Minimize parachute penalties.

Techniques are available to soften the impact of parachute payments.

When executives at United Airlines began calculating what they would have to pay to acquire rival US Airways if the merger had been completed, due diligence took them on an eye-opening ride beyond the balance sheet. Detailed in the employment contracts between US Airways and its senior executives were severance provisions for the top five managers that would add approximately $165 million to the cost of United's takeover deal. Even in a merger valued at more than $11 billion, that was no small sum.

The proposed payout didn't scare away United Airlines, which was convinced that it needed to complete the deal for competitive reasons. As it happens, the company never made those payments because it abandoned the merger in July, right after the U.S. Justice Department said it would sue to stop the deal on antitrust grounds. But as the size of its potential severance expense illustrated, so-called golden parachutes--big compensation packages paid out to executives due to a change in control of the company--shouldn't be overlooked by companies contemplating a merger or acquisition.

Nor should companies enter into parachute plans without careful consideration. CPAs called in to help draft these agreements can, through prudent planning, save their employers and clients significant sums of money (see "Planning for Parachutes").

Planning for Parachutes

Want to help your client or employer craft a good parachute plan--or
minimize the cost of one during a merger or acquisition? Compensation
experts offer this advice:

* Identify the value of comparable severance plans at similar companies
within your industry and region to ensure that you're competitive but
not unnecessarily generous.

* Review the language of your plans carefully, especially the sections
that spell out what will trigger a parachute payment. Some
single-trigger plans take effect on a change of control of the company,
whether or not the covered executive actually loses his or her job.
Dual-trigger plans require that both conditions--a change of control
and loss of position--be met. Other plans are triggered simply by
shareholder approval of a merger or acquisition, which can backfire if
the deal is subsequently scotched by antitrust regulators. Most
compensation experts suggest avoiding that kind of language. Whatever
your objective, "the last thing you want in an acquisition
deal is a plan that is unclear,"
warns Stephen Pennacchio,
CPA and executive director
of compensation and benefits
for Texaco, Inc. "You
want to review the language
both internally and externally
with your accountants
and lawyers."

* Keep things simple wherever
possible. "If telling people
that you'll give them extra
years of service credit in a
pension plan is causing long delays because it requires extra
calculations by actuaries, you may want to assign that benefit a value
equal to the percentage of base salary," Pennacchio says. As to other
benefits, such as medical benefits, using a percentage or dollar amount
also makes the calculation easier.

* Carefully review all benefit plans for their definition of a change
in control, and for the impact of those change-in-control provisions.
Bill Coleman, vice president of compensation for Salary.com, recalls
an incident in which a company was going to buy a smaller business,
and in the midst of its negotiations discovered the purchase would have
triggered parachute payments at one of its own subsidiaries, where no
executives would have lost their jobs because the
company being acquired was
in a different business. The
deal eventually fell through
for other reasons, but had it
not, it could have saddled the
acquirer with expenses it
never intended to incur--and
perhaps even encouraged the
departure of key executives at
its existing subsidiary, who
would have been showered
with an unexpected windfall.

Because of the unusual federal tax treatment parachute plans receive, including a 20% excise tax on payments exceeding a complexly calculated threshold, poor planning can lead to unexpected and exorbitant costs. In worst-case scenarios, companies can find themselves spending more than $3 for every $1 of benefits received by the departing executive. In other cases, poorly worded documents can trigger payments in circumstances where none were intended. "Companies absolutely do not spend enough time thinking about these things," insists Alan Johnson, a managing director with the New York City-based executive compensation firm Johnson Associates. "The issue isn't just how you calculate the parachute payment, but what should trigger it. A lot of companies just copied what everybody else was doing 5 or 10 years ago and haven't thought about it since. But we've been involved in change of control transactions twice where these things became a huge barrier to the deal."

"They can present some thorny issues," agrees Gregory Sneddon, cofounder and senior managing director of Consilium Partners, a boutique mergers-and-acquisitions firm based in Boston. "If the management team of the selling company is asking for usurious levels of financial compensation, it can cause a fair amount of friction."

REIN IN GENEROSITY

Golden parachutes became popular in the early 1980s, the heyday of corporate raiders such as Carl Icahn and T. Boone Pickens. The payout agreements were presented to shareholders as a tool for keeping senior managers focused on the company's interests, rather than on saving their own skin, during a hostile takeover attempt. (For more about types of parachutes, see "Golden Parachutes ... Plus Silver, Tin and Platinum".)

