Types of Funding for Irrevocable Secular Trusts by lxw16409


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									    NON-QUALIFIED PLANS -

            ANNE L. LEARY
       Gallagher & Kennedy, P.A.
       2575 East Camelback Road
         Phoenix, Arizona 85013
            (602) 530-8333
The tax implications of deferred compensation
arrangements (hereafter referred to as “DCP”)
have always been the primary focus of employers,
employees and practitioners. The enactment of
Section 409A of the Internal Revenue Code of
1986, as amended (the “Code”) has only
intensified that focus.
While the impact of the Code on DCPs is obviously
significant, such a narrow focus has caused many
employers and practitioners to overlook the impact
of the Employee Retirement Income Security Act
of 1986, as amended (“ERISA”) on such
Failure to properly structure and administer a DCP
in accordance with the requirements of ERISA can
lead to significant liability and penalties.
ERISA does not contain an express definition of
“deferred compensation plan.”

Such arrangements are defined through the
exclusionary provisions of ERISA Sections 201(2),
301(a)(3) and 401(a)(1); 29 U.S.C. Sections
1051(2), 1081(a)(3) and 1101(a)(1).
Under those sections, a plan that “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...” is exempt from Parts
2, 3 and 4 of Title I of ERISA.

Such plans are commonly referred to as “top hat
Excess benefit plans.
Excess benefit plans provide benefits to an
executive equal to the amount by which his annual
contributions and/or benefits under a qualified plan
maintained by his employer are reduced because
of the limitations imposed by Section 415 of the
Code. ERISA Section 3(36); 29 U.S.C. Section
 If an excess benefit plan provides any
  benefits other than Section 415 “make
  whole” benefits, it will be subject to all of
  the requirements of Title I of ERISA unless
  it qualifies as an unfunded top hat plan.
All plans that are “nonqualified deferred
compensation plans” under Code
Section 409A.

The definition of a nonqualified DCP under Code Section
409A covers arrangements with non-employees and
arrangements with employees who are not part of a select
group of management or highly compensated employees.

Some Code Section 409A nonqualified DCP may be top
hat plans depending on the facts and circumstances (i.e.,
do they cover only employees and are those employees
part of a select group of management or highly
compensated employees?).
First Step: Determine whether the plan is
“primarily for a select group of management or
highly compensated employees”
     Neither ERISA nor the regulations thereunder define
      the phrase “primarily for a select group of
      management or highly compensated employees.”

     At one point, Department of Labor (“DOL”) attempted
      to develop regulations; however, it announced in
      1992 that it was discontinuing those efforts. DOL
      Announcement 57 F.R. 16977.
In the absence of regulations, employers and
practitioners must look to the prior advisory
opinions and court cases for guidance.
The definition of highly compensated employee
under Code Section 414(q).

     The preamble to the Section 414(q) regulations
      specifically notes that the Treasury Department
      and DOL agree that the Section 414(q)’s
      definition of “highly compensated employee” is
      not applicable to the determination of the
      meaning of the same phrase under ERISA.
DOL Advisory Opinions

Initially, DOL took a quantitative approach and
focused on the numbers.

It compared

     the number of employees eligible to
      participate in the top hat plan to the
      employer’s total number of employees

     the eligible employees’ average salary in
      relation to the average salary of the
      employer’s employees as a whole.
Examples of this approach

Favorable Opinions
     Advisory Opinion 75-63 (July 22, 1975) - An
      unfunded DCP which covered employees who
      earned at least $18,200, were exempt under
      the Fair Labor Standards Act as an
      administrative, supervisory, or professional
      employee and were classified as a key
      employee by the committee that administered
      the plan was a top hat plan.
   Advisory Opinion 75-64 (August 1, 1975) -
    An unfunded DCP under which (1) annual
    participation was limited to 115 of the
    employer’s key executives and managerial
    employees, (2) fewer than 4% of active
    employees were covered, and (3) the average
    annual compensation of the participants
    exceeded $28,000 as compared to $19,000
    for all management employees was a top hat

DOL has repudiated both Advisory Opinions.
Unfavorable Opinions
     Advisory Opinion 76-100 (November 15,
      1976) - An unfunded DCP under which all
      supervisory personnel, executive staff
      members, department heads, and employees
      with three years of service was not a top hat

     Advisory Opinion 79-75A (October 29,
      1979) - An unfunded arrangement under
      which an employer provided his secretary with
      retirement benefits was not a top hat plan.
   Advisory Opinion 85-37A (October 25,
    1985) - An unfunded DCP which covered
    officers, directors, an accountant, an
    accounting assistant, a comptroller and
    department foremen was not a top hat plan.
    DOL noted that the average annual pay of the
    six participating officers and directors was
    $37,910, and the average annual pay of the
    34 remaining participants was $18,584 and
    only one of them had pay in excess $29,100.
In Advisory Opinion 90-14A (May 8, 1990)
DOL adopted a qualitative approach.

