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Make top-hat plan benefits appear magically

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in Small Business Tax

There’s a way that your company can provide extra benefits to higher-ups like yourself without bumping up against the usual limits for qualified retirement plans.

Strategy: Set up a “top-hat” plan. Despite the name, it involves no sleight of hand, but the results can be magical.

This technique may appear more intriguing as retirement plan limits remain flat in 2016 (see box).

Here’s the whole story: A top-hat retirement plan is a nonqualified deferred compensation plan covered under the landmark “Employee Retire­­ment Income Security Act” (ERISA) of 1974. ERISA imposes a wide range of funding, but favorable exceptions may apply to a select group of employees (i.e., the top-hat group).

Top-hat plans have generated more interest in recent years due to the restrictions on qualified retirement plans, especially as they relate to high wage-earners. Example: The maximum annual compensation that may be taken into account for qualified retirement plan purposes in 2016 is $265,000 (the same as 2015).

An employer may want to use a non­­qualified top-hat plan to reward long-standing em­­ployees or to attract or retain other valuable performers without being restricted by such limitations.

But a top-hat plan comes at a tax price. Under rules instituted after 2004, amounts that are deferred under a nonqualified plan must be included in taxable income unless there is a substantial forfeiture risk. The plan should be carefully drafted with the tax consequences in mind.

Also, top-hat plans must meet certain reporting and disclosure rules under ERISA. For example, a plan description must be filed with the U.S. Department of Labor (DOL) within 120 days of inception. Plus, an employer may have to provide plan documentation if the DOL requests it. If the one-time filing requirement isn’t met, the full reporting and disclosure rules of ERISA may be imposed.

Which employees may be covered under a top-hat plan? This is somewhat of a “gray area,” but here are some general guidelines:

  • A top-hat plan can’t extend coverage beyond a select group of managers or highly-compensated employees.
  • The group must be small in comparison to the total workforce.
  • The average income of the plan participants must be higher than the average income of the other employees.
  • The participants must be in a position to affect or substantially influence the design and operation of the plan. Example: In a typical small business, a top-hat plan might cover only the company’s owner, officers and leading salespeople. Similarly, a plan might be set up to benefit physicians in a medical practice or partners in a law firm.

Tip: This type of plan is best left to the pros. Consult with a benefits specialist.

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