Golden Parachutes ...
Plus Silver, Tin and Platinum

Not all parachutes are golden. Depending on the size and
scope of the payout, severance packages can also be called
silver or tin parachutes.

Golden parachutes are generally defined as those that exceed the
IRS threshold for excessive severance payments, meaning that they
equal or exceed three times the recipient's average salary for the
prior five years.

While it can offer much more, the typical golden parachute provides
the recipient with a minimum of three times his or her annual
salary, three years' worth of bonus, and three years' continuation of
principal benefits, says Roger Siske, a partner at Sonnenschein Nath
& Rosenthal in Chicago and chairman of its national employee
benefits and executive compensation practice. Companies typically
provide golden parachutes only to their top five executives, although
at very large businesses they may include additional high-level
executives.

Judith Fischer, managing director of Executive Compensation Advisory
Services, says that in its 2001 Golden Parachute Report, which
was based on surveys of the entire Fortune 1000, 81% of the
companies reported having golden parachute plans, up from 35%
in 1987. Although she did not have specific data, she said parachute
plans have also become common at smaller companies.

Less prevalent than golden parachute plans, and slightly less
lucrative, are so-called "silver" parachutes, which are sometimes
awarded to executives below the top level. Siske says these plans
typically pay out about 1.5 to 2.5 times the recipient's annual
salary, bonus and benefits, although they sometimes do not cover
bonuses. Often the last isn't a significant issue, since for executives
at this level bonuses tend to account for a much smaller percentage
of total compensation than they do for CEOs and other
senior managers.

Even less common than gold or silver parachutes are tin
parachutes--severance plans that cover all of the employees of a
company in the event it undergoes a change in control. The value of a
tin parachute will vary significantly from company to company, says
Siske, but will typically provide a severance payment linked to the
recipients' years of service and/or their age, often with a cap,
such as 1.5 times annual compensation. Fischer reports that in her
firm's most recent survey of the Fortune 1000, only 7% had tin
parachute plans.

In some cases, severance packages awarded to senior executives
have been termed "platinum parachutes" by the business media, both
because of the enormous size of the payments and because they
haven't always been tied to a change in control of the company. Some
of the most prominent recipients have included former Mattel Inc.
CEO Jill Barad, who benefited from a deal valued at $50 million
when she left the toy maker amid mounting losses; Durk Jager, who
got a $9.5 million severance package after presiding over a 50% decline
in the stock price of Procter & Gamble during a 17-month tour
of duty at the helm of that consumer products giant; and John Reed,
who took away a $30 million package plus $5 million a year for life
after being forced out as co-chair at CitiGroup.

It wasn't long before Congress began to worry that the severance packages could be so generous they would actually divorce senior management's interests from those of other shareholders. Their response was a provision in the Deficit Reduction Act of 1984 creating tax penalties for companies awarding excessive severance packages, or what had come to be called golden parachutes. Wags called the legislation the "Bill Agee bill" because it was prompted in part by Congressional indignation over a severance package awarded to the Bendix Corp. chairman during a hostile takeover attempt by Martin Marietta Corp. Bendix's Agee-led board approved golden parachutes for the company's top executives totaling $15.7 million, including a salary for Agee of $800,000 per year for five years.

Today, golden parachutes can encompass a wide variety of benefits, including not just extended salaries and cash payouts but also early vesting of stock options, bonuses, pensions and other benefits such as health and life insurance policies, says Marianne Heard, CPA, a manager at American Express Tax and Business Services. Because of the complexity of the rules that govern them and their tax treatment, most golden parachutes generate attest work for accountants when they are triggered. The IRS published proposed regulations for golden parachutes in 1989 in Section 280G of the tax code specifying that companies could offer the payments without penalty if they totaled less than three times the executive's average annual compensation for the prior five years, with that base salary including bonuses and any stock options the executives might have exercised during that period. Once that threshold was exceeded, however, the recipient would owe a 20% excise tax on any portion of the severance package that exceeded one times his or her base salary. In addition, the company would not be able to claim that portion of the severance payment as a corporate tax deduction.

"As far as I am aware, this is the only income tax in America that isn't calculated at the margin," observes Johnson. "Let's say I'm an executive getting a parachute payment and my five-year average annual pay is $1 million. If my severance package is worth $2,999,999.99, I pay no excise tax and my company gets a full deduction for that amount. But if my severance is $3 million exactly--one penny over the line--I owe a 20% excise tax on $2 million, which means that penny cost me almost $400,000 in extra income taxes at the federal level alone. My company also loses a $2 million tax deduction."

