The “golden parachute”—a payment to key executives of an acquired company who help ensure the success of the sale—has become a common component of corporate combinations. These payments have not gone unnoticed by the tax authorities; under certain circumstances they can be subject to significant taxation. The authors provide an overview of the golden parachute rules, including definitions of important terms, how the IRS and the courts have applied the rules, and certain exemptions.
If a company is considering entering into an agreement with key executives to provide them with an incentive to assist in the successful sale of the company, these payments may be considered “golden parachute payments.” This article summarizes the issues surrounding these payments, outlines the golden parachute rules under Internal Revenue Code (IRC) section 280G, and examines the application of such rules to payments contingent on or closely related to a change of control of the paying corporation. In addition, it summarizes certain exemptions from the parachute rules and possible opportunities for structuring the payments to minimize the effect of the parachute rules and the related excise tax under IRC section 4999. These issues are timely in light of the number of retirement-bound baby boomers heading family corporations.
Issues Surrounding Executive Payments
Payments made to certain key executives and employees because of a change in control may be subject to the golden parachute rules. If these payments are determined to be subject to the golden parachute rules and the payments equal or exceed three times the individual’s average base compensation, then the payment in excess of that average base is subject to a 20% federal excise tax in addition to the normal federal and state withholding requirements. In addition, the excess payments are not deductible to the company.
The meanings of “parachute pament,” “excess parachute payment,” and “exempt payments” are critical in the discussion. A “parachute payment” for purposes of IRC section 280G means any compensation payment made to, or for the benefit of, a disqualified individual that is contingent upon a change in the ownership of a corporation, in the effective control of a corporation, or in the ownership of a substantial portion of the assets of a corporation, with an aggregate present value of at least three times the individual’s base compensation amount. The definition of “parachute payments” also includes any compensation payment pursuant to an agreement that violates a generally enforced securities law or regulation. These agreements ordinarily have two features: 1) a change-in-control clause, which allows the executive to vest certain benefits upon a specified shift in the ownership of the company stock or membership of its board; and 2) a termination clause, which provides for certain payments or benefits if the executive is dismissed or her job responsibilities or status diminished. The term “excess parachute payment” means an amount equal to the excess of any parachute payment over the portion of the base amount allocated to the payment. The base amount of a disqualified individual is the average annual compensation for services performed for the corporation that is subject to the change in ownership or control. The base amount only includes compensation that has been included in gross income.
Why Statutes Were Enacted
The golden parachute provisions (IRC sections 280G and 4999) were added by the Deficit Reduction Act of 1984 in order to discourage the use of golden parachute payments to senior executives of a company in the event of a corporate takeover (Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts, Warren Gorham & Lamont, 1989, pp. 22–35). Congress found that agreements to make such payments hindered “acquisition activity in the marketplace” by making target corporations less attractive to prospective suitors [Bittker and Lokken, quoting Staff of Joint Comm. On Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 199 (J. Comm. Print 1984)]. The prospect of a large payment tends to encourage management personnel of the target corporation to favor a proposed takeover, regardless of whether the takeover would be in the best interests of the target corporation’s shareholders. The payments promised to the executives also decrease the amounts paid to the target corporation shareholders. For these reasons, Congress made such parachute payments “nondeductible to the payor and subject to an excise tax of 20%, in addition to the regular income tax, in the hands of the recipient” (Bittker and Lokken).
The prospect of a large payment tends to encourage management personnel of the target corporation to favor a proposed takeover, regardless of whether the takeover would be in the best interests of the target corporation’s shareholders.
The provisions contain a complex set of definitions and interrelated applications. IRC section 280G(b) defines both “parachute payment” and “excess parachute payment,” and section 4999(a) imposes a 20% excise tax on excess parachute payments. As stated above, section 280G defines a “parachute payment” as a payment to a corporate officer that is made contingent on a change in the control or ownership of the corporation. To fall within the definition, however, the present value of that payment must equal or exceed three times the individual’s “base amount” [IRC section 280G(b)(2)(A)(ii)], which is the average of the individual’s compensation for the previous five years [IRC sections 280G(b)(3), 280G(d)(2)]. The parachute payment rules do not apply to a payment that the individual establishes, by clear and convincing evidence, to be “reasonable compensation” for personal services on or after the date of acquisition of the corporation [IRC section 280G(b)(4)]. An “excess parachute payment” is defined to mean any parachute payment that exceeds the individual’s base amount [IRC section 280G(b)(1)]. To the extent the rules apply, therefore, “any excess of the payments over the recipient’s average annual compensation is generally nondeductible” (Bittker and Lokken). The recipient must pay a 20% excise tax on the nondeductible amount [IRC section 4999(a)].
