Corporate Counsel Magazine (April 1997)
The Problem
By now, most companies have heard of the Year 2000 Problem. In general, the Year 2000 Problem results from the use in software of only the last two digits to indicate the year in a date ("96" for "1996"). When first done, that was a very clever bit of programming -- it saved storage space and simplified calculations. Unfortunately, those clever programmers never anticipated that their software would still be around when the two digits that were assumed to begin each year ("19") would change to "20." Much of that software is still around, however, and will still be around on January 1, 2000 -- it just won't work properly from then on. Many companies now realize that someone must go through the old software, line by line, to fill in the missing information.
As the Year 2000 grows closer, programmers who can rewrite software to fix the "Year 2000 problem" will be in great demand. Companies currently having a full staff at work addressing the issue are the fortunate ones; others may not be so fortunate. As the millennium approaches, companies may start offering bigger and better compensation packages to attract qualified programmers. That suggests that now is the time focus on hiring and retaining key personnel. Some creative compensation planning now can reduce the risk that your programmers will go the highest bidder.
Key Issues
A well-designed Year 2000 compensation package will recognize and take advantage of several key factors. First, an employee who completes the project is worth more than one who leaves halfway through the project. Second, the demand for skilled programmers to address the Year 2000 problem will increase over the next three years. Third, that demand has a finite life. Fourth, the sooner one particular company's Year 2000 problems are solved, the sooner the programmer will be able to undertake the same project for another company. Fifth, the individuals who address the most sensitive Year 2000 issues probably have access to confidential or proprietary information. Finally, the compensation package should not be completely out of line with the compensation programs applicable to other employees. Some of these factors are inconsistent with others. There is certainly no one perfect solution. Striking the proper balance between the competing interests will be important to retaining the right people.
The Standard Responses
There are a number of traditional compensation arrangements that address each of those points. The following list summarizes some of the more typical forms of compensation and the relevant considerations:
High Compensation High compensation will obviously attract more and better programmers, and bidding wars may become common. Management may resist paying high compensation on the ground that it is inconsistent with the company culture. Management may not be willing to pay more than it pays to existing employees who appear to be much more valuable -- not realizing how important the right programmers can be to the company.
Performance Bonuses Performance bonuses are more difficult than high compensation because it is not obvious what the goals should be or how performance can be measured. These are technical issues which depend on the precise tasks which are required and the specific skills which the programmer has.
Retention Bonuses Retention bonuses are commonly used in reductions in force to assure that there will be competent personnel left to turn out the lights. Hiring the best programmers will not help significantly if the programmers leave before finishing the task. Retention bonuses may be a critical element in a well-designed Year 2000 compensation package.
Refundable Compensation Sometimes retention bonuses are paid up front, subject to an obligation to repay if the employee quits before a stated time. Refundable compensation is more expensive than retention bonuses because it requires earlier payment and may be difficult or impossible to recover. The programmer may not have the money to repay, or the courts may hold that repayment is against public policy. Refundable compensation works better when the programmer is an independent contractor. An independent contractor is entitled to a full tax deduction for the repayment, both for income tax purposes and for employment tax purposes, and the public policy argument is less persuasive.
Stock Options Most companies already provide some form of equity compensation to many employees. Some existing stock option plans can easily be extended to the programmers, with little or no change. In other cases, the class of eligible employees must be expanded or the vesting provisions should be changed. 1/ Shareholder approval may be required. It also may be possible to issue free-standing stock options without reference to any plan. In some cases, securities law exemptions will be available; in other cases, it may be necessary to register, obtain a permit, or file, on the federal or state level. Stock appreciation rights may be issued as part of the stock option or alone, without a related option.
Restricted Stock Restricted stock may similarly be issued pursuant to an existing plan, with or without change, or may be issued on a free-standing basis.
Phantom Stock Phantom stock is more flexible than stock options or restricted stock and often is more appropriate for a programmer.
Medical Programs Some programmers, particularly those closer to retirement age, will feel that it is important to have medical coverage which is better than generally available to the company's employees. It may be possible to include a programmer in the normal executive program, or it may be possible to arrange for special coverage.
