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.

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.