Retaining key executives by using a parachute payment agreement.
Facts: Becker Toys, Inc., a successful toy manufacturer's owned by Mike Becker, the founder, and his three children. The corporation has 1,000 shares of common stock outstanding. Mike has managed the corporation for 25 years. Several years ago, when Mike first considered retirement, he realized that he needed to identify and train a successor. For the past three years, he has worked closely with Ray Malone, Vice President of Operations. Mike is confident that Ray, who is very talented, can replace him when he retires. * Recently, several international corporations have expressed a desire to buy Becker Toys. Ray is concerned that Mike might accept one of the offers, leaving him without a job. Ray has indicated he might start looking for Looking for
In the context of general equities, this describing a buy interest in which a dealer is asked to offer stock, often involving a capital commitment. Antithesis of in touch with. other work because financial security is important to him. * Mike does not want Ray to leave the company. He is considering agreeing to pay Ray a large bonus if the corporation is sold, and he has asked his tax adviser for assistance in designing the plan. Issue: How can Becker structure a compensation plan for Ray that will assure him of financial security if the corporation is sold and influence him to stay with the corporation?
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 Buyout
The purchase of a company or a controlling interest of a corporation's shares.
A leveraged buyout is accomplished with borrowed money or by issuing more stock. . 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;
v. cen·tral·ized, cen·tral·iz·ing, cen·tral·iz·es
1. To draw into or toward a center; consolidate.
2. 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 Tax Bracket
The rate at which an individual is taxed due to a particular income level.
Each income class is taxed at a different level. Generally, the more you make the more you are taxed. Other: Financial security
is driving force in
Based on these discussions, the tax adviser suggests a "golden parachute golden parachute, a contract given to top executives of a corporation to provide benefits in case of job loss due to a takeover by another firm or a merger. The unusually generous benefits may include substantial severance pay, a one-time bonus payment when " arrangement, under which Ray would be paid additional compensation, four times his current earnings, in the event that Becker Toys is sold.
A parachute parachute, umbrellalike device designed to retard the descent of a falling body by creating drag as it passes through the air. The development of modern aircraft has led to many experiments in the aerodynamic problems of parachute design, with the result that the payment is defined as compensation paid to a disqualified dis·qual·i·fy
tr.v. dis·qual·i·fied, dis·qual·i·fy·ing, dis·qual·i·fies
a. To render unqualified or unfit.
b. To declare unqualified or ineligible.
2. 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 FMV - full-motion video ) 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 That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). . However, in certain situations, the employer is not allowed a deduction for, and the employee must pay a 20% excise tax Excise Tax
1. An indirect tax charged on the sale of a particular good.
2. A penalty tax applied to ineligible transactions in retirement accounts. This penalty is assessed by and paid to the IRS.
1. 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 dis·al·low
tr.v. dis·al·lowed, dis·al·low·ing, dis·al·lows
1. To refuse to allow: "[The government] and excise tax apply only to excess parachute payments made to disqualified individuals. Disqualified individuals are persons who perform personal services personal services n. in contract law, the talents of a person which are unusual, special or unique and cannot be performed exactly the same by another. These can include the talents of an artist, an actor, a writer, or professional 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 annualized
Of or relating to a variable that has been mathematically converted to a yearly rate. Inflation and interest rates are generally annualized since it is on this basis that these two variables are ordinarily stated and compared. 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 publicly traded company
A company whose shares of common stock are held by the public and are available for purchase by investors. The shares of publicly traded firms are bought and sold on the organized exchanges or in the over-the-counter market. , 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 non·res·i·dent
1. Not living in a particular place: nonresident students who commute to classes.
2. 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 shareholders' meeting n. a meeting, usually annual, of all shareholders of a corporation (although in large corporations only a small percentage attend) to elect the Board of Directors and hear reports on the company's business situation. .)
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 in·el·i·gi·ble
1. Disqualified by law, rule, or provision: ineligible to run for office; ineligible for health benefits.
2. 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 de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. 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.