In response to a request by U.S. Senators Ron Wyden (Oregon), Bernie Sanders (Vermont) and Patty Murray (Washington), the Government Accountability Office (“GAO”) earlier this year completed a study and published a report with its findings on executive retirement plans and specifically “top hat” plans. The report examined the prevalence, key advantages and revenue effects of executive retirement plans and how federal oversight protects benefits and prevents ineligible participation.

As a reminder, “top hat” retirement plans are unfunded employee benefit plans maintained by employers to provide deferred compensation to a select group of management or highly compensated employees. Properly designed top hat plans are exempt from the eligibility, vesting, funding and fiduciary rules under ERISA, but do remain subject to its administration and enforcement provisions and to some limited disclosure requirements. To qualify as a top hat plan and be eligible for the ERISA exemptions, the plan must be unfunded and must ensure that the “select group” of management or highly compensated employees is not inadvertently expanded to include individuals who may be determined to be outside the “select group”. The “select group” that can be covered under a top hat plan is not defined under ERISA or the regulations, so plan sponsors must follow the guidelines developed by the courts and the Department of Labor (“DOL”). Moreover, the DOL takes the view that the inclusion of any employees who are not from a select group of management or highly compensated employees cause the plan to fail the “select group” requirement and would subject the plan to all of the requirements of Title I of ERISA. See DOL Advisory Opinion 90-14A.

In addition, since retirement plans with top hat status cannot be tax-qualified plans, given the requirement that they cover only the more highly compensated of the employer’s workforce, they must qualify for an exemption from or comply with Section 409A of the Internal Revenue Code, which governs the taxation of nonqualified deferred compensation. The deferred compensation must also remain part of the employer’s general assets and subject to the employer’s creditor claims until executives receive actual distributions in order to receive tax deferral.

According to the GAO, as of 2017, more than 400 of the S&P 500 companies offered top hat retirement plans to almost 2,300 of their top executives, totaling about $13 billion in accumulated benefit promises.

The GAO report reviewed the role of the Internal Revenue Service (“IRS”) in overseeing executive retirement plans for compliance with federal tax laws, which it does through audits of sponsoring companies. The IRS’s role is to verify that key executives are taxed on deferred compensation when required by law. In particular, the IRS is responsible for overseeing the requirement, added to the Internal Revenue Code as Section 409A(b)(3) in 2006, that, during a restricted period, which includes bankruptcy, if a company that sponsors a qualified single employer defined benefit plan sets aside or reserves assets in a trust for the purposes of paying nonqualified deferred compensation to certain key executives, the key executives are required to include the amount of assets in their gross income for the taxable year in which the compensation was set aside. However, the GAO found that IRS audit guide instructions do not have enough information on what data to collect or questions to ask to help its auditors know if companies are complying with these requirements. Therefore, the GAO report concluded, the IRS is not able to verify that companies are reporting this compensation as part of key executives’ income for taxation.

One role of the DOL with respect to top hat executive retirement plans is to oversee these types of plans to ensure that only eligible employees participate in them. Currently, top hat plans are not required to provide summary plan descriptions or file annual reports (Forms 5500) with the DOL. Under its alternative reporting method regulation, the administrator of the executive retirement plan need only submit a one-time single page filing statement within 120 days of the plan’s establishment; no other ERISA disclosures are necessary. The alternative method requires companies to initially report the number of participants in the plan, but it does not collect information on job title or salary or the percentage of the company’s workforce participating in these plans, nor need the information be updated as the participants change. This type of key information would let the DOL better identify plans that may be including ineligible employees. As it is now, the DOL lacks insight into the make-up of these plans and cannot be sure that only select managers and highly compensated employees are participating.

One interesting nugget from the GAO report addresses the situation where a company that offers a top hat plan discovers that it has included in the plan participants who do not qualify as part of the select group. DOL officials reported to the GAO that they have not issued any guidance on how companies should correct eligibility errors found in executive retirement plans. Instead, the DOL directed the GAO to an amicus brief it filed where the DOL suggested that plans can be modified to exclude ineligible rank-and-file employees, awarding them the full vesting and other protections under ERISA and distributing their benefits from the plan while maintaining the plan’s status as an executive retirement plan for those executives who do qualify. Specifically, the DOL stated in its amicus brief that “it may be that the appropriate remedy would be to provide relief only to those non-management, non-highly-compensated employees who were improperly included in the plan – e.g., to reform the plan to exclude the non-qualifying employees and award them the full vesting and other protections and benefits while maintaining the plan in its exempt status for the management and highly-compensated employees who do qualify.” According to the DOL, this “approach would avoid providing a windfall gain to the management and highly-compensated employees who could properly have been included in a plan covered by Section 1051(2), who possess sufficient economic bargaining power to protect their own rights and are not the intended beneficiaries of the substantive ERISA provisions at issue.”

However, the IRS responded that removing employees from the plan and awarding them full and immediate vesting and payout of benefits could violate Section 409A of the Internal Revenue Code, which does not usually permit the accelerated payment of nonqualified deferred compensation. The IRS said it was willing to work with the DOL to promulgate new section 409A regulations to create an exception to the accelerated payment rule for plans that seek to remove ineligible rank-and-file employees from a top hat plan, and make distributions to an employee’s qualified retirement plan in order to maintain the plan’s ERISA exemption. But the DOL would first need to better define an executive retirement plan employee and then decide the proper approach for removing ineligible rank-and-file employees from a plan before any new regulations under Section 409A could be considered.

The GAO report concluded with one recommendation for the IRS and three for the DOL, with a view to improving oversight of executive retirement plans. The GAO recommended that the IRS develop specific instructions to help examiners determine when a restricted period exists with respect to a single employer defined benefit plan, and whether a company with single employer defined benefit plan has, during a restricted period, set aside assets for the purpose of paying deferred compensation under an executive retirement plan. The recommendations to the DOL were to (1) review and determine whether its reporting requirements for executive retirement plans should be modified to provide additional information that the DOL could use to oversee whether these plans are meeting eligibility requirements; (2) explore actions that the agency could take to help companies prevent the inclusion of rank-and-file employees in executive retirement plans and determine which, if any, actions should be implemented; and (3) provide specific instructions for companies to follow to correct eligibility errors that occur when rank-and-file employees are found to be participating in executive retirement plans, coordinating with other federal agencies on these instructions as appropriate.

Based on the findings of the GAO report, U.S. Senators Bernie Sanders and Chris Van Hollen (Maryland) introduced legislation on February 27, 2020 that focuses on reducing the tax advantages for executives who participate in top hat plans, and that would require the IRS and DOL to respond to the recommendations in the GAO report. The CEO and Worker Pension Fairness Act would include deferred compensation in taxable income when it vests rather than at distribution. According to the proposed legislation, this would result in $15 billion in federal revenue that would be transferred to the Pension Benefit Guarantee Corporation to shore up multiemployer pension plans. Bills targeting deferred compensation in this manner have become common in recent years, but none have yet become law.

Although the fate of the Sander-Van Hollen bill is unknown, employers should expect top hat plans to continue to be scrutinized by regulators. In particular, in light of the GAO report and Congress’s renewed focus on top hat plans, this is a good time for plan sponsors to review the guidelines that have been issued regarding determining the “select group” eligible to participate in such plans.