Top-Hat Plans (Including SERPs)

What Is It?

In General

A top-hat plan is a kind of non-qualified deferred compensation (NQDC) scheme designed to offer unfunded benefits of deferred compensation to a limited number of highly compensated employees or members of management. (The term "unfunded" refers to the fact that employers use their general assets rather than explicitly setting aside money for these perks.) The majority of the stringent Employee Retirement Income Security Act (ERISA) regulations that apply to funded NQDC plans and qualified benefit plans are not applicable to top-hat plans. Because of this, top-hat plans have a great deal of flexibility when it comes to determining which employees receive benefits, how much benefits are awarded, and when employees are eligible for benefits.

Tip: Although the terms "supplemental executive retirement plan" and "top-hat plan" are sometimes used interchangeably, a "supplemental executive retirement plan" (also known as a "SERP") is a particular kind of top-hat plan that adds to an employee's qualified plan benefits. Later in this post, we'll go into greater detail about SERPs.

Caution: A top-hat plan has to be underfunded and restricted to highly compensated staff or a small subset of management. If either of these conditions isn't met, a NQDC plan will usually be heavily regulated by ERISA.

What Constitutes a 'Select Group of Management or Highly Compensated Employees?'

Although the term "select group of management or highly compensated employees" lacks a clear legal definition, it typically refers to a small portion of the workforce that consists of key management personnel or those whose salaries are much higher than those of other employees.

The number of employees in the company compared to the number of workers covered by the NQDC plan; the select group's average salary in comparison to other employees' average salaries; the select group's average salary in comparison to the average salary of all management or highly compensated workers; the range of salaries paid to select group members; and the degree to which the select group is able to negotiate salary and compensation packages are just a few of the factors that courts and the Department of Labor (DOL) have examined over the years.

Caution: The highest percentage of the workforce that can be covered under a NQDC plan in order to have a "select group" is 15%, according to case law. When creating a NQDC plan, you should speak with a pension specialist as there isn't a clear-cut test.

Furthermore, according to the DOL, the term only applies to those workers who, as a result of their position or pay grade, have the power to influence how the deferred compensation plan is created and run. Stated differently, the DOL suggests that the select group should be made up of workers who would normally have the ability to bargain for their pay. From this perspective, the benefits of a NQDC plan would only accrue to a very tiny portion of the workforce. But historically, the courts have acted more liberally than the DOL.

Why Would You Want to Establish a Top-Hat Plan?

To Provide Employer-Paid Deferred Compensation to Key Executives

Key executives who are in a high tax rate can delay their income until retirement, when they will probably be in a lower tax band, by implementing a top-hat plan. This delay has a large positive economic impact, particularly if the money are held back for an extended length of time. This perk might assist you in drawing in and hiring competent workers as well as act as a motivator for executives to stay with your business.

To Provide Deferred Benefits to Key Executives Above And Beyond the Limitations on Contributions and Benefits Under Qualified Plans

There are several restrictions on contributions and benefits for qualified plans. High-paid CEOs are especially hard hit by these restrictions. For instance, in a qualified defined contribution plan, the maximum annual contribution amount to a participant's account that can be made by the employer, employee, and forfeitures is $57,000 (in 2020, instead of $56,000 as in 2019) or 100% of the participant's pay. [In 2020, (increased from $6,000 in 2019), employees fifty years of age and over may defer up to $6,500 to a 401(k) plan in excess of these dollar restrictions.]

The highest annual benefit that can be obtained from a qualified defined benefit plan is 100% of final average salary, or $230,000 (in 2020, instead of $225,000 in 2019). Furthermore, the highest yearly salary that can be taken into account for these computations is $285,000 (for 2020, up from $280,000 in 2019). The limitations on contributions for eligible benefit plans don't end here. With a top-hat plan, on the other hand, you can offer deferred pay to your most valuable employees without being constrained by the same rules and regulations that apply to qualified plans with respect to contribution caps and benefits.