Under this new approach, it

     Focused on the ability of the covered
      employees to affect or substantially influence
      the design and operation of the plan, and

     Held that covering even one non-qualifying
      employee would cause the DCP to fail to
      qualify as a top hat plan.
According to DOL

 Congress recognized that certain individuals, by
virtue of their position or compensation level, had
the ability to affect or substantially influence the
design and operation of their DCP and therefore,
would not need the substantive rights and
protections of Title I.
  “Primarily”, as used in the top hat plan definition,
refers to the nature of the benefits provided by the
DCP and not to the group of the participants
covered by it, and therefore, a plan which extends
coverage beyond “a select group of management
or highly compensated employees” cannot
constitute a top hat plan.
DOL subsequently announced that it would no
longer issue advisory opinions on whether a plan
covers a select group of management or highly
compensated employees.
Court Cases
Initially, the courts applied a quantitative standard,
however, they now apply a standard incorporating
both quantitative and qualitative factors.
Under the current standard, the most significant
 factors are
   the percentage of the employer’s total
    workforce invited to join the plan (quantitative)
   the nature of the eligible employees’
    employment duties (qualitative)
   the disparity in compensation between plan
    participants and non-participants (qualitative)
   the plan language (quantitative)
Darden v. Nationwide, 922 F.2d 2031 (4th Cir. 1991).
A DCP covering 18.7% of the employer’s workforce
was not a top hat plan because it covered too large a
group of employees.

Duggan v. Hobbs, 99 F.3d 307 (9th Cir. 1996). A
plan covering one highly compensated employee was
a top hat plan. The court applied DOL’s test regarding
the employee’s status relative to the employer.
Because the employee had retained an attorney to
review the plan, proposed changes and generally
negotiated with the employer, the court determined
that he had sufficient influence to warrant being
deemed a member of a select group.
Demery v. Extebank Deferred Compensation Plan
(B), 216 F 3d 283 (2d Cir. 2000). An unfunded DCP
covering senior officers, managers, vice presidents
and assistant vice presidents qualified as a top hat
plan even though it covered 15% of the bank’s
workforce and employees making as little as
$30,000 per year.
The court rejected DOL’s definition of “primarily”
and held that the covered employees, as a group,
had the power to influence the structure and
operation of the plan even if some participants
lacked that power.
Carrabba v. Randalls Food Markets, 252 F. 3d 721
(5th Cir. 2001). A DCP which was available to all
salaried employees working in the employer’s Texas
facilities was not a top hat plan.
The court DOL’s approach in Advisory Opinion 90-14A
regarding whether the group members had such
positions of influence with the employer that they can
protect their retirement expectations by direct
negotiations with the employer.
Unlike the Demery court, it declined to apply the test
on a group-wide basis. Applying the test on an
individual basis, the court determined that not all of the
participants had the requisite bargaining power.
Bakri v. Venture, 473 F.3d 677 (6th Cir. 2007).
The Sixth Circuit held that a DCP was not a top hat
plan because the participant group did not meet
ERISA’s selectivity requirements. The plan
covered employees who had no supervisory,
policy making or executive responsibility and had
little ability to negotiate pension, pay or bonus
1. Advest established an unfunded DCP. Although the
 plan stated it was available only to “a select group of
 highly compensated account executives,” it was
 actually available to all Advest brokers who
 generated a specified level of gross commissions
 during the year (initially,$200,000; increasing over
 time to $275,000). Once a broker became a
 participant, he or she continued to be a participant
 even if the broker failed to generate the required
 level of gross commissions each year.
 The plan covered 12.78% of Advest’s workforce.
 The average annual compensation of plan
 participants between 1992 and 2002 ranged from 2
 to 4 times the average annual compensation of all
 Advest employees.
 Is the plan a top hat plan?
Daft v. Advest, Inc., ___F. Supp.2d ___ (N.D. Ohio
2008); 2008 U.S. Dist. LEXIS 7384.

