Golden Parachutes
A golden parachute is the part of the employment contract that provides the employee will receive large benefits if the company is acquired and the employee’s employment is terminated. Such benefits can take the form of severance pay (cash), bonus, stock options, or some combination thereof.
Because so many companies offer golden parachutes, others need to do so as well to remain competitive. Without a golden parachute, some industries that could be targets (particularly in consolidating industries) may have difficulty hiring executives because they would be worried about the company being bought out and they will lose their job. The parachute softens that blow by providing a hefty severance.
Pros and Cons
Some believe that the existence of a parachute will preserve neutrality in management’s decision-making process when deciding whether to support a sale of the company. For instance, some believe that an executive will be more objective about the loss of their job if they have the parachute to fall back on. However, others believe that the existence of the golden parachute can in fact entice the executive to sell the company to get the big payout. This can be particularly true for executives who are ready to make a move anyway or those that are considering retirement.
Background: Many business sales are accomplished in a friendly manner and in order for that to happen, the executives need to consider an offer and then send it to the Board of Directors for a vote. If an affirmative vote is reached by the Board, then (in the case of a corporation) the shareholders vote. The percentage of votes required to pass depends on the state of incorporation. Knowing this, can you see how the existence of a golden parachute may create a conflict rather than solve the conflict for an executive?
💡 Think about the fiduciary duties that executives have to the company. What are your thoughts?
Some companies do not want to be taken over and a hostile attempt may occur. In these circumstances, making the takeover or purchase of the company cost more is a strategy that sometimes thwarts the takeover. (If you are interested in this aspect of mergers and acquisitions, feel free to research “poison pill” strategies. Unfortunately, they are beyond the scope of this book.) One way of making a takeover cost more is by having golden parachutes.
Parachutes can also serve another purpose, to reward long service in the company’s ending. Critics point out that executives are well paid and should not need to have a parachute.
Taxation
You may or may not be surprised that the US Department of Treasury and the IRS have some impact on golden parachutes given by C-corporations. (S-Corps are exempt.) Sections 280G and 4999 are designed to discourage corporations from making large compensation payments to senior executives and other key service providers in connection with a change in control. (We will discuss further below the applicability and non-applicability to partnerships and LLCs. For now, we keep our focus on C-corps.)
As you will soon learn, 280G and 4999 create adverse consequences for both the corporation paying the compensation and the individual receiving it. IRC § 280G makes “excess parachute payments” non-deductible for the corporation that pays such payments. IRC §4999 wields a 20% excise tax on the executives who receive excess parachute payments. Let’s walk through these provisions and the multitude of defined terms therein.
Section 280G(a) prohibits a deduction for “excess parachute payments.” Section 280G(b)(1) defines “excess parachute payment” as “an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment.” Clearly, we need to know what the underlined terms mean.
Section 280G(b)(2)(A) defines “parachute payment” and introduces another term, “disqualified individual.”
(2) Parachute Payment Defined
(A) In General
The Term “parachute payment” means any payment in the nature of compensation to (or for the benefit of) a disqualified individual if –
(i) such payment is contingent on a change-
(I) in the ownership or effective control of the corporation, or
(II) in the ownership of a substantial portion of the assets of the corporation, and
(ii) the aggregate present value of the payments in the nature of compensation to (or for the benefits of) such individual which are contingent on such change equals or exceeds an amount equal to 3 times the base amount.
For purposes of clause (ii), payments not treated as parachute payments under paragraph (4)(A), (5), or (6) shall not be taken into account
From §280G(b)(2)(A), we determine that we need to have:
- A payment of compensation to a “disqualified individual”
- Contingent upon a change in control
- Aggregate payments equal or exceed 3x the disqualified individual’s “base amount”
Who are the disqualified individuals? Let’s consult the definition in §280G(b)(2)(C).
(c) DISQUALIFIED INDIVIDUALS
For purposes of this section, the term “disqualified individual” means any individual who is-
(1) an employee, independent contractor, or other person specified in regulations by the Secretary who performs personal services for any corporation, and
(2) is an officer, shareholder, or highly-compensated individual.
For purposes of this section, a personal service corporation (or similar entity) shall be treated as an individual. For purposes of paragraph (2), the term “highly-compensated individual” only includes an individual who is (or would be if the individual were an employee) a member of the group consisting of the highest paid 1 percent of the employees of the corporation or, if less, the highest paid 250 employees of the corporation.
