Opinion ID: 3021464
Heading Depth: 2
Heading Rank: 1

Heading: Deferred Compensation Plans Generally

Text: A deferred compensation plan “is an agreement by the employer to pay compensation to employees at a future date. The main purpose of the plan is to defer the payment of taxes.” David J. Cartano, Taxation of Compensation & Benefits § 20.01, at 709 (2004). The idea is to defer the receipt of compensation until retirement or termination of employment, when the employee is in a lower tax bracket, thus reducing the overall amount of taxes paid. Id. at § 20.02[A], at 710. Certain deferred compensation plans, known as “top hat” plans, are subject to ERISA’s administrative and enforcement provisions, but exempt from the substantive provisions that regulate plan funding and impose fiduciary 7 duties.1 Because the Participants’ claims arise under ERISA’s substantive provisions, see Pls.’ 2d Am. Compl. at 29-37, they depend on a finding that the IT Group Deferred Compensation Plan is subject to ERISA’s substantive protections, i.e., that it is not a “top hat” plan. ERISA defines a top hat plan as: a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. 29 U.S.C. § 1051(2). See also 29 U.S.C. §§ 1081(a)(3), 1101(a)(1). 1 The Department of Labor has explained that Congress exempted “top hat” plans from ERISA’s substantive protections because it believed that, unlike other employees, management and highly compensated employees have sufficient bargaining power to negotiate favorable deferred compensation plans and are capable of taking the risks attendant to such plans into account. Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 90-14A, 1990 ERISA LEXIS 12, at -4 (May 8, 1990). 8 When a plan is “unfunded,” [t]he employer promises to pay the employee the deferred compensation at a specified time, but does not set aside the funds in an escrow, trust fund, or otherwise. The assets used to pay the deferred compensation are the general assets of the employer and are subject to the claims of the employer’s creditors. Cartano, at § 20.02[A], at 721. The employee is not subject to tax on the compensation until he or she actually receives the deferred amount because “the employee may never receive the money if the company becomes insolvent.” Id. An employer may set aside deferred compensation amounts in a segregated fund or trust without jeopardizing a plan’s “unfunded” status if the fund or trust remains “subject to the claims of the employer’s creditors in the event of insolvency or bankruptcy.” Id. at § 20.05[D], at 731. One commonly-used mechanism is the “rabbi trust,” which is an irrevocable trust for deferred compensation. Funds held by the trust are out of reach of the employer, but are subject to the claims of the 9 employer’s creditors in the event of bankruptcy or insolvency. The rabbi trust gives employees some measure of security, while at the same time deferring taxes. The assets set aside in the trust are segregated from the employer’s other assets and can be used only to pay the deferred compensation. If there is a change in control of the company, the new owners cannot take back the assets of the trust. The employee is not taxed until receipt of benefits as long as the trust funds are subject to the claims of the employer’s creditors. The employer is treated as the owner of the funds and taxed on all fund earnings until the date of distribution. Id. at § 20.05[D][3], at 735. The Department of Labor has opined that “a plan will not fail to be ‘unfunded’ . . . solely because there is maintained in connection with such plan a ‘rabbi trust.’” Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 91-16A, 1991 ERISA LEXIS 16, at -7 (Apr. 5, 1991). 10