Tax Law

Only a "Select Group" Can Wear a Top Hat

Deferred Compensation Plans for Management or Highly Compensated Employees

Men rarely wear hats anymore.  I'm not talking about baseball hats or knit stocking caps, I mean fancy felt and structured hats:  fedoras or silk top hats (think Abraham Lincoln).  Some hat historians have attributed the demise of the gentlemen's hat to President Kennedy, who chose not to wear a hat.  It's unclear though whether Kennedy was setting the trend or in fact following a trend that had already begun before he entered the limelight.  See Neil Steinberg, Hatless Jack - The President, the Fedora and the Death of the Hat, 2005.  Regardless of the source of the demise, the last person I can recall to sport a black top hat was the guitarist Slash of the band Guns N' Roses, which experienced its own demise in the mid-90s without any help from the Kennedy family.  Today, the top hat lives on in the form of high level executive retirement planning.

Top hat plans are special retirement plans for select groups of key executives or high level employees.  They take the form of either nonqualified deferred compensation plans (NQDCs) or Supplemental Executive Retirement Plans (SERPs).  Top hat plans that fulfill certain requirements are exempt from most of the strict Employee Retirement Income Security Act (ERISA) rules applicable to qualified benefit plans and funded nonqualified deferred compensation plans.   In order to qualify for an exemption from ERISA's vesting, funding, accrual, participation and fiduciary responsibility rules, a top hat plan must be unfunded (that is, it must rely upon a company's general assets to fund the benefit and is available to the employer's general creditors in even of employer bankruptcy or insolvency) and the plan must be maintained by an employer "primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees." [1]

There are no statutory or regulatory bright line rules to determine whether a plan qualifies as a top hat plan. As a result, case law is king. [2]  Among the issues that must be addressed is what constitutes a "select group" of employees. [3]  The Sixth Circuit in Bakri v. Venture Manufacturing Co. [4] set forth the following four-part test for identifying whether the "select group" requirement had been met:  (1) the percentage of the total workforce invited to join the plan (quantitative), (2) the nature of their employment duties (qualitative), (3) the compensation disparity between top hat plan members and non-members (qualitative), and (4) the actual language of the plan agreement (qualitative).

A recent California district court decision also followed the Bakri test, leading observers to suggest that we may be closer to a clearer common law standard for defining a "select group."  In Callan v. Merrill Lynch & Co.[5] the plaintiffs were former employees who alleged that the Merrill Lynch WealthBuilder Plan for financial advisers covered so many Merrill Lynch employees that it did not cover only a "select group" of employees.  Interestingly, the plaintiffs were three brothers who left Merrill Lynch to start their own financial advisory firm and, because of a clause in the Merrill Lynch plan, had to forfeit some of the deferred compensation awards previously received under the plan.  Their argument was that the plan did not qualify as a top hat and that it violated ERISA's minimum vesting rules.  Applying the Bakri test, the court ruled that Merrill Lynch's plan met the four-part inquiry and ruled that the ERISA vesting rules did not apply. Although the Callan decision is precedential only in the Southern District of California, there is limited case law in this area and so courts may adopt the same test in their jurisdictions.  The Callan case may take us one step closer to a bright-line rule regarding the determination of a "select group."

Although in the Callan case failure to follow the requirements for top hat status would have benefited the former employees, the consequences of administering a top hat improperly are significant for the employer and the existing employees (the tax deferral benefit is lost for the employee and ERISA rules found to apply resulting in fines/penalties for the employer).  With the current high level of scrutiny on executive bonuses, top hat plans remain a legitimate mechanism for providing an incentive to executives and key employees.  Although top hat plans are unfunded and unsecured, insurance policies may be structured to create security for nonqualified benefits (e.g., split dollar insurance policies).  Interestingly, shareholders are often unaware of decisions involving top hat benefit plans.  Companies may group the expenses and liabilities related to top hat plans with the cost of their other employee benefit plans and the terms of top hat plans are often not disclosed to shareholders and do not require shareholder approval.    This lack of shareholder oversight can lead to enhanced benefit for top hat employee participants.

Top hat plans are exempt from most ERISA rules because the employees who qualify for the plans are thought to have considerable bargaining and negotiating power and do not need ERISA protection (note though that although top hat plans are exempt from the vesting, participation, funding & fiduciary rules under ERISA, they must still comply with certain ERISA enforcement provisions).  Given the uncertainty with respect to the requirements for top hat status, and the potential for top hat employees to benefit greatly without shareholder oversight, perhaps it is time for everyone to take a closer look at who is benefiting under these plans.  Official guidance from the DOL or IRS could assist employers attempting to administer top hat plans and also create a system for disclosure and oversight.

[1] ERISA § 301(a)(3); 29 USC § 1081(a)(3).

[2] Prior courts have determined that a percentage limitation is required for top hat plans (no more than 15% of the workforce may be included).  Others have determined that certain "rank & file" employees may be included but do not offer specifics regarding what percentage or number.  See Lexis Tax Advisor - Federal Topical, Ch. 1C:18.02

[3] See Lexis Tax Advisor - Federal Topical, Ch. 1C:7.01[3][c] for discussion of other issues that must also be addressed. 

[4] See Bakri v. Venture Manufacturing Co., 473 F.3d 677, 678 (6th Cir. 2007).

[5]  No. 09 CV-0566-BEN-BGS (S.D. Cal., Aug. 30, 2010)


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