The IRS did specify four types of payments that would not be considered part of a golden parachute and would not be subject to penalty, regardless of their size. They include payments made to executives of companies that, immediately before a change in control or ownership, were (a) considered small businesses under IRC Section 1361(b) without regard to paragraph (1)(C); or (b) had not issued stock that was readily tradable as long as certain shareholder approvals of the payment had been met. Other exemptions included payments made from a qualified retirement plan, a section 403(a) annuity plan or a simplified employee pension (SEP) under section 408(k) of the tax code, or payments that could be shown to be reasonable compensation for personal services performed after the change in ownership or control of the company.

Far from discouraging lucrative severance plans, the Deficit Reduction Act of 1984 led to the proliferation of so-called "299%" deals in which an ousted executive got a payout that fell just under the excise tax trigger, because Congress had "authorized" payments of that amount. Still, some companies concluded that to attract and retain the best possible talent, especially at the CEO level, they needed to offer more than a 299% package. That's when golden parachutes really got expensive.

"Companies recognized their executives didn't want to get an enormous excise tax bill for going over the threshold, so one of the solutions they devised was the gross-up," says Bill Coleman, vice-president of compensation for Salary.com, a Wellesley, Massachusetts company that conducts research on pay practices. "Depending upon what state you are in, it can be the most expensive corporate cost associated with an individual executive's compensation package."

As its name implies, a gross-up provision layers an additional payment on top of the golden parachute to reimburse the recipient for the excise tax he or she will owe. According to the 2001 Golden Parachute Report by Executive Compensation Advisory Services, 52% of the Fortune 1000 golden parachute agreements include gross-up provisions.

It isn't hard to see how those provisions can quickly become expensive. Most senior executives are in the highest federal tax bracket of 39.1% (under the newly enacted tax legislation), and after the phase-out or disallowance of various itemized deductions that apply to high wage-earners, plus the addition of the 1.45% Medicare tax, they typically labor under a maximum marginal rate of about 42.5%, explains attorney Roger Siske, a partner at Sonnenschein Nath & Rosenthal in Chicago and chair of its national employee benefits and executive compensation practice. Throw on a 20% federal excise tax plus state income taxes, and the total tax burden on gross-ups in some states can exceed 70%. "For every dollar the company gives you for the gross-up, you spend 70 cents on an additional tax on the gross-up. As you increase the gross-up to keep the executive even, it can end up taking about $3.33 to pay $1 of excise tax," Siske says. "And while that's significant, it understates the real cost because the employer can't deduct any of the dollars subjected to the excise tax." (see "Golden Parachute Costs Can Skyrocket".)

Golden Parachute Costs
Can Skyrocket

Can employers really end up spending more
than $3 for every $1 of benefits they award to departing
executives in the form of a golden parachute? At the
margin, absolutely. And the after-tax cost can be even
worse: as much as $5 for every $1 of benefits.

Consider a theoretical CEO in California who loses
his job on the takeover of his company by a larger competitor.
The CEO's average annual compensation for the
prior five years was $1 million, and his golden parachute
is worth $4 million. Based on current IRS regulations, $3
million of the parachute payment will be subject to a
20% federal excise tax, or, in this case, $600,000.

If our CEO has a "gross-up" provision in his severance
agreement, the company is now
obliged to increase his golden parachute
by an amount sufficient to offset the excise
tax liability. Unfortunately, it can't
just raise his payment by $600,000, because
the executive will have to pay
taxes--lots of taxes--on that sum, too.
In fact, every dollar shelled out for the
gross-up in this example will be taxed at
a total rate of 69.85%, consisting of the
following levies: 39.1% federal income
tax, 1.45% Medicare tax, 9.3% state income
tax and 20% federal excise tax.
Accordingly, the company will have to
spend an extra $1,990,050 for the gross-up,
which is the amount it will take,
pretax, to net the executive an additional
$600,000. That's about $3.32 for
every $1 of benefits received.

In fact, current law makes the actual cost to the
corporation even higher, because the company
can't deduct any amount of the golden parachute
that exceeds one times the executive's average compensation
over the prior five years. In this case, that's
a forfeited $3 million deduction. Nor can the company
deduct the cost of the gross-up itself. If we assume the
company pays a marginal income tax rate of 40% (federal
and state combined), this represents an additional cost of
$1,996,020.

In total then, the additional cost to the company of
giving its departing CEO a $4 million golden parachute
with a gross-up provision, rather than a $2,999,999 parachute,
is not $1,000,000.01. Instead, it is a whopping
$4,986,070.01 (see worksheet below), or nearly $5 for
every $1 of net additional benefits.

