Golden parachute payments.

The multitude of mergers and acquisitions in recent years (especially in the banking industry) has raised various issues that practitioners need to consider even before the prospect of an acquisition arises. These issues range from the proper structuring of a transaction to provide tax-free treatment to the shareholders and the corporations, to the use of tax attributes carried forward from a target following the acquisition.

One issue common to many acquisitions is the application of the golden parachute rules of Sec. 280G. Golden parachute payments are severance payments to be made to a corporation's top employees and directors on a change in control. The reasons for these are varied, but the tax implications are comparatively straightforward. Sec. 4999 imposes a 20% nondeductible excise tax on the recipient of an "excess parachute payment." In addition, the corporation making the payments cannot deduct any amount considered an excess parachute payment. These results can be costly, both to the recipient of the payments and the corporation. In some cases, the recipient will receive substantially fewer benefits than if the change in control had not occurred.

One of the more difficult and time-consuming tasks involving golden parachute payments is the determination and computation of excess parachute payments. Although some other issues must first be resolved, these computations are critical. Additionally, this is the area in which the recipient and the corporation have the best opportunity to minimize the effects of the golden parachute rules through careful tax planning.

Sec. 280G contains some basic definitions related to excess parachute payments, but Prop. Regs. Sec. 1.280G-1 includes numerous questions and answers providing far more explanations (and examples).

Parachute Payments

The golden parachute rules apply to "payments in the nature of compensation" to a "disqualified individual," if such payments are contingent (1) on a change in ownership or effective control of a corporation or (2) in the ownership of a substantial portion of a corporation's assets. Payments are in the nature of compensation "if they arise out of an employment relationship or are associated with the performance of services" (Prop. Regs. Sec. 1.280G-1, Q&A-11). These payments generally include wages, bonuses, severance pay, fringe benefits, pension benefits and other deferred compensation.

Certain payments are exempt from the golden parachute rules, even if they would otherwise be considered in the nature of compensation. These include payments from qualified plans (e.g., Sec. 401(a) plans), certain payments of reasonable compensation, payments made by a small business corporation (i.e., a corporation meeting the requirements of Sec. 1361(b), without regard to Sec. 1361(b)(1)(C)) and certain payments made by a corporation, no stock of which is readily tradable on an established securities market (Kegs. Sec. 1.280G-1, Q&A-5).

Disqualified Individual

A disqualified individual is any employee or independent contractor of a corporation who, during the 12-month period immediately preceding the date of the change in control of the corporation, was a shareholder, an officer or a highly compensated individual (Prop. Regs. Sec. 1.280G-1, Q&A- 15). For purposes of these rules, a shareholder is an individual who owns stock of a corporation with a fair market value (FMV) that exceeds the lesser of $1 million or 1% of the total FMV of the outstanding shares of all classes of the corporation's stock (Prop. Regs. Sec. 1.280G-1, Q&A-17).

The determination of whether an individual is an officer is based on all the facts and circumstances. Generally, an officer is "an administrative executive who is in regular and continued service." The maximum number Of individuals who can be considered officers for this purpose is the greater of three employees or 10% of the total number of employees (not to exceed 50) (Prop. Regs. Sec. 1.280G-1, Q&A-18).

A highly compensated individual is an individual who is (or would be, if the individual were an employee) a member of the group consisting of the highest-paid 1% of the employees of a corporation, or (if less) the highest-paid 250 employees of a corporation. However, a highly compensated individual does not include an individual whose annualized compensation, during the 12-month period immediately preceding the date of the change in control of the corporation, is less than $75,000 (Prop. Regs. Sec. 1.280G-1, Q&A-19).

Excess Parachute Payments

The Sec. 280G golden parachute provisions apply when the aggregate present value of the parachute payments equals or exceeds three times the "base amount" of a disqualified individual. The base amount is the average annual compensation includible in a disqualified individual's gross income for the most recent five tax years (or portion thereof) ending before the date of the change in control. Present value is determined by using a discount rate equal to 120% of the applicable Federal rate, compounded semiannually.

