Companies planning a merger, or an acquisition have plenty of issues to consider, among them executive golden parachutes. Accounting for the consequences of executives’ golden parachutes during an M&A transaction is important because of their potential for producing unpleasant surprises: such as disqualified individuals who owe excise taxes or how they can jeopardize companies’ tax deductions.
Golden parachute payments are payments of compensation made to individuals whose companies experience a change in control. Congress added Sec. 280G to the IRC to discourage companies from paying golden parachutes. This change was the result of critics of such contracts asserting that golden parachutes encouraged company management to pursue a merger or acquisition that was not in shareholders’ best interest in order to ensure large payouts for management.
The golden parachute payment rules under Sec. 280G are easier to navigate if you understand how they work. To help this understanding, this article reviews frequently asked questions and their answers.
- What are parachute payments?
They are payments of compensation made to “disqualified individuals” (see the definition below) that are contingent on a “changes in control” (also defined below).
- Who are disqualified individuals?
There are three categories of disqualified individuals: shareholders who own more than 1% of the fair market value of the corporation’s stock and provide services, officers of the corporation and highly compensated individuals. Highly compensated individuals generally include the top 1% paid (limited to 250 individuals) over the one-year period preceding a “change in control.” A disqualified individual can be an employee, an independent contractor or a director.
- What is a change in control?
A change in control involves any of three events:
- A change in ownership of the corporation’s stock. This generally includes when one person (or more than one person acting as a group) acquires stock of the corporation that, when aggregated with previously owned stock, results in ownership of more than 50% of the total fair market value or total voting power of the corporation’s stock.
- A change in ownership of a substantial portion of the corporation’s assets. This generally occurs when one person (or more than one person acting as a group) acquires assets from the corporation that have a total gross fair market value equal to or greater than one-third of the total gross fair market value of all the assets of the corporation.
- A change in effective control of the corporation. A change in effective control is presumed to occur if (1.) one person (or more than one person acting as a group) acquires stock of the corporation possessing 20% or more of the total voting power of the corporation, or (2.) a majority of the corporation’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the board prior to the date of the appointment or election.
- Do parachute payments create tax penalties?
Parachute payments do not result in adverse tax consequences, but excess parachute payments do. Disqualified individuals must pay a 20% excise tax on all excess parachute payments they receive in addition to the ordinary income taxes owed on those excess payments. Also, corporations cannot take a tax deduction for the excess parachute payments.
- When do parachute payments become excess parachute payments?
Excess parachute payments result if total parachute payments equal or exceed a threshold. The threshold is three times the disqualified individual’s “base amount” (the average annual compensation of the individual over the past five years, as described in more detail below). If the total parachute payments equal or exceed three times the base amount, excess parachute payments exist. However, the three-times-base-amount calculation is simply a threshold test. If the parachute payments equal or exceed three times the base amount, the total excess parachute payments equal the total parachute payments less one times the base amount.
- Can the corporation “gross up” the disqualified individual for the excise tax?
Yes, the corporation can make additional payments to the disqualified individual to cover the excise tax on the excess parachute payments. The corporation can do this to make the disqualified individual whole and pass the excise tax burden to the corporation. The corporation should be aware that the gross-up payments will also be considered excess parachute payments. The gross-up payments will be subject to the 20% excise tax and will not be deductible by the corporation. The cost to the company of a gross-up payment can be significant.
- Besides penalties, why should a corporation care about parachute payments?
The corporation is responsible for withholding the 20% excise tax from the payments made to the disqualified individual and depositing the excise tax with the IRS. In addition, the corporation must report the excise tax separately on Form W-2 or Form 1099 provided to the disqualified individual and the IRS.
The disqualified individual’s employment or service contract may require the corporation to gross up the disqualified individual for the 20% excise tax if excess parachute payments exist, so the corporation must calculate the excise tax accurately. In addition, the employment or service contract may include a “haircut” provision limiting the amount of parachute payments so that no payments result in an excess parachute payment. The corporation must be able to identify and calculate all parachute payments that will be made to the disqualified individual so that the haircut provision can be applied accurately.
The entity acquiring the corporation in the change in control may require the corporation to represent that no payments will result in excess parachute payments. If excess parachute payments will be made, the acquiring corporation may require an adjustment in the purchase price of the corporation.
- Can a change in control occur if a parent corporation sells all the stock of a subsidiary?
Yes, a change in control of the parent can occur if the subsidiary’s stock is a substantial portion of the parent corporation’s assets. A change in control does not occur separately for the subsidiary because the parent and subsidiary are treated as a single corporation for this purpose.
- When is a payment contingent on a change in control?
A payment is contingent on a change in control if the payment was generated by the change in control or is made as a result of an event that’s closely associated with the change in control and the event is materially related to the change in control. For example, separation from service — whether voluntary or not — is an event closely associated with a change in control. If the separation from service is materially related to the change in control, payments made to the disqualified individual as a result of the separation from service will be parachute payments. A payment that becomes vested as a result of the change in control is a payment that is contingent on the change in control.
- Are any payments presumed to be contingent on a change in control?
Payments are presumed to be contingent on a change in control if they are made according to an agreement entered into within one year before the change in control or according to an amendment to an agreement made within one year before the change in control. This presumption can be rebutted by showing clear and convincing evidence that the agreement was entered into, or the amendment was made, without regard to the change in control.
- How are stock options treated for purposes of the parachute payment rules?