Worksheet for Net Cost of Golden Parachute to Corporation

CEO's average annual compensation, prior five years      $1,000,000.00
Safe harbor parachute payment(*)                         $2,999,999.99
Actual value of parachute payment                        $4,000,000.00
Parachute amount subject to excise tax (line 3-line 1)   $3,000,000.00
Excise tax liability (line 4x.20)                          $600,000.00
CEO's marginal tax rate                                         69.85%
Total gross-up needed to pay excise tax
  (line 5/(1.00-.6985))                                  $1,990,049.70
Total cash cost (parachute+gross-up) (line 3 + line 7)   $5,990,050.00
Amount of cash cost not tax deductible to company
  (line 8-line 1)                                        $4,990,050.00
40% marginal corporate tax rate (state and federal)             40.00%
Forfeited tax deduction (line 9 x line 10)               $1,996,020.00
Total cost to corporation (line 8+ line 11)              $7,986,070.00

Total cost to increase CEO parachute by                  $4,986,070.01
$1,000,000.01 to $4,000,000.00 instead of $2,999,999.99
(line 12-line 2)

(*) Under this amount, recipient owes no excise tax on parachute
payment and employer enjoys full deductibility of parachute payment
for state and federal income tax purposes. Calculated
by multiplying line 1 by 3, less $.01.

Those numbers also don't address the soft costs a company incurs, notes Heard, such as time spent by legal staff, human resources, payroll, tax and other executives in managing the severance agreement.

MITIGATING THE COSTS

Although the IRS has yet to finalize its Section 280G rules on golden parachutes, practical application of the proposed regulations, buttressed in some cases by letter rulings from the IRS, have led to the development of several common techniques for mitigating their cost. CPAs can build cost-savings into the design of a golden parachute agreement, while they can use other techniques retroactively once a parachute payment has been triggered.

One of the most popular techniques takes advantage of the provision in the proposed regulations exempting from golden parachutes payments made to executives for services they provide after a change in control. Accordingly, companies that temporarily retain an executive to assist with the merger transition have argued that some of the money he or she receives is just that type of compensation. Even executives who know they will be losing their jobs can sometimes find these short-term assignments agreeable if it helps them avoid the onerous 20% excise tax on their parachute payments.

A more novel application of the same rule endorsed by the IRS in a letter ruling to KPMG last year, is to designate some portion of the executives' compensation after the change of control as payment for entering into a noncompete agreement with the acquiring company. The challenge for CPAs, of course, is to affix a defensible value to the noncompete agreement. That value can vary tremendously based on the size of the company and its industry, the executive's prominence within that industry and the impact he or she could have as a competitor. Because of rules governing when an accounting firm can conduct appraisals for an audit client, it is not uncommon to bring in a third-party appraiser to do the job.

"A consulting arrangement for specific expertise is the most used vehicle to mitigate tax consequences," notes Heard. "But again, the issue of reasonable compensation must be addressed. Showing up for a few meetings and a lunch may be questioned. A retainer that states the amount is being paid for advice and expertise `as needed' is the most aggressive approach."

One way to avoid the onerous tax consequences of a golden parachute is to implement what some compensation experts refer to as a "claw-back" clause, which says that if the net proceeds to the executive meet or exceed the three-times-base-salary threshold, the parachute payment will be capped to stay below it. Suppose, Heard notes, that an executive's base salary for purposes of calculating his golden parachute is $100,000. If his all-inclusive severance is $300,000, $200,000 of that amount would be subject to the penalty. By cutting the payout to $299,999, none of the severance package would be subject to the penalty.

Yet another option is to boost the salaries of executives slated to receive golden parachutes in the year before the change of control, so that their base salaries are higher. The executives can receive larger parachute payments without triggering the excise tax, but it's not easy to do this. In its enabling legislation, Congress specified that a parachute payment is one based on a change in control of the company. To prevent companies from doling out huge bonuses or stock awards immediately before a change in control--a blatant attempt, in other words, to avoid the tax consequences of a large parachute---Congress said any such payment made within a year of the change of control would be presumed to be attributable to the change in control unless the company could prove otherwise (for example, if it had awarded similar payments in prior years).

"Our members have not seen this put into play that often, as it would take sufficient advance warning and adequate time for adjustment," concedes Heard, who is also president of the American Woman's Society of CPAs.

