Parachute Payments: Beware of the Tax Hazards

7-3-13_Crowe.pngDoes your employment contract with your CEO offer too much severance pay? If so, there could be significant tax consequences for the bank and the CEO.

Section 280G of the Internal Revenue Code (IRC) contains a rule that can result in punitive tax burdens for both the payer and the recipient of “excessive,” or “golden parachute,” payments, which are generally triggered during a change-in-control. The rule applies to public companies and certain other corporations that do not meet shareholder approval requirements for parachute payments. Parachute payments are considered excessive if they equal or exceed three times a defined base amount, generally the average taxable compensation paid to the recipient from the payer during the five calendar years preceding the year in which the change-in-control occurs.

Benefits such as stock options and restricted stock awards that are vested at an accelerated rate are factored into the calculation.

If the three-times-base measurement is triggered, then all parachute payments in excess of one times the base amount are subject to a 20 percent excise tax at the individual level (required to be withheld by the payer) and the payer must forgo its tax deduction for the same amount. The result is particularly harsh given the retroactive manner in which the tax burdens are applied.

For instance, assume a base salary of $500,000 for an officer of a public company and a change-in- control that entitles the officer to receive parachute payments. Under Section 280G, up to $1,499,999 (three times $500,000 minus $1) of parachute payments can be paid without any tax consequences. However, if one incremental dollar is paid and the three-times-base measurement is triggered, then the officer is subject to excise tax of $200,000 (20 percent of $1.5 million minus $500,000 base), and the payer is denied a deduction of $1 million (excess of parachute payments over base amount). Assuming a 40 percent marginal income tax rate, this amounts to a lost tax benefit of $400,000 to the payer. The one additional dollar of parachute payment results in combined additional taxes of $600,000 to the officer and the payer and represents one of the most expensive tax burdens in the entire tax code.

Planning Ahead
Planning around the application of parachute payments can be difficult and is best addressed in the negotiation stage of the change-in-control transaction. The tax rules are designed to prohibit obvious reallocations of income (such as reducing parachute payments in exchange for large bonuses in post-takeover employment contracts). However, there are some means of effective planning.

Recipients of parachute payments can accelerate taxable income into the calendar year preceding the year in which the change-in-control occurs, effectively increasing the base amount and allowing more room for parachute payments before triggering the three-times-base measurement. Accelerating taxable income can be achieved by exercising stock options, cashing out deferred compensation arrangements, and adjusting incentive plans. However, public companies must be mindful of the $1 million compensation deduction limit for certain officers imposed under IRC Section 162(m).

Payers can address potential golden parachute issues by drafting employment agreements to stipulate who bears the tax burdens should Section 280G be triggered. Under a “cut-back” provision, the employee’s parachute payments are simply reduced until they drop below the three-times-base trigger (leaving the employee to bear the entire tax burden). Under a “gross-up” provision, the employer is required to gross-up the parachute payments for all income and excise taxes until the employee receives the net amount called for in the employment agreement irrespective of the application of Section 280G. Gross-up provisions can exponentially increase an employer’s obligation under the contract, though, as the gross-up payments are subject to excise taxes and are nondeductible to the employer.

There are a variety of common contractual provisions that fall in between the more extreme cut-back and gross-up provisions and that call for a shared burden between the employer and the employee. These provisions often are negotiated as part of an overall transaction and should be considered carefully before offers are made and agreements are signed. The result of not doing so can be costly to all parties involved.