Steve Leimberg’s Employee Benefits and Retirement Planning Email Newsletter – Archive Message #629 Date: 23-Oct-13 From: Steve Leimberg’s Employee Benefits and Retirement Planning Newsletter Subject: Carol Cantrell on Cantrell v. Briggs: Impact of the Fifth Circuit’s Ruling on Accounting Firm Succcession Plans “Accounting firms with succession plans that have forfeiture provisions should carefully review their plans to determine whether they are ERISA plans. Whether a plan has enough ongoing, particularized, administrative discretionary analysis to make it an ERISA plan is a fact specific determination generally made by balancing the weight of all the facts. ERISA’s application to a firm’s succession plan can also have significant income tax consequences. If ERISA applies, the payments will be deductible by the firm as compensation and reported to the employee as ordinary income on Form W-2. But if ERISA does not apply, the payments will not likely be deductible by the employer, but rather constitute redemption payments, which the former owner should report as capital gain on sale of his or her interest in the firm.” In Employee Benefits & Retirement Planning Newsletter #628 LISI provided members with commentary on Cantrell v. Briggs, which we described as an “important ERISA non-qualified deferred compensation case.” Now Carol Cantrell provides members with her first-hand observations on this significant decision. Carol A. Cantrell is the managing member of Cantrell & Cantrell, PLLC, a law firm based in Houston, Texas. Carol is Board Certified in Tax Law and Estate Planning & Probate Law by the Texas Board of Legal Specialization. She is Vice-Chair of the Income and Transfer Tax Planning Group of the American Bar Association’s RPTE Section and serves as the ABA’s liaison to the National Conference of Lawyers and Corporate Fiduciaries. Carol was co-counsel for the Rudkin Testamentary Trust in Knight v. Commissioner before the U.S. Supreme Court in 2007. She is the author of “Stock Options: Guide to Estate, Tax, and Financial Planning” and co-author with Gordon Spoor of -“The Fiduciary Accounting Answer Book”, both published by CCH. Here is her commentary: EXECUTIVE SUMMARY: After denying a rehearing request last week, the Fifth Circuit confirmed its 2-1 decision in Cantrell v. Briggs & Veselka Co. that the deferred compensation provisions in the employment contracts of two former CPA shareholders of Briggs & Veselka, a Houston accounting firm, did not constitute an ERISA plan.[ No. 12-20294 (5th Cir. Aug. 27, 2013), reh’g denied Oct. 16, 2013] The decision is consistent with the court’s prior rulings and that of other circuits and is because the “plan” did not require the company to engage in “enough ongoing, particularized, administrative discretionary analysis” to constitute an “ongoing administrative scheme” as required by ERISA. The ongoing administrative scheme requirement was first articulated by the U.S. Supreme Court in Fort Halifax Packing Company, Inc. v. Coyne.[482 U.S. 1 (1987)] Consequently, the parties’ dispute over the former shareholders’ entitlement to deferred compensation payments must be resolved in Texas state court rather than federal court. Most accounting firms would not even consider their shareholder succession plans to be ERISA plans. However, that is the position that Briggs & Veselka took when the Cantrells brought suit in state court to recover their payments. The court’s finding that the deferred payments did not constitute an ERISA plan can have enormous implications for CPA firms that pay deferred compensation to their retired owners. This is especially true when there are clawback provisions, which reduce the originally agreed upon payments to a former shareholder-employee who fails to transition their book of business, fails to give adequate notice before leaving, competes with the firm after retirement, or a number of other transgressions. [AICPA 2012 PCPS Succession Survey] If a dispute arises over whether the retired owner violated one of these requirements, it can make a big difference whether the plan is an ERISA plan or not. If the deferred payment plan is found not to be an ERISA plan, as in Cantrell v. Briggs & Veselka, disputes over the former owner’s entitlement to payments must be resolved in state court, where state laws generally protect employees from overly broad or unreasonable forfeiture clauses. However, if the plan is an ERISA plan, the dispute must be resolved under federal law, which generally affords a great deal of deference to the plan administrator’s decision to pay, or not, under the plan [ERISA § 514(a); 29 U.S.C. § 1144(a)] Partnership plans are expressly excluded from ERISA coverage if they are partnership buy-out agreements described in IRC § 736. [29 C.F.R. 2510.3-3(b)] However, accounting firms that are not taxed as a partnership potentially face this issue. Cantrell v. Briggs & Veselka Co. contains an excellent discussion of how to determine whether a firm’s succession plan is an ERISA plan based on the ongoing administrative scheme requirement in Fort Halifax. But even if the