RCG Magazine - 4th Quarter 2004 | Table of Contents

Resolving the Top Hat Quandry

By Joseph M. Few
Vice President, RCG Southeast
Executive Benefits Practice

What can a company do when its top hat group is downsized and many important employees lose a valuable benefit? What is an alternative to traditional deferred compensation which provides the same benefit, but is not subject to the top hat rules?

Traditional nonqualified deferred compensation plans enjoy an exemption from the onerous testing and reporting requirements of ERISA under the relief given to plans designated as top hat. However, the guidelines companies use to define their top hat group are imprecise and many companies and their advisors have found themselves searching for strategies from a myriad of advisory opinions and court cases. Neither the IRS nor the Department of Labor (DOL) has given direct and clear guidance.

Section 201(2) of ERISA defines a top-hat plan as 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." The DOL in Advisory Opinion 90-14A (1990) noted; "It is the view of the Department that in providing relief for Top-Hat Plans from the board remedial provisions of ERISA, Congress recognized that certain individuals by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration, any risks attendant thereto, and, therefore, would not need the substantive rights and protections of Title I.".

Recently many have referred to the "Demery v. Extebank" case of 2000 for direction. In Extebank, the 2 nd Circuit Court of Appeals ruled a plan providing benefits for 15.34% of the employee population was indeed a top hat plan, even though those employees did not have the "ability to negotiate for themselves" the design of the plan. No percentage test can prevail, of course, but the case does indicate the courts will provide significant leeway for companies to define their top hat group. In fact, for many advisors, 15% of the employee population has become an unofficial benchmark for the maximum percentage of top hat employees.

Such was the case for a RCG client recently. The client is a high-tech company with a large population of highly compensated employees. The company had a nonqualified deferred compensation plan in place to replace benefits lost because of the testing and limitations of its 401(k) plan. As the company went through an economic downturn, and significant numbers of employees were laid off, the top hat group grew from approximately 12% of the population to almost 20%. On the advice of its ERISA counsel, the company made the difficult decision to reduce the size of the top hat group (using the now popular 15% rule, along with income and job description criteria for guidance). The result: many participants no longer qualified for the plan and thus lost a valuable benefit.

This company solved its problem in an innovative approach: the Security Option Plan (SOP). A SOP duplicates the financial benefits of traditional deferred compensation, but does so within a nonqualified stock option platform. For example, if Employee A wants to defer $10,000 in the plan, the company will issue "in the money" options on mutual funds with a starting value of $10,000. The "in the money" portion, or "spread" will fluctuate in value in sync with the increase or decrease of the share price of the mutual funds. When Employee A wishes to access cash, he simply exercises the option and receives the money.

How does this solve the top hat problem? Nonqualified stock options are governed by Section 83 and are available to all classes of employees so an employer has almost unlimited leeway in defining the eligible group. For this company, the result was a good one: they were able to restore a valued benefit to many of the high-impact employees, while preserving the original plan's financial benefits for all.

Return to Table of Contents