Check on Your Unicorns: Is Your Top-Hat Plan Really a Top-Hat Plan?

If you were to ask benefits professionals which type of plan is simplest to oversee, many of them would likely say top-hat plans. That is because while they are technically ERISA plans, top-hat plans are not subject to ERISA’s most stringent requirements, including the participation and vesting rules, minimum funding requirements or fiduciary responsibility. As a result, many organizations have a tendency to “set and forget” their top-hat plans, often for years at a time. Unfortunately, such organizations often forget the most important fact about top-hat plans: in order to remain exempt from most of ERISA’s requirements, top-hat plans must continuously satisfy a certain set of criteria.

To qualify as a top-hat plan, a plan must be unfunded and “maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” Like many requirements in the benefits world, satisfying this set of exemption criteria is easier said than done for one simple reason: none of these phrases have ever been officially defined by the U.S. Department of Labor (DOL). This article examines what it means to satisfy those criteria and what the stakes are for sponsoring employers who get it wrong.

The Enforcement Landscape

The good news for sponsors of top-hat plans is that the area does not appear to be an enforcement priority for the DOL or the Internal Revenue Service (IRS). In a 2020 report issued by the Government Accountability Office (GAO), the DOL stated that it rarely encounters compliance issues with top-hat plans because it is not a commonly reviewed issue. The DOL also noted that although the one time required top-hat filing does not request any data regarding the class of eligible participants – which would help it enforce the exemption criteria for top-hat plans – it had no plans to begin collecting such information.

The bad news is that the issue does commonly arise in a more chaotic setting – federal courts. Lawsuits challenging the validity of a top-hat plan generally have a similar factual background: a high-level employee leaves a company on bad terms, and for one reason or another does not receive any benefits from the company’s top-hat plan. The disgruntled employee then sues for benefits, arguing that the top-hat plan does not satisfy the exemption criteria and is therefore subject to the full gamut of ERISA requirements, including vesting provisions and fiduciary responsibility.

A court ruling that a top-hat plan is not actually a top-hat plan can be devastating for the sponsoring company. Benefits it did not previously believe were subject to vesting may become payable to former participants. Further, company leaders responsible for overseeing the plan can be found as having a fiduciary duty and be held personally liable for paying any benefits or damages owed. To add insult to injury, both the DOL and the IRS have acknowledged that there is no approved method to correct top-hat plan compliance issues – meaning the plan, once declared not a top-hat plan, will remain that way indefinitely.

What Meets the Exemption?

Arguments that a plan is not a top-hat plan generally fall into two categories: that the plan does not provide for “deferred compensation” and that participation is not limited to a “select group of management or highly compensated employees.” The first category has, historically, not been a winner for plaintiffs. That is because courts have generally been willing to adopt a broad reading of the phrase “deferred compensation” – which is left undefined in the relevant ERISA provisions. As a judge for U.S. District Court for the Southern District of Ohio recently held in Kramer v. American Electric Power Executive Severance Plan, it is generally enough that a top-hat plan simply “provide future compensation for past work.”

It is the second category – challenges to the “select group” criterion – where problems tend to arise. The DOL guidance on what constitutes a “select group” is generally limited to a handful of Opinion Letters (which the DOL no longer issues on this topic). As a result, courts have developed their own set of analyses and criterion over the years. Nationally, courts agree that there is no bright line test for what constitutes a “select group” and that answering the question requires weighing both qualitative and quantitative elements. While weight given to each element varies by jurisdiction, the following are the most common questions courts ask when evaluating for selectivity:

1. What percentage of the employer’s total workforce is eligible to participate in the plan?

The fewer employees who can participate, the more likely it is that a plan will meet the “select group” requirement. For a long time, it appeared the unofficial cutoff point for courts was around 15 percent – this was thanks to a Second Circuit decision, Demery v. Extebank Deferred Compensation Plan (B), which held that a plan permitting 15.34% of an employer’s workforce to participate was “at or near the upper limit of the acceptable size for a ‘select group.’” Similarly, the Fourth Circuit ruled in Darden v. Nationwide Mutual Insurance Company that a plan with 18.7% participation was too big to qualify. However, in a 2021 case, Browe v. CTC Corporation, the Second Circuit noted that a top-hat plan open to 30 percent of a company’s workforce could potentially meet the selectivity criteria – especially if the company at issue was small. The ruling suggests there may be more flexibility in this category than previously thought.

2. What is the nature of employment duties for plan participants?

Legislative history shows that Congress did not intend for top-hat plans to be available to “rank and file” employees. Accordingly, the broader the eligibility factors, the less likely a plan is to meet the “select group” requirement. As noted in Browe, courts look to see whether participants hold actual managerial responsibilities. For example, in Bakri v. Venture MFG Company, the Sixth Circuit found that a plan whose participants included secretarial/administrative positions and individuals who had “manager” titles but did not actually supervise anyone did not satisfy the selectivity requirement. Similarly, a 1985 DOL Advisory Opinion found that a plan which covered a wide swath of employees at a shoe company – from the Chairman of the Board to an ordering clerk – did not meet the “select group” requirement.

3. What is the compensation disparity between plan participants and other company employees?

The broader the compensation disparity between plan participants and other company employees, the more likely a plan is to satisfy the “select group” requirement. For example, the court in Demery found that plan participants earning an average of twice the salary of non-participating employees would suggest a plan is sufficiently selective. In contrast, in Browe the court noted that plan participants earning anywhere from $10,000 to $100,000 a year would suggest a plan does not satisfy the “select group” requirement.

4. Do plan participants collectively have the ability to negotiate the terms of the plan?

In evaluating selectivity, the Second, Sixth, and Ninth Circuits have all looked to the underlying rationale of the top-hat exemption – that the intended beneficiaries are those who do not require ERISA’s stringent protections because they have the ability to negotiate the terms of the plan. Accordingly, these three circuits have analyzed whether there is any evidence that plan participants could, or did, negotiate regarding plan terms. In contrast, the First and Third Circuits have expressly refused to consider the bargaining power of plan participants, noting that Congress chose not to include such a criterion in the final top-hat statute.

Any small child can tell you that a unicorn without a horn is just a horse. Similarly, benefits professionals must remember that a top-hat plan that doesn’t meet the exemption criteria is just an ordinary ERISA plan – and a neglected one at that. A ruling that a top-hat plan is not really a top-hat plan is potentially devastating – leaving both the sponsoring employer and individual company leaders found to be fiduciaries liable for previously awarded plan benefits and additional damages. In order to avoid such a scenario, employers offering top-hat plans should regularly review who is participating in their plan and consider how a court might judge the arrangement based on the questions above.

If you have questions about top-hat plans or would like to review your plan, contact Emily Pelligrini or another member of Reinhart’s Employee Benefits Practice.