Avoiding sec. 280G sanctions: valuation of covenants not to compete.

Payment of severance and other benefits that are contingent on a change in corporate control may trigger the application of statutory sanctions imposed on "golden parachute" payments. Sec. 280G disallows corporate deductions of excess parachute payments, and Sec. 4999 imposes a 20% excise tax on the recipient of excess parachute payments. Although generally applied to public companies, these provisions also may apply to nonpublic corporations undergoing a change in control. In many cases, it may be possible to minimize or avoid these costly sanctions.

A parachute payment is any payment that meets all of the following conditions:

1. The payment is in the nature of compensation.

2. The payment is to, or for the benefit of, a disqualified individual (i.e., certain shareholders, officers and highly compensated individuals).

3. The payment is contingent on a change in a corporation's ownership, its effective control, or the ownership of a substantial portion of its assets.

4. The payment, together with all other payments described with respect to the same individual, has an aggregate present value of at least three times the individual's base amount.

An individual's "base amount" in general is the individual's average annualized taxable compensation for the five most recent tax years ending before the change in ownership or control. Parachute payments become subject to the sanctions once they reach three times this base amount. The portion of the parachute payments subject to excise tax and nondeductibility (i.e., the excess parachute payment) is the excess of such payments over the base amount.

Companies may seek to ensure that payments to disqualified executives triggered by a change in control are within parameters not considered excess under Sec. 280G. However, situations may arise in which it is not economically possible to keep aggregate change-in-control payments for a particular disqualified individual below the threshold. A covenant not to compete typically exists as part of an executive's employment agreement. A portion of the aggregate severance payment may be attributable to reasonable compensation for the covenant. Amounts attributable to the covenant could eliminate or reduce the level of excess parachute payments and provide for minimization of tax liability to both the company and the executive.

The valuation of a covenant involves estimating future cash flows under two distinct scenarios. First, in the absence of any competition from the covenantor, cash flows are estimated over the covenant's term (and any additional time period to reflect residual benefits that might accrue beyond this term). Second, future cash flows are estimated under a scenario involving competition in the absence of the covenant. This latter scenario considers the probability of the covenantor competing, along with the potential financial impact on the business from competition. Based on this analysis, the value of the covenant is then represented by the difference in the present value of the cash flows between the two distinct scenarios.

The valuation of covenants arising under change in control and other employment agreements can provide employers and executives with significant tax advantages and should be considered in their overall tax planning. In order to avoid potential pitfalls, it is important to work with experienced employee benefits and valuation personnel who can provide comprehensive review and planning for any adverse tax consequences arising from the application of Sec. 280G.