Vested stock options are generally treated as outstanding stock, including when determining who is a shareholder for purposes of identifying disqualified individuals. Stock options that become vested because of the change in control are treated as outstanding stock for purposes of identifying disqualified individuals. Vested stock options are also treated as outstanding when determining if a change in ownership of the corporation has occurred. On the other hand, if stock options are not vested, they are not treated as outstanding stock. Vested stock options generally do not result parachute payments, while stock options that become vested because of the change in control do result in parachute payments.
- What are examples of parachute payments?
Parachute payments include all payments of compensation that are contingent on a change in control. This is a broad definition that could include forms of compensation that you may not identify initially. Some examples include the following:
- Bonuses paid because of the consummation of the change in control
- Retention bonuses paid after the change in control
- Accelerated vesting of stock options, restricted stock or other forms of equity-based compensation
- Fringe benefits
- Severance payments
- Accelerated vesting of nonqualified deferred compensation
- Life insurance
- Forgiven loans
- Post-change-in-control employment or consulting arrangements
- How can a company reduce or eliminate parachute payments or excess parachute payments?
A parachute payment can be reduced or eliminated by demonstrating with clear and convincing evidence that the payment is reasonable compensation for personal services provided after the change in control. For example, a severance agreement may state that the disqualified individual cannot compete with the corporation for a certain period of time after employment is terminated. The corporation may be able to demonstrate that all or a portion of the severance payment is reasonable compensation for the disqualified individual not to provide services to a competitor. If so, the parachute payment for the severance can be reduced by the amount that is reasonable compensation for not competing with the corporation. Post-transaction reasonable compensation is the most beneficial because it reduces the parachute payment before the three times base amount test is applied. Before attempting to determine whether payments are reasonable compensation for a non-compete, corporations should ensure that the non-compete is enforceable under applicable law. Some states and localities have pass laws to eliminate or limit the enforceability on non-competes.
Excess parachute payments can also be reduced by demonstrating with clear and convincing evidence that a portion of the excess parachute payment is reasonable compensation for services performed before the change in control. For example, when compared to similar executives at peer companies, the disqualified individual may have been underpaid in years before the change in control. The corporation may be able to show that all or a portion of a change-in-control bonus or other parachute payment is a “catch up” payment to the disqualified individual for being underpaid in previous years. While pre-transaction reasonable compensation will reduce the excess parachute payments subject to the 20% excise tax, it likely will not completely eliminate the excess parachute payments subject to the penalties.
To reduce parachute payments or excess parachute payments for reasonable compensation, the corporation must show clear and convincing evidence that the compensation is reasonable. This may require a compensation study.
- What is the base amount, and how is it calculated?
The base amount is used to calculate the three-times and one-times thresholds discussed previously. A disqualified individual’s base amount is equal to the disqualified individual’s average annualized wages over the five years preceding the year in which the change in control occurs. The disqualified individual’s wages for the year of the change in control do not count toward the base amount. A disqualified individual’s wages include the amount reported on his or her Form W-2 in box 1 or Form 1099-NEC in box 1. Special rules apply for disqualified individuals who did not provide services to the corporation for the entire five years before the change in control, who joined the corporation as a result of an acquisition, who were hired midyear or who were hired during the year of the change in control.
- Do the parachute payment rules apply to private and public corporations?
Both private and public corporations that experience a change in control are subject to the parachute payment rules under Sec. 280G.
- Do the parachute payment rules apply to entities other than corporations?
Generally, no, but be careful. Entities like partnerships, limited liability companies (LLCs) and tax-exempt organizations are not subject to the parachute payment rules. However, if a partnership or LLC is sold and the partnership or LLC represents a substantial portion of a parent corporation’s assets, a change in control will occur for the parent corporation. In addition, if a parent partnership or LLC owns a corporation and the parent is sold, a change in control can occur. Some other entities that are not corporations, such as publicly traded partnerships and real estate investment trusts, are treated as corporations for purposes of the parachute payment rules.
- Which if any corporations are not subject to the parachute payment rules?
A corporation that qualifies as a “small business corporation” is not subject to the rules. To qualify as a small business corporation for this purpose, the corporation cannot have more than 100 shareholders, cannot have as a shareholder a person other than an individual (with certain exceptions) and cannot have more than one class of stock. Certain other requirements must be met. Generally, these are the requirements a corporation must meet to elect to be treated as an S corporation. However, a corporation is not required to have made an S election to qualify as a small business corporation for purposes of the parachute payment rules.
- When should I begin considering parachute payments?
You can start preparing as early as when the corporation enters into an employment or service contract with an individual who may be considered a disqualified individual. The plan can include certain provisions to limit exposure to the rules.
Do not wait until immediately before or after a change in control to address parachute payments. Certain planning opportunities may be available if you plan in the year before the change in control occurs. If the change in control is imminent or has already occurred, consult a tax professional quickly to help identify parachute payments and determine whether adverse tax consequences apply.
- What are some ways to plan for parachute payments?
You can implement various planning strategies to reduce the likelihood that excess parachute payments will exist upon a change in control. For example, there are strategies to increase a disqualified individual’s base amount, reducing the likelihood that the total parachute payments will exceed the three-times base amount threshold. Under a special rule, if private companies can get shareholder approval of payments that will be made to a disqualified individual upon a change in control, the approved amounts are not treated as parachute payments.
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