What is a golden parachute?
Golden parachutes are severance and other compensation agreements that protect key employees from the effects of a corporate takeover or change in control. Payments under golden parachutes are triggered by a change in ownership or control of the corporation. They provide key employees, whose employment is often terminated as a result of a takeover or change in control, with either continued compensation for a specified period following their departure, or a lump-sum payment, or some other negotiated benefit.
Although golden parachute payments are deductible by corporations if the payments are reasonable, Internal Revenue Code Section 280G provides that no deduction will be allowed to an employer for any “excess parachute payment.” In addition, IRC Section 4999 imposes a 20% excise tax on the recipient of any excess parachute payment.
Internal Revenue Code definition–Section 280G
Under IRC Section 280G, “parachute payments” are any payments:
- in the nature of compensation,
- made to a “disqualified individual,”
- that are contingent on a change in control in the ownership of a corporation, in the effective control of a corporation, or in the ownership of a substantial portion of the assets of a corporation, and
- that have an aggregate present value of at least three times the individual’s base amount of compensation. (The “base amount” is the employee’s average annual compensation includable in the employee’s gross income for the most recent five tax years ending before the date of the change in ownership.)
Example(s): Lee is an officer of XYZ Corporation and his base amount is $100,000. A payment of $400,000 that was contingent on a change in the ownership of XYZ Corporation is made to Lee on the date of the change of ownership. The payment is considered a parachute payment because it is at least three times Lee’s base amount. (3 x $100,000 = $300,000). If the payment amounted to only $299,999, however, the payment would not be viewed by the Internal Revenue Service as a parachute payment (because the payment didn’t equal or exceed three times Lee’s base).
Caution: The term “parachute payment” also includes any payment in the nature of compensation to (or for the benefit of) a disqualified individual that’s made pursuant to an agreement that violates a generally enforced securities law or regulation. These payments are not included in the three-times-base amount test–they are parachute payments regardless of whether that test is met, and regardless of any change in control or ownership of a corporation.
In the nature of compensation
Generally, all payments that arise out of an employment relationship or are associated with the performance of services are considered to be payments in the nature of compensation. These payments include wages and salary, bonuses, severance pay, fringe benefits, transfers of property, pension benefits, and other forms of deferred compensation.
For purposes of the parachute payment rules, a disqualified individual is any employee or independent contractor who, at any time during the “disqualified individual determination period,” is a shareholder who owns more than 1% of the corporation, an officer, or a highly compensated individual.
Tip: The “disqualified individual determination period” is the 12 months prior to, and ending on, the date of a change in ownership or control of the corporation.
A highly compensated individual is a member of the group consisting of the lesser of the highest-paid 1% of the employees of the corporation or the highest-paid 250 employees of the corporation. However, an individual is not considered highly compensated unless he or she has compensation in the year the change in control occurs of at least the amount described in IRC Section 414(q) ($120,000 for both 2016 and 2015).
Whether an individual is an officer is determined on the basis of all the facts and circumstances. However, no more than 50 (or if less, the greater of 3 employees, or 10% of employees) are treated as officers for this purpose.
Change in ownership or control
A payment is considered to be contingent on a change in ownership or control if the payment would not have been made had no change in ownership or control occurred. If it’s substantially certain that a payment would have been made whether or not the change occurred, then the payment is not considered to be contingent on a change in ownership or control.
In general, a payment is also treated as contingent on a change in ownership or control if the following conditions exist:
- The payment is contingent on an event that is closely associated with a change in ownership or control
- A change in ownership or control actually does occur
- The event is materially related to the change in ownership or control (i.e., the event occurs within the period that begins one year before and ends one year after the date of change in ownership or control)
Examples of events that are closely associated with a change in ownership or control include:
- the onset of a tender offer
- a substantial increase in the market price of the stock that occurs within a short period prior to a change in ownership or control
- the cessation of the listing of the stock on an established securities market
- the acquisition of more than five percent of the corporation’s stock by a person or persons acting as a group not in control of the corporation
Tip: If an employee has a vested right to receive a payment in the future, and the payment is accelerated as a result of a change in ownership or control, only the excess (if any) of the amount actually received over the present value of the future payment is treated as contingent on the change. In certain instances, even if a future payment is not accelerated, a portion of the payment may be treated as contingent on a change in ownership or control if the right to the payment becomes vested as a result of the change.
Caution: IRS regulations provide that a payment is presumed to be contingent on a change in ownership or control if the payment is made pursuant to an agreement entered into (or significantly modified) within one year before the date of the change in ownership or control. This presumption can be rebutted only by clear and convincing evidence that the payment was not contingent on a change in ownership or control of the corporation.
