The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 9, April 2002, Panel Publishers, New York, NY.


By Robert W. Wood

Golden parachute payments under Section 280G have been in the law for a good while now, and everyone ought to be used to dealing with these rules. Proposed regs on the golden parachute rules were adopted all the way back in 1989. Section 280G was once controversial, making payments of so-called "excess parachute payments" nondeductible to the paying corporation. This slap on the wrists from a tax perspective was (and still is) coupled with a nondeductible 20% excise tax on excess parachute payments. I.R.C. §4999(a). Between nondeductibility for the payment itself, and a 20% excise tax (that itself is also nondeductible), the cost of paying such amounts can be quite steep.

This harsh regime applies only to "excess" parachute payments. 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) where:

Determining whether a payment constitutes a parachute payment is typically rather 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).

Since it is only "excess" parachute payments that are sanctioned, the definition of excess is important. A parachute payment is "excess" if:

(1) it is made to a "disqualified individual";

(2) the payment is contingent on a change in 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 a five-year period ending before the date of the change in control.

As a result of this formulaic approach, savings clauses have become quite common. A savings clause in a contract might say that, notwithstanding any other arrangement or commitment, the company will have no liability to pay an excess parachute payment that would incur the wrath of the nondeductible excess tax. Apart from the mechanics of such a provision, it obviously can have significant substantive effects, particularly on the payee whose benefits will be cut off. Still, these provisions are cropping up more and more.

New Regs

Now, the Service has published proposed regs (REG-209114-90) that provide guidance on golden parachute payments. These proposed regulations adopt, with some modifications, the proposed regulations that were published way back on May 5, 1989. The new proposed rules would retain the 1989 proposed regulations' determination of whether an individual is a "disqualified" individual, but with several significant changes. The changes worth noting include:

(1) eliminating the $1 million test and replacing it with a determination of whether the individual owns stock of a corporation with a fair market value exceeding 1% of the total fair market value of all outstanding shares of the corporation's stock;

(2) modifying the annualized compensation method under Q&A 19 by reference to Section 414(q)(1)(B)(i); and

(3) changing the disqualified individual determination period under Q&A 20 to the twelve months before and ending on the date of the change in ownership or control of the corporation.

Q&A 19 (of the 1989 proposed regulations) concerns who a highly compensated individual includes. Q&A 19 says this category includes a member of the group consisting of the lesser of (1) the highest paid 1% of the employees of the corporation, or (2) the highest paid 250 employees of the corporation, when ranked on the basis of compensation paid during the disqualified individual determination period. However, no one whose annualized compensation during the disqualified individual determination period is less than $75,000 will be treated as a highly compensated individual. Q&A 20 defines the "disqualified individual determination period" as the portion of the year ending on the date of the change in ownership or control of the company and the twelve-month period immediately preceding that change in ownership.

Q&A 13 deals with the treatment of stock options under the golden parachute rules. The new proposed rules would modify Q&A 13 to provide that statutory and nonstatutory stock options are treated the same for purposes of Section 280G. Valuation and stock options are also addressed. The proposed regulations retain Q&A 13 with its valuation method factors, but authority is now to be delegated to the IRS to provide methods for valuation through published guidance. Revenue Procedure 2002-13 is to provide guidance on several valuation methods, including a safe harbor.

Speaking of stock options, one of the issues that has received significant attention in letter rulings is how to calculate the amount of excess parachute payments resulting from the accelerated vesting of stock options, especially where there are two changes of control. For discussion of a number of letter rulings on this point, see Wood, "Holes in Golden Parachutes," Vol. 9, No. 6 M&A Tax Report, Jan. 2001, p. 1.

What's a "Change in Ownership or Control"?

Understandably, questions often arise about what constitutes a change in ownership or control. The proposed regulations would follow the same basic approach set forth way back in 1989. However, the new rules clarify that when determining whether two or more persons acting as a group are considered to own more than 50% of the total fair market value or voting power of the stock of a corporation on the date of a merger or similar transaction, a person owning stock in both corporations involved in the deal will be treated as acting as a group only to the extent of that person's ownership of stock in that corporation before the transaction, and not for his ownership in the other entity.

The proposed regulations would also clarify that a shareholder approval vote is valid only if it is a vote of more than 75% of the shareholders entitled to vote, and disclosure is made of all payments that would otherwise be parachute payments for an individual. Other modifications under the proposed regulations include clarifying what constitutes reasonable compensation for services performed after a change in control; the treatment of payments made by a tax-exempt organization; the definition of a "corporation"; the determination of excess parachute payments; and the timing of the payment for purposes of Section 4999.

Effective Date?

In some ways, the changes made by these proposed regulations are significant. In other ways not. In any event, these proposed rules would not apply for some time. As written, they would apply to any payments contingent on a change in ownership or control occurring as of January 1, 2004. However, taxpayers can choose to rely on these new proposed regs, or on the 1989 version, for any payment that occurs before January 1, 2004.

Proposed Golden Parachute Regs, Vol. 10, No. 9, M&A Tax Report (April 2002), p. 1.