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By Charles M. Dyke and David L. Bacon
Thelen Reid Brown Raysman & Steiner LLP
Introduction
Is a working owner who enrolls in the pension or welfare plan he sponsors for his employees a "participant" under ERISA? Common sense suggests the answer should be "yes," as both he and his employees participate in the plan. But until the U.S. Supreme Court's decision affirming this answer in Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon, 124 S.Ct. 1330 (2004), this seemingly straight-forward question divided lower courts and produced decisions ranging from an unequivocal "no" in the 6th U.S. Circuit Court of Appeals to a qualified "yes" - so long as the owner is a corporate shareholder and not a sole proprietor - in the 4th Circuit. 1/
The owner's status as a participant matters because it effectively determines the scope of ERISA's coverage, which can expand or limit an owner-plaintiff's rights and remedies depending on the circumstances. As the Supreme Court has explained, ERISA resolved many conflicts among competing interest groups, not all in favor of potential plaintiffs. 2/ In Yates, the debtor-plaintiff argued he was a "participant" in an effort to invoke ERISA's anti-alienation rule to keep his creditors from recapturing monies he transferred to the plan just before an involuntary bankruptcy petition was filed against him. 3/ More frequently, the issue arises in connection with an insurer's denial of health or disability benefits. In that setting, the working owner argues that he is not a "participant," that ERISA does not apply and that he, therefore, may pursue generous state law compensatory and punitive damage remedies that ERISA does not allow. 4/
In Yates, the Supreme Court stated the rule plainly: All working owners - whether they are sole proprietors, partners or shareholder-employees - can be participants in the employee benefit plans they sponsor so long as the plan covers at least one common law employee other than the business owner and his or her spouse. The court's opinion brings much needed clarity to this area and has important implications. The court also left several questions open for future resolution.
The Statutory Backdrop
ERISA's main coverage section is intentionally broad and applies to most "employee benefit plans." 5/ The term "employee benefit plan" means an employee welfare benefit plan or an employee pension benefit plan. An "employee welfare benefit plan" is a program that provides health, disability or other specified benefits to "participants or their beneficiaries." 6/ An "employee pension benefit plan" is a program that provides retirement benefits to "employees." 7/
ERISA §3 (7) defines a "participant" as "any employee or former employee of an employer... who is or may become eligible to receive a benefit of any type from an employee benefit plan which covers employees of such employer..., or whose beneficiaries may be eligible to receive any such benefit." 8/ A "beneficiary" is "a person designated by a participant, or by the terms of an employee benefit plan, who is or may become entitled to a benefit thereunder." 9/
These coverage provisions all point to the definition of "employee." An "employee" is "any individual employed by an employer." 10/ As the Supreme Court noted in Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318, 323 (1992), this nominal definition "is completely circular and explains nothing." Finding no other provision in the statute helpful, Darden adopted a common-law test for determining whether a person is an employee. 11/
The Lower Court Decisions in Yates
Dr. Raymond Yates was the sole shareholder and president of Raymond B. Yates, M.D., P.C., a professional corporation. The corporation sponsored a profit-sharing plan that covered four persons designated as participants, including Dr. Yates. The plan contained an ERISA-required spendthrift clause that provided: "Except for... loans to Participants as [provided for in the Plan], no benefit or interest available hereunder will be subject to assignment or alienation, either voluntarily or involuntarily." 12/
In 1989, Dr. Yates took out a five-year, $20,000 loan at 11 percent interest from a money purchase pension plan that his company then sponsored. He made no payments on the loan. In 1992, he merged the money purchase pension plan into the profit-sharing plan and at that time renewed the loan for another five-year term. Again, he failed to make a single payment on the loan until November 1996, when he became insolvent. At that time, he sold his home and used more than $50,000 of the proceeds to repay the loan in full. Three weeks later, his creditors filed an involuntary bankruptcy petition, and within a year the bankruptcy trustee moved to recover the loan repayment as a preference under 11 USC §547 (b). The Bankruptcy Court found the transfer to be a preference, a ruling Dr. Yates did not contest on appeal. 13/
The central issue was whether Dr. Yates could invoke ERISA's anti-alienation rule to put the assets he transferred to the plan beyond the bankruptcy trustee's reach. The lower courts never actually reached the issue. Instead, they held that, under binding 6th Circuit precedent, a sole shareholder such as Dr. Yates must be considered an "employer" under ERISA and, therefore, cannot qualify as an "employee."
