The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 6, January 1999, Panel Publishers, New York, NY.
WATCH OUT FOR GOLDEN PARACHUTE RULES IN RESTRUCTURING
By Robert W. Wood, San Francisco
Periodically, all of us need reminders that in this age of multiple digit compensation packages, the golden parachute rules remain unyielding. Section 280G of the Code makes payments of "excess parachute payments" nondeductible to the paying corporation. This nondeductible slap on the corporate wrist is coupled with a nondeductible 20% excise tax on the excess parachute payments (imposed by Section 4999(a)). Between nondeductibility for the payment itself, and a 20% excise tax that is also nondeductible, the cost of paying excess parachute payments is severe.
One of the tricks, of course, is to avoid the "excess" moniker. A parachute payment is subject to the harsh regime only if it is "excess." A recent private letter ruling, Letter Ruling 9847011, highlights the importance of ascertaining that a mere corporate restructuring will not trigger the change in ownership which can spell the dreaded excess "rubric."
A parachute payment is defined as any compensatory payment to or for the benefit of a disqualified person (officer, shareholder, key employee or highly compensated person performing personal services for the corporation) under the following circumstances:
the payment is contingent on a change in the ownership or effective
control of the corporation or a substantial portion of its assets, and
the aggregate present value of the compensatory payments equals or exceeds
three times the base amount; or
the payment is made pursuant to an agreement that violates any generally enforced securities laws or regulations.
Determining whether a payment constitutes a parachute payment is typically easy. Significantly, though, a parachute payment normally does not include payments to or from qualified pension and profit-sharing plans, annuity plans and simplified employee pensions. (See I.R.C. §280G(b)(6).)
As it is only the excess parachute payments that are sanctioned, the definition of "excess" is crucial. A parachute payment is excess if: (1) it is made to a "disqualified individual;" (2) the payment is contingent on a change in the control or ownership of the corporation; and (3) the present value of the payment is at least three times the individual's base amount. This base amount is essentially annualized compensation for the individual for five-year period ending before the date of the change in control.
What About Restructuring?
One question is whether a change in control occurs in a corporate restructuring such as that presented in the facts of Letter Ruling 9847011. There, a parent's sale of its subsidiary stock was held not to be a change in ownership or control of the parent, nor was it even considered an event closely associated with a change in ownership or control. The parent and its wholly-owned subsidiary, were members of an affiliated group. The subsidiary accounted for less than 20% of the parent's value. This subsidiary was sold to an independent purchaser, thus triggering termination payments to the subsidiary's executives. In the same year that the subsidiary was sold, another purchaser acquired all of the parent's stock.
The question in the ruling was whether the payments made on termination to the executives of the subsidiary were made because of a change in ownership or control. The Service ruled that they were not. Even though the payments made to the executives of the subsidiary were contingent on the sale of the subsidiary, they were not held to be parachute payments under Section 280G.
Despite such a favorable determination, it is becoming increasingly common to see some type of savings clause in any significant executive compensation package. A savings clause in a contract might say that, notwithstanding any other arrangement or commitment, a company will have no liability to pay an excess parachute payment that would incur the wrath of the nondeductible excise tax. Although such clauses can dramatically limit the size of the payment made to a departing executive, they can act as an effective reign on the corporation's liability both for large payments and for liability for the golden parachute payment tax.
Watch Out for Golden Parachute Rules in Restructuring, Vol. 7, No. 6, The M&A Tax Report (January 1999), p. 7.