What's a Top-Hat Plan?

There are two basic ways a court can end up deciding whther a plan is a top-hat plan or not. The first is to decide under ERISA exemption provisions, and the second is in a claim for benefits where the sponsor is bankrupt. In In re IT Group, Inc., 2006 WL 1421016 (3rd Cir. 2006), the Third Ciruit got one of the latter. The case not only looks at top-hat status, but also clearly pijnts out the downside of being "unfunded".

The claimants were participants who alleged that the plan required the establishment of rabbi trust, with all the customary disclaimers in the plan and the trust agreement. The decision also assumed that the plan was for a select group of management and highly compensated employees. so that funding was the only real issue.

The court decided that this was a case of first impression. Footnote 3 says "In previous cases involving deferred compensation plans offered to management and highly compensated employees, we have always assumed, without further examination, that ERISA’s “top hat” exemption applies. See, e.g., Goldstein v. Johnson & Johnson, 251 F.3d 433, 435 (3d Cir. 2001) (considering the proper scope of judicial review of an administrator’s decision to deny benefits owed under a top hat plan); Senior Executive Benefit Plan Participants v. New Valley Corp. (In re New Valley Corp.), 89 F.3d 143, 148 (3d Cir. 1996) (“Both plans at issue are top hat plans . . . .”); Kemmerer v. ICI Americas Inc., 70 F.3d 281, 284 (3d Cir. 1995) (“The dispute on appeal centers around [an] executive deferred compensation plan, which like all such plans is commonly referred to as a ‘top hat’ plan.”)."

However , they still manage to cite other decisions on unfunded welfare plan status, as follows: The Eighth Circuit Court of Appeals has examined this issue from both sides. In considering whether a death benefit plan supported by a life insurance policy was subject to ERISA’s substantive requirements, it stated that “[f]unding implies the existence of a res separate from the ordinary assets of the corporation.” Dependahl v. Falstaff Brewing Corp., 653 F.2d 1208, 1214 (8th Cir. 1981). The plan was “funded” because the insurance policy provided “a res separate from the corporation” to which beneficiaries could look for payment of benefits under the plan. Id. On the other hand, an excess benefit plan that specified that the rights of the beneficiary under the plan would “be solely those of an unsecured creditor” was unfunded, even though the employer had purchased an insurance policy to help it finance the plan, because the policy in that case “simply became a general, unpledged, unrestricted asset of the [employer] and those . . . assets in turn would be used to fund [the] plan.” Belsky v. First Nat’l Life Ins. Co., 818 F.2d 661, 663-64 (8th Cir. 1987). Similarly, the Second Circuit Court of Appeals has observed that a plan under which benefits were to be paid “‘solely from the general assets of the employer’” is unfunded. Demery v. Extebank Deferred Compensation Plan, 216 F.3d 283, 287 (2d Cir. 2000) (quoting Gallione v. 17 Flaherty, 70 F.3d 724, 725 (2d Cir. 1995)). More recently, it adopted a standard first articulated in Miller v. Heller, 915 F. Supp. 651 (S.D.N.Y. 1996):
the question a court must ask in determining whether a plan is unfunded is: can the beneficiary establish, through the plan documents, a legal right any greater than that of an unsecured creditor to a specific set of funds from which the employer is, under the terms of the plan, obligated to pay the deferred compensation?” Demery, 216 F.3d at 287 (quoting Miller, 915 F. Supp. at 660). Applying this test, the court found that a deferred compensation plan that was financed using life insurance contracts, the proceeds of which were kept in a separate account, was unfunded. According to the court, the plan’s terms did not “give plaintiffs a greater legal right to the funds in the Deferred Compensation Liability Account than that possessed by an unsecured creditor.” Id. Although the account was separate, it was part of the “general assets” of the corporation, and the plan was therefore “unfunded as a matter of law.” Id. The Fifth Circuit Court of Appeals employed a similar analysis, but also considered the tax treatment of the plan. In Reliable Home Health Care, Inc. v. Union Central Insurance Co., 295 F.3d 505 (5th Cir. 2002), it surveyed the decisions of the other courts of appeals, and noted that the Department of Labor had provided the following guidance: “‘[A]ny determination of the ‘unfunded’ status of an ‘excess benefit’ or ‘top hat’ plan of deferred compensation requires an
examination of the facts and circumstances, including the status of the plan under non-ERISA law.’” Id. at 513 (quoting Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7 (May 19, 1992)). More specifically, the court emphasized DOL’s advice that the tax consequences of the plan should be considered in the analysis, id. (citing DOL Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7), and noted a district court’s holding that “a ‘plan is more likely than not to be regarded as unfunded if the beneficiaries under the plan do not incur tax liability during the year that the contributions to the plan are made,’” id. at 514 (quoting Miller, 915 F. Supp. at 659). Combining all of this information, the court devised the following test: in determining whether a plan is “funded” or “unfunded” under ERISA, a court must first look to the surrounding facts and circumstances, including the status of the plan under non-ERISA law. Second, a court should identify whether a [plan] is funded by a res separate from the general assets of the company. Id. 4As noted above, a plan under which the beneficiaries do not incur tax liability during the year that the contributions to the plan are made is “more likely than not” an “unfunded” plan. Miller v. Heller, 915 F. Supp. 651, 659 (S.D.N.Y. 1996). This is so because the tests for taxation of deferred compensation and for funding status ovelap–deferred compensation is not taxable as current income only where the future payment of the compensation is somehow uncertain, i.e., where the assets used The Reliable court concluded, under this test, that a death benefit plan was unfunded. Like the plans at issue in Demery and Belsky, the plan was financed through the purchase of life insurance contracts on behalf of participating employees. However, those contracts belonged to the company, not the participating employees. Plan participants were prohibited from contributing to the plan, and did not treat the company’s contributions to the plan on their behalf as taxable income. Thus, the plan was unfunded and exempt from ERISA’s substantive provisions. Id. at 514-15. We agree with our fellow courts of appeals that the keys to the determination of whether a plan is “funded” or “unfunded” under ERISA are (1) whether beneficiaries of the plan can look to a res separate from the general assets of the corporation to satisfy their claims; (2) whether beneficiaries of the plan have a legal right greater than that of general, unsecured creditors to the assets of the corporation or to some specific subset of corporate assets. We may also consider the plan’s intended and actual tax treatment. We will analyze the to pay participants’ claims are also subject to other creditors’ claims. Thus, the fact that a plan qualifies for deferred taxtreatment strongly supports the conclusion that it was unfunded.
See Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7 (May 19, 1992) (noting that “the tax consequences to trust beneficiaries should be accorded significant weight” in determining whether a plan is “funded” or “unfunded”)."

Th Court then determined (1) that the plan was a top-hat plan, (2) that the employees were not entitled to a priority claim in the bakruptcy, and (3) that no one involved with the plan had breached any fiduciary duties.

This decision is not overwhelmingly important for Sections 403(b) and 457, certainly not as important as an effort to determine what constitutes a select group. Nonetheless, it points out the fact that some legalese has a purpose, and shows what language needs to be included in nongovernmental Section 457 plans.