The legislative history establishes a presumption “that no parachute payment is reasonable compensation for personal services actually rendered,” a presumption that can be rebutted “only by clear and convincing evidence.” One factor to be considered is comparable compensation paid to other individuals for similar services. Can it be shown that total compensation is comparable to the levels of compensation earned by executives in comparable positions?
The determination of what is “reasonable compensation” is a question of fact, which a court reviews only for clear error [RTS Investment Corp. v. Comm’r, 89-1 USTC section 9364, 877 F.2d 647, 650 (8th Cir. 1989)]. The burden of proving the reasonableness of the compensation is on the taxpayer (Hammond Lead Prods. v. Comm’r, 70-1 USTC section 9322, 425 F.2d at 33). In making the factual findings, the court is the exclusive judge of the credibility of the witnesses (RTS Investment Corp.).
A payment is treated as contingent on a change in ownership or control if the payment would not have been made had no change in ownership or control occurred, even if the payment is also conditioned on the occurrence of another event.
In determining that the additional compensation is not reasonable under IRC section 280G(b)(4)(A) for services after a change in control, the court may employ as its decisional standard the congressional conference committee’s presumption of unreasonableness that may be rebutted only by clear and convincing evidence (Cline v. Comm’r, 100 T.C. 331, at 349). The court may also employ the three factors offered by the Joint Committee on Taxation for determining whether the compensation is reasonable: 1) the individual’s historic compensation, 2) the duties to be performed under the contract, and 3) the compensation of individuals of comparable skills (Cline). In addition, the question of whether there are substantial nontax purposes for entering into the agreement is a factor for consideration.
Finally, the IRS has previously ruled that reasonable amounts paid in consideration for a covenant not to compete are compensation for services to be rendered (or not rendered) after the change in control [Treasury Regulations section 1.280G-1, Q&A 11(a)].
Contingent on a Change in Ownership or Control
A payment is treated as contingent on a change in ownership or control if the payment would not have been made had no change in ownership or control occurred, even if the payment is also conditioned on the occurrence of another event. A payment generally is treated as one that would not have been made in the absence of a change in ownership or control, unless it is substantially certain at the time that the payment would have been made whether or not the change occurred. A payment that becomes vested as a result of a change in ownership or control is not treated as one that was substantially certain to have been made whether or not the change occurred.
An event is considered closely associated with a change in ownership or control if the event is of a type often preliminary or subsequent to, or otherwise closely associated with, a change in ownership or control. An event is presumed to be materially related to a change in ownership or control if the event occurs within a period beginning one year before and ending one year after the date of the change in ownership or control. If the event occurs outside of this period, it is presumed not materially related to the change in ownership or control. A payment does not fail to be contingent upon a change in ownership or control merely because it is also contingent on the occurrence of a second event, without regard to whether the second event is closely associated with or materially related to a change in ownership or control. IRC section 280G also includes payments based on a change in ownership of a substantial portion of assets.
The golden parachute rules apply to payments to “disqualified individuals” [IRC section 280G]. Disqualified individuals are employees, independent contractors, and other persons who perform services for a corporation and who are officers, shareholders, or highly compensated individuals. Disqualified individuals also include personal service corporations and similar entities created by individuals [IRC section 280G(c); Treasury Regulations section 1.280G-1, Q&A 16]. An officer generally is an administrative executive who is in regular and continued service; an individual employed for a special and single transaction is not an officer. Whether an individual is an officer for this purpose is determined on the basis of all facts and circumstances, including the source of the individual’s authority, the term for which he is elected or appointed, and the nature and extent of his duties. Any individual who has the title of officer is presumed to be an officer unless the facts and circumstances demonstrate that the individual does not have the requisite authority; however, an individual who does not have the title of officer may nevertheless be considered an officer if the facts and circumstances demonstrate that the individual has the authority of an officer [Treasury Regulations section 1.280G-1, Q&A 18(a)]. Any individual who is an officer of any member of an affiliated group that is treated as one corporation for purposes of the golden parachute rules is treated as an officer of the corporation [IRC section 280G(d)(5); Treasury Regulations section 1.280G-1, Q&A 18(b)]. A highly compensated individual is a disqualified individual when she is (or would be if employed by the corporation) one of the highest-paid 1% of employees or, if less, one of the 250 highest-paid employees of the corporation [IRC section 280G(c)].