Because the parachute provisions are aimed primarily at publicly traded companies, these provisions do not apply to payments made by small business corporations and certain others. Specifically, the term “parachute payment” does not include any payment to a disqualified individual from:
- A corporation eligible to elect S status, as defined in Internal Revenue Code Section 1361
- A corporation whose stock is not readily tradable prior to the change in ownership–but only if more than 75% of the shareholders approve the payment
- A qualified plan, SEP, or SIMPLE IRA
- A tax exempt organization under sections 501(c), 501(d), and 529, if certain requirements are satisfied
If the individual establishes (by clear and convincing evidence) that certain payments are reasonable compensation for personal services to be rendered on or after the date of the change in ownership or control, these payments are also excluded from the definition of parachute payment (and are not included in the three-times-base amount test).
Caution: Severance pay and payments that are parachute payments as a result of agreements that violate securities laws or regulations are never treated as reasonable compensation.
What are the tax consequences?
Generally, parachute payments are includable in the taxable income of the recipient when received. In addition, IRC Section 4999 imposes a 20% excise tax on the recipient of any “excess parachute payment.”
Generally, parachute payments are deductible as reasonable compensation for personal services actually rendered. However, IRC Section 280G disallows a deduction for any “excess parachute payment” paid or accrued.
Excess parachute payments
An excess parachute payment means an amount equal to the excess of any parachute payment over the individual’s “base amount.” The base amount is the individual’s average annual taxable compensation for the most recent five years before the takeover.
Example(s): John was a director of the ABC Corporation, which was taken over by another business. John had been averaging a $120,000 salary for the past five years. Under an agreement, ABC Corporation paid John $500,000 on the date of the takeover. Assume John’s base amount is $120,000. The $500,000 payment to John was an excess parachute payment because it exceeded the $360,000 base amount ($120,000 x 3). The excess payment of $380,000 ($500,000 – $120,000) is not deductible by the corporation, and John must pay an excise tax of $76,000 (20% of $380,000).
Caution: Payments are not parachute payments unless the aggregate amount received is at least three times the employee’s base amount of compensation. However, once this threshold is met, the amount that is an excess parachute payment is the portion of the parachute payment that exceeds the employee’s base amount of compensation.
If a disqualified individual receives more than one parachute payment, the base amount must be allocated among the payments in order to calculate the excess parachute payment amount. The portion of the base amount allocated to any parachute payment is determined by multiplying the base amount by a fraction, the numerator of which is the present value of the parachute payment and the denominator of which is the aggregate present value of all the parachute payments.
Example(s): Jane, whose base amount is $100,000, is entitled to receive two parachute payments, one of $200,000 and the other of $400,000. The $200,000 payment is made at the time of the change in ownership or control, and the $400,000 payment is to be made at a future date. The present value of the $400,000 payment is $300,000 on the date of the change in ownership or control. The portions of the base amount allocated to these payments are $40,000 (($200,000/ $500,000) × $100,000) and $60,000 (($300,000/$500,000) × $100,000), respectively. Thus, the amount of the first excess parachute payment is $160,000 ($200,000 minus $40,000) and that of the second is $340,000 ($400,000 minus $60,000).
An excess parachute payment can be reduced by any portion of the payment that the individual establishes (by clear and convincing evidence) is reasonable compensation for personal services actually rendered by the individual before the date of the change in ownership or control. Reasonable compensation is based on the facts and circumstances of each case. Factors relevant to the determination include the following:
- The nature of the services rendered
- The individual’s past compensation for performing similar services
- The compensation of individuals performing comparable services in situations where the compensation is not contingent on a change in ownership or control
The following example illustrates how an excess parachute payment is calculated where a disqualified individual establishes that a portion of the payment constitutes reasonable compensation.
Example(s): Assume that a parachute payment of $600,000 is made to a disqualified individual, and the portion of the individual’s base amount that is allocated to the parachute payment is $100,000. Also assume that $300,000 of the $600,000 parachute payment is established as reasonable compensation for personal services actually rendered by the disqualified individual before the date of the change in ownership or control. Before the reasonable compensation is taken into account, the amount of the excess parachute payment is $500,000 ($600,000-$100,000). The $300,000 of reasonable compensation is first allocated to the disqualified individual’s base amount ($100,000). The excess ($200,000) then reduces the excess parachute payment. Thus, in this case, the excess parachute payment of $500,000 is reduced by $200,000 of reasonable compensation, resulting in an adjusted excess parachute payment of $300,000.
Why would an employer want to use golden parachutes?
Employers provide golden parachutes to key employees for several reasons, including:
- To provide incentives to sought-after employees to join an employer (or to remain with an employer) despite significant risk of a takeover or change in control that could result in employees losing their jobs
Example(s): Toy Shop, Inc. employed Bob Smith as a top executive. Because the company was very profitable, several international corporations expressed a desire to buy Toy Shop, Inc. Smith feared that he’d be left without a job if the company accepted one of the foreign offers, so he asked the officers of Toy Shop, Inc. to pay him a large bonus if the corporation got sold. This bonus would amount to three times his average annual salary.
- To reduce key employees’ incentive to oppose takeovers that are beneficial to the organization but may endanger the employees’ job