Top Hat Retirement Plan ‘Traps for the Unwary’

“Top hat” retirement plans aren’t subject to many ERISA requirements, but the unique treatment of the plans under employee benefit and tax law can lead to plan sponsor confusion and costly mistakes.

Top hat plans—or non-qualified retirement plans offered primarily to executives—escape most requirements of the Employee Retirement Income Security Act (ERISA), notes James E. Earle, partner at K&L Gates.

There are no funding, minimum participation, minimum vesting or ERISA fiduciary duty requirements. However, top hat plans are subject to ERISA claims procedures and reporting and disclosure requirements, Earle warns.

At the 44th Annual Retirement & Benefits Management Seminar, hosted by the Darla Moore School of Business at the University of South Carolina, and co-sponsored by PLANSPONSOR, Earle shared some “traps for the unwary” that top hat retirement plan sponsors need to avoid.

For example, the failure to collect FICA (Social Security/Medicare taxes) at the time deferred compensation is first credited, accrued or vested could result in higher FICA taxes for participants at the time of payment. Earle pointed to a recent court decision in Davidson v. Henkel Corp. in which a federal district court found that, rather than properly withholding nonqualified retirement plan participants’ Federal Income Contributions Act (FICA) taxes as required by the plan, Henkel Corp. caused participants to pay these taxes at the time of each benefit payment, effectively reducing their anticipated retirement benefits.

Offering a deferred compensation plan to a broader group of employees than a “top hat” group can also result in trouble for plan sponsors, including ERISA failures, potential lawsuits and very bad tax results if sponsors are required to fund the plan.

According to Earle, the federal courts do not all agree, but a common analysis applies a mix of quantitative and qualitative factors to determine a “top hat” group, broken into four categories:

  • Percentage of work force eligible to participate – no more than 15% of the work force should be eligible to participate;
  • Nature of plan members’ employment duties – all members should be either part of management or highly compensated; some courts have permitted a few members outside of these categories; most courts have rejected the requirement that members have power to negotiate their own terms and conditions of employment;
  • Compensation of plan members’ versus all other employees – the average compensation of participants in the top hat plan should be at least double that of the average compensation for all employees;
  • Definition of eligible group in plan terms. 

Plan sponsors should also remember to make a Department of Labor (DOL) top hat filing when a deferred compensation or other nonqualified plan is adopted. Penalties for failure to file Form 5500s can be significant, Earle warned. There is a self-correction program available, however, at a limited cost.

Plan sponsors should also watch out for “traps for the unwary” as top hat retirement plans relate to other executive or general employee benefits. Earle noted that an executive employee agreement with a severance provision that says the executive will be entitled to all benefits she was entitled to before the severance is unworkable. Letting a terminated employee continue to participate in a retirement plan violates plan terms and employers could potentially face a lawsuit for violating the terms of the agreement, he said.

Susan G. Odom, Esq., member at Nexsen Pruet LLC, noted that sometimes nonqualified plans run in tandem with qualified plans and there are rules for how they interact. Plan sponsors need to know how their qualified plan defines compensation and whether payments to nonqualified plans are included in the definition.

In addition, according to Odom, some sponsors may want to encourage executives to not defer into their qualified plan in order to pass nondiscrimination testing by contributing a certain percentage into the nonqualified plan if they do not. She warned seminar attendees that this is in violation of ERISA’s contingent benefit rule.