Strasburger & Price, LLP Publication

Author Luke D. Bailey
LUKE D. BAILEY
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Taxes, Estate Planning & Employee Benefits Practice

  

Golden Parachutes Under IRC Sections 280G and 4999 — Rules, Strategies, and Tactics

Strasburger is called upon frequently to advise corporations and executives in the areas of executive employment contracts, severance agreements, and changes in corporate control. A substantial tax issue often involved in these engagements is the Internal Revenue Code's "golden parachute" rules found in Code Sections 280G and 4999.

Luke Bailey, a partner in the Dallas office of Strasburger, specializes in ERISA and executive compensation.
  

Outline

 

BUSINESS REASONS FOR PARACHUTES

  1. Maintain competitiveness of organization's executive compensation.
  2. In industries undergoing rapid or frequent consolidation (which aren't?), insulate executives from concern that organization may be target.
    1. Consolidations inevitably produce executive redundancies.
    2. May be necessary to recruit executives to, or retain executives at, smaller or weaker entities.
    3. "Tin parachutes" for upper management employees to help them resist headhunters.
  3. Troubled companies that need to "hang in" long enough to be acquired.
    1. Again, concern over degradation of organization's attractiveness and value as target if attrition of key personnel occurs.
    2. Again, "tin parachutes" for upper management.
  4. Provide an equity-type bonus that enables senior executives to share in payoff to shareholders beyond increase in value of stock and options owned by them (but typically parachutes are not tied to stock value at time of change in control).
  5. Remove what might be executives' personal bias against success of takeover attempt.
      

IRC § 280G makes nondeductible to the payor, and IRC § 4999 imposes a 20% nondeductible excise tax on the recipient of, an "excess parachute payment."

IRC §§ 280G(a) and 4999(a)

  1. An "excess parachute payment" is a payment:
    1. That is "contingent" on a change in control of a corporation. IRC § 280G(b)(2)(A)(i)
    2. To a "disqualified individual." IRC § 280G(b)(2)(A)
    3. To the extent it exceeds one times disqualified individual's "base amount." IRC § 280G(b)(1)
    4. Which taxpayer does not establish "by clear and convincing evidence" is reasonable compensation for services performed before, or to be performed after, change in control. IRC § 280G(b)(4)
  2. Unlike IRC § 162(m), which applies only to public companies, payments in connection with changes in control of both public and private corporations are potentially subject to the "golden parachute" penalties. Exceptions for:
    1. Non-corporate entities. IRC § 280G(b)(2)(A)(i). For LLC's, would depend on whether taxed as corporation or partnership.
    2. S Corporations. IRC § 280G(b)(5)(A)(i)
    3. Corporations that would qualify to be S corporations, but that haven't made S election (i.e., domestic corporations with 75 or fewer shareholders, and no nonindividual shareholders other than estates, qualified S Corp trusts, or qualified plans). IRC § 280G(b)(5)(A)(i)
    4. Any non-publicly traded corporations if shareholders representing 75% of voting power immediately before change in control approve payment in a separate vote. IRC § 280G(b)(5)(A)(ii)
      1. Non-publicly traded corporation must not be member of an affiliated group (80% ownership requirement) with publicly traded member. IRC § 280G(d)(5); Prop. Reg. § 1.280G-1, Q&A-6(c)
      2. Stock in non-publicly traded payor corporation must not represent more than 1/3 of assets of shareholder in corporation if shareholder has any publicly traded equity outstanding. IRC § 280G(b)(5) (flush language); Prop. Reg. § 1.280G-1, Q&A-6(c).
      3. Payment must be at risk, i.e., vote must be on whether payment will be made, not just on whether to ratify and thereby make deductible. Prop. Reg. § 1.280G-1, Q&A-7(a)(2)
      4. Vote can't be combined with other votes, i.e., approval of payment can't be built into approval of change in control. Prop. Reg. § 1.280G-1, Q&A-7(a)(1)
      5. Must be adequate disclosure of all material facts concerning payment. Prop. Reg. § 1.280G-1, Q&A-7(a)(2)
      6. Special issues with respect to 75% of voting power:
        1. If stock of corporation that will potentially make payment represents "substantial portion" of assets of entity shareholder, approval by entity shareholder requires approval by 75% of voting power of shareholders of entity. Prop. Reg. § 1.280G-1, Q&A-7(b). But follow normal voting rights of entity shareholder (e.g., if limited partnership, general partner will typically have 100% of voting power on this issue). Id.
        2. Except in cases where all shareholders are "disqualified individuals," in determining 75% of voting power exclude from both numerator and denominator shares owned by disqualified individuals who have change in control compensation subject to shareholder approval. Prop. Reg. § 1.280G-1, Q&A-7(c)
  3. A "disqualified individual" is any individual or "personal service corporation" under IRC § 269A(b)(1), See IRC § 280G(c)(1), that performs services for corporation as an employee or independent contractor and that is an:
    1. Officer. IRC § 280G(c)(2)
      1. Who is an officer is determined by function, not title. Prop. Reg. § 1.280G-1, Q&A-18(a).
      2. There are limits on number of individuals who will be treated as "officers," based on total number of employees of corporation:

