Retaining key executives by using a parachute payment agreement.
The tax adviser should first establish that nonqualified benefits are needed in this situation and that the company can afford to fund them. In discussions with Ray, the tax adviser determines that, while satisfied with his current compensation package, Ray is concerned that it may take him a long time to find new employment if he loses his job due to a buyout. Because of his financial commitments, Pay feels that he cannot afford to lose his job without having replacement employment available immediately.
In discussions with Mike, the tax adviser determines that Mike is willing to guarantee Ray four times his annual compensation in the event the company is sold if Ray is willing to stay with Becker. The company will have no problem funding the compensation because the sale will generate a large amount of cash.
Corporate and Executive
Next, the tax adviser prepares the following profiles to ensure that all parties agree on the objectives of the compensation plan.
Becker Toys Profile
Stability: Established Market: Moderate growth Capitalization: Adequate Need for expansion capital: No need Management: Established;
centralized in owner
and one key employee Key nonowner executives: One with potential
Ray Malone Profile
Age: Midlife Career: Stable, growing
career Financial need: Need for financial
security Tax: High tax bracket Other: Financial security
is driving force in
Based on these discussions, the tax adviser suggests a "golden parachute" arrangement, under which Ray would be paid additional compensation, four times his current earnings, in the event that Becker Toys is sold.
A parachute payment is defined as compensation paid to a disqualified individual if: 1. The payment is conditioned on either of two events: a. A change in ownership or control of the corporation. This occurs on the date that any one person (or a group acting together) acquires ownership of stock that, together with any stock already held by that person, gives him more than 50% of the corporations total fair market value (FMV) or total voting power. If anyone already owns more than 50%, acquisition of additional stock by that person win not cause a change in ownership. b. A change in ownership of a substantial portion of the corporations assets. This occurs when one person (or a group acting together) acquires assets from the corporation that have a total FMV equal to or exceeding one-third of the total FMV of all corporate assets immediately prior to the acquisition. 2. The present value of the payment is at least three times the base amount. The base amount is the employee's average compensation for the past five years ending before the date of the ownership change.
A parachute payment is considered to be conditioned on a change in ownership or control if the payment would not have been made to the disqualified individual if no change in ownership or control had occurred; the existence of additional justifications for the payment will not save the agreement from being designated a golden parachute.
A parachute payment generally is deductible. However, in certain situations, the employer is not allowed a deduction for, and the employee must pay a 20% excise tax on, the portion considered an excess parachute payment. This is the amount by which the payment exceeds the employees average compensation for the five preceding years ending before the date of the ownership change (i.e., the base amount).
The deduction disallowance and excise tax apply only to excess parachute payments made to disqualified individuals. Disqualified individuals are persons who perform personal services for the corporation who are: 1. Shareholders. For this purpose, only a shareholder who owns stock of the corporation with an FMV of the lesser of $1 million or 1% of the total FMV of the outstanding shares of all classes of the corporation's stock is treated as a shareholder. 2. Officers. Whether an individual is an officer will be determined based on all the facts and circumstances. Generally, the term "officer" means an administrative executive who is in regular and continued service. 3. Highly compensated employees. These are individuals who are members of a group consisting of the lesser of the 250 highest paid employees or the highest paid 1% of a corporations employees. No individual whose annualized compensation is less than $75,000 will be treated as a highly compensated individual.
A payment can be considered a parachute payment even if the disqualified individual terminates his employment voluntarily.
Because the parachute provisions are aimed primarily at publicly traded companies, these provisions do not apply to payments made by corporations: 1. eligible to elect S status, as defined in Sec. 1361 (without regard to the provision regarding nonresident aliens), or 2. whose stock is not readily tradable prior to the change in ownership and, after the plan has been adequately disclosed t o the shareholders, more than 75% of the shareholders approve the payment. (Shareholder approval should be documented in the minutes of the annual or special shareholders' meeting.)
With regard to the exception listed in item 1, Becker meets the eligibility requirements for electing S status because: 1. it is a domestic corporation, 2. there are no more than 35 shareholders (75 for tax years beginning after 1996), 3. there are no ineligible shareholders and 4. there is only one class of stock. Thus, because Becker is eligible to make an S election, it is exempted from the golden parachute provisions, and the proposed payment may be deducted by the corporation. Even if the corporation is ineligible to make the S election (e.g., because it has a preferred class of stock), the payment is likely to be exempt under the second exception for nontraded stock companies. Consequently, the employee recognizes ordinary income on the receipt of the payment but is not liable for the 20% excise tax. These provisions also do not apply to: 1. payments to or from a qualified plan, or 2. payments of reasonable compensation.
A written agreement does not have to exist for a payment to be classified as a golden parachute.
The tax adviser, by means of the parachute payment arrangement, is able to help Mike meet his objective of providing incentive for Ray to stay with the company. Ray is guaranteed financial security in the event of the sale of Becker.