A top hat plan is an unfunded non-qualified deferred compensation agreement for a select group of management or highly compensated employees.
What does this mean in plain English?
A top hat plan is a non-secured (unfunded) agreement between employer and employee to pay the employee deferred income at a specific time when certain milestones are met. Unfunded means there is not a trustee holding the monies as with a qualified retirement plan. The employer makes a bookkeeping entry on the company general ledger for the deferred amount which is an unsecured liability. The employer usually, at the same time, sets aside funds to pay the liability. However, these funds are subject to claims of the general creditors of the company. For a qualified plan on the other hand, the company would deposit funds on a periodic basis with the plan trustee to be held for the sole benefit of the employee.
Non-qualified means the plan does not have the advantage of permitting an employee to defer tax on the funds set aside for his benefit while at the same time permitting the employer a current income tax deduction for the funds that are set aside. A contribution deposited for your benefit with a qualified plan trustee is not taxed to you this year. Instead it is deferred until you take the distribution from the qualified plan. For a top hat plan (also called a non-qualified deferred compensation plan, NQDC) the amount deferred is taxed when you have the ability to access the money at which time the employer is entitled to take a compensation deduction..
Who is a select group of management or highly compensated employees?
This group consists of people who by virtue of their position or their compensation level at the company 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 (of ERISA) (from The Department of Labor Advisory Opinion 90-14A issued May 8, 1990). In other words, upper management of the company are the only ones who can have top hat plans. Careful attention needs to be paid to this definition for a plan to have top hat status This is because Title I of ERISA imposes on nonqualified deferred compensation plans many of the same requirements designed to protect beneficiaries (including the non-discrimination provisions) as Title II of ERISA imposes on qualified plans unless a non qualified plan meets the top hat exception.
Why would anyone want an unfunded plan subject to the company’s general creditors?
A top hat plan is a desired addition to an executive’s compensation package and is an effective tool to incentivize key management to stay with the company. If it is funded it would not be exempt from the ERISA Title I provisions that require nonqualified deferred compensation plans to not be discriminatory. In addition, generally recognized tax rules would require a beneficiary of a funded plan to pay tax at the time funds are set aside for his benefit.The top hat plan is most often in addition to the company’s qualified plans. The amount of income which an executive can defer in a top hat plan is not subject to statutory limitations.
Is there an administrative burden?
As mentioned above, top hat plans are exempt from many requirements of ERISA including participation, vesting, notice and eligibility requirements. The company has the discretion to determine who has a top hat plan.
Is any filing required for a top hat plan?
A top hat plan does not have the administrative burden of filing annual reports as does a qualified plan or a non qualified plan not meeting the requirements of a top hat plan as long as a simple one page notice of the plan is filed with the US Department of Labor. To qualify for this administrative relief the Plan must file the notice with the US Department of Labor within 120 days of creation.
What other requirements must be considered?
Any overview of top hat plans must include IRC §409A. §409A was codified in response to the corporate scandals of companies such as Enron and Global Crossings. The purpose of §409A is to prevent executives from manipulating and abusing deferred compensation in financially troubled companies. All deferred compensation plans need to be in compliance with the requirements of §409A. IRC §409A restricts the ability of the executive to change deferral elections and requires prohibitions on the acceleration of the deferred amount by the executive.
How to determine if a top hat plan would work for you?
Top hat plans can be used by for profit and not for profit companies. Employees of tax exempt not-for profit employers, however, are taxed on the deferred income when they have a nonforfeitable right to receive it rather than being able to wait until they actually or constructively receive the funds as is permitted for employees of taxable employers. Top hat plans are advantageous for employees who want to defer more income than is permitted by the qualified plan rules The same deferral opportunities would not necessarily be available to owners of an S corporation or an LLC as income is passed through to the owner each year and the deferral amount is not deductible until paid to the employee.
There are different types of top hat plans to be considered including SERPs (supplemental employee retirement plans), unfunded excess benefit plans, voluntary deferral plans and wraparound §401(k) plans.
There are also commonly used methods of informally funding the unfunded plans.
A top hat plan can provide significant advantages to key employees and should be considered in detail as part of an overall executive compensation review for your company.