Still, if competitive conditions allow for it and the sums of money justify it, companies can make this strategy work. Salary.com's Coleman notes that in a previous job with a large benefits consulting firm, he saw two companies renegotiate the closing of their merger into another calendar year so that the departing CEO could first exercise stock options and increase his base salary.

Alternatively, says Peter I. Elinsky, CPA and national partner-in-charge of compensation and benefits at KPMG, LLP in McLean, Virginia, companies with the flexibility to do so can accelerate into December 31 of the year before the change of control one-time payments they would have made anyway to the departing executive after the change. In that case, the payment is considered a parachute, but it will also count toward the executive's average base salary for the five years before to the change in control. The net effect increases the average base salary by 20 cents for every dollar of the bonus. Since parachutes are not penalized below the three-times-base-salary cap, 60 cents of each bonus dollar will avoid the parachute tax (see "How to Make Tax Sense of the Parachute Bonus").

How to Make Tax Sense of the
Parachute Bonus

CPA Peter I. Elinsky of KPMG offers this advice on avoiding
taxes on 60 cents of every parachute bonus dollar:

Suppose a CEO receives a bonus in the year prior to his termination,
rather than in the year of his termination. The law
says that a bonus paid within 12 months of a change in corporate
control is presumed to be a parachute payment.

Using $1 as the amount of the bonus, if this were paid
out after the change in control, like a normal parachute
payment, the entire amount would be subject to the 20%
excise tax (assuming this $1 is at the margin, meaning it is
above and beyond that portion of the parachute equal to
three times the base salary, which is the average salary for
the prior five years).

If the company pays the bonus in the year prior to the
change in control, only 40 cents of that $1 would be subject
to the excise tax, leaving 60% free of the parachute penalty.
The reason: Even though the $1 bonus itself is considered a
parachute payment, it also counts in the calculation of the five-year
average base salary. In this case, increasing last year's salary by
$1 increases the five-year average salary by 20 cents ($1 / 5 =
.20). Parachute payments under three times the base limit are acceptable
and not subject to the 20% excise tax. Here, increasing
the base by 20 cents means the departing executive can receive
three times that amount (or 60 cents more) free of the excise
tax. Accordingly, he/she gets 60 cents of the $1 bonus excise-tax
free due to receiving the bonus in the year prior to change in
control rather than in the year after.

In some circumstances, Elinsky adds, companies can successfully argue only a portion of a bonus paid out within a year of a change of control should be deemed part of the parachute. Suppose, for example, an executive had a contract calling for him or her to receive a $1 million bonus after five years of service, payable immediately if there was a change of control. If such a change does take place--after four years, let's say--the company can argue that 80% of the payment should be credited against the four years of service already performed, so that only the remaining 20% would be part of the parachute.

"People often have stock options or restricted stock that vests over five years, but vests immediately if there is a change of control," Elinsky observes. "In those cases, the one-year rule gives us the right to treat some of that compensation as not being part of the parachute payment. It helps to mitigate the tax consequences."

Mitigation, not elimination, is often the most that any CPA can offer a client or employer seeking to soften the impact of a golden parachute payout. Given the sums at stake, though, even that relief can be material.

Popular Payments

In a recent survey of Fortune 1000 companies, 81% of respondents offer golden parachute plans, up from 35% in 1987.

Source: Executive Compensation Advisory Services, research subsidiary of Harcourt, Inc., Alexandria, Virginia.

EXECUTIVE SUMMARY

* COMPANIES SHOULD NOT ENTER into golden parachute plans without careful consideration. CPAs called in to help draft these agreements can, through prudent planning, save their employers and clients significant sums.

* GOLDEN PARACHUTES CAN ENCOMPASS A VARIETY of benefits, including not just extended salaries and cash payouts but also early vesting of stock options, bonuses, pensions and other benefits. Because of the complexity of rules governing parachutes and their tax treatment, most parachutes generate attest work for CPAs when they are triggered,

* THE DEFICIT REDUCTION ACT OF 1984 led to the proliferation of so-called "299%" deals in which an executive losing his or her job due to a change in corporate control got a payout that fell just under the excise tax trigger.

* A GROSS-UP PROVISION LAYERS an additional payment on top of the golden parachute to reimburse the recipient for the excise tax he or she will owe.

* ONE OF THE MOST POPULAR TECHNIQUES to mitigate the cost of a parachute payment is to take advantage of an IRS provision that says payments made to executives for services they provide after a change in control are not part of the golden parachute.

RANDY MYERS is a freelance financial writer who lives in Dover, Pennsylvania. His e-mail address is [e-mail].