        IF CORPORATION HAS BETWEEN

        MAXIMUM NUMBER OF "DISQUALIFIED INDIVIDUAL" OFFICERS
        0 and 30 employees 3
        31 and 500 employees 10%
        500+ employees 50

        Prop. Reg. § 1.280G-1, Q&A-18(c)
    2. Shareholders owning lesser of 1% or $1 million of stock. IRC § 280G(c)(2); Prop. Reg. § 1.280G-1, Q&A-17
    3. "Highly compensated individual," IRC § 280G(c)(2), which is anyone who is among top 1% of employees by pay, or among top 250 employees if corporation has 25,000 or more employees. IRC § 1.280G(c) (flush language) and Prop. Reg. § 1.280G-1, Q&A-19
  4. For purposes of IRC §§ 280G and 4999, a "change in control" occurs:
    1. When one person, or group of persons acting together, acquires stock that, together with other stock previously owned by person or group, causes person's or group's ownership to go over 50% by value or voting power. Prop. Reg. § 1.280G-1, Q&A-27(a). Such increase in ownership percentage may occur by way of non-pro rata redemption. Id.
    2. There is a rebuttable presumption that a change in control occurs if over a 12-month period either (a) one person, or a group of persons acting together, acquires more than 20% of corporation's voting power or (b) more than half of board is replaced. Prop. Reg. § 1.280G-1, Q&A-28. Presumption may be rebutted by showing that acquisition of stock or change in board membership does not transfer power to directly or indirectly control corporation's management and policies. Id.
    3. When there is a sale over a 12-month or shorter period to one person or a group of persons acting together of 1/3 or more of corporation's assets. Except transfers to:
      1. Shareholder(s) as a dividend or to redeem stock.
      2. 50% or more subsidiary.
      3. 50% or more shareholder or group of shareholders owning 50%.
      4. 50% or more brother/sister company.
          
        Prop. Reg. § 1.280G-1, Q&A-29
          
  5. To be subject to IRC §§ 280G and 4999 penalties, payment to "disqualified person" must be "contingent" on change in control. IRC § 280G(b)(2)(A)(i)
    1. Proposed regulations use a "but for" test for determining whether a payment is "contingent." Prop. Reg. § 1.280G-1, Q&A-22(a)
    2. Special "deemed contingent" rules for:
      1. Payments contingent on events closely associated with changes in control. Prop Reg. § 1.280G-1., Q&A-22(b)
      2. Payments not formally contingent on change in control, but made under agreements entered into within one year of change in control. Prop. Reg. § 1.280G-1, Q&As -25 and -26
          

An "excess parachute payment" is a "parachute payment" that equals or exceeds one times the disqualified individual's "base amount." IRC § 280G(b)(1). A "parachute payment" is a payment contingent on a change in control where the sum of all payments contingent on the change in control equals or exceeds three times the disqualified individual's "base amount."

