The Employee Retirement Income Security Act of 1974, commonly known as ERISA, is probably the most comprehensive set of rules and regulations ever imposed on the maintenance of employee benefit plans. Its primary intent is to limit abuse and discrimination in retirement plans, with respect to benefits and contributions, and participation afforded "rank and file" employees as compared to management and highly compensated employees.

In return for following the rules of ERISA, qualified plans enjoy favorable tax status to both the employer and employee:

  • Employers get an immediate income tax deduction (within limits) for contributions to qualified plans.
  • Employees are not taxed on contributions and earnings credited to the plan until they are actually received.

This is one of the rare occurrences in tax law in which a tax deduction (employer's) is not immediately offset with some entity incurring taxable income (employee's).

ERISA also imposes specific obstacles unrelated to taxes. These obstacles are found under Title I of ERISA and deal with administrative and design issues, which if not overcome, could seriously impact corporate objectives with respect to Nonqualified Deferral Plans (NQDP).

An NQDP should be designed to be exempt from most, if not all, the requirements of ERISA Title I.

Plans Exempt From ERISA
Certain plans are statutorily exempt from Title I of ERISA:

  • Plans of state, federal, or local governments
  • Plans of churches, synagogues, or related organizations 
  • Plans maintained outside the U.S. for non-resident aliens 
  • Unfunded excess benefit plans 
  • Top hat plans

The first three exemptions listed above do not apply to U.S. businesses and corporations. The fourth, the unfunded excess benefit plan, is an exemption for a type of plan that provides a benefit in excess of the Internal Revenue Code (IRC) Section 415 benefit limitation. Section 415 limits the amount of the benefit that may be provided through a qualified defined benefit pension plan.

The fifth exemption, for top hat plans, is the one that is utilized by almost every NQDP. Top hat plans are unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.

A key objective of NQDP design is to avoid the Plan being considered funded for ERISA purposes, thereby qualifying for the top hat exemption. Critical to the qualification for the top hat exemption are:

If a NQDP were not to qualify for the top hat exemption, the impact of ERISA would be an additional burden, without enjoying the tax advantages of a qualified plan.
The following are the specific parts of Title I that would affect an NQDP if it were not exempt from ERISA.


Non-Exempt Plans

Top Hat Exempt Plans

No non-exempt plan may require, as a condition of participation in the plan, that an employee complete a period of service extending beyond the later of (a) attaining age 21, or (b) completing one (1) year of service.  As an example, a qualified pension plan may postpone participation until the later of  (a) the employee reaching age 21 or (b) completing 1 year of service, but could not use an age/service requirement greater than 21/1.

An exempt plan is permitted to use any age and any service requirement for participation.  So a nonqualified plan satisfying the top hat exemption may exclude, as an example, all executives, under the age of 45, with less than 5 years of service.


Non-Exempt Plans

Top Hat Exempt Plans

A non-exempt plan is required to provide a vesting schedule, which gives the participant a non-forfeitable right to his benefits derived from employer contributions, according to one of two schedules:

         Full vesting after 5 years of service-no vesting prior to 5 years (Cliff Vesting).

         20% vesting after 3 years of service, increasing by 20% per year, with full vesting after 7 years (Graded Vesting).

It must also provide immediate non-forfeitability (vesting) to benefits derived from the employee's contributions.

A top hat exempt plan is not required to provide any vesting schedule.  Employer matching or discretionary contributions balances may be set up to reward long term employees by employing long term vesting schedules, or even no vesting at all until retirement.


Non-Exempt Plans

Top Hat Exempt Plans

ERISA requires plan sponsors to make sufficient contributions to the plan to ensure that the plan will have enough money to pay the benefits promised. The funds must be held in a trust that may not revert to the employer, without incurring a penalty.   Funding would result in the contributions or benefits being taxed to the participant as they vest.  This would defeat the main purpose of the plan, and also place the participant in the position of having to pay tax on plan benefits prior to receipt.

A top hat exempt plan is not required to set aside any funds to cover the liabilities of the plan.

