March 1, 2006
Summary of the “Golden Parachute” Rules Under Internal Revenue Code Sections 280G and 4999

The Golden Parachute rules are located in Section 280G and 4999 of the Internal Revenue Code (the “Code”) and the Treasury Regulations (the “Regulations”) promulgated thereunder.  In brief, the Golden Parachute rules were implemented by Congress in order to address the perceived excessive payments typically made to executives and high-level employees in connection with a change in ownership, such as a merger or acquisition. As a penalty for those payments, Sections 280G and 4999 impose a 20% excise tax on individuals who receive “excess parachute payments.” Additionally, the company making the payments is precluded from utilizing any deduction associated with an excess parachute payment.

The golden parachute rules only apply to “disqualified individuals.” For purposes of the golden parachute rules, a disqualified individual means those persons who are employees or independent contractors who perform personal services for the company and in addition also qualify as an officer, shareholder, or highly compensated individual. Highly compensated individuals are those persons which make up the highest paid 1% of the company.  In most cases, this rule has the effect of removing the majority of the rank and file employees from a Section 280G analysis 

An “excess parachute payment” means any payment which is the excess of any “parachute payment” (defined below) less the individual’s base amount (defined below).  More simply, an excess parachute payment, in most cases, is the excess of the amount of payment received (assuming such payment qualifies as a parachute payment) less the individual’s base amount.  It is this figure which is ultimately subject to the 20% excise tax. 

In order to have an excess parachute payment and be subject to the excise tax, the payment received by the disqualified individual must first qualify as a parachute payment.  The Code’s definition of a parachute payment is a two step analysis.  First, such payment must be in the nature of compensation and must also be contingent upon either (i) a change in the ownership or effective control of a corporation or (ii) a change in ownership of a substantial portion of the company’s assets.  Second, the aggregate present value of all such payments must equal or exceed three times (3x) the individuals base amount. 

The Code and the Regulations construe the concept of a contingent payment quite broadly.  The concept encompasses any payment that a disqualified individual is entitled to receive that is closely related to a change in control.  Thus, amounts received in the form of retention bonuses or severance pay generally constitute contingent payments.  Additionally, stock options or grants of restricted stock which contain accelerated vesting provisions in the event of a change of control also fall within the statutory definition. 

Section 280G contains a “12-month look-back” rule.  Under this rule, any payment made pursuant to an agreement entered into with 12 months prior to a change in control (or an amendment to a prior agreement if such amendment is made within such 12 month window) is presumed to be a payment which is contingent upon a change in control.  This presumption can be overcome only by showing, by clear and convincing evidence, that such payment was unrelated to the change in control event. 

An individual’s base amount is the average of the individual’s annual compensation over the five-year period (or the number of years such individual has been employed, if less) immediately preceding the change in control.  In the event the individual has been employed for only a portion of a year, the compensation received for such partial year is annualized. 

Determination of an individual’s base amount is critically important to a 280G analysis.  First, the golden parachute rules can only apply to the extent that the payment received equals or exceeds three times (3x) the individual’s base amount.  Second, it is the excess parachute payment that is subject to the twenty percent (20%) excise tax.  Again, an excess parachute payment is the total amount of the payments received reduced by one times (1x) the individual’s base amount. 

Certain payments can be excluded from the golden parachute payment rules.  For instance, payments to or from (i) a plan described in Section 401(a) (relating to qualified plans), (ii) certain annuity plans, and (iii) certain simplified employee pension or retirement accounts are expressly excluded from the 280G calculation.  Additionally, in certain instances, a recipient may be successful is asserting the position that the payments received should rightfully be treated as reasonable compensation for personal services rendered before or after the change in control  The burden is on the taxpayer to establish such claim by clear and convincing evidence. 

Pursuant to the Regulations, accelerated vesting constitutes a transfer of property and therefore potentially a parachute payment.  While a bit of an oversimplification, the Regulations compare the present value of the options had they continued to vest in accordance with the vesting schedule against the value of the options as accelerated.  The excess, if any, will be included in the 280G calculation.  This pro-taxpayer rule is only available in the event that the previously unvested stock options which accelerate upon a change of control were subjected only to time vesting (i.e. no performance vesting).

Private companies (those with stock not traded on an established securities market) are able to “cleanse” the taint of a golden parachute payment by obtaining 75% approval of disinterested shareholders following an adequate disclosure of all material facts.  Public companies are not permitted to utilize this relief provision.  

The Regulations provide that such disclosure must be full and truthful and provide enough information to avoid making the disclosure misleading.  Such disclosure must be made to every shareholder entitled to vote and include, without limitation, (i) a description of the events triggering the parachute payments, (ii) the total amount of the payments that would be parachute payments if the requisite shareholder vote is not obtained, and (iii) a brief description of each payment (i.e. severance, accelerated stock options, etc). 

CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.  ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.