IRC § 280G(b)(2)(A)(ii)

  1. Thus penalties have a "cliff effect." Can go up to 2.99 times base amount without having penalties apply, but if equal or exceed three times base amount, penalties apply to everything over one times base amount.
  2. "Base amount" is average W-2 compensation over five years preceding year in which change in control occurs. IRC §§ 280G(b)(3)(A) and (d)(1) and (2). Prop. Reg. § 1.280G-1, Q&A-34(a)
    1. Option exercises and payouts of previously deferred nonqualified deferred compensation occurring in any of five years preceding year in which change in control occurs increase executive's base amount.
    2. Deferrals of amounts under nonqualified deferred compensation plans during five years preceding year in which change in control occurs decrease executive's base amount.
    3. If executive's "base period" is less than 5 years, average over shorter period. Annualize partial years, but don't include signing bonuses when annualize. Prop. Reg. § 1.280G-1, Q&A-34(b)
    4. Otherwise similarly situated executives may have substantially different "base amounts" because of different hire dates, patterns of exercise of options, or utilization of nonqualified deferred compensation plans.

      EXAMPLE 1
        
  3. Amounts that otherwise would be "excess parachute payments," but that are demonstrated to be reasonable compensation for services performed before date of change in control, are "parachute payments" for purposes of determining whether the 2.99 ceiling exceeded, but are not in themselves "excess parachute payments" subject to the IRC §§ 280G and 4999 penalties. IRC § 280G(b)(4)(A)
  4. Amounts that otherwise would be "parachute payments," but that are demonstrated to be reasonable compensation for services performed after date of change in control are not "parachute payments" taken into account in determining whether 2.99 ceiling exceeded, and are not themselves "excess parachute payments" subject to IRC §§ 280G and 4999 penalties. IRC § 280G(b)(4)(A)

  

PARACHUTE PAYMENTS OTHER THAN EXECUTIVE SEVERANCE PAYMENTS

  1. Value of acceleration of stock options, SARs, and restricted stock. Prop. Reg. § 1.280G-1, Q&A-22(c)
  2. Value of accelerated SERP accrual and vesting. Id.
  3. Agreement to pay post-termination welfare (e.g., health and/or life insurance premiums) or fringe (e.g., club memberships) benefits.
  4. Make sure option plans not only accelerate vesting but also lengthen period during which options may be exercised following termination of employment.
  5. Make sure to have objective, automatic triggers for acceleration and lengthening of exercise period following termination of employment:
    1. Puts board in almost impossible situation if potential acquiror proposes to reduce the acquisition price by value of accelerations.
    2. Last minute changes to options and other compensatory arrangements will not be possible if acquisition is conditioned on pooling of interests accounting treatment.
  6. In cases of accelerated vesting of options, restricted stock, SARs, etc, only part of value received by executive is subject to IRC §§ 280G and 4999 penalties. This part is sum of:
    1. Excess of amount of payment made in connection with change in control over present value of same payment on date it would otherwise have become vested.
    2. 1% times number of months from date of change in control to date when amount would otherwise have become vested.
        
      Prop. Reg. § 1.280G-1, Q&A-24(c)
        
      EXAMPLE 2
        
  7. Not parachute payments:
    1. Payments from qualified retirement plan, even if plan provides for enhanced vesting or increased accruals following change in control. Prop. Reg. § 1.280G-1, Q&A-8(a)
    2. Payments that merely accelerate receipt of previously vested nonqualified deferred compensation, or that provide for actuarially discounted payment of vested SERP benefit. Prop. Reg. § 1.280G-1, Q&A-24(b)
    3. "Pop" in value of options, SARs, and restricted stock that is attributable to increase in stock price associated with change in control.

