Congress is attempting to curb excess executive compensation by taxing what it refers to as “golden parachute payments.” Golden parachute payments are payments to high-level corporate employees that are contingent on certain events. The Internal Revenue Code imposes a 20% penalty tax on all qualifying payments. An excess parachute payment is any compensation meeting the following conditions:
- Paid to a disqualified individual,
- Contingent on a change in control, and
- In excess of a base amount.
Section 280G defines golden parachute payments and disallows the employer corporation from deducting such payments. Section 4999 actually imposes the tax on employees and requires employer withholding on any amount paid as wages.
Only “disqualified individuals” as defined by the Code are subject to this penalty tax. See Treas. Reg. § 1.280G-1 A-15. A disqualified individual includes any employee or independent contractor who is also a shareholder, officer, or highly compensated individual and meets the following criteria at any point during the twelve months preceding a change in control:
- Shareholder: The Fair Market Value of the shareholder’s stock must exceed 1% of the Fair Market Value of the outstanding shares of all classes of stock (including any vested options owned by the shareholder).
- Officer: Whether an individual is an officer is determined by all the facts and circumstances of a particular case. Factors include the source of the individual’s authority, the term for which the individual is elected or appointed, and the nature and extent of his duties. If the employee has the title of an officer, he is presumed to be an officer. Generally, an officer is “an administrative executive who is in regular and continued service.” Only 50 employees may be considered officers under this provision. If the corporation has more than 50 officers, only the 50 highest paid officers are included.
- Highly-Compensated Individual: This includes either the company’s highest paid 1% of employees or the highest paid 250 employees, whichever is fewer. No one with income less than $115,000 (2014) or $120,000 (2015) is included.
Contingent on a Change in Control
Section 280G defines change of control to include three scenarios. A change of control includes a change in ownership of a corporation, a change in effective control of a corporation or a change in control of substantially all of the corporation’s assets. See I.R.C. § 280G(b)(2)(A). In addition to change of control payments, certain other payments are also subject to this penalty tax. Compensation paid pursuant to an agreement in violation of any generally enforced securities law or regulation is also subject to this excise tax. See I.R.C. § 280G(b)(2)(B).
A payment is contingent on a change in control if it would not have been paid if no change in control had occurred. This applies even if the payment is also contingent on other events. A payment is contingent on an event unless it is substantially certain that the payment would have been made whether or not the event occurred.
Payments contingent on an event closely associated with a change in control are included if a change in ownership actually occurs and the contingent event was materially related to a change in control. For example, a payment contingent on the onset of a tender offer, the delisting of a corporation’s stock on a securities market or the termination of the taxpayer’s employment all may be materially related to a change in control. See Treas. Reg. 1.280G-1 A—22. Payments made pursuant to agreements entered into after the change of control are not treated as contingent on a change in control. See Treas. Reg. 1.280G-1 A–23(a).
A payment is presumed to be contingent on a change in control if entered into within one year of the change in control. This applies to amendments modifying older agreements if the amendment is made within one year of the change in control. The taxpayer must establish by clear and convincing evidence that the payment was not contingent on a change in control based on all the facts and circumstances. See Treas. Reg. 1.280G-1 A–25.
Base Amount and Payments Subject to Tax
Compensation includes any payments arising out of an employment relationship or associated with the performance of services. See Treas. Reg. 1.280G-1 A–11(a). The base amount equals the employee’s average gross compensation from the corporation for the preceding five years. This excludes certain non-reoccurring payments such as signing bonuses or relocation expenses. Payments must be at least three times greater than a base amount to be subject to tax. See I.R.C. § 280G(b)(2)(ii).
Only payments in excess of a base amount are subject to the excise tax. For example, if an employee receives $1,000,000 upon change of control of a corporation and his average annual salary equals $250,000 per year, then he will owe $150,000 in excise taxes ($750,000 X 20%). The employer is responsible for increasing withholding if the payment is made in the form of wages, or the employee can elect to prepay. See I.R.C. § 4999(c)(1).
Some limited exceptions may apply to §280G taxes. Payments pursuant to qualified retirement plans, §403(a) annuities, simplified employee pensions under 408(k), and simple retirement accounts under 408(p) are not subject to the executive compensation penalty tax. See Treas. Reg. 1.280G-1 A—8. Additionally, no tax is due if the payment is approved by 75% of disinterested shareholders informed of all material facts. See Treas. Reg. 1.280G-1 A—6(a)(2)(ii). Charitable organizations under Section 501(c)(3) are also exempt.
Payments made by qualifying small business corporation are also exempt from this penalty tax. See id. As defined under subchapter S, a corporation is a small business corporation if it has less than one hundred shareholders, only individual shareholders and only one class of stock. See I.R.C. 1361(b). Financial institutions, insurance companies and domestic international sales corporations cannot qualify as small business corporations. While the definition of a small business corporation is found under Subchapter S, it does not have to elect S Corporation treatment to be exempt from the 280G tax. Unlike the requirements for an S Corporation, such corporation may have a nonresident alien shareholder. A corporation with no stock tradable on an established securities market prior to the change in control also qualifies for this exemption as long as substantially all its assets are not stock of a corporation that is readily traded on such a market.
The corporation may establish by clear and convincing evidence that the payment is reasonable compensation for services performed before the change of control. See I.R.C. § 280G(b)(4). For example, if the employee was underpaid in previous years, he or she may receive catch-up payments. The IRS will also consider the nature of the services and the taxpayer’s historic compensation. See Treas. Reg. 1.280G-1 A-40(a). Such evidence may also include compensation studies that compare the compensation of similar employees in similar companies. A related exception applies if the payment is for services to be rendered after the change in control.
Common contract terms may limit an employee’s liability for this tax. Some companies provide full gross-up protection, where the payment increases to minimize the tax liability. However, this option is often seen as too expensive. See Thompson Reuters. Alternatively, the company may include a cutback provision capping the parachute payment so that it cannot exceed the base amount.
Management and highly-compensated employees should be aware of the tax imposed by § 280G. The effect of this tax should be considered when negotiating an employment agreement. Additionally, proper planning and application of the various exceptions discussed above can mitigate or avoid the impact of this penalty.