What Is a Top Hat Plan for Executive Compensation?

Executive compensation strategies aim to attract and retain highly skilled individuals whose contributions are central to a company’s success. Companies often utilize deferred compensation arrangements to provide incentives and secure the long-term commitment of these key employees. These arrangements allow a portion of an individual’s earnings to be paid at a future date, often after their active employment concludes. Among the various types of deferred compensation, “top hat plans” represent a distinct approach tailored for a specific segment of a company’s workforce.

Understanding Top Hat Plans

A top hat plan is a specific non-qualified deferred compensation arrangement designed to provide benefits primarily for a select group of management or highly compensated employees. This arrangement serves as a contractual agreement between an employer and an employee, deferring compensation payment to a future date. These plans supplement retirement income or provide performance-based incentives beyond the limitations of traditional, qualified retirement plans like 401(k)s.

Companies implement top hat plans to attract and retain top talent, especially those in high tax brackets whose contributions are significant. For employees, these plans offer a way to defer income and potentially minimize current tax liabilities, allowing for tax-deferred growth until distribution. The term “top hat” suggests exclusivity, referring to individuals at the top of the organizational structure, highlighting that these plans are not intended for the general workforce.

Distinguishing Features

Top hat plans are distinguished by several core characteristics. One feature is their “non-qualified” status, meaning they do not adhere to the broad participation, funding, and vesting rules mandated by the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code (IRC) for qualified plans. Unlike qualified plans, which offer immediate tax deductions to the employer, the employer generally cannot deduct amounts contributed to a non-qualified plan until the employee receives the compensation. For the employee, compensation is not taxed until paid, providing a tax deferral benefit.

Another characteristic is their “unfunded” nature from an ERISA perspective. Assets designated for future benefit payments remain the general assets of the employer and are subject to creditor claims in the event of insolvency or bankruptcy. Participants hold an unsecured promise from the employer to pay future benefits, introducing a risk not present in qualified plans where assets are held in trust for the sole benefit of participants. This structure is a fundamental aspect of their design, allowing them to bypass many ERISA requirements.

The “select group of management or highly compensated employees” criterion is also central. While there is no precise legal definition, it generally refers to a small percentage of a company’s employee population who are key management personnel or earn substantially higher salaries. This limitation recognizes that these individuals can influence their deferred compensation arrangements.

Regulatory Considerations

Top hat plans operate within a unique regulatory framework, primarily characterized by broad exemption from most of ERISA’s substantive requirements. These plans are largely exempt from ERISA’s participation, vesting, funding, and fiduciary responsibility rules due to their unfunded nature and design for a select group. High-level employees are considered capable of negotiating their compensation terms and do not require the same protections as the broader workforce.

Employers must fulfill minimal reporting requirements, typically a one-time filing of a “top hat statement” with the Department of Labor (DOL). This statement includes the employer’s name and address, the number of plans, and the number of employees covered. This limited reporting contrasts sharply with the extensive annual reporting obligations of qualified plans.

Beyond ERISA, top hat plans are subject to the Internal Revenue Code, particularly Section 409A, which governs non-qualified deferred compensation. This section was enacted to prevent abusive tax deferral practices and imposes strict rules on the timing of deferral elections and distributions. Employees typically must make deferral elections by the end of the tax year preceding the year compensation is earned. Non-compliance with these rules can result in severe penalties for the employee, including immediate taxation of all deferred amounts, an additional 20% excise tax, and interest penalties.

Structuring and Operation

Top hat plans can take various forms depending on employer and executive objectives. Common structures include Supplemental Executive Retirement Plans (SERPs), which provide additional retirement income beyond qualified plans, and Excess Benefit Plans, designed to make up for benefits lost due to IRC limitations. Standalone deferred compensation agreements also offer tailored arrangements for individual executives. These plans provide flexibility in design, allowing companies to customize benefits to specific needs.

While technically “unfunded,” companies often use informal financing mechanisms to meet future obligations. A common method is a “rabbi trust,” an irrevocable trust where assets are set aside to cover deferred compensation liabilities. Assets in a rabbi trust remain subject to creditor claims in the event of bankruptcy or insolvency, reinforcing the plan’s unfunded status. Corporate-owned life insurance (COLI) is another informal funding strategy, where the company purchases life insurance policies on key executives, using the cash value to offset future plan payouts.

Benefit payouts are typically triggered by specific events, such as retirement, separation from service, disability, or death, or at a fixed future date. Payments can be structured as a lump sum or as installments. All distribution terms must comply with these rules to maintain tax-deferred status. Employers bear administrative responsibility for tracking deferrals, calculating benefits, and managing distributions in accordance with the plan’s terms and regulatory requirements.