Disqualified individuals are:
- Officers
- If the corporation has less than 30 employees, only the 3 highest paid are officers
- If the corporation has between 31 and 500, then 10% of the highest paid are officers
- If the corporation has 500+ then 50 of the highest paid are officers
- 1% shareholders (or $1 million worth)
- Top 1% of employees by compensation (highly compensated individuals)
For examples and additional information, see 26 CFR §1.280G-1 – Golden parachute payments.
Change in control means:
- A person or group acquires 50% of the stock of the corporation.
- 20% change in stock ownership of person or group or 50% change in board membership within 12 months (rebuttable presumption)
- Sale to nonaffiliate of 1/3 or more of assets of the corporation within 12 months
Computing the aggregate payments
In order to determine whether the aggregate payments equal or exceed 3x the disqualified individual’s “base amount,” we need to know the definition of “base amount.” See §280G(b)(3) and then §280G(d)(1). In its simplest form, the base amount will equal a year’s compensation. Once the 3x base amount threshold is met, ALL parachute payments in excess of only 1x the executive’s base amount are generally treated as excess parachute payments that are non-deductible and subject to the §4999 excise tax.
Let’s look at an example. Executive has a base amount of $300,000 and receives a severance of $1mill upon a change in control.
Step 1 – Is there an “excess”?
Parachute payment $1,000,000
3x base $ 900,000
Excess $ 100,000
Answer: YES there is an excess because the threshold (3x base) is exceeded. Establishing the existence of an excess triggers step 2. It does not matter how much the excess is for purposes of step 1. If the excess was $1, we would still move to step 2.
Step 2 – Compute the excess parachute payment
Now we must compute the excess parachute payment that will be subject to taxation.
Parachute payment $1,000,000
1x base $ 300,000
Excess Parachute Payment $ 700,000
§4999 20% excise tax $ 140,000
In our example, we first determined there was an excess and then computed the amount of “excess parachute payment” that will be non-deductible. Here, the corporation may not deduct $700,000 of the $1,000,000 payment it made to the Executive upon the change in control. Additionally, Executive will have to pay $140,000 in excise tax. How much did Executive net before paying income tax on the parachute payment? $860,000. Remember Executive will have to pay income tax on the entire $1,000,000 as well.
What if we change the example to give a Parachute Payment of $899,999 instead of $1,000,000. Redo the steps.
Step 1
Parachute payment $ 899,999
3x base $ 900,000
Excess $ -1
No excess, no need to go to Step 2. Executive receives $899,999 with no excise tax. Executive will have to pay income tax on the $899,999. The corporation gets a deduction on the entire $899,999.
Remember, it is not how much one makes but rather what they keep!
Drafting Considerations
Clearly when it comes to parachutes we want to be sure the most money ends up in the hands of the executive and that the corporation does not lose valuable deductible expenses. However, sometimes it cannot be avoided. If the executive is going to have to pay excise tax, sometimes the corporation covers that cost as well. This would be additional income to the executive.
Drafting to include language that references 280G and the 4999 excise tax is important.
Here is an example from an employment agreement
9. Tax Matters
(a) Withholding of Taxes. The Company may withhold from any amounts payable under this Agreement all federal, state, city or other taxes as the Company is required to withhold pursuant to any applicable law, regulation or ruling.
(b) Parachute Excise Tax. In the event that any amounts payable under this Agreement or otherwise to Executive would (i) constitute “parachute payments” within the meaning of section 280G of the Internal Revenue Code of 1986, as amended (the “Code”), or any comparable successor provisions and (ii) but for this Subsection (b) would be subject to the excise tax imposed by section 4999 of the Code or any comparable successor provisions (the “Excise Tax”), then such amounts payable to Executive hereunder shall be either:
(i) Provided to Executive in full; or
(ii) Provided to Executive to the maximum extent that would result in no portion of such benefits being subject to the Excise Tax;
whichever of the foregoing amounts, when taking into account applicable federal, state, local and foreign income and employment taxes, the Excise Tax and any other applicable taxes, results in the receipt by Executive, on an after-tax basis, of the greatest amount of benefits, notwithstanding that all or some portion of such benefits may be taxable under the Excise Tax.
Applicability to Unincorporated Entities
Generally speaking, LLCs and partnerships (Sub K entities) are not subject to §280G but there are instances where it could apply. The details on how this can work should be beyond this course but if you are interested in seeing some examples of how 280G could apply in a Sub K entity setting, see Devin Tenney and Christine Faris, Revisiting the application of Sec. 280G on partnerships and LLCs (Oct. 1, 2018).