Corporations planning for or undergoing mergers or acquisitions, also referred to as changes in control (CIC), must consider a vast number of issues, including the often unexpected and unwelcome challenges surrounding “golden parachute” payments to key executives. The tax rules surrounding golden parachutes are important because of the possible penalties: a loss of deduction for the corporation and a 20% excise tax (in addition to normal taxes) imposed on the employees. A reasonable compensation analysis may eliminate or reduce the exposure, should a company and its key executives be subject to these penalties.
Golden parachute payments, as defined under Section 280G of the Internal Revenue Code, are compensation paid to certain service providers, including officers, shareholders and highly compensated individuals, in connection with their company’s experiencing a CIC. Golden parachutes result in “excess parachute payments” when an individual’s aggregate golden parachutes equal or exceed a certain threshold amount (three times the individual’s five-year average compensation). Harsh penalties are imposed on these excess parachute payments. Unfortunately, the excess parachute payment is not the amount by which the aggregate golden parachutes exceed the threshold but is equal to the aggregate golden parachutes, less one times the individual’s average five-year compensation.
For example, assume Jill’s aggregate golden parachute payment is $1 million, and her average annual five-year compensation is $300,000. Jill has excess parachute payments because her golden parachutes ($1 million) exceed three times her average five-year compensation ($900,000). The amount of her excess parachute payments is $700,000 ($1 million - $300,000). Because Jill’s golden parachutes exceed her threshold by $100,000, Jill will pay a 20% excise tax on $700,000, and the company will lose a deduction for the same amount.
Fortunately for Jill and the company, parachute payments do not include payments that are reasonable compensation for services to be performed following the CIC event. If Jill and the company can determine that more than $100,000 of her golden parachutes are reasonable compensation for services after the CIC, Jill’s total golden parachutes will be less than her threshold, which will eliminate the penalties for Jill and the company.
To take advantage of this exception, Jill and the company must be able to show clear and convincing evidence
that the compensation is reasonable. This includes applying legislative history, regulatory guidance and case law to support the facts and circumstances.
Forms of compensation that may be considered reasonable for post-CIC services
In our example below, we will show how a severance parachute payment can be reduced or eliminated for reasonable compensation not to compete. Severance is a typical parachute payment that can be reduced for reasonable compensation as long as it is attached to a noncompete agreement. However, not all severance can be reduced for reasonable compensation. Severance is not eligible for reasonable compensation if it is paid because of termination of employment prior to the end of a contract term (e.g., severance is equal to what the employee would have been paid over the remaining term of the employment contract). Alternatively severance is eligible for reasonable compensation if the severance would have been paid to the employee, regardless of when the termination occurred (e.g., severance is equal to one year of salary regardless of when the employee is terminated).
If an employee is terminating employment at the time of the CIC, but signs a consulting agreement with the buyer prior to the CIC, the payments under that consulting agreement may be parachute payments. However, the parachute payments may be reduced or eliminated to the extent the consulting agreement payments are reasonable for the services that the employee will actually provide after the CIC.
The key employee and the buyer may enter into a retention bonus agreement prior to the CIC, providing for a bonus payment if the employee remains employed for a year after the CIC. This is a parachute payment. However, the retention bonus can be eliminated from the parachute payments if it is deemed to be reasonable after all the employee’s other compensation during the one-year period after the CIC is taken into account.
How is reasonable compensation determined?
In general, whether payments are reasonable compensation for services rendered, or to be rendered, is determined on a facts-and-circumstances basis. Unfortunately, “reasonable compensation” is not further defined in Section 280G, nor does Section 280G provide a method or test for determining whether compensation is reasonable. The IRS does provide a few relevant factors within the Section 280G regulations, which should be taken into consideration:
The nature of the services rendered or to be rendered
The individual’s historic compensation for performing such services
The compensation of individuals performing comparable services in situations where the compensation is not contingent on a CIC
Let’s assume that $400,000 of Jill’s $1 million in golden parachutes is a severance payment that will be paid to Jill when she is terminated following the CIC, but only if Jill does not violate a noncompete agreement for one year.
By applying the relevant factors above, we can determine if the severance payment is reasonable compensation for agreeing not to compete for one year.
The first step is to assess the nature of the services rendered or to be rendered. In our example, Jill agrees not to compete against the company for one year. To evaluate this factor, it is helpful to place a value on the noncompete agreement, which can be determined by a valuation expert. The value will take into account factors such as whether the noncompete agreement is enforceable, whether the noncompete agreement actually restricts the employee’s ability to compete, the company’s past history of enforcing noncompetes, Jill’s ability and willingness to compete, Jill’s age and health, and the harm the company could experience if Jill were to compete.
— For our example, a valuation expert determined the value of the noncompete agreement to be $500,000. While this value exceeds the amount of the severance payment, we can’t stop here. We must also assess the remaining relevant factors.
- The next step is to assess Jill’s compensation prior to termination.
— Jill was paid $300,000 for services performed during the year prior to termination. It may be reasonable to pay Jill the same amount of compensation not to compete as the company would pay her to perform services. Alternatively, it may not be reasonable to pay her more not to compete.
- The third step is to assess what similar companies pay similarly situated employees not to compete for one year. To make this assessment, the company can complete a competitive benchmarking analysis of its peers’ severance benefits and noncompete policies.
— The market practice for Jill’s peers is to pay $400,000 in severance for a one-year noncompete agreement.
Two of the factors provided values that exceed or equal the amount of Jill’s severance. Yet one factor, Jill’s historical compensation, indicates a value below the amount of severance. What portion of the $400,000 severance payment can be considered reasonable compensation? A conservative approach is to conclude that the lowest value derived from the above factors is reasonable compensation. So $300,000 of Jill’s severance is reasonable compensation for Jill not to compete with the company for one year, and Jill’s severance golden parachute is reduced from $400,000 to $100,000.
Jill now has total golden parachute payments of $700,000, (after removing the $300,000 of reasonable compensation), which is below Jill’s threshold amount, resulting in no penalties for Jill or the company.
To attribute reasonable compensation to a noncompete agreement and reduce a golden parachute, the company should be able to show that it can stop making payments or recover payments if the noncompete is violated. Also, a noncompete will likely not be respected if it is added to an already existing severance agreement unless the employee receives additional consideration for adding the noncompete. Unfortunately, the additional consideration may also be considered a golden parachute and may be deemed the market value for the noncompete. For example, if Jill received a $50,000 payment for adding a noncompete to her severance agreement immediately prior to the CIC, the $50,000 could set the bar for the maximum amount of compensation that is reasonable for her not to compete. Taking into account that the $50,000 may also be a parachute payment, the exercise of adding the noncompete agreement would result in no net benefit when determining if Jill has excess parachute payments.
To show clear and convincing evidence that compensation is reasonable for services on or after the CIC, the employee must actually provide services. Compensation paid to “consult” after the CIC will not be reasonable unless the individual actually provides valuable consulting services after the CIC.
Penalties triggered by Section 280G can be severe for both the individual and the company. Companies that are considering a future potential CIC event or are entering into new employment agreements with key executives need to consider the impact of Section 280G, and whether potential penalties exist. The time to implement planning opportunities, such as attaching a valid, enforceable noncompetition agreement to parachute payments, is before a potential CIC event is on the table. Opportunities are limited once a CIC event is in process.
Before getting far into a CIC, seek advice from a tax professional.
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