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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 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?

Analysis

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

Profiles

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

as manager

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

employee's decision

Solution

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.

Tax Review

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.

Conclusion

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.
COPYRIGHT 1997 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Article Details
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Jan 1, 1997
Words:1251
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