Edward M. Kaplan, Jeanine L. Poole, William D. Pandolph, James E. Owers, Timothy A. Gudas, Editors
Sulloway & Hollis, P.L.L.C.

Vol. 13, No. 2
April 2008

EMPLOYEE BENEFITS

Putting on my top hat

Most private-sector employee benefit plans are subject to stringent regulations under the Employee Retirement Income Security Act of 1974 (ERISA). The regulations are particularly rigorous for employee pension benefit plans, including defined benefit pension and 401(k) profit-sharing plans. So-called "nonqualified" plans, while generally subject to ERISA, have historically been more lightly regulated, however, particularly if they are primarily designed to benefit management or highly compensated employees. Those plans are popularly referred to as "top-hat" plans.

A case recently decided in the U.S. Court of Appeals for the First Circuit (which covers New Hampshire) explores the issue of when a plan may be classified as a top- hat plan under ERISA.

Legal context: top-hat plans

Sections 201(2), 301(a)(3), and 401(a)(1) of ERISA exempt top-hat plans from many statutory requirements governing participation, vesting, funding, and certain duties of plan fiduciaries. Under those provisions, a top-hat plan is defined as any "plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly-compensated employees."

The requirement that the plan be "unfunded" typically means that the employer simply pays benefits from its general assets to participating employees as those benefits become payable under the terms of the plan. Unlike the case of a tax- qualified retirement plan, these sums need not ― and generally may not ― be set aside in a separate trust fund or other contract or arrangement in which the employee has any legal or beneficial ownership interest.

Certain exceptions to the rule apply. For example, an employer wishing to fund the benefits on an informal basis may do so by setting up separate accounts for bookkeeping purposes so long as they remain part of the employer's unrestricted general assets and are subject to the claims of the employer's creditors. Also, the funds may be placed in a special type of trust, called a "rabbi" trust (because the first one was established for a rabbi by his congregation), which is irrevocable, meaning that the employer can't voluntarily remove the accumulated assets from the trust. The contents of the fund, however, must still be subject to the claims of the employer's creditors.

The other principal requirement applicable to top-hat plans is that they be maintained "primarily for the purpose of providing deferred compensation for a select group of management or highly-compensated employees." Naturally, most of the issues that have arisen surrounding that requirement involve defining exactly what is meant by "management or highly-compensated employee" as well as the meaning of the word "primarily" in this context; ERISA provides no definitions or explanations of these terms. The U.S. Department of Labor (DOL) has never issued any interpretive regulations in this area.

Rules of thumb for measuring top-hat plans

Since the enactment of ERISA, practitioners have devised various rules of thumb designed to keep employers out of trouble. Concerning the requirement that the plan "primarily" benefit the select group, the consensus is that while a substantial majority of the participants in a plan must be management and highly compensated employees, the plan may also include some employees who don't fall into that category.

For example, a plan could be established to benefit the headquarters staff of a large, multinational corporation that has thousands of employees. The plan could cover several dozen senior corporate officers as well as a relatively modest number of administrative assistants and other headquarters staff members who couldn't fairly be classified as management or highly compensated employees. As noted above, since the exact contours of the provision have never been firmly established by statute, regulation, or litigation, you should exercise great care when working with this aspect of the top-hat exemption.

More frequently, employers seek to define the precise limits of the management or highly compensated employees aspect of the exemption. Strictly speaking, and depending on the context, the term "management" may be applied to a wide range of employees, from the CEO of a multinational corporation to a shop foreman who supervises one or two assistants while working alongside them. It should be noted that certain regulatory definitions often cited in this context (such as the concept of exempt and nonexempt employees for purposes of federal and state wage and hour laws), while perhaps marginally useful, aren't controlling for this purpose.

Similar difficulties surround the concept of the highly compensated employee. A person earning $75,000 in New Hampshire (and indeed the nation at large) may be viewed as being very well compensated (by himself as well as his employer), but that would be far from the case for an employee based in Manhattan who earns a similar amount. As with the definition of "management," definitions of the term "highly compensated" applicable in other contexts (for example, in determining whether a qualified retirement plan is discriminatory or whether a 401(k) plan violates certain testing requirements) are likewise inapplicable, although they may provide a fair amount of general guidance.