  

CHANGE IN CONTROL SEVERANCE AGREEMENTS

  1. Categorized by "trigger" and by planned interaction with IRC §§ 280G and 4999 penalties.
  2. Triggers:
    1. Single Trigger. Executive receives payment if change in control occurs, or if terminates employment for any reason after change in control. Requirement that executive quit in order to receive payment enables negotiation of post-change-in-control retention agreement that may avoid IRC §§ 280G and 4999 penalties, (discussed below).
    2. Double Trigger. Executive receives payment if terminated without cause or quits for "good reason" after change in control.
      1. No standard "good reason" definition; varies from company to company and sometimes among executives within company.
      2. "Tin parachutes" typically are double trigger, with fairly stiff second trigger.
    3. Modified Double Trigger. Agreement provides for double trigger for "transition period" (e.g., one year, but has single trigger during "window" following transition period, e.g., for 30 days commencing on first anniversary of change in control).
      1. Encourages executive to stay through transition period.
      2. Encourages both executive and corporation to come to terms or part ways following expiration of transition period.
  3. Alternatives for dealing with IRC §§ 280G and 4999 penalties:
    1. Do nothing. Never a good strategy:
      1. Results in potentially widely varying results for otherwise similarly situated executives.
      2. Results potentially in executive's receiving less than if there were no severance agreement, or than if severance agreement provided for smaller payment.
    2. 2.99 agreements.
      1. Agreement contains formula that automatically reduces severance payment to extent necessary to ensure that sum of severance payment and other "parachute payments" does not exceed 2.99 times executive's "base amount."
        1. Can work well if base amounts of all covered executives are reasonably high and uniform as to similarly situated executives, and potential "other parachute payments" (see above) are low.
        2. Otherwise, can result in unreasonably small severance payments and/or inequities among otherwise similarly situated executives.
      2. IRC § 4999 excise tax "gross-up":
        1. Ensures payment of reasonably large severance amounts and prevents inequities among otherwise similarly situated executives.
        2. Gross-up payments are, of course, subject to federal income tax themselves and, because they would not be paid but for change in control, are subject to IRC §§ 280G and 499 penalties as well. Gross-up will typically gross executive up for (a) excise tax on initial parachute amount, (b) income and excise tax on gross-up payments themselves.
        3. Only problem with tax gross-ups is they are very expensive — (i) Can be irrationally expensive where sum of severance payment and other parachute amounts exceeds 2.99 times base amount (280G "cliff edge") only marginally; (ii) Even if parachute well in excess of 2.99 times base amount, gross-ups are very tax inefficient when compared to nonparachute compensation. It costs company $1 to have executive receive $1 of non-penalized compensation. It costs company approximately $2.50 to have executive receive $1 of grossed-up parachute payment.
  4. Another key issue in designing severance agreements is how to determine initial amount of severance payments (i.e., before cutback in 2.99 agreements, and before gross-up in agreements with gross-up provisions).
    1. Typically use base salary plus some portion of annual bonus, LTIP, etc.
    2. Should not be based on 280G definition of "base amount," although some severance agreements do that. Basing severance amount on 280G "base amount" can over-reward executives who exercised options and shunned nonqualified deferred compensation opportunities during five years preceding year in which change in control occurs, while penalizing executives who did not exercise and did defer during same period.
  5. Make change-in-control severance agreement triggers as objective and mechanical as possible to avoid conflict of interest for board.
  6. Include provision for reimbursing executive for legal fees and other costs of enforcing severance agreement.
      
