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Sally Schreiber
Sally Schreiber
Court holds deferred compensation plan is not an ERISA plan

How a firm structures a deferred compensation plan can make a big difference.

September 12, 2013
by Sally P. Schreiber, J.D., editor

Companies often go to great lengths to make sure their deferred compensation plans comply with Sec. 409A to avoid onerous tax consequences, but they may not realize that whether the Employment Retirement Income Security Act (ERISA) applies to a plan can be equally significant. Not all deferred compensation plans are ERISA plans. A recent Fifth Circuit decision, Cantrell v. Briggs & Veselka Co., No. 12-20294 (5th Cir. 8/27/13), contains an excellent discussion on how to distinguish an ERISA plan from an employment contract and a road map for how to design and administer a plan if ERISA coverage is desired.

The facts

Cantrell involved a dispute between an accounting firm and two former shareholders over whether the shareholders were entitled to deferred compensation payments under their employment agreements, which were due when they retired. In 2000, Carol and Patrick Cantrell merged their accounting firm with another firm, Briggs & Veselka Co. (B&V). Under the merger agreement, the Cantrells agreed to payments upon retirement equal to four times their average annual Form W-2 wages at the time they retired, to be paid over 10 years. According to a 2012 AICPA survey, this is a typical succession or “retirement pay” plan for a CPA firm, designed to compensate the owner for the value of his or her equity in the firm. In addition, the Cantrells signed a stock redemption agreement that paid them a nominal amount for their share of firm cash and fixed assets upon termination.

After working 11 years at B&V, Carol Cantrell announced her retirement from the firm. She intended to practice law with her husband, Patrick Cantrell, who had retired from B&V four years earlier. Briggs & Veselka refused to accept her resignation and purported to terminate her “for cause” several days later, which, under the deferred compensation plan, allowed B&V to withhold her deferred compensation payments. At the same time, the firm notified Patrick that he also forfeited the remainder of his payments by allegedly competing with the accounting firm by practicing law with his wife. The firm claimed that conduct was grounds for terminating his payments.

When the Cantrells sued B&V in state court to recover these payments, the firm removed the case to federal court on the grounds that the deferred compensation payments in the employment contracts constituted an ERISA “top hat” plan, which preempted state jurisdiction.

What is a top hat plan?

A top hat plan is a special breed of nonqualified plan under ERISA “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)).

A top hat plan is exempt from most ERISA oversight, reporting, and fiduciary duties (29 U.S.C. §1101(a)). All claims for benefits under a top hat plan must be submitted to the plan administrator, who has the sole authority to make decisions. If there is a dispute over benefits, the employee’s state law claims and defenses are preempted by federal law (ERISA §514(a); 29 U.S.C. §1144(a)).

Top hat plans often provide that an employee’s benefits are forfeited if the employee violates a noncompete provision or is terminated “for cause.” In that case, the plan administrator acts as the sole judge of whether the employee violated the noncompete provision or was terminated “for cause.” Although this creates a clear conflict of interest if the employer is also the plan administrator, it is legal in an ERISA top hat plan. For this reason, top hat plans have been called “an employment lawyer’s best friend” (Baker, “ERISA’s Better Mousetrap,” 24 Benefits Law J. (Spring 2011)).

Because a top hat plan is an ERISA plan, a dispute over its benefits is governed solely by federal law. Employees are precluded from bringing any state law claims or defenses, such as the enforceability of an unreasonable noncompete provision, which is why the parties in Cantrell fought over the jurisdiction issue for nearly two years before the Fifth Circuit rendered its decision.

The holding

To qualify as a plan under ERISA, a plan must require “an ongoing administrative program” (Fort Halifax Packing Co. v. Coyne, 482 U.S. 1, 11 (1987)). The Fifth Circuit held that the deferred compensation provisions in B&V’s employment contracts are not ERISA-governed plans because they do not require “enough ongoing, particularized, administrative discretionary analysis” to be considered an ongoing administrative program. The payments were based on a one-time calculation using a fixed formula and paid over 10 years. They required only writing a check each quarter, which, the court said, is “hardly an administrative scheme.”

Eligibility was based on a specific triggering event such as death, disability, or termination, which did not require any more than a “modicum of discretion.” Even though the accounting firm could terminate the payments if the employee was fired for cause or violated the noncompete provision during the 10-year period, this “minimal quantum of discretion” was insufficient to turn it into an ERISA plan, the court held. Moreover, the plan did not expressly grant the employer the sole discretion to determine whether the employee was competing with the firm.

