Avoiding the Excess Parachute Payments Trap in M&A Deals

parachute-payment-11-27-15.pngIn the normal course of M&A events, compliance with Section 280G of the Internal Revenue Code to be an eleventh hour thing. In very general terms, 280G applies to compensation paid to an employee in connection with the employer’s change in control. It’s not that the merger partners don’t care at all about this provision in the tax code, it’s just that there are a lot of other issues—like the merger agreement itself—that need to be settled first. However, waiting until the last minute can have adverse financial implications for the selling bank and its employees, so here are a few ideas for 280G planning.

Specifically, 280G makes “excess parachute payments” nondeductible to the employer and subject to a 20 percent excise tax payable by the employee if the aggregate payments equal or exceed three times the employee’s base compensation. An employee’s “base amount” is the average of W-2 compensation for the five years before the year of the transaction. To avoid 280G’s negative consequences, an employee’s change in control payments must be no more than one dollar less than three times the base amount.

For example, if we assume Employee A has a base amount (i.e., five-year average) of $200,000, the maximum change in control payment she could receive without triggering 280G is $599,999 (i.e., $1 less than $200,000 times three. If payments to Employee A equal or exceed $600,000, then any amount in excess of $200,000 (i.e., the base amount) will be nondeductible and subject to the excise tax.

Cutbacks and gross ups are the most common form of 280G planning. A cutback provision in a contract ensures that no amount will be paid in excess of the 280G threshold. In contrast, a gross up provision ensures that the employee will be made whole for any excise tax.

Another 280G planning method is managing the base amount. The more advance managing that can be done, the better. Still, some planning can be done even in the calendar year prior to a transaction. Any increase in the base amount will serve to also increase the threshold amount. As such, employers can consider (1) increasing base salary payable in the year (or years) preceding the year of a transaction; (2) accelerating calendar year bonuses, which are typically paid in the spring of the following calendar year, to December of the current calendar year; or (3) encouraging an employee to exercise vested stock options in the year prior to the transaction. Any of these three could have an impact on the base amount.

A little more complex approach would be an employer’s affirmative action to accelerate the vesting of restricted stock or accelerate the settlement of restricted stock units to the year before the year of a transaction. Also, keep in mind that payments with respect to certain restrictive covenants can have value that is not counted as a change in control payment.

Finally, employers should note that in certain circumstances, 280G provides for a “cleansing” shareholder vote. If at least 75 percent of shareholders agree to the change in control payments, regardless of amount, they will not be subject to 280G’s bad consequences.

If selling the bank is one of the strategic options you are considering, you should give some thought to these planning opportunities in an effort to avoid 280G problems.