What are Golden Parachute Payments?
The phrase “golden parachute” refers to an agreement between a company and a high ranking executive which calls for the executive to receive a large predetermined amount of compensation in the event there is a “change-in-control” of the company. Although employment agreements may limit the circumstances under which the compensation is received, the rules regulating the tax treatment of golden parachute payments apply regardless of whether or not the executive’s employment is terminated.
In theory, golden parachutes allow executives to retain their objectivity during the takeover process by enabling them to evaluate the terms of the proposed take-over agreements without the concern they will not be adequately compensated by the new owners of the company. Golden parachute payments also enable companies in industries where mergers are common to attract and retain talented executives that would otherwise seek employment in “safer” sectors. The effectiveness of golden parachutes in accomplishing these tasks is periodically an area of intense public and academic debate.
Rules Surrounding Golden Parachute Payments
Federal and state laws do not prohibit or limit a company’s ability to make golden parachute payments to executives or the amount of those payments.
Instead, the Federal Government regulates those payments through the Internal Revenue Code (the “Code”), specifically 26 U.S.C. Section 280G and 26 U.S.C. Section 4999, by taxing them to the employee and not allowing them to be used as a deduction for the company. Payments that are defined by the Code as “excess payments” are subjected to significant adverse tax consequences.
Determining whether compensation paid as a golden parachute constitutes an “excess payment” involves three steps:
- Determine whether the compensation is subject to Section280G of the Code.
- Determine whether the compensation falls under the Code’s safe harbor provision.
- Determine whether the payment is subject to any statutory or regulatory exceptions to the parachute payment rules.
Compensation Subject to Section 280G of the Code
Compensation is only subject to Section 280G of the Code if the payment is:
- To a Disqualified Individual: Disqualified individuals include officers (defined in several Internal Revenue Service regulations), shareholders owning at least one percent of all outstanding stock of the company, and highly compensated individuals. In companies with over 25,000 employees, the highest paid 250 employees are considered highly paid as long as the employee’s income exceeds the amount stated in the Code. In all other companies, the highest paid one percent of all employees is considered highly paid to the extent the employee’s income exceeds the amount stated in the Code.
- In the Nature of Compensation: Regardless of how payments are received, payments are “in the nature of compensation” if the payments are made in exchange for the performance of services for the company. Payments can take a variety of forms including salary, bonuses, severance payments, pension benefits, deferred compensation, life insurance premiums, and other fringe benefits.
- Contingent on a Change in Ownership or Control: As a general rule, change in ownership or control occurs when (i) a person or group acquires half of the corporation’s stock, measured by the number of shares or value of those shares or (ii) a person or group acquires a third or more of the company’s assets, measured by the fair market value of the assets. In addition, a rebuttable presumption that a change of control has occurred is created if a person or group acquires twenty percent or more of a company’s voting power or if more than half of the members of the Board of Directors change within one year as a result of an acquisition of stock.
The Safe Harbor Provision of Section 280G of the Code
Payments which qualify for the Code’s statutory “safe harbor” are automatically exempt from being deemed excess parachute payments. A payment qualifies for the “safe harbor” if the payment is less than three times the executive’s “base amount.”
An executive’s “base amount” is his average compensation over the five completed calendar years immediately preceding the year in which the change in control occurs. An executive’s compensation is defined as the amount of compensation entered on his W-2 form. If an executive has worked at the company for less than five years, his base amount is the average of his compensation for the years he worked for the company. Compensation for partial years worked is annualized.
Other Statutory and Regulatory Exceptions
The Code provides a host of statutory exceptions for specific situations. These provisions are detailed and varied. As always, consulting a lawyer with experience in executive compensation issues is the best way of determining if a payment is subject to any statutory or regulatory exceptions.
Consequences of Violating the Rules Surrounding Golden Parachute Payments
In the event a parachute payment is deemed to be an “excess parachute payment,” the tax code provides two significant negative tax consequences:
- Excise Tax: If a payment to an executive is considered an “excess payment,” the employee must pay a twenty percent excise tax on the FULL AMOUNT of the payment. In addition to the excise tax, the payment is also subject to ordinary income and social security taxes.
- No Employer Tax Deduction: Ordinarily, compensation paid to employees is tax deductible to the company. If a payment is deemed an excess parachute payment, the company is denied a tax deduction on the FULL AMOUNT of the payment. This means the payment is made with after-tax dollars rather than pre-tax dollars.
Solutions to Potential Golden Parachute Payments
Because of the severity of the negative consequences associated with excess parachute payments, companies and employees both routinely seek to protect themselves in the event a payment constitutes an excess payment. Although a variety of arrangements are possible, most agreements use a combination of two approaches:
- Gross-Up: The most desirable approach from the executive’s standpoint is to have the company pay the amount of the excise tax imposed on the excess parachute payment. This is called the “gross-up” method. Companies often resist gross-ups because they are expensive. Not only is the company on the hook for the amount of the excise tax, but the excise tax payment by the company is itself taxable and non-deductible to the company, AND subject to the excise tax. All told, each “gross up” dollar could cost the company significantly more than one dollar.
- Cut-Back: The most desirable approach from the company’s standpoint is a contractual “cut-back” clause which limits the amount of the parachute payment to an amount not to exceed the Code’s safe harbor provision. If an executive anticipates compensation that is more than the safe harbor, such a provision will likely be unacceptable to the executive as well as defeat the purposes for golden parachutes as described above.
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