To Provide an Incentive for Early Retirement

Your important employees might need to enroll in both a top-hat plan and a qualified retirement plan in order to have the money to retire early. If an employee exclusively participates in a qualified plan, they might not have enough money to retire early due to the plan's many restrictions and contribution caps. A qualified plan also has a significant early distribution penalty tax. Participating in both the qualifying plan and the top-hat plan allows an employee to save enough money for a prosperous early retirement.

To Avoid Certain ERISA Requirements

Retirement plans covered by ERISA are required to adhere to stringent regulations on fiduciary, distribution, reporting, participation, vesting, and funding. A top-hat plan is, however, free from the majority of these regulations. This exception is based on the argument that since top executives are able to bargain directly with their employers for their own remuneration packages, they are not in need of ERISA protection. Governmental and the majority of church retirement plans are exempt from ERISA. Referred to as 457 plans, NQDC plans managed by government and tax-exempt companies are subject to a unique set of regulations.

How Does a Top-Hat Plan Work?

In General

When the benefits under a top-hat plan come due, you usually use your general assets to cover the costs. Consequently, the executive takes the risk that these benefits might not be paid at all and must rely only on your unfunded pledge to pay them. You can decide to fund your top-hat plan with company-owned life insurance or a rabbi trust, which will give your employees differing degrees of security about the payment of promised benefits.

Any vehicle you choose to covertly fund your top-hat strategy, however, needs to continue to be vulnerable to general creditors' claims. Therefore, in the event of your bankruptcy or insolvency, your employees may forfeit their benefits. From the viewpoint of the worker, this is one of the main drawbacks of an unfunded NQDC scheme.

Caution: Most top-hat plans are subject to the special requirements found in IRC Section 409A regarding deferral elections, distributions, and funding. The plan benefits of impacted participants for that year and all previous years may become immediately taxable and subject to fines and interest charges if your top-hat plan does not adhere to these standards. When creating a top-hat plan, it is crucial that you are aware of and abide by the regulations under IRC Section 409A.

 

Employee Elective Salary and Bonus Deferrals

It is possible to design a top-hat plan that gives members the option to choose to contribute a portion of their bonus and/or income to the NQDC plan. In contrast to a "non-elective" plan, which offers benefits entirely funded by the employer, this is frequently referred to as a "elective" NQDC plan. Generally speaking, the election needs to be submitted in writing prior to the tax year in which the pay is actually collected. If the performance term is at least 12 months, there are situations in which the decision to defer bonuses can be made as late as six months before the conclusion of the period. When choosing to postpone remuneration, an employee generally has to choose the mode and date of payment as well.

Unlike a 401(k) plan, where (in 2020) deferrals are limited to $19,500 ($26,000 if age 50 or older) and total contributions are limited to $57,000 (with catch-up contributions), a participant in a top-hat plan can defer any amount of remuneration.

Discretionary Employer Contributions

Employer contributions may be included in a top-hat plan in addition to or instead of employee salary deferrals. Usually, these employer contributions are optional. In other words, the majority of plans are designed to provide employers full control over the payments they make. The employer is not obliged to make any deposits in any given year. Vesting provisions typically apply to employer contributions. For instance, a plan can stipulate that employer contributions and associated profits are forfeited in the event that an employee leaves the company before reaching a certain age or doesn't work for the company for a predetermined period of time.

Accounting and Investment Control

Defined contribution (also known as individual account) plans and defined benefit plans are the two primary categories of unfunded NQDC plans. Pension-like benefits are paid out under defined benefit plans, frequently in accordance with final average pay or years of service. The benefits offered by the plan are frequently greater than those that fall under the purview of an employer's eligible pension plan. The value of each employee's individual deferred compensation account determines their benefit under an individual account plan. This is a bookkeeping account that is credited with employee deferrals, employer "contributions," and investment earnings; it is not a genuine, funded account.

Because they are merely credits to the participant's NQDC plan bookkeeping account, these are frequently referred to as "hypothetical" or "notational" earnings. Employees are frequently able to 'guide' the investments made in their own accounts. Generally, the employer (or trustee in an informal NQDC plan funded by a rabbi trust) is under no need to make any real investments in the way the participant has chosen. The employer agrees to credit the participant's accounting account with a certain amount of hypothetical earnings on a periodic basis; this is controlled by the participant's investment election. The IRS has previously argued that the participant's "dominion and control" over the employer (or trustee) could lead to immediate taxation under the constructive receipt or economic advantage theories if the employer (or trustee) is required to actually invest assets as instructed by the participation.