For example, for 2008, an employee is considered to be highly compensated for purposes of Section 401(k) plan testing if she earns more than $105,000 and/or certain other tests are met. While many employers and practitioners use the Section 401(k) definition as a rule of thumb in the context of top-hat plans, it must again be stressed that no statutory or regulatory authority sanctions the practice.

First Circuit's decision

In January 2008, the First Circuit issued a decision that represents its first attempt to define the scope of the top-hat exemption. In the case, the court upheld a ruling that the plans at issue were valid top-hat plans. In so doing, the court rejected claims by Dr. Eben Alexander that the plans benefited more than a select group of highly compensated employees. The court also rejected Alexander's contention that the exemption should apply only if the employees in question are in a position to bargain with their employer to shape the provisions of the plan to their liking.

The court first dealt with Alexander's contention that the plans in question weren't maintained for the requisite "select" group of employees. The doctor argued that the plans were, by their terms, open to about 30 percent of the employer's workforce, which could hardly be considered a "select" group of employees.

The First Circuit agreed with the lower court's conclusion, however, that the plans were effectively available to only a much smaller percentage (5.8% to 8.7%) of the employees, which could indeed be viewed as "select." The First Circuit found that while theoretically, the plans might be available to the larger percentage of employees asserted by Alexander, in practical terms, they could benefit only the lower percentage of the workforce that was truly highly compensated.

Having reached that conclusion and focusing on a maximum of 8.7 percent of the employer's workforce, the court found that this group consisted of surgeons with an average income of $440,000 ― more than five times the average income of the employer's workforce as a whole. While in some cases, as suggested above, it may be difficult to determine whether a group of employees covered by a top-hat plan is both "select" and "highly compensated" (and/or "management"), the court found that in this case, the issue was scarcely in doubt.

The court then considered and rejected the doctor's argument that in any case, the plan shouldn't be viewed as an exempt plan because the top-hat exemption contains an implicit requirement that each participant have sufficient bargaining power in his or her own right to shape the provisions of the plan. In dismissing that claim, the court first found that no such requirement can be inferred from the language or legislative history of ERISA. In any case, as a voting member of the physician group in question, Alexander possessed power in common with the rest of the voting members of the group to take corporate action to craft the plans as they saw fit.

In reaching its conclusion, the court specifically rejected as unpersuasive Alexander's references to a number of DOL opinion letters that did indeed focus on the individualized bargaining power of top-hat plan participants. Moreover, the court declined to rule that even collective bargaining power on the part of plan participants constitutes a prerequisite to the existence of a valid top-hat plan.

The First Circuit's decision represents a useful first excursion by the court into the realm of top-hat plans. Because of the facts of this case (and, in particular, the court's finding that the plans in question effectively benefited a small, highly compensated percentage of the employer's workforce), this decision furnishes only limited guidance to employers attempting to craft plans benefiting a somewhat broader group of employees who may arguably be classified as management and whose compensation, while generous, doesn't rise to the level enjoyed by Alexander and his colleagues.

The court's rejection of any implicit requirement of individual or collective bargaining power on the part of participating employees is a welcome development, however. Thus, the decision should prove helpful for New Hampshire employers seeking to craft plans for their management and highly compensated employees within the bounds of the top-hat exemption. Alexander v. Brigham and Women's Physician Organization, Inc., January 23, 2008, First Cir. Ct of App.

Bottom line

While nonqualified deferred compensation plans have in recent years become subject to increased regulation from the tax standpoint, because of the 2004 enactment of Code Section 409A discussed in previous articles, the plans remain lightly regulated under ERISA so long as they can avail themselves of the top-hat exemption.

The First Circuit's decision suggests that you still retain a good deal of leeway in terms of defining the eligible employee group for these plans. Because of the continued lack of statutory or regulatory guidance and safe harbors, however, you should still exercise prudence by limiting participation to employees who are indisputably part of the senior management team and/or are truly highly compensated ― both in absolute terms and relative to the rest of your workforce.

You can research ERISA, nonqualified deferred compensation plans, or any other employment law topic in the subscribers' area of www.HRhero.com, the website for New Hampshire Employment Law Letter. Access to this online library is included in your newsletter subscription at no additional charge.

Copyright 2008 M. Lee Smith Publishers LLC

NEW HAMPSHIRE EMPLOYMENT LAW LETTER should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only. Anyone needing specific legal advice should consult an attorney.