In rejecting Advest’s claim that the plan was a top hat
plan, the court held that

         the analysis of whether the plan was designed
          for highly compensated employees should not
          be based on the average annual compensation
          of all Advest employees, but instead should be
          based on a comparison of the salary earned by
          those employees who met the plan’s basic
          eligibility requirements for participation in the
          plan with the average salary of all Advest
2.   Brigham Surgical Group (BSG) established two
     unfunded DCPs under which it would credit a certain
     percentage of the salary of a physician who (a) was
     employed by BSG, (b) was a member of the Harvard
     faculty and (c) generated a certain level of net practice
     income (“NPI”). If the participating physician had a NPI
     deficit for a year, the amount credited to his plan
     accounts would be reduced by the amount of the deficit.
     BSG treated the plans as top hat plans.
        The years in question were 1997, 1998, and 1999.
     As a group, the surgeons constituted 32.4%, 30.7%,
     and 27.2%, respectively, of BSG’s total workforce. The
     percentage of surgeons who actually were covered by
     one or both of the plans was significantly smaller. In
     1997, 8.7% of BSG’s overall employee population
     contributed to one plan and 5.8% to the other; in 1998,
     the figures were 6.2% and 3.3%, respectively; and in
     1999, the figures were 4.9% and 3.1%, respectively.
During the three years in question, BSG employees as
a whole averaged annual earnings of $83,403 (1997),
$80,491 (1998), and $74,376 (1999). Meanwhile, the
participants in one plan earned on average $434,840
(1997), $476,024 (1998), and $418,059 (1999). The
participants in the second plan earned on average
$503,730 (1997), $581,320 (1998), and $483,073
In April 2001, Alexander, participant in the plans, was
notified by BSG that his employment was being
terminated. Because he had an NPI deficit of
approximately $442,000, his plan accounts were
reduced by a corresponding amount.
Are the plans top hat plans?
Alexander v. Brigham & Women’s Physicians
Organization Inc., 513 F. 3d 37 (1st Cir. 2008).
The court found that the surgeons who contributed to
the plans were part of a select group, both qualitatively
and quantitatively.
The court rejected Alexander’s argument that the
plans could not be top hat plans because he and other
participants did not have the power to negotiate and
actually had not negotiated the terms of the plans.
The court said ERISA did not require that highly
compensated employees have substantial bargaining
power for a plan to achieve top hat status.
3. John C. Deal joined a law firm in 1988 in an of-counsel
   capacity and worked there as of-counsel until 2004.
   In September 1992, the firm adopted a DCP covering
   attorneys who were directors, partners or signatories to
   the plan (the “director plan”).
   In 1994, the firm entered into separate oral DCPs with
   certain of-counsel attorneys, including Deal. Six years
   later, The firm discontinued both the of- counsel and
   director plans and as a result credited no additional
   amounts to Deal’s account under his plan.

Is Deal’s oral DCP a top hat plan?
Deal v. Kegler Brown Hill & Ritter Co., ___ F. Supp.
2d____ (S.D. Ohio 2008), 2008 U.S. Dist. LEXIS 6594.
The court aggregated the director plan with the of-counsel
plans for testing purposes, and focused on the percentage
of the total workforce invited to join the plan and the nature
of their employment duties in concluding Deal’s of-counsel
plan was not a top hat plan.
The court ruled that the 29 employees who were invited to
join the director plan, all of whom were in a select group of
highly compensated individuals, had to be taken into
The court also held that Deal’s employment duties were
more like those of associates than those of the 29
employees eligible for the director plan.
Second Step: Determine whether the plan
is unfunded
     A DCP will be deemed to be unfunded if
      benefits are payable solely from the general
      assets of the employer, are provided
      exclusively through insurance contracts or
      policies, the premiums for which are paid
      directly by the employer from its general
      assets or from combination of the foregoing.
      DOL Regulation Section 2520.104-24.
The most common types of “funding” are
     Rabbi Trusts.
       A  trust established to provide deferred
         compensation, the assets of which are
         available to satisfy the claims of the
         employer’s general creditors in the event of
         the employer’s insolvency or bankruptcy.
         Although it is most often irrevocable, it can be
 The Internal Revenue Service’s (IRS)
 determination regarding a plan’s funded
 status for tax purposes will generally be
 accepted by DOL. See Letter of Elliot I.
 Daniel to Richard Manfreda, 13 Pens. Rep.
 (BNA) at 702 (Apr. 7, 1986)
   Secular Trusts.
      An  irrevocable trust established to fund
       certain benefits; however, unlike a rabbi
       trust, an employee is subject to current
       taxation under a secular trust and the
       secular trust’s assets cannot be reached
       by the employer’s creditors.
   Corporate Owned Life Insurance (COLI).
      The  employer purchases whole life
       insurance policies on the lives of plan
       participants. Plan benefits are paid out the
       policies’ cash surrender value or their
       death benefit proceeds. The policies are
       general assets of the employer and are
       available to satisfy claims of the
       employer’s creditors.
Exempt from

     The written plan document requirement of
      ERISA Section 402(a)(1); 29 U.S.C. Section
        Oral   agreements are okay
   The trust requirement of ERISA Section
    403(a); 29 U.S.C. Section 1103(a).
      Do not have to set up a trust to hold plan
   The fiduciary requirements of ERISA Section
    404; 29 U.S.C. Section 1104.
      Do  not have to be concerned with the
       exclusive benefit rule, the prudent man
       rule, prohibited transactions and other
       fiduciary requirements.

