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Top-hat plans are unfunded plans maintained by a for-profit or nonprofit employer primarily to provide deferred compensation for management or highly compensated employees, according to the Benefits and Compensation Library's “Top-Hat Plans” chapter.
Because these plans are not intended to be tax qualified, the employer may choose the employees covered and the benefit amount to be provided, without regard to the Internal Revenue Code's nondiscrimination rules for qualified plans, it said.
Top-hat plans are exempt from the participation, funding, vesting, accrual and fiduciary provisions of the Employee Retirement Income Security Act and are subject to a few other requirements, such as reporting and disclosure rules, the chapter said.
The economic viability of a nonqualified deferred-compensation arrangement often depends on the arrangement being structured to fit within the top-hat plan exemption because it is the only means that such a plan has of avoiding compliance with ERISA's substantive requirements.
Unlike other types of employer-sponsored retirement plans that are set aside in a trust for an employee, funds in a top-hat plan remain an asset of the employer until distribution when the employee leaves the company, exposing the fund to claims by the employer's general creditors until distribution. When distributed, the assets are subject to income taxes.
A major benefit of top-hat plans is that employees may contribute the maximum amount to them, regardless of other retirement plans.
However, because companies only create top-hat plans for a handful of executives, the plans often are not as closely supervised by plan administrators as other types of retirement accounts, which may inadvertently result in compliance issues.
In the Nov. 15, 2013, “IRS launches ‘top hat' compliance checks,” news article by Dan Berman on the trade publication BenefitsPro website, Roger Rovell, president of Fiduciary Partners Retirement Group in Clearwater, Fla., addressed the areas that the IRS focuses on when it conducts compliance checks of 457(b) top-hat plans, which are plans designated for use by a state or local government or a tax-exempt organization under Internal Revenue Code 501(c).
Top-hat plans have a forfeiture risk, but also allow unlimited annual contributions.
Rovell listed the following as areas that the IRS examined when auditing 457(b) plans:
• Verify that employee contributions reported on a plan sponsor's Form W-2 were made to the 457(b) plan.
• Determine whether the plan sponsor is eligible to have a 457(b) plan.
• Verify that plan eligibility is limited to the top-hat group.
• Determine whether the plan contains improper features, such as loans, emergency distributions, age-based catch-up provisions or contributions that have been placed in trust.
• Determine whether hardship or “unforeseeable emergency” distributions have been made from the plan.
• Verify that the plan filed for top-hat status with the Labor Department and has a copy of the application.
Companies should regularly review their top-hat plans to ensure the plans meet regulatory requirements, Erin A. Kartheiser, a partner with Winston & Strawn LLP said in the Jan. 28, 2014, article, “Make a New Year's Resolution to Review Your Top Hat Plans” news article on the law firm's web site.
“Most importantly, your plan must be a top hat plan to qualify for exemptions from certain qualified retirement plans rules,” Kartheiser said. “An inadvertent failure to satisfy the top hat requirements can have serious repercussions.”
“For example, employers typically impose a vesting schedule under their non-qualified deferred compensation plans that is at least as strict as the schedule in their qualified retirement plans,” Kartheiser said.
“If a plan is found not to be a top hat plan, ERISA's minimum vesting requirements (along with additional disclosure and fiduciary requirements) will apply,” Kartheiser said.
A top-hat plan must limit eligibility to “a select group of management or highly compensated employees.” However, ERISA, does not define what is meant by this phrase.
Kartheiser offered the following as “an informal list of key factors, based on existing case law,” as well as on Labor Department views and on her experience with clients, for determining whether a plan limits coverage to a select group:
• number of employees covered by the plan;
• percentage of total workforce covered by the plan;
• compensation of lowest levels of employees covered by the plan and the location of the employees covered by the plan (e.g., $100,000 in annual compensation means something different in Manhattan, New York, than it does in Manhattan, Kansas);
• titles or responsibilities of covered employees;
• extent to which the employees were selected by the board or management, as opposed to being covered because they fall within a general plan definition; and
• extent to which covered employees have a say in management or any other ability to influence management decisions.
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