The accounting firm had no system in place to monitor whether employees were violating the noncompete provision, suggesting that one was not needed. Nor could the firm explain how such a system would work or establish that it would require an ongoing administrative scheme to implement. Accordingly, because the federal court determined that plan was not an ERISA plan, it remanded the case to state court, where the dispute will be governed by Texas law.

In a dissenting opinion, Judge Priscilla R. Owen said the contract provisions were sufficiently complex and required enough discretion to render the plan an ERISA-governed plan. In particular, Owen focused on a benefit cap in the agreements, which she said was complicated enough to be an administrative scheme. Caps, which are common in many CPA firm buyout and retirement plans, put a ceiling on the total payouts to all partners receiving benefits. The caps protect the firm if many partners retire at once. These deferred amounts are restored in later years when the ceiling does not apply.

Thirty-six percent of CPA firms surveyed have these caps in their partner buyout plans, according to the 2012 AICPA survey mentioned above. Owen also said that the employer’s ability to terminate an employee for cause was sufficient discretion to constitute an ongoing administrative scheme, despite case law to the contrary in other circuits.

Planning implications

Employers that have deferred compensation plans with forfeiture provisions should carefully review their plans to make sure they are governed by ERISA if they want to avoid employees’ being able to sue in state court. Whether a plan requires ongoing, particularized, administrative discretion sufficient to make it an ERISA plan is a fact-specific determination.

If the employer wants ERISA to apply, it should generally avoid plans that contain a one-time calculation using a fixed formula. Eligibility for benefits should not be based solely on fixed and determinable events, such as death, disability, or retirement, but rather on factors that require more than a modicum of discretionary analysis. According to the Fifth Circuit, the right to terminate an employee “for cause” does not require enough discretionary analysis to meet ERISA’s standard, because every employer has this right even if there is no compensation plan.

An example of sufficient discretionary analysis would be the employer’s right to determine whether the employee suffered a substantial reduction in job responsibilities before and after a merger, according to another recent Fifth Circuit case cited in Cantrell  (Clayton v. ConocoPhillips, No. 12-20102 (5th Cir. 7/3/13)). In addition, if the plan contains a noncompete provision, the employer should be solely responsible for deciding whether the employee, in fact, violated the provision, and the plan should describe how the employer will monitor that activity.

Implications for CPA partner buyout plans

CPA firms with partner buyout plans structured as “deferred compensation” or “retirement pay” plans should be aware that ERISA may apply, depending on how the plans are structured. CPA firms typically compensate a retired owner for his or her equity in the firm by paying the owner a fixed sum over time based on his or her share of the firm’s value, which can be calculated in a number of ways.

The 2012 AICPA survey cited above lists the most common ways. Retirement pay for an owner can be based on the number of shares owned, a multiple of average salary, or one times the owner’s book of business. Regardless of how it is calculated, if it is found to be an ERISA plan, the retired partner or shareholder may lose all or part of his or her hard-earned equity in the firm if the plan has a forfeiture provision that he or she is found to have violated. Before signing any agreement, the employee should have competent legal counsel advise whether the plan is governed by ERISA.

Structuring partner buyout plans as “deferred compensation” or “retirement pay” can also raise income tax questions about whether the payments are truly compensation for services or consideration for the sale of a practice. If the employer has treated the payments as tax-deductible compensation or guaranteed payments, but the IRS views them as disguised payments for the sale of the owner’s equity in the firm, the IRS or the courts may recharacterize the transaction to properly reflect its substance. In that case, the employer cannot deduct the payments, and the employee may be entitled to report them as long-term capital gain. Such a determination may also affect whether the plan is an ERISA plan at all, because ERISA plans must be employee benefit plans, not consideration for the sale of a business. The Cantrell court did not address this issue.

Conclusion

Companies with deferred compensation arrangements should carefully review their plans to determine whether ERISA applies. If ERISA applies, disputes over coverage and benefits must be resolved in federal court, and employees will be barred from raising state law issues. If ERISA does not apply, on the other hand, employees can invoke favorable state law protections and may possibly avoid losing valuable deferred compensation benefits. If the plan is part of an enforceable contract with the employee, both the employee and the employer must agree to any changes.

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Sally P. Schreiber, J.D., is a senior editor in the AICPA’s magazines and newsletters group. She contributes to The Tax Adviser and Journal of Accountancy as well as the Corporate Taxation Insider and Tax Insider newsletters.