This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
“Nonqualified deferred compensation plan” (NDCP) is a widely used term and has even been set in statutory stone by its inclusion as a definition in the final 409A regulations. However, while 409A defines what constitutes such a plan and creates numerous rules governing these arrangements, one area it does not address is which employees of the plan sponsor are permitted to participate in an NDCP. Nevertheless, accurately capturing the correct covered group is an essential first step and ongoing process for NDCP sponsors. So who exactly can be included in an NDCP? Well, due to the lack of any specific, official government guidance on this topic, the process of determining the answer to that question is really more of an art than a science. In order to attempt to paint a proper picture of permissible NDCP participation, we must first look to the Employee Retirement Income Security Act (ERISA).
Sizing NDCPs for an ERISA’s “top hat”
ERISA imposes a number of substantive and procedural requirements on qualified plans. Similarly, the Internal Revenue Code (IRC) creates additional restrictions through its various limitations on compensation and benefit amounts. However, ERISA includes an exemption for plans that are unfunded and “maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” Plans that fit this standard are exempt from many ERISA and IRC requirements and are commonly referred to as “top hat” plans. However, given that to date the only official ERISA definition of which employees can be included in such plans consists solely of the above general description, the identification process, like art, is very much subject to interpretation.
While the IRC has its own definition of “highly compensated employee,” this definition is not the standard for “top hat plan” purposes. The U.S. Department of Labor (DOL) has the authority to impose ERISA penalties and thus it is the DOL definition that must be met. Generally, the IRC definition is much less restrictive than the DOL definition. In fact, the DOL has indicated that the IRC definition of highly compensated employee (generally earning at least $120,000 for 2016 limit as indexed) is not appropriate for this purpose. The DOL would presumably focus on a more restrictive group of employees as it issued a past ERISA advisory opinion that warned employers to restrict eligibility for top hat plans to only those individuals who, by virtue of their position in the company, have the ability to negotiate the terms of their employment and thus influence the design and operation of the plan. This rule would be very limiting and, as several commentators have noted, would exclude some people who in the past clearly have been considered “top hat” individuals. The DOL, however, has never issued regulations formalizing its position on this matter.
Stretching the top hat
In the absence of such DOL regulatory guidance on this issue and with a strict interpretation of the DOL’s unofficial stance too tight a fit, ERISA attorneys and other benefits practitioners have construed their own definitions based on case law (which have no precedential value outside of their jurisdictions). Without giving the specific case law, some courts’ benchmarks for defining a top hat group have included:
(1) Whether or not the individuals covered under the plan had significant managerial, supervisory, policy-making, or executive responsibility.
(2) A group representing 5% or less of the employee population (though there have been some cases where percentages as high as 15% have been accepted).
(3) The average compensation of the covered group is three times the average of the noncovered group. For example, if the average pay of the noncovered group is $50,000, with limited exceptions, no employee making less than $150,000 should be permitted to participate in the top hat plan.
(4) Plan document language describing that the plan is “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.”
In recent years, companies have been including more people in NDCPs, which is due to the restrictive effects of the qualified plan limits. This is particularly true in cases where a company maintains a 401(k) plan that has trouble passing the required nondiscrimination testing. Under such a scenario, the “highly compensated employees”—i.e., the Internal Revenue Service (IRS) definition of such employees—are prevented from contributing the maximum dollar amounts because of low contribution rates by the employees that are not highly compensated. Some plan sponsors seek to address this problem by creating an NDCP that is open to all highly compensated employees, which, as described above, may not be sufficient in itself and satisfy the “top hat” facts and circumstances test if challenged.
Potential penalties for tearing the top hat
In order to assess whether to take an aggressive position or not, NDCP sponsors should understand the potential penalties in the event that a court ruling finds their plan tears through that ever-elusive-to-define lining of the top hat definition by including “non-top hat” employees and thereby exposing them to the attendant risk of limited ERISA protection:
(1) The plan assets would have to be held in a trust, and in some cases, minimum funding standards would have to be met.
(2) Once the plan is funded (held in a trust), the participants would lose the tax-deferred aspect of their deferrals to the extent their benefits are vested (i.e., amounts would immediately be included in the participant’s income and would be subject to income tax withholding and employment taxes).
(3) In future years, all highly compensated employees would be taxed on any allocable trust income.
(4) General participation and vesting requirements of ERISA would have to be met (although the plan could be terminated, possibly avoiding extending participation; however, any such termination would need to meet the 409A requirements).
(5) Penalties could be imposed on the plan administrator and parties in interest for failing to comply with ERISA (for example, for failing to file Form 5500/5500-C and distribute summary plan descriptions).
(6) Civil actions could also be brought by plan participants to enforce ERISA rights.
In practice, the plan sponsor’s most likely exposure is founded in a dissatisfied participant (e.g., someone terminated prior to being vested in a nonqualified plan) bringing a civil action, possibly resulting in penalties. Most court cases on this issue were instituted by one or more disgruntled participants. The issue could also be raised by the DOL. Even though we may have not seen many reports of NDCP sponsors being audited for this each year, the frequency of such audits may increase now that NDCPs have come under more intense scrutiny.
Find the right top hat fit for your firm
Whether an NDCP sponsor is starting a new plan or administering an ongoing plan, careful consideration must be given to avoid dropping too far down the corporate ladder when determining who will be covered by the plan. The various ERISA and IRC rules are structured to protect the rights of rank and file employees and limit the total compensation that can be tax-deferred. A byproduct of these rules is that they restrict the amounts that executives can accumulate under qualified plans. The “top hat” exemption was created to allow employers to provide additional benefits (i.e., over and above those permitted under qualified plans) to a select group of management or highly compensated employees who have sufficient leverage within, and knowledge of, the employer to not need complete ERISA or IRC protection. Because there is currently no “one size fits all” absolute bright line test for determining such eligibility, NDCP sponsors need to assess whether or not their covered “top hat” group can withstand the overall facts and circumstances test that a court would apply if the plan’s status were challenged by a participant or the DOL. For example, the salary range and titles for an acceptable top hat group from a small manufacturing company in the Midwest is going to vary significantly from a Madison Avenue advertising firm in New York. Accordingly, when setting up a new NDCP or if there are any doubts regarding the group covered by an existing NDCP, sponsors should contact their employee benefit consultants and ERISA counsel for assistance in making sure their top hat determination is a custom fit for their organization’s unique structure.