NON-QUALIFIED PLANS - WHAT’S SO SPECIAL ABOUT THEM? DEFERRED COMPENSATION PLANS UNDER ERISA ANNE L. LEARY Gallagher & Kennedy, P.A. 2575 East Camelback Road Phoenix, Arizona 85013 (602) 530-8333 email@example.com INTRODUCTION 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 arrangements. Failure to properly structure and administer a DCP in accordance with the requirements of ERISA can lead to significant liability and penalties. HOW DOES ERISA DEFINED “DEFERRED COMPENSATION PLAN”? 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 plans.” WHAT PLANS ARE NOT TOP HAT PLANS UNDER ERISA? 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 1002(36). 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?). DETERMINING WHETHER A DEFERRED COMPENSATION PLAN IS A TOP HAT PLAN 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. DO NOT RELY ON 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 plan. 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 plan. 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 compensation. HYPOTHETICALS 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? No. 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 employees. 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 (1999). 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? Yes. 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? No. 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 account. 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 revocable. 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. ADVANTAGES OF BEING A TOP HAT PLAN Exempt from The written plan document requirement of ERISA Section 402(a)(1); 29 U.S.C. Section 1102(a)(1). 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 assets 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 schedules. 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 24612) 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 (unpublished)) 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 requirements. 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 80760. CONSEQUENCES OF FAILING TO QUALIFY AS A TOP HAT PLAN Lossof exemptions described previously. 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). QUESTIONS?