The key item is that the golden parachute rules apply when a disqualified individual receives payments in excess of three times his base amount. However, the 20% excise tax (and the amount not deductible by the corporation) is based on the excess parachute payments, which are equal to the parachute payments in excess of one times the base amount. An employment contract that limits severance payments to 2.99 times an employee's base salary often fails to avoid the parachute payment rules. In most cases, the employee also receives benefits from deferred compensation plans, stock option plans, etc., that cause the total parachute payments to exceed three times the base amount, subjecting not only these additional benefits to the parachute rules, but also a large portion of the severance payments.

The proposed regulations provide some additional rules when computing the aggregate present value of the parachute payments. Prop. Regs. Sec. 1.280G-1, Q&A-24(b), provides that, if a payment would have been made whether or not a change in control occurred, but receipt of the payment is accelerated due to a change in control, the payment is considered a parachute payment only to the extent the accelerated payment exceeds the present value of the payment absent the acceleration.

Prop. Regs. Sec. 1.280G-1, Q&A24(c), applies to a payment accelerated by a change in control that was "substantially certain ... to have been made without regard to the change if the disqualified individual had continued to perform services for the corporation for a specified period of time." Simply put, a vesting period applies to the payment. In this situation, the parachute payment equals the lesser of (1) the amount of the accelerated payment or (2) the amount by which the accelerated payment exceeds the present value of the payment that was expected to be made absent the acceleration, plus an amount reflecting the lapse of the obligation to continue to perform services (but not less than 1% of the amount of the accelerated payment multiplied by the number of full months that the vesting is accelerated).

Example: R is an officer of T Corporation. R has an employment agreement with T. The agreement states that, in the event of a change in control of T, R is entitled to a lump-sum payment from T equal to 2.99 times R'S annual base salary (including bonuses and pre-tax contributions to any qualified T plans). In addition, T will continue to provide health, life and disability coverage for R and his family for the five-year period following the change in control. R also has nonqualified T stock options and participates in T's nonqualified deferred compensation plan. On Jan. 1, 1999, 100% of the stock of T was acquired by an unrelated third party; T was merged into the acquiring corporation.

R'S salary (including deferred compensation and Sec. 401(k) contributions) for the past five years was as follows: 1994--$100,000; 1995--$125,000; 1996--$150,000; 1997--$175,000; 1998--$200,000. In addition, R exercised stock options in 1996, resulting in $250,000 of ordinary income, which was included on R's 1996 Form W-2. Consequently, R's base amount is $200,000.

In accordance with his employment agreement, R is to receive 2.99 times his base salary, plus health, life and disability coverage for the next five years. R'S base salary is $200,000; therefore, he will receive a $598,000 severance payment. The premiums for insurance coverage are $100 per month. The present value of the insurance premiums for five years (assuming a 5% discount factor) is approximately $5,300.

The sales agreement between T and the acquiring corporation provided for the payment of benefits under T's nonqualified stock option and deferred compensation plans. The deferred compensation plan was terminated and the accrued benefits thereunder were paid. All outstanding T options (vested or otherwise) were caused to be exercised or cancelled or both, in exchange for a cash payment to the option holders, equal to the stock's current FMV, less the exercise price of the options. R had accrued $100,000 of benefits under the deferred compensation plan, which would have been paid on Jan. 1, 2001. R also had options to acquire 10,000 shares of T stock at $10 a share; half would have vested on Jan. 1, 2000 and half on Jan. 1, 2001. As of Jan. 1,1999, the stock was valued at $50 per share; R received $400,000 for his options (($50 FMV - $10 exercise price) x 10,000 shares).

Absent the acquisition of T, R would have received the $100,000 of accrued benefits under the deferred compensation plan on Jan. 1, 2001. The present value of this payment, assuming a 5% discount factor (compounded semiannually), is approximately $90,000. Therefore, $10,000 ($100,000 - $90,000) of the deferred compensation is considered a parachute payment.