Parachute payments contingent on the change in ownership or effective control include 1) payments where an individual’s right to receive the payment (or to receive the payment more quickly) is expressly contingent on the change; 2) payments contingent on an event that is closely associated with a change where the change in ownership or control actually occurs and the occurrence of the event is materially related to the change; and 3) payments made under a contract that is entered into or amended within one year before the change, unless the presumption that payments under the contract are contingent upon a change of control is rebutted based upon the facts and circumstances under which the contract was entered into.
Employment agreements entered into within one year of the change in control (including amendments to such agreements) have a rebuttable presumption that they are contingent on a change in control.
Several exceptions exist that exempt certain payments from the definition of “parachute payment.” Pursuant to IRC section 280G(b)(5), a “parachute payment” does not include any payment made to a “disqualified individual” with respect to a corporation that, immediately before the change in ownership or control, was a small business corporation [as defined in IRC section 1361(b), without regard to paragraph (1)(C)], without regard to whether the corporation had an election to be treated as a corporation under IRC section 1361 in effect on the date of the change in ownership or control.
IRC section 280G(b)(5) also provides that the small business exception will apply where 1) immediately before the change in ownership or control, no stock in the corporation was readily tradable on an established securities market or otherwise; and 2) shareholder approval requirements are met regarding the payment (i.e., the no-market exemption).
The amount of an excess parachute payment is the amount of any parachute payment over the portion of the disqualified individual’s base amount that is allocated to such payment.
The “shareholder approval” required to qualify for the no-market exemption means a vote of persons who, immediately before the change in ownership or control, owned more than 75% of the voting power of all outstanding stock of the corporation entitled to vote, and wherein the adequate disclosure rules are met. Such approval also must be premised upon adequate disclosure of “all material facts concerning all payments” that, but for the no-market exemption, would be parachute payments. An omitted fact will be treated as material if there is a substantial likelihood that a reasonable shareholder would consider it important. The proposed regulations state that the shareholder vote, which can be prospective or retrospective, must determine the right of the disqualified individual to receive the payment, or, in the case of a payment made before the vote, the right of the disqualified individual to retain the payment. If either of the tests is met, the subject payments will not result in the application of the parachute payment rules.
Calculation of Excise Tax and Nondeductibility
The amount of an excess parachute payment is the amount of any parachute payment over the portion of the disqualified individual’s base amount (average annual compensation over the five years before the change in ownership) that is allocated to such payment.
For example, assume that a parachute payment of $600,000 is made to a disqualified individual, and the portion of the individual’s base amount that is allocated to the parachute payment is $100,000. Assume also that none of the $600,000 parachute payment is established as reasonable compensation for personal services actually rendered before the date of the change in ownership or control. In this case, the excess parachute payment is $500,000 and thus, is subject to the 20% excise tax of IRC section 4999 payable by the disqualified individual. In addition, the payor does not receive a deduction for the $500,000 excess parachute payment.
Smith, who has a base amount of $1,000,000 (five-year averaging), is entitled to receive two parachute payments, one of $4,000,000 and the other of $2,000,000. The $4,000,000 is immediately paid upon the change in ownership or control, while the other $2,000,000 payment is postponed to a future date. The present value of the $2,000,000 future payment is $1,000,000 on the date of change. The portions of the base amount allocated to these payments are $800,000 [($4,000,000 ÷ $5,000,000) × $1,000,000] and $200,000 [ ($1,000,000 ÷ $5,000,000) × $1,000,000], respectively. Thus, the excess amount of the first parachute payment is $3,200,000 ($4,000,000 − $800,000) and the excess amount of the second parachute payment is $1,800,000 ($2,000,000 − $200,000).
The following action steps are warranted if the executive compensation awarded by a company would be subject to the golden parachute rules:
- Determine if any of the small business exemptions could apply.
- Calculate the “base” compensation of each of the employees involved.
- Determine which, if any, of the possible structuring alternatives would be most appealing to the employees and the company.
The following steps should be taken to determine the impact of the golden parachute rules and excise tax on the proposed payments:
- Determine whether any of the exemptions can be applied to the subject payments.
- Determine each individual’s base amount based on the prior five years’ includible compensation and, based on the calculation of the base amount, calculate the 300% excess parachute payment threshold.
As soon as it is determined that a potential change in ownership or control may be on the horizon, tax planners should alert the affected individuals of the impact of the golden parachute rules. A working knowledge of the rules will allow for proper planning steps to determine any exemptions and explain the impact to disqualified individuals.