   The minimum participation standard of ERISA
    Section 202; 29 U.S.C. Section 1052.
      The plan can discriminate in favor of the
       highly compensated.
   The minimum vesting standards of ERISA
    Section 203; 29 U.S.C. Section 1053.
      Donot have use the ERISA’s vesting
      Canadopt “bad boy” and other clauses
      imposing conditions on benefit entitlement.
Benefits forfeited for
      Improper loan approvals (Picard v. Best
       Source Credit Union, ___F. Supp.2d ____
       (E.D. Mich. 2005), 2005 U.S. Dist. LEXIS

      Disloyalty (Whitescarver v. Sabin Robbins
       Paper Co., ___ F. Supp. _____2d (S.D. Ohio
       2007). S.D. Ohio, July 30, 2007, No. 1:03-cv-
       911 (filed under seal)

      Prohibited competition with employer (Bryan v.
       the Pep Boys—Manny, Moe and Jack, ___F.
       Supp.2d ____ (E.D. Pa. 2001), 2001 U.S. .
       Dist. LEXIS 9090
Benefits denied for
     Failure to obtain employer’s consent for early
      retirement benefits as required by plan
      (Simpson v. Mead Corp.,2006 U.S. App.
      LEXIS 16607, 6th Cir., June 27, 2006

     Failure to meet plan’s age requirement
      (Straney v. General Motors Corp., _____ F.
      Supp.2d _____ (E.D. Mich. 2007), 2007 U.S.
      Dist. LEXIS 82910)
   The benefit accrual requirements of ERISA
    Section 204; 29 U.S.C. Section 1054.
      Do not have to accrue benefits ratably
       over time.

   The provisions governing the form and time of
    payment under ERISA Sections 205 and 206;
    29 U.S.C. Sections 1055 and 1056.
      Can   pay in any form and at any time.
   The minimum funding standards of ERISA
    Sections 302 et seq.; 29 U.S.C. Sections
    1082 et seq.
      Do   not have to pre-fund promised benefits.

   ERISA’s reporting and disclosure
      Provided that the plan sponsor makes a
       one-time filing requirement with DOL.
       DOL Regulation Section 2520.104-23(a).
 The   filing must

   identifythe employer, provide its address
    and EIN, specify that the plan is being
    maintained primarily for the purpose of
    providing deferred compensation for a
    select group of management or highly
    compensated employees, the number of
    such plans and the number of employees
    in each plan, and agree to provide DOL
    with plan documents upon request, and

   be filed with DOL within 120 days after the
    plan becomes subject to Title I of ERISA.
No obligation to update the filing
      DOL has informally taken the position that any
       changes to a plan, including a change in the
       number of participants, should be reported on
       an amended filing.

      Few practitioners do this since the plain
       language of the regulation makes it clear that
       the filing is a one-time requirement.
   If satisfy the one-time filing requirement, the
    plan is exempt from all of Title I’s reporting
    and disclosure requirements (e.g., the
    obligation to file annual reports on Form 5500
    and distribute SPDs)

      Ifthe plan sponsor fails to comply, the
       exemption is lost.
      However,   it can be reinstated by
       requesting relief under DOL’s Delinquent
       Filer Voluntary Compliance Program.
Not exempt from

     Compliance with ERISA’s claims procedure.
        Top  hat plans are subject to ERISA’s
         claims procedures as set forth in DOL
         Regulation Section 2560.503-1. DOL
         FAQs about the Benefit Claims Procedure
         Regulation, A-12. www.dol.gov/ebsa.
   ERISA preemption
      State   law claims are generally preempted.
         See, e.g., Paneccasio v. Unisource
         Worldwide Inc., ____ F. Supp.2d _____
         (D. Conn. 2003), 2003 U.S. Dist. LEXIS
         4757; Hutchison v. Crane Plastics
         Manufacturing Ltd., ____ F. Supp.2d
         _____ (S.D. Ohio 2006), 2005 U.S.
         Dist. LEXIS 43628; Starr v. MGM
         Mirage, ____ F. Supp.2d _____ (D.
         Nev. 2006), 2006 U.S. Dist. LEXIS
 Lossof exemptions described

 Potential   civil penalties
 Liability   for Benefits.

     Carrabba v. Randalls Food Markets, 252
     F. 3d 721 (5th Cir. 2001).
     In this class action lawsuit, the class was
     awarded $13,625,673.82 in damages
     ($6.7million for underpayments after
     applying ERISA’s vesting and funding
     rules, $3.8 million in interest on the
     underpayments and $3.1 million in
     lawyers’ fees).

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