The District Court found that because Dr. Yates could not become an employee, he necessarily never became a participant in the plan, which meant that none of the money he contributed to the plan, including the loan repayment, was part of an ERISA-covered plan. 14/ The 6th Circuit affirmed on the ground that Dr. Yates's status as an employer precluded him from being a participant or a beneficiary, which meant that he did not have standing under ERISA's exclusive remedial provision, §502 (a), to enforce the anti-alienation rule.
The lower courts in Yates all regarded themselves bound by Fugarino v. Hartford Life and Accident Insurance Co., 969 F.2d 178 (6th Cir. 1992). There, the 6th Circuit held that a sole proprietor cannot qualify as a participant under ERISA for two reasons. First, the court relied on one subsection in a Department of Labor regulation that clarifies the statutory definition of "employee benefit plan." The subsection provides:
Employees. For purposes of this section: (1) An individual and his or her spouse shall not be deemed to be employees with respect to a trade or business, whether incorporated or unincorporated, which is wholly owned by the individual or by the individual and his spouse. 15/
Despite the "[f]or purposes of this section" language, the court apparently found the provision controlling for all purposes under Title I of ERISA, including whether an owner can ever be a participant. 16/
Second, the Fugarino court relied on ERISA's anti-inurement rule, which generally provides that the assets of a plan shall not inure to the benefit of an employer and must instead be held for the exclusive purpose of providing benefits and defraying reasonable plan expenses. 17/ The court appeared to reason that because working owners are "employers," the anti-inurement rule precluded them from becoming employees and, therefore, from participation. 18/
The Supreme Court Reverses
The Supreme Court rejected both Fugarino rationales. It noted that the subsection relied upon by the 6th Circuit only governs "this section," i.e., 29 CFR §2510.3-3, which is limited to defining the term "employee benefit plan." It does not control for all purposes of Title I of ERISA. The thrust of the regulation provides in part:
Plans without employees. For purposes of title I of the Act and this chapter, the term "employee benefit plan" shall not include any plan, fund or program... under which no employees are participants.... For example, a so-called "Keogh"... plan under which only partners or only a sole proprietor are participants covered under the plan will not be covered under title I. However, a Keogh plan under which one or more common law employees, in addition to the self-employed individuals, are participants covered under the plan, will be covered under Title I. 19/
Thus, read in context, Subsections (b) and (c) merely clarify that a plan covering only working owners and no other common law employees is not subject to ERISA -- owners can look out for themselves -- but a plan covering both working owners and at least one common law employee is subject to ERISA.
As for the anti-inurement rule, the court held it ensures that plan assets will be used only to pay for benefits. It does not address whether working owners may participate in benefit plans alongside their common law employees and receive bona fide benefit payments.
Rejecting the 6th Circuit's approach, the court concluded that working owners can qualify as participants, based on a three-part rationale.
First, it looked to the broader text of ERISA for guidance. There it found a number of indications that Congress intended working owners to qualify as participants. As a result, it saw no need to resort to the common law as it had in Darden.
The court found that ERISA was enacted against a 30-year history of participation by sole proprietors, partners and sole shareholders in tax-qualified plans. Rather than change the status quo, the new statute took pains to harmonize the labor provisions of Titles I and IV and the tax provisions of Title II with the existing Internal Revenue Code (IRC). Numerous provisions under the Act and the IRC expressly contemplate working owner participation.
For example, ERISA §401 (29 USC §1101) exempts from fiduciary requirements plans maintained primarily for the purpose of providing deferred compensation to a select group of "highly compensated employees" (so-called Top Hat plans). The IRC defines a "highly compensated employee" as a person who owns 5 percent or more of the employer-corporation's stock or, if the employer is not a corporation, 5 percent of the employer's capital or profits interest. This definition appears to capture typical single-shareholder and sole-proprietor working owners. If working owners could not be participants in ERISA-covered plans, there would have been no need for Congress to write an exemption for plans that cover some of them.