Special Working Conditions Some programmers are less interested in money and more interested in independence. They may wish to work at home or at odd hours and they may wish special reporting arrangements. Corporate flexibility is often extremely important.
Enhanced Retirement Plan Benefits Many of the programmers may be interested in having additional contributions made on their behalf to the Company's retirement plans. If the programmers earn less than 80,000 per year, enhanced retirement plan benefits can be provided fairly easily. 2/ If the programmers earn more than 80,000 per year, providing enhanced retirement plan benefits can still be done, but may require extensive additional testing to insure that the benefit is not discriminatory. 3/
Early Retirement Many of the programmers, especially those familiar with older software, are relatively old but will not have reached normal retirement age by the time the task is finished. In some cases, the company will have no further use for their skills. In other cases, the company will be able to use their skills but will not be willing to continue the high level of compensation. In still other cases, the programmer will find the guarantee of early retirement to be a very attractive element of a compensation package. If the programmer is earning more than 80,000, the same testing issues referred to in connection with enhanced retirement benefits will be present.
A More Interesting Approach
Because all of those arrangements are fairly traditional, they may not appeal to employees who sense that they are in control of a seller's market. Other more "glamorous" arrangements may be more appropriate for those key employees. One approach that may work, depending on the make up of a particular company's workforce, is commonly referred to as a "top-hat plan."
A top-hat plan is "a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of . . . highly compensated employees . . . ." 4/ Generally, top-hat plans are "employee pension benefit plans" because they either provide retirement income or because they defer income to termination of employment. 5/ Pension plans, particularly pension plans which are qualified plans under the Internal Revenue Code, 6/ are normally subject to a number of special rules regarding participation, funding and vesting. 7/ If a pension plan is a top-hat plan, however, the more onerous provisions of ERISA do not apply 8/ because a top plan is not a qualified plan, the strict requirements of the Internal Revenue Code are inapplicable as well.
Top-hat plans are typically utilized by companies to provide additional deferred compensation to senior executives. There is nothing that requires that such a plan be established only for the top executives however, so long as it is limited to a select group of highly compensated employees. The U.S. Department of Labor has the authority to issue regulations providing rules for determining whether a plan qualifies as a top-hat plan; however, to date no regulations have been published. Thus, it is not clear that a plan covering only Year 2000 computer programmers would qualify as a top-hat group. Nevertheless, in some instances, if the group is relatively small and the salaries are significant, this alternative should be considered.
To accomplish the deferral of taxation on amounts payable under a top-hat plan, the participants must remain unsecured general creditors of the employer. 9/ If benefits are secured, the IRS takes the view that the employee is currently taxable. 10/ Thus, plan benefits frequently are paid out of the employer's general assets. That usually makes employees unhappy, particularly if the plan payments won't be made until after termination of employment. From an employee's perspective, if there is anything worse than being an unsecured creditor of your employer, its being an unsecured creditor of your former employer.
Recognizing that key employees were unhappy without any security for plan benefits, employers have sought methods to "secure" the benefit without triggering current taxation. The most common method (and one that has now been specifically blessed by the IRS) is the creation of a "rabbi trust." 11/ In general, a rabbi trust is a trust to which the employer transfers assets sufficient to pay benefits under a top-hat plan. The trust document specifically recites that the trust assets remain subject to the claims of the employer's general creditors. Thus, a rabbi trust would not protect employees in the event of employer bankruptcy, but it generally would protect employees against the possibility that the employer will change its mind about paying plan benefits. The peace of mind that comes from seeing a specific pool of assets for plan payments, combined with the knowledge that getting any additional security would likely result in current taxation, usually satisfies the employee's concerns.
Rabbi trusts are also frequently combined with certain "bells and whistles" that appeal to participants. For example, it is now fairly common for such plans to provide that the participants have the ability to self-direct the investment of the assets held in their rabbi trust accounts. 12/ Some plans provide for unlimited self-direction; others merely allow a choice among a menu of investment alternatives, such as mutual funds, selected by the employer. Some plans allow investments in employer stock. Finally, recent federal legislation also makes it more difficult for states to tax top-hat plan payments to non-residents. 13/ Thus a well-designed top-hat plan not only provides a deferral of federal income taxes, it may also provide an overall reduction of state taxes.