Reporting and Disclosure

This section of Title I is probably the most costly and time consuming.

Non-Exempt Plans

Top Hat Exempt Plans

The Reporting  and Disclosure provisions require non-exempt plans to provide a variety of information and forms to plan participants, in addition requiring a number of forms to be filed with the Department of Labor (DOL) and the Internal Revenue Service (IRS).  The following is a partial list of required information and forms:

         Form 5500
Filed with the IRS each year.  It provides financial information with regard to the Plan, and consists of many schedules and statements.  Form 5500 is essentially a tax return for the plan.

         Summary Annual Report (SAR)
This is a brief summary of key financial information from Form 5500, and must be provided to plan participants each year.

         Summary Plan Description (SPD)
This document summarizes major provisions of the plan, and must contain the required information as decided by the DOL.  The SPD must be filed with the DOL and a copy given to each plan participant.

A top hat plan is also subject to ERISA's Reporting and Disclosure requirement but on a limited basis.  Fortunately, the DOL permits a simple method of compliance, as opposed to the requirements discussed to the left:

The employer must file a statement with the DOL within 120 days of establishing the plan and it must include:

         the employer's name, address, and Federal ID number.

         a statement that the employer maintains  the plan primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.

         a statement of the number of such plans and the number of employees in each plan.

The employer is also required to provide plan documents to the DOL upon request.

Fiduciary Standards

Non-Exempt Plans

Top Hat Exempt Plans

A non-exempt plan is subject to the Fiduciary section of Title I requiring the following:

         The plan must be in writing.

         Plan assets must be held in trust (except for insurance policies).

         The plan must have a named fiduciary.

         The plan must provide a procedure for carrying out a funding policy and method consistent with the objectives of the plan.

         The plan must provide a formal procedure for amending the plan.

         The plan must specify the basis on which payments are made to and from the plan. 

         The plan or fiduciary cannot engage in any of the prohibited transactions.

In general, fiduciaries have specific duties and responsibilities and must conduct business under "established standards of care" and can be held liable for their actions.

A top hat exempt plan is completely exempt from the fiduciary standards.

Administration and Enforcement

Non-Exempt Plans

Top Hat Exempt Plans

Non-exempt plans are required to:

         implement a formal claims procedure.

         provide adequate notice in writing to any participant or beneficiary whose claim for benefits under the plan has been denied.

         afford a reasonable opportunity to any participant whose claim for benefits has been denied for a full and fair review.

Top hat exempt plans are subject to the Administration and Enforcement rules.

How To Achieve the Top Hat Exemption

The keys to achieving the top hat exemption are satisfying the:

  • select group definition. 
  • unfunded definition.

Select Group Definition
The DOL has never issued a clear definition of "management", "select group", or " highly compensated". They have issued opinion letters in the past, but have since stated that these opinions may no longer be relied on for guidance, and a separate determination must be made for each employer based on the compensation and management demographics of the employer's total work force.

Some practitioners have relied upon the definition used for qualified plans, which in essence considers any employee with compensation in excess of $90,000 (for calendar year 2004) a highly compensated employee. Many plans define eligible participants as those earning salary in excess of the annual compensation limit, currently $205,000 (for calendar year 2004).

Most practitioners would agree that the plan should limit participation to a small group of highly paid executives, relative to the employee population - not to exceed 15% of the employees of an organization. In addition, an employee to be considered as management, should have definitive management responsibilities and duties.

An NQDP should also contain what is commonly called an "unwind provision", which states that if a plan participant is found not to be a member of the select group for any reason, then that participant's account balance would be distributed immediately.

Unfunded Definition
A plan is considered unfunded as long as the contributions are not held in trust for the exclusive benefit of paying out benefits, as is the case for qualified plans. The assets that are accumulated must be subject to the claims of corporate creditors.

This does not prevent the employer from "informally" accumulating assets earmarked for paying out benefits, such as purchasing mutual funds, corporate owned life insurance, or any other accumulation vehicle.



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