Section 401 also exempts any agreement under IRC §736 (26 USC §736), which provides payments to retired or deceased partners. Such agreements "surely involve plans in which working partners participate." 20/
Exempt from ERISA's requirement that plan assets must be held in trust are plans in which "self-employed individuals" participate but only to the extent assets are deposited in qualifying insurance or banking custodial accounts. A "self-employed individual" includes a person with earned income from a trade or business in which in which personal services of the taxpayer are a material income-producing factor. This encompasses working sole proprietors and partners. 21/
ERISA's prohibited transaction rules exempt qualifying plan loan programs but exclude from the exemption loans to "owner-employees," which include certain partners. 22/
Title IV excludes from coverage under the pension insurance system those plans "established and maintained exclusively for substantial owners," a term that includes sole proprietors, shareholders and partners with a 10 percent or greater ownership interest. But, it does cover plans in which such owners participate alongside other employees. 23/
Both Title IV and the IRC expressly contemplate that a working owner can be both an employee entitled to participate in the plan and an employer. "An individual who owns the entire interest in an unincorporated trade or business is treated as his own employer, and a partnership is treated as the employer of each partner who is [a self-employed individual]." 24/
Second, the court considered ERISA's purpose of promoting and facilitating plans. The court found that recognizing working owners as participants not only would serve that purpose but also would "avoid the anomaly that the same plan will be controlled by discrete regimes: federal-law governance for the non-owner employees; state-law governance for the working owner." 25/
Third, the court found persuasive a Department of Labor Advisory Opinion that was fully consistent with its decision. 26/
Based on these three considerations - the statutory text, the statute's purpose and the Department of Labor's position - the court held that all working owners may qualify as participants so long as the plan covers at least one common law employee who is not an owner or married to one.
Implications
One upshot of Yates is that it expands the meaning of the term "employee" beyond the common law definition adopted by the court in Darden. This apparently was necessary for the court to develop a uniformly applicable rule that treats all working owners - sole proprietors, single shareholders and partners - alike. Indeed, the court could have turned to the common law again, with the probable result that Dr. Yates, as a sole shareholder, would have been found to be an employee. See Yates, 124 S. Ct. at 1347 (Thomas, J., concurring). But in other cases down the road, where the working owner happened to be doing business in the form of a partnership or as a sole proprietorship, the common law would produce the opposite result. This would leave the problem of different legal regimes governing different participants in the same plan unresolved. The court's solution appears to eliminate this problem once and for all.
Another potential implication of the Yates decision is that it may pull the rug out from under a related line of cases holding that a working owner who participates in a plan qualifies as a plan "beneficiary" under ERISA. The Supreme Court noted a split in the circuits on this issue but expressly declined to reach it. 27/
In these cases, the courts apply the statutory definition of "beneficiary" - "a person designated by a participant, or by the terms of an employee benefit plan, who is or may become entitled to a benefit thereunder" - literally and, we argue, out of context to find ERISA coverage based on the working owner's purported status as a beneficiary.
But the term "beneficiary" cannot be viewed in isolation. It is informed by other ERISA provisions, which repeatedly refer to "participants... and their beneficiaries" and "participants or their beneficiaries." 28/ It appears that the term was intended to cover persons designated by the participant or by operation of the terms of the plan in lieu of such a designation, as can happen for example when a designation has not been updated prior to the participant's death. As the United States argued in an amicus brief filed in Yates, if the term "beneficiary" is divorced from the participant-employee nexus, then virtually anyone, including even independent contractors, could be permitted to participate in the plan by virtue of a simple designation.
