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Look before you leap: what you should know about golden parachute payments

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Golden parachute FAQsCompanies planning a merger or an acquisition have plenty of issues to consider. An important one is golden parachutes because there’s potential for disqualified individuals to owe excise taxes and companies to lose their tax deduction.

Golden parachute payments are payments of compensation made to individuals whose companies experience a change in control. Congress added Section 280G to the Internal Revenue Code in response to critics of the arrangement, to discourage companies from paying golden parachutes. The critics believed that golden parachutes encouraged company management to pursue a merger or acquisition that wasn’t in shareholders’ best interest in order to ensure large payouts for management.

The golden parachute payment rules under Section 280G are easier to navigate if you understand how they work. These frequently asked questions and answers will help.

What are parachute payments?
They’re payments of compensation made to “disqualified individuals” (see the definition below) triggered by changes in control (also defined below).

Who are disqualified individuals?
These include shareholders who own more than 1% of the fair market value of the corporation’s stock, officers of the corporation and highly compensated individuals. A disqualified individual can be an employee, an independent contractor or a director.

What is a change in control?
It involves a change in any of these three circumstances:
  • Ownership of the corporation’s stock
  • Ownership of a substantial portion of the corporation’s assets
  • Effective control of the corporation

When do parachute payments become excess parachute payments?
Excess parachute payments result if total parachute payments 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 detailed 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 exceed three times the base amount, the total excess parachute payments equal the total parachute payments less one times the base amount.

Do parachute payments create tax penalties?
Parachute payments don’t 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 can’t take a tax deduction for the excess parachute payments.

Can the corporation “gross up” the disqualified individual for the excise tax?

Yes, the corporation can make additional payments to the disqualified individual to gross up him or her for 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, will be subject to the 20% excise tax and won’t be deductible by the corporation.

Besides penalties, why should a corporation care about parachute payments?
A 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, a 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 the purchase price of the corporation to be adjusted.

Public corporations must pay special attention to parachute payments because of the reporting requirements associated with their annual proxy statements. They must report in a separate table in the proxy statement all parachute payments that may be made if a change in control occurs on the last day of the fiscal year. In addition, all parachute payments made in connection with a change in control must be documented on the proxy statement.

Can a change in control occur if a parent corporation sells all the stock of a subsidiary?
Yes, a change in control will occur for the subsidiary if it is a corporation. Also, a change in control can occur for the parent corporation if the subsidiary’s stock is a substantial portion of the parent corporation’s assets.

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.

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 in order to identify 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 there has been a change in ownership of the corporation. On the other hand, if stock options aren’t vested, they aren’t treated as outstanding stock. Vested stock options aren’t treated as a 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:

  • 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
  • Post-change-in-control 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 can’t 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.  

Excess parachute payments can 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 eliminate all 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’s 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. So the disqualified individual’s wages for the year of the change in control don’t 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 in box 7. Special rules apply for disqualified individuals who didn’t provide services to the corporation for the entire five years before the change in control, 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 Section 280G.

Do the parachute payment rules apply to entities other than corporations?
Generally no. Entities like partnerships, LLCs and tax-exempt organizations aren’t subject to the parachute payment rules. However, if a partnership or an LLC is sold and either one 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 corporation owns a corporation and the parent is sold, the subsidiary corporation can experience a change in effective control. Some other entities that aren’t corporations, like publicly traded partnerships and real estate investment trusts, are treated as corporations for purposes of the parachute payment rules.

Which if any corporations aren’t subject to the parachute payment rules?
A corporation that qualifies as a “small business corporation” isn’t subject to the rules. To qualify as a small business corporation for this purpose, the corporation can’t have more than 100 shareholders, can’t have as a shareholder a person other than an individual (with certain exceptions) and can’t 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 isn’t 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.

Don’t 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 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 aren’t treated as parachute payments.

For answers to other questions or more information, email or call Jeff Martin at +1 202 521 1526.

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