Planning for Golden Parachute Payments

A Primer on the Tax Law Issues

Years ago, “golden parachute” payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code § 162. However, due to controversy over large executive pay packages, the Tax Reform Act of 1984 added § 280G to the Internal Revenue Code. This article discusses planning and tax deductibility issues under the current law.

Golden parachute arrangements typically provide for large cash payments to a corporation’s key executives if those individuals are terminated due to a change in the control of the company.

Years ago, these payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code § 162. However, due to controversy over large executive pay packages, the Tax Reform Act of 1984 added § 280G to the Internal Revenue Code.

General Rules

Section 280G provides that no deduction is allowed for any “excess parachute payment” paid because of a change in effective control of the corporation or a change in the ownership of a substantial portion of its assets. The affected payment may be to an employee, independent contractor, or other person who performs personal services for the company and is an officer, shareholder, or highly compensated individual (§ 280G(c)).

In addition, Code § 4999(a) imposes a 20 percent excise tax on the recipient of any such payment. Since the payment would be taxed to the recipient as ordinary income, his or her total tax could exceed 65 percent. This could include federal income tax, Medicare tax, the 20 percent excise tax, and any state and local income taxes.

Determining an “Excess” Parachute Payment

The rules for determining an excess parachute payment are somewhat complex. The first step is to determine whether a “parachute payment” even exists. A parachute payment is defined as any payment in the nature of compensation to an officer, shareholder, or highly compensated individual which is contingent on a change of control, if the aggregate payment equals or exceeds a dollar figure equal to three times such person’s “base amount” (§ 280G(b)(2)).

For this purpose, the base amount is an individual’s average annualized compensation for the five taxable years ending prior to the year of the change of control (§ 280G(b)(3)(A)).

If the aggregate amount contingent on a change of control exceeds three times the base amount, the excess parachute payment includes the entire portion of such payment which exceeds the base amount. Notice that if the total contingent payment exceeds three times the base amount by even one dollar, the entire amount of the contingent payments in excess of the base amount is an excess parachute payment subject to the loss of deduction and the 20 percent excise tax (§ 280G(b)(1)).

Example

Pam’s average annual compensation for the prior five years was $400,000. Upon a change of control and her impending termination, she is to receive a parachute payment of $1,250,000. Since this amount exceeds three times her base (by $50,000), the entire portion in excess of her base amount ($400,000) is an excess parachute payment. Therefore, $850,000 is non-deductible by the company and Pam must pay an excise tax of $170,000 (20 percent of $850,000). If the payment to her had been one dollar less than $1,200,000, it could have all been deductible and none would have been subject to the excise tax.

Closely Held Companies

Although the golden parachute rules were primarily intended to deal with perceived abuses at publicly traded companies, these rules can also apply to closely held companies. Under § 280G(b)(5), these rules apply to a small business unless the shareholders approve the payment by a super majority vote of more than 75 percent and there was adequate disclosure to shareholders of “all” material facts concerning “all” parachute payments.

Special Rules

The parachute payment amount includes the fair market value of any property. Present value is determined by using a discount rate equal to 120 percent of the applicable Federal rate under § 1274(d), compounded semiannually (§ 280G(d)(3)).

In the case of stock options which provide for accelerated vesting upon a change of control, the regulations include a method for calculating the value of such acceleration (Reg. 1.280G-1, Q/A-13).

Payments to or from a qualified retirement plan are not considered to be parachute payments (§ 280G(b)(6)). However, any compensatory payment made in violation of securities laws may be treated as a parachute payment (§ 280G(b)(2)(B)).

If the excess payment is made while the individual is still an employee, the employer must withhold the full 20 percent excise tax in addition to any other withholding (§ 4999(c)(1)).

Also, note that if an agreement to pay was entered into or amended within a year prior to the change of control, it is “presumed to be contingent” on a change of control unless clearly shown not to be (§ 280G(b)(2(C)(ii)).

Exception for Services to be Provided

Any amount paid for personal services to be rendered on or after the date of the change in control is not considered to be a parachute payment if the company establishes by “clear and convincing evidence” that the amount is “reasonable compensation.” There is a similar exception for reasonable compensation paid for services rendered before the change of control (§ 280G(b)(4)).

Conclusion

There are potential tax traps to avoid while designing parachute payments, so § 280G and § 4999 should be read carefully. The regulations under § 280G were written in a question and answer format. And, although these regulations are lengthy, they should be perused before any agreement providing for a parachute payment is finalized or modified.

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Stephen D. Kirkland, CPA, CMC, CFF, is a compensation consultant with Atlantic Executive Consulting, LLC. He serves as an expert witness in cases involving potentially unreasonable compensation.

Mr. Kirkland can be contacted at (803) 724-1414 or through ReasonableComp.biz, at Stephen.Kirkland@AECG.biz.