Golden parachutes shot full of holes.

GOLDEN PARACHUTES SHOT FULL OF HOLES

One innovation used by corporate executives heavily involved in hostile mergers and takeovers is the "golden parachute" contract. Under this arrangement, if a corporation goes through a change in ownership (or control) and the officer (or key employee) loses his or her job as a result, he or she will receive a special payment typically well in excess of normal compensation.

Originally, when these arrangements were first introduced, the amounts paid were deducted by the corporation as a normal business expense. The Tax Reform Act of 1984, however, changed this treatment; the portion of these payments considered "excess" is no longer deductible by the corporation, and the recipient is subject to added tax on this amount.

"PARACHUTE" PAYMENTS

In general, a "parachute" payment is any payment under an agreement made after June 14, 1984, that

* Is in the nature of compensation.

* Is paid to a disqualified individual.

* Is contingent on a change in ownership (or effective control).

* Exceeds three times that individual's "base" amount.

Compensation. Payments are in the nature of compensation if they arise out of an employment relationship, or are associated with the performance of services. This includes the availability to perform services, as well as refraining from such work (that is, covenants not to compete), and may include transfers of property.

Disqualified individuals. These rules apply to any individual (or personal service corporation) who is both an employee or independent contractor and an officer, shareholder (with stock worth the lesser of $1 million or 1% of total value) or highly compensated individual (that is, making at least $75,000 and among the highest paid 1% or 250 corporate employees).

Applicable transactions. The golden parachute rules apply only if payments are made contingent on a change in a corporation's ownership, in effective control of the corporation or in the ownership of a substantial portion of the corporation's assets.

A payment may be treated as contingent even if the individual's employment or independent contractor relationship is not terminated.

Generally, a payment that would not have been made if there had not been the change in control is contingent. Additionally, a payment is contingent if premised on an event closely associated with the change, such as a tender offer, a 5% acquisition of the corporation's stock, voluntary or involuntary termination of the individual's employment or a reduction in his responsibilities.

In general, a payment that would have been made even without the change in ownership is contingent if the change accelerates the time when the payment is made. If a payment is accelerated and it was substantially certain the payment would have been made if the individual had continued working, only the portion of the payment attributable to the acceleration would be excess.

Excess parachute payments. The excess payment (that is, the amount subject to additional taxation) is the portion of the executive's payment that exceeds three times the individual's average annual compensation for the five previous years.

Note: Certain payments are not included:

* Payments with respect to an S corporation.

* Payments with respect to a corporation in which no stock was readily tradeable.

* Payments from qualified pension plans or simplified employee pensions.

* Payments that can be shown to be reasonable compensation for personal services to be rendered on or after the date of the ownership change.

The portion considered an excess payment may be reduced by any amount that can be proven to be reasonable compensation for personal services actually rendered to the corporation. However, all parachute payments are presumed to be unreasonable; it is up to the individual to prove otherwise.

Certain previously earned compensation paid out by reason of the ownership change may be considered reasonable:

* Payments in cancellation of normal stock options or appreciation rights granted more than one year before the change.

* Pension benefits previously earned but not yet vested.

* Deferred compensation amounts.

* Damages for breach of an employment contract.

For a discussion of the recent regulations in this area, see "New Developments in Compensation and Benefits (Part I)," by Deborah Walker, Joan Vines and Kevin Davis, in the November 1989 issue of The Tax Adviser.

Ed. note: The material discussed provides general information. Before taking any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.

Nicholas J. Fiore, editor The Tax Adviser