Top-Hat Plans That Supplement Qualified Plan Benefits — SERPs

A typical non-elective top-hat plan offers a post-retirement pension benefit that is paid on top of Social Security and eligible plan benefits for the employee. These programs are frequently referred to as SERPs, or supplementary executive retirement plans. The NQDC plan retirement benefit is what the employer pays to the employee after the employee retires. For instance, these SERPs may compute a certain pension for the employee and then deduct that amount from the benefits the employee actually receives from Social Security and the employer's qualified plans. These plans frequently have vesting clauses or are connected to the employer's qualifying plan's vesting schedule.

Payment of Benefits

Employers have the option to design a top-hat plan that will pay benefits at a predetermined time or upon retirement, separation from service, disability, death, or unanticipated emergency. Benefits may be awarded as a single large payment or as a series of yearly installments. It's customary to get payments for a set number of years, such five or ten, or life annuities.

If the plan is properly structured, the majority of ERISA regulations won't apply, thus you can usually design your own forfeiture and vesting timeline with some degree of flexibility. For instance, you might make it clear that workers who quit before reaching retirement age will no longer be eligible for benefits.

Caution: IRC Section 409A contains detailed rules that govern the distribution of NQDC plan benefits.

ERISA Requirements

As previously mentioned, top-hat plans are free from the majority of onerous ERISA regulations. Nonetheless, there are typically two ERISA requirements that you need to make sure you adhere to while putting a top-hat plan into action. The Department of Labor (DOL) must first receive a one-page notification letter from you (or, more precisely, the plan administrator, which is usually the employer). This letter must include your company's name, address, employer identification number, number of top-hat plans you maintain, number of participants in each plan, and a statement stating that the employer maintains the plan(s) primarily for the purpose of providing deferred compensation for a select group of highly compensated employees or management.

In order to avoid the plan being subject to all of ERISA's reporting and disclosure requirements, the letter must be sent to the DOL within 120 days of the plan's establishment. Second, you have to notify participants about the ERISA claims processes that are applicable to your plan (which are usually outlined in the NQDC plan document), as top-hat plans are subject to the administrative provisions of ERISA.

Tip: In Advisory Opinion 2008-08A, the DOL has provided guidance on how to file the top-hat letter if your plan covers employees of more than one employer (for example, where two or more employers in a controlled group of corporations sponsor the plan).

Federal Income Tax Treatment

Employer Considerations

You are entitled to deduct amounts you contribute to the top-hat plan when they are includable in your employee's gross income. In other words, you can generally take the deduction when your employee actually receives the money from the plan. You can also deduct earnings when paid from the plan.

Caution: If you set aside assets too informally fund future benefits under the plan (for example, in a rabbi trust), you must pay income tax on any earnings attributable to those allocated funds. For this reason, corporate-owned life insurance (COLI) is often used to informally fund top-hat plans, because the inside cash value builds up on a tax deferred basis (unless the alternative minimum tax rules apply).

Employee considerations

In most cases, your employee doesn't incur any income tax on amounts contributed to a top-hat plan until the funds are actually paid to him or her from the plan.

Caution: In some cases, it may be possible for an employee to be subject to federal income tax on amounts contributed to a top-hat plan prior to the actual receipt of the funds by the employee. For more information, see our separate topic discussion, Non-qualified Deferred Compensation Plans.

Internal Revenue Code Section 409A

IRC Section 409A, enacted as part of the American Jobs Creation Act of 2004, contains election, distribution, and funding rules that apply to top-hat plans. These new rules generally apply to compensation deferred after December 31, 2004 (although compensation deferred earlier is also covered in some cases). If a plan fails to comply with Section 409A's requirements, then affected participants will be subject to income tax and penalties on their accrued benefits in the year of the failure (or if later, when those benefits vest). You should consult your pension professional regarding the potential impact of Section 409A before adopting any top-hat plan.

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