    EXAMPLE 3

  

COMPENSATION COMMITTEE ISSUES IN CONNECTION WITH PARACHUTES

  1. Generally, decision to put parachutes in place, including gross-ups, broadly protected by business judgment rule if done before acquisition offer emerges.
    1. Company just keeping up with competitive practices.
    2. Compensation cost nationally "amortizable" over expected period of service before change in control occurs, and "discountable" by risk that no change in control will occur.
  2. If decision is made after offer emerges, tougher Unocal standard (actions must be reasonable in light of threat to corporate policy) applies.
    1. Only justifications are retention during transition and elimination of executives' conflicts of interest concerning acquisition.
    2. Adoption of post-offer single trigger agreements nearly impossible to justify.
  3. In either case, decision to put parachutes in place should be made by outside directors who will not themselves have parachutes. See Tate & Lyle PLC v. Staley Continental, Inc., [1987-1988 Transfer Binder] Fed. Sec. L. Rep. (CCH) 93,764 (Del. Ch. May 9, 1988).
  4. In deciding on design of parachutes, compensation committee should:
    1. Seek input from both legal counsel and compensation consultants.
    2. Base decisions on information concerning:
      1. Competitive practices in industry(ies) from which executives recruited.
      2. Special factors affecting company.
    3. Understand how severance agreements operate, circumstances under which would be triggered, and approximate costs under alternative scenarios.
  5. Very little litigation over parachutes since 1980's.

  

STRATEGIES FOR ATTEMPTING TO AVOID IRC §§ 280G AND 4999 PENAL TIES

  1. Costs company approximately 2.5 times as much to pay an amount as a parachute payment instead of a non-parachute payment. Both corporation and (since corporation will typically be willing to share some of tax savings with executive in order to ensure executive's cooperation) executive have strong financial incentives to avoid "excess parachute payment" characterization.
  2. Possible methods of avoiding parachute treatment:
    1. Boost "base amounts" by exercising options and paying out nonqualified deferred comp, LTIP etc. in year preceding year of change in control.
    2. Where executives have double trigger severance agreements, don't terminate executive or give him or her "good reason" following change in control.
    3. Post-change-in-control employment or consulting agreements.
      1. Acquiror makes generous offer to executive in exchange for executive's agreement not to terminate during period in which would need to do so in order to receive severance payment under single trigger or modified single trigger severance agreement:
        1. Signing bonus.
        2. Raise in base pay over what target paid.
        3. Employment contract with no mitigation provision.
        4. Higher annual bonus and LTIP.
        5. Amount paid for covenant not to compete.
        6. New SERP.
      2. As long as non-severance amounts (e.g., option and SERP acceleration) do not exceed three times base amount, can let those be triggered and replace only severance agreement.
      3. Despite what would have appeared to be good case law to contrary in Balch, 100 TC 331, aff'd 34 F.2d 480 (1994), proposed regulations provide that agreements entered into after date of change in control will not result in parachute payments.
        1. Balch allowed an inference that if executive's post-change in control rate of pay appeared to be in excess of "market," excess was parachute payment, because would not in fact have been paid "but for" change in control.
        2. Proposed regulations seem to cripple Balch. See Prop. Reg. § 1.280 G-F, Q&A-23
    4. Long-term employment contract with mitigation provisions.
      1. Proposed regulations provided that amounts received as damages for breach of employment contract are not parachute payments if executive has obligation to mitigate damages by seeking comparable employment following termination.
      2. In effect, ensures executive's continued employment at current rate of pay — by someone — following change-in-control and for term of original contract. Does not, however, permit early or temporary "retirement."
    5. Provide that severance amount will be paid to executive upon termination of employment in all events, whether or not change in control occurs. Must enter into contract at least one year before change in control occurs; otherwise, presumption that payment is parachute payment.
    6. Additional large grants of vested options in year before year in which change in control occurs. Could work well in turn-around situations where substantial option compensation is warranted for large increases in stock value, whether or not change in control occurs.
    7. If there are grounds for dispute concerning obligation to make severance payment, as well as over other matters in employment relationship, rescind severance agreement as part of "settlement" and pay "settlement." Subject to factual inquiry as to authenticity of dispute. Presumably IRS would try to apply "origin of claim" doctrine to extent allocated settlement payment to parachutes.

  

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