plan meets the ongoing administrative scheme test, it may not qualify as an ERISA plan unless it is also an employee benefit or welfare plan. Plans that are intended to buy out the owner’s equity in the firm would not likely be employee benefit or welfare plans and thus would not likely be ERISA plans. The parties extensively briefed this issue in Cantrell v. Briggs & Veselka, but the Fifth Circuit declined to address the issue because it found that the plan failed under the ongoing administration scheme test. FACTS: Cantrell v. Briggs & Veselka involved a dispute between an accounting firm and two former shareholders over whether the shareholders were entitled to the deferred compensation payments under their employment agreements when they retired. The Cantrells had merged their accounting firm with Briggs & Veselka Co. in 2000 in exchange for a series of payments at retirement equal to four times their average annual W-2 wages to be paid over 10 years. In addition, a stock redemption agreement paid them a nominal amount for their share of the firm’s cash and fixed assets upon retirement. 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, goodwill, or “book of business” in the firm. After working eleven years at Briggs & Veselka, Carol Cantrell announced her retirement and intent to practice law with her husband, Patrick Cantrell, who was also a lawyer and a former Briggs & Veselka shareholder who retired four years earlier. Cantrell resigned on January 3, 2012. But Briggs & Veselka refused to accept her resignation and ten days later purported to terminate her “for cause” under the company’s deferred compensation plan. Such a “for cause” termination would allow Briggs & Veselka to withhold Carol’s deferred compensation payments. Briggs & Veselka also notified Patrick that he too forfeited the remainder of his payments for practicing law with his wife, Carol Cantrell. When the Cantrells sued to recover their benefits in state court, Briggs & Veselka immediately removed the case to federal court on the grounds that the deferred compensation payments were an ERISA “top hat” plan. 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)] It is exempt from most of ERISA’s 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 under the plan. If there is a dispute over benefits, the employee’s state law claims and defenses are null and void because all state causes are trumped by federal law.[ERISA § 514(a); 29 U.S.C. 1144(a)] It is common for a top hat plan to provide that an employee’s benefits are entirely forfeited if the employee competes with the employer or is terminated “for cause.” In that case, the plan administrator acts as the sole judge, jury, and arbiter of whether the employee competed or was terminated “with cause.” This is a conflict of interest if the employer is also the plan administrator. But it is entirely legal in an ERISA top hat plan. For this reason, top hat plans have been called “an employer’s best friend.”[James P. Baker, “ERISA’s Better Mousetrap,” Benefits Law Journal, Vol. 24. No. 1, Spring 2011] The rationale for the lack of fiduciary duties in a top hat plan is that its participants are supposedly sophisticated enough to negotiate for themselves and do not need ERISA’s protection. But because a top hat plan is still 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 in the plan. This is why the parties in Cantrell v. Briggs & Veselka fought so hard over whether they should be in state or federal court. Holding Applying Fifth Circuit and other precedent, the court held that deferred compensation provisions in Briggs & Veselka’s employment contracts are not ERISA plans because they do not require “enough ongoing, particularized, administrative discretionary analysis” to be considered an ERISA plan. The payments were based on a one-time calculation using a fixed formula and paid over a 10-year period. They required only writing a check each quarter, which 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 with cause or competed with the employer during the 10-year period, this “minimal quantum of discretion” was not sufficient to turn it into an ERISA plan. Moreover, the plan did not expressly grant the employer the sole discretion to make the decision. The accounting firm had no system in place to monitor for competition, suggesting that one was not needed. Nor could it explain how such a system would work or that it would require an ongoing administrative scheme to implement. Accordingly, the case was remanded to state court where the dispute will be governed by Texas law. In a separate dissenting opinion, Judge Priscilla R. Owen perceived the provisions to be complex and therefore subject to ERISA. In particular, she focused on a benefit cap in the agreements. Such a cap is common in many CPA firm succession plans. It acts as a cash flow cushion by placing a ceiling on the total payouts to all retired partners in a single year. Any deficit is caught up and paid in later years when the ceiling doesn’t apply. Thirty-six percent of CPA firms surveyed have such caps in their partner buy-out plans, according to a