The second reason offered by courts in support of a broad reading of "beneficiary" is that "to hold otherwise would create the anomaly of requiring some insureds to pursue benefit claims under state law while requiring others covered by the identical policy to proceed under ERISA." Wolk v. UNUM Life Insurance Co., 186 F.3d 352, 357 (3d Cir. 1999). After Yates, however, this rationale evaporates, as the court employed the exact same reasoning to hold that working owners can qualify as participants. Accordingly, most of the impetus for these cases appears to have disappeared.
Bankruptcy-ERISA Questions Unanswered
The court remanded the case for further proceedings consistent with the opinion, with instructions to consider the bankruptcy-ERISA issues raised but never fully addressed in the courts below: 1.) Whether Dr. Yates's 1996 loan repayment, "despite the prior defaults, became 'a portion of Yates's interest in a qualified retirement plan... excluded from his bankruptcy estate"; and 2.) If so, whether those payments were subject to the bankruptcy trustee's power to avoid and recover preferential transfers. The court also raised the issue of whether Dr. Yates's handling of the entire loan transaction, from 1989 until 1996, violated ERISA's anti-inurement rule.
Conclusion
The Supreme Court's decision brings much needed common sense to the law governing working-owner participation in employee benefit plans. By holding that working owners may qualify as plan participants, so long as there is at least one employee in the plan who is not an owner or a spouse of one, the court has adopted an understandable, fair rule that should lead to predictable results.
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For more information about the issues covered in this report, please contact Charles M. Dyke in our San Francisco office at 415-369-7206 or at cmdyke@thelen.com, David L. Bacon in our Los Angeles office at 213-576-8078 or at dlbacon@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
ENDNOTES
1/ Hendon v. Raymond B. Yates, M.D., P.C. Profit Sharing Plan, 287 F.3d 521 (6th Cir. 2002); Agrawal v. Paul Revere Life Insurance Co., 205 F.3d 297 (6th Cir. 2000); Fugarino v. Hartford Life & Accident Insurance Co., 969 F.2d 178 (6th Cir. 1992); Madonia v. Blue Cross and Blue Shield of Virginia, 11 F.3d 444 (4th Cir. 1993).
2/ Mertens v. Hewitt Associates, 508 U.S. 248, 262 (1993).
3/ ERISA §206 (d) (1), 29 USC §1056 (d) (1).
4/ E.g., Fugarino v. Hartford Life and Accident Insurance Co., 969 F.2d 178 (6th Cir. 1992). ERISA bars extra-contractual remedies. ERISA §§404 (a), 502 (a), 29 USC §§1104 (a), 1132 (a); Massachusetts Mut. Life Insurance Co. v. Russell, 473 U.S. 134 (1985); Pilot Life Insurance Co. v. Dedeaux, 481 U.S. 41, 54 (1987).
5/ ERISA §4 (a), 29 USC §1003 (a).
6/ ERISA §3 (1), 29 USC §1002 (1).
7/ ERISA §3(2), 29 USC §1002 (2).
8/ 29 USC §1002 (7).
9/ ERISA §3 (8), 29 USC §1002 (8).
10/ ERISA §3 (6), 29 USC §1002 (6).
11/ The precise issue in Darden was whether the plaintiff was an employee or an independent contractor. It did not involve a working owner.
12/ Yates, 124 S. Ct. at 1336.
13/ Id. at 1336-37; see 287 F.3d at 524-25.
14/ 124 S. Ct. at 1338.
15/ 29 CFR §2510.3-3 (c) (1).
16/ 969 F.2d at 185-86.
17/ ERISA §403 (c) (1), 29 USC §1103 (c) (1).
18/ 969 F.2d at 186.
19/ 29 CFR §2510.3-3 (b).
20/ 124 S. Ct. at 1340.
21/ ERISA §403 (b) (3), 29 USC §1103 (b) (3).
22/ Id.
23/ Id. at 1340-41.
24/ Id. at 1341.
25/ Id.
26/ Id. at 1342.
27/ Id. at 1338 n.2.
28/ See ERISA §§2 (b), 3 (1), 404 (a) (1) (A ) (i), 29 USC §§1001 (b), 1002 (1), 1104 (a) (1) (A) (i).
©2005Thelen Reid Brown Raysman & Steiner LLP
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