Although top-hat plans are not subject to the participation, vesting and funding rules of ERISA, they remain subject to other provisions of ERISA such as the reporting and disclosure requirements, and the claims and enforcement provisions. 14/ Although many employers react with horror when told that one of their employee benefit plans is covered by ERISA, their concerns are misplaced. Complying with the reporting and disclosure requirements for a top-hat plan is very simple and generally requires only a one-time filing with the Department of Labor at the time the plan is adopted. 15/
Having the ERISA and its claims and enforcement provisions apply is generally a very good thing for employers for several reasons. First, employers generally would not have any exposure for extracontractual remedies, such as punitive damages or damages for emotional distress. The liability would be limited to benefits described in the plan. Second, employers can require claimants to exhaust a plan's internal administrative appeals process before seeking a judicial remedy. Careful use of the appeals procedure means that an employer's decision under the plan will not be overturned by a court unless that decision was an "abuse of discretion." That standard of review is a significant obstacle for claimants to overcome. Third, ERISA provides ready access to the federal courts, typically preferred by defending employers. Finally, ERISA gives courts discretion to award attorney's fees to prevailing parties, and courts recently have begun awarding fees to prevailing defendants. Thus, given a choice of compensation arrangements to consider, employers should seek, not hide from, ERISA coverage.
Top-hat plans, if available, will provide the protections of ERISA, while also filling the objectives of a Year 2000 compensation program. Such arrangements, although common, must be carefully crafted to comply with a number of legal requirements. Not only must an arrangement be "unfunded" to satisfy the IRS rules for avoiding current taxation, and cover only a select of highly compensated employees to qualify as a top-hat plan under ERISA (and the DOL views that have never been published), but also the SEC has recently gotten into the act by suggesting that some top-hat plans may constitute securities subject to the securities registration requirements. None of these problems, however, will be insurmountable. Careful analysis and planning should minimize any risks.
Employers faced with designing a compensation package that will attract and retain key personnel to help address Year 2000 issues should carefully consider whether a top-hat plan would work for them. With its combination of tax deferral, investment appeal and "exclusivity," it may just what is needed.
_____________________________
1 For example, a plan providing for options intended to qualify as incentive stock options, as defined in Internal Revenue Code ("Code") '422, must specify the class of employee eligible to receive option grants.
2 The Code section 401(a)(4) prohibits qualified retirement plans from providing benefits that discriminate in favor of highly compensated employees. Effective January 1, 1997 for most employers, an employee who earns less than 80,000 in a particular year will not be treated as a highly compensated employee.
3 An enhanced retirement benefit under a qualified plan must be provided to a nondiscriminatory group of employees or the plan will be disqualified. Code '401(a)(4), 410(b).
4 Employee Retirement Income Security Act of 1974 ("ERISA") Section 201(2).
5 ERISA Section 3(2)
6 A qualified pension plan is one that meets the requirements of Section 401(a) of the Internal Revenue Code. Such plans allow are referred to as "qualified plans" because they qualify for favorable tax treatment including: (i) current employer deductions for contributions; (ii) no tax on income generated by plan assets; and (iii) no tax on participants until plan assets are distributed to them.
7 See generally, ERISA sections 201-211 and 301-308; see, also Code sections 410-412.
8 Top-hat plans are not "qualified plans" covered by Code sections 401 et seq. ERISA sections 201, 301 and 401 expressly exclude top-hat plans.
9 There will be no current taxation of amounts to be paid in the future under a top-hat plan, so long as no "property" has been "transferred" from the employer to the employee. Code section 83. An unfunded, unsecured promise by the employer to pay the employee in the future does not constitute "property." Treasury Regulation section 1.83-3(e); Revenue Procedure 71-19, 1971-1 C.B. 698; Revenue Procedure 92-65, 1992-2 C.B. 428.
10 Treasury Regulation section 1.83-3(e).
11 Revenue Procedure 92-64, 1992-2 C.B. 422.
12 The IRS will not currently issue rulings specifically authorizing participant self-direction, unless the documents provide that the trustee is not required to follow the participant directions.
13 4 U.S.C. '114.
14 ERISA '101; 501.
15 DOL Regulation '2520.104-23.