recent AICPA Survey. Owen also said that the employer’s ability to terminate an employee for cause was sufficient discretion to constitute an ongoing administrative scheme, despite a contrary holding in Velarde v. PACE Membership Warehouse, Inc., 105 F3d 1313 (9th Cir. 1997). Planning Implications for CPA Firm Succession Plans Accounting firms with succession plans that have forfeiture provisions should carefully review their plans to determine whether they are ERISA plans. Whether a plan has enough ongoing, particularized, administrative discretionary analysis to make it an ERISA plan is a fact specific determination generally made by balancing the weight of all the facts. If the employer wants ERISA to apply, it should generally avoid plans that contain a one-time calculation using a fixed formula. CPA firms typically compensate a retired owner for his equity in the firm by paying the owner a fixed sum over time based on his share of the firm’s value. This can be calculated in a number of ways. The most common ways are listed in a survey conducted by the AICPA in 2012 and include payments based on the number of shares owned, a multiple of the shareholder’s average salary, or the value of his or her book of business. 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. The right to terminate an employee “for cause” does not require enough discretionary analysis to meet ERISA’s standard according to the Fifth Circuit. An example of sufficient discretionary analysis would be the employer’s right to determine whether the employee suffered a substantial reduction in his job responsibilities before and after a merger, according to another recent Fifth Circuit case.[Clayton v. ConocoPhillips, No. 12-20102, 2013 WL 3357574 (5th Cir. 2013)] In addition, if the plan contains a noncompete provision, the plan should expressly reserve the sole authority to the employer to decide whether the employee, in fact, competed and describe how the employer will monitor for such activity. Based on all of these factors, if the “succession plan” is found to be an ERISA plan, the retired owner can lose all or part of his hard-earned equity if the plan administrator decides that he or she has violated one of the provisions. Therefore, both the firm and the employee should seek competent legal advice on whether the plan is subject to ERISA before entering into such an agreement. Income Tax Considerations ERISA’s application to a firm’s succession plan can also have significant income tax consequences. If ERISA applies, the payments will be deductible by the firm as compensation and reported to the employee as ordinary income on Form W-2. But if ERISA does not apply, the payments will not likely be deductible by the employer, but rather constitute redemption payments, which the former owner should report as long-term capital gain on sale of his or her interest in the firm. As noted above, partnership succession plans are expressly excluded from ERISA coverage under the DOL regulations if they are partnership buy-out agreements described in IRC § 736. [29 C.F.R. 2510.3-3(b)] Thus, retirement payments made by an entity taxed as a partnership in liquidation of a retired partner’s interest are generally treated as a distributive share of partnership income or as a guaranteed payment. This includes a partner’s share of unrealized receivables and unstated goodwill of a general partnership. However, payments for a partner’s interest in property, including goodwill expressly provided for in the partnership agreement, are Section 736(b) payments, which are treated as distributions by the partnership and taxable as capital gain to the partner to the extent they exceed the basis of his partnership interest. Conclusion Accounting firms should carefully review their succession plans to determine whether ERISA applies. If ERISA applies, disputes over coverage and benefits must be resolved in federal court where employees have no state law protections. If ERISA does not apply, employees can invoke favorable state law protections to protect against losing valuable deferred compensation benefits. Not all ‘broken” plans can be amended. If the plan is part of an enforceable contract with the employee, both the employee and the employer must agree to any changes. HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE! Carol Cantrell CITE AS: LISI Employee Benefits and Retirement Planning Newsletter #629 (October 23, 2013) at https://www.LeimbergServices.com Copyright 2013 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission CITES: Cantrell v. Briggs & Veselka Co., No. 12-20294 (5th Cir. Aug. 27, 2013), reh’g denied Oct. 16, 2013; Fort Halifax Packing Company, Inc. v. Coyne.[482 U.S. 1 (1987); Clayton v. ConocoPhillips, No. 12-20102, 2013 WL 3357574 (5th Cir. 2013); Velarde v PACE Membership Warehouse, Inc., 105 F3d 1313 (9th Cir. 1997); ERISA § 514(a); 29 U.S.C. § 1144(a); 29 U.S.C. § 1051(2); 29 U.S.C § 1101(a); 29 C.F.R. 2510.3-3(b); James P. Baker, “ERISA’s Better Mousetrap,” Benefits Law Journal, Vol. 24. No. 1, Spring 2011; AICPA 2012 PCPS Succession Survey, available at Survey