat plans in front of the 4th Circuit Court of Appeals, the Department of Labor (DOL) wrote an amicus brief providing its opinion on the statutory wording around top-hat plans.

So, I know that those not familiar are just itching to find out. What does the statute say?

Congress gave us an exception to certain provisions of ERISA for a "[p]lan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees."

What is the primary purpose of a top-hat plan? Is it to be primarily for providing deferred compensation to a select group that is composed of management or highly compensated employees? Or, is it to be for providing deferred compensation to select group that is composed primarily of management or highly compensated employees?

It's one of those great questions that has confounded us through the ages. No, actually, it's a question that has confounded a select group of us since the passage of ERISA in 1974. To add to that confounding just a bit, everyone who practices in this field knows what a highly compensated employee is. The term is well defined in Code Section 414(q). But wait, Section 414(q), as written, has only been around since 1986 (added by Tax Reform) meaning that perhaps for these purposes, we don't even know what a highly compensated employee really is.

In its amicus brief, the DOL gives us its opinion, one that it claims to have held at least since 1985 and perhaps longer. The DOL tells the court that the primary purpose should be the provision of deferred compensation [for this select group] and that other purposes might include retaining top talent, allowing highly compensated individuals to defer taxation to years with lower marginal tax rates, or avoiding certain limitations applicable to qualified plans in the Internal Revenue Code. DOL further tells us that it does not mean that the select group may be composed primarily [emphasis added] of management or highly compensated employees or that the plan may have some other secondary purpose which is not consistent with its primary purpose.

The brief goes on to give us the judicial history around the provision and of course informs us which case law got it right and which did not. But, the DOL is clear in its claims and steadfastly denies that exceptions should be allowed.

I may be missing something here regarding the DOL. I think that the DOL has regulatory purview over ERISA. While the DOL has ceded that purview most of the time to the IRS where the Internal Revenue Code has a conforming section, that does not seem to be the case here. Could the DOL not have written regulations in 1975 or 1985 or 1995, or 2005 clarifying who, in fact, is eligible for participation in a top-hat plan? Or did they think it so clear that it was not worth their effort, despite being befuddled by decision after decision handed down by federal courts?

I know that when I got into this business, coincidentally in 1985, the more experienced people who taught me instructed that top-hat plans were to be for a group that was primarily management or highly compensated. In fact, it is difficult, in my experience to find practitioners who learned otherwise.

Perhaps that's wishful thinking. Perhaps, on the other hand, it's wishful thinking on the DOL's part. Perhaps the case will go to the US Supreme Court eventually so that nine wise jurists can put their own spin on it and settle this argument once and for all.

Until then, ...

Do You Have a Top-Hat Plan?

Recently, the 6th Circuit Court of Appeals ruled in a top-hat plan case, Daft v Advest, Inc. This case adds to the litany of top-hat decisions rendered by different appeals courts. Most of them are similar in their conclusions. No two are the same.

The good news is that I have two potential remedies: 1) The US Supreme Court could hear one of these cases and give us a litmus test to live by in determining who is eligible to participate in a top-hat plan; or 2) More than 37 years later, the Department of Labor could write regulations on the topic.

We might not like either one, but at the very least, we would have some certainty. People making business decisions like certainty. As a consultant, and I'm sure it's the same for an attorney, it's not a good client relationship technique to tell a client that their eligibility criteria are probably okay, or that they seem to comport with the current law in the circuits in which they operate. Should be and seem to are horrible consulting words. Since I can't give a legal opinion, though, they may be the best I can do.

So, at least in the 6th Circuit (Kentucky, Michigan, Ohio, and Tennessee), Daft gives us a four-prong test (sort of):

1. What percentage of the workforce is covered by the plan? 
2. What is the nature of employment duties of the participants covered by the plan?
3. What is the compensation disparity between members of the plan and non-members of the plan?
4. What does the plan language say?

Unfortunately, or perhaps fortunately, Daft does not give us a bright-line test for any of 1, 2, 3, or 4. In fact, Daft doesn't even give us a hint. 

Think back to your school days. One of your friends is good enough to steal the test questions from the teacher (I do not condone this) and give them to you. The problem is that every question is subjective and you don't know the teacher's thoughts.

Alas ...