Absent the acquisition of T, R would have received $200,000 on Jan. 1, 2000, as a result of exercising half of his stock options. R would have received an additional $200,000 on Jan. 1, 2001, as a result of exercising the remaining options. The present value of the options vesting Jan. 1, 2000, assuming a 5% discount factor (compounded semiannually), is approximately $190,000. The amount reflecting the lapse of the obligation to continue to perform services for the options is $24,000 ($200,000 accelerated payment x 1% x 12 months). The amount of the options considered a parachute payment is, therefore, $34,000 ($200,000 - $190,000 + $24,000).

The present value of the options vesting Jan. 1, 2001, assuming a 5% discount factor (compounded semiannually), is approximately $181,000. The amount reflecting the lapse of the obligation to continue to perform services for these options is $48,000 ($200,000 accelerated payment x 1% x 24 months). The amount of these options considered a parachute payment is, therefore, $67,000 ($200,000 - $181,000 + $48,000).

The aggregate present value of the parachute payments made to R is $714,300, comprised of the following amounts:

Severance payment             $598,000
Insurance benefits               5,300
Deferred compensation           10,000
Stock options                  101,000
Total                         $714,300

As previously determined, R's base amount is $200,000; three times this base amount is $600,000. The aggregate present value of the parachute payments exceeds $600,000; therefore, Sec. 280G applies to the payments.

The excess parachute payment is $514,300 ($714,300 present value of parachute payments - $200,000 base amount). This is the amount subject to the 20% excise tax and not deductible by T. The excise tax that R will owe on the payments received from T is approximately $103,000 ($514,300 x 20%). Therefore, R will receive $103,000 less than if T had not been acquired and a change in control had not occurred.

Planning Suggestions

To resolve this loss in benefits to R, T can gross up the payments to R for the excise tax he will owe on the excess parachute payments. Usually, a second gross-up will be made to cover the income taxes due on the excise tax gross-up (which is additional income to R). This, however, can be costly to T--upwards of 25% of the total payments otherwise made to P,, not to mention the large deduction T loses for the excess parachute payments.

T could do several things to minimize (or even eliminate) the excess parachute payments. It can increase R's base amount by substantially increasing his compensation in the year prior to the year in which the change of control occurs, This can be achieved by accelerating the vesting period of nonqualified stock options, so as to allow R to exercise the options prior to the change in control.

Accelerating the vesting period of nonqualified stock options would also serve to reduce the amount of the option payments considered to be parachute payments. For example, if all of R's stock options were vested as of Jan. 1,1999 (the date of the change in control), none of the option payments would be considered parachute payments. The aggregate present value of the parachute payments would, therefore, equal $613,300 ($714,300 - $101,000), which would not exceed three times R's base amount. R would not owe any excise tax on the payments he receives from T, and T could deduct the full amount of the payments made to R.

The excess parachute payments Could also be reduced by deferring the date on which the severance payments (or other benefit payments) become payable to R. By deferring the payments, the present value of the parachute payments is reduced, which may reduce the present value of the payments below three times R's base amount.

T may also want to establish that a portion of the payments made to R is reasonable compensation for services rendered on or after the date of the change in control. Payments for reasonable compensation are not considered to be parachute payments. Therefore, they are not included in the computation of excess parachute payments, are not subject to the 20% excise tax and are fully deductible by T Prop. Regs. Sec. 1.280G-1, Q&A-42, provides examples of reasonable compensation for services rendered on or after the date of a change in control.

Amounts established to be reasonable compensation for services rendered prior to a change in control are not excluded from the parachute payment provisions. Instead, they reduce the portion of the individual's base amount allocated to such parachute payment; any remaining portion of the parachute payment established as reasonable compensation reduces the excess parachute payment (Prop. Regs. Sec. 1.280G-1, Q&A-39, Example 1).

Conclusion

The golden parachute payment roles are complex, and the computations can be time-consuming--up to 50 or more individuals could fall under the Sec. 280G provisions when a change in control occurs. However, with careful planning, the payor corporation and relevant individuals should be able to rearrange the various employment agreements and benefits plans to minimize the effect and cost of parachute payments.

FROM KEVIN F. POWERS, CPA, OAK BROOK, IL3