By Ira H. Goldman, Esq., Richard I. Cohen, Esq., Kelly Smith Hathorn, Esq., and Bryanne E. Kelleher, Esq.
The "top hat plan" exception to full ERISA coverage of an employee benefit plan is the very foundation of executive deferred compensation. The exception provides that "a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation to a select group of management or highly compensated employees" need not comply with a myriad of ERISA requirements, most notably the vesting and funding rules that apply to ERISA plans. The exception applies to all types of deferred compensation arrangements, from an employment agreement that is customized for a single top executive to a program that supplements a 401(k) plan for a wider range of top employees.
Even though the exception has existed since 1976, the Department of Labor has never issued regulations regarding who falls into the category of "a select group of management or highly compensated employees." The most quoted statement from the DOL came in 1990, when in an advisory opinion it said that the category would be limited to "individuals [who] by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attendant thereto, and, therefore, would not need the substantive rights and protections of [ERISA]." Advisory Opinion 90-14A. For employers wanting a bright line as guidance, this was not very helpful.
There has been only a small amount of litigation in this area in 40 years, and therefore not much in the way of case law guidance. The cases that have arisen tend to be brought by terminated employees who were not vested in their top hat plan benefit, and who are arguing that the more favorable ERISA vesting schedules should apply because the plan did not fit into the top hat plan exception.
A recent decision in the Southern District of Texas, Tolbert v. RBC Capital Markets Corp.,1 serves as a reminder of just how unsettled the definition of "top hat plan" is. In short, the case was brought by former participants in an unfunded wealth accumulation plan who argued that the ERISA vesting rules should apply. The court determined that it could not decide whether the plan met the requirements of the top hat plan exception without a full trial.
The court focused on a number of issues. On what it called the "selectivity" issue, i.e. what is a select group of management or highly compensated employees, the court held that there are both quantitative and qualitative factors. As to quantitative factors, the court noted that some courts have focused on the percentage of the workforce covered by the plan. For example, the Second Circuit in a 2000 case, Demery v. Extebank,2 found a plan that covered 15.34% of the workforce was still a top hat plan, although the court remarked that such percentage was probably at or near the upper limit of the acceptable size for a "select group."
But the court also listed some relevant qualitative factors: the nature of the participants' employment duties; the compensation disparity between covered and non-covered employees; and the actual language of the plan. And the court added to the mix a separate possible factor suggested by the DOL's 1990 comments: whether the covered employees had the requisite "substantial influence, by negotiation or otherwise." The court found that all of these factors raised factual questions that made determination prior to a trial inappropriate.
Although it does not offer any definitive answers, the Tolbert decision is a good summary of the existing law. Courts focus on the percentage of the workforce covered (and no court yet has gone beyond the 15.34% allowed in Demery) as well as what the Tolbert court called the qualitative factors. While no court to date has required evidence of substantial influence, the issue remains because of the DOL's much quoted statement. Another issue that is still debated is whether the presence of a small number of participants who do not meet the selectivity criteria can taint the entire plan: the Second Circuit in Demery said a small number of such employees would not taint the plan, but the DOL apparently continues to take the opposite position.
What does this mean for the many employers who have top hat plans? First, the good news is that the DOL does not seem to be spending its resources in policing top hat plan status, and the court cases only seem to be brought by participants who are not vested under the plan at the time of their termination and are disputing that result. Other than vesting claims, there generally is little motivation for a challenge by a participant to be brought to court. So for the many top hat plans in which participant benefits are fully vested, it seems unlikely that a court case will be brought. For non-profits, whose top hat plans are very often 457(f) programs that must be subject to forfeiture to avoid taxation, there may be more cases ending up in court.
But for every employer who has a top hat plan, it may be a good idea to revisit the restrictions on participation, and articulate how the test set out by the courts has been met with respect to all participants. Employers should focus on percentage of workforce covered, but also compensation disparity between participants and other employees, and the sophisticated nature of those covered by virtue of their employment responsibilities. A written statement that these factors have been considered and that the test has been met may be a good idea, both in the plan document and in the minutes of periodic meetings held by the plan administrator. Finally, a good summary of the program, noting that it is a top hat plan and that there are differences from the qualified plan in which all employees participate, is always a good practice.
For more information, in the Tax Management Portfolios, see Brisendine, Drigotas and Pevarnik, 385 T.M., Deferred Compensation Arrangements, and in Tax Practice Series, see ¶5710, Deferred Compensation Tax Concepts and Structures.
© Shipman & Goodwin LLP, 2015. All Rights Reserved.
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