# Golden Parachute Calculations: 10 Misunderstood Aspects of Secs. 280G and 4999

By Robert W. Delgado, J.D., LL.M., Washington, D.C.

Editor: Mary Van Leuven, J.D., LL.M.

Expenses & Deductions

When a company experiences a change in control, the golden parachute rules are intended to discourage excessive compensation for “disqualified individuals” (certain officers, highly compensated individuals, and 1% shareholders) by imposing adverse tax consequences on both the company and the disqualified individuals. The adverse tax consequences are triggered if the present value of change-in-control payments to a disqualified individual equals or exceeds a “safe harbor” equal to three times the individual’s “base amount” (Sec. 280G; Regs. Sec. 1.280G-1).

The base amount is the individual’s average taxable compensation from the company over the five most recent tax years preceding the change in control (Secs. 280G(d)(1) and (2)). If the golden parachute rules are triggered, the company loses tax deductions for the amount considered an “excess parachute payment” under Sec. 280G, and the disqualified individual incurs a 20% excise tax on the excess parachute payment under Sec. 4999.

Below are some misunderstood aspects of the golden parachute calculations.

##### 1. Calculation of Penalties on Excess Parachute Payments: Three—Not One—Times the BaseAmount

If the present value of change-in-control payments to a disqualified individual is outside the safe harbor, that is, the present value equals or exceeds three times the base amount, then the excess parachute payments are calculated on amounts paid in excess of the disqualified individual’s base amount, rather than the amount in excess of the safe harbor (Sec. 280G(b)(2)(A)(ii); Regs. Sec. 1.280G-1, Q&A-38(a)). In other words, parachute payments can go up to 2.99 times the base amount without penalty, but if the payments equal or exceed three times the base amount, penalties apply to everything over the base amount.

##### 2. Identification of Disqualified Individuals Includes Foreign Individuals

There are several common misunderstandings with respect to the identification of disqualified individuals subject to the parachute calculations. Among these are the failure to include foreign individuals in the calculations—a foreign disqualified individual may not be subject to the Sec. 4999 excise tax, but the company remains subject to the Sec. 280G deduction limitation (Regs. Sec. 1.280G-1, Q&A-1(b) and Q&A-15). Similarly, U.S. persons are subject to Sec. 4999, even if the company making the payments does not have a deduction limited under Sec. 280G (e.g., the buyer is making the payment, but the selling company is subject to the deduction limitation).

##### 3. Consideration of Payments for Services Performed Before the Change in Control

Parachute payments are broadly defined to include all payments made on account of a change in control (Sec. 280G(b)(2)). This includes any payment that is compensation for services actually rendered before a change in control. If there is clear and convincing evidence that a portion of the payment is reasonable compensation for services actually rendered before the change in control, then the calculated amount of excess parachute payments is reduced by that portion (Regs. Sec. 1.280G-1, Q&A-39).

In these situations, the allocable base amount may be replaced by the amount of reasonable compensation. The “excess parachute payment” is calculated by subtracting from each parachute payment the greater of the allocable base amount or the reasonable compensation. However, the payments are still included in the calculation of whether parachute payments are in excess of the safe harbor (Sec. 280G(b)(4)(B); Regs. Sec. 1.280G-1, Q&A-38).

##### 4. The Gross-Up Is a Parachute Payment

In some instances, companies will “gross up” payments to disqualified individuals to cover the excise tax. The gross-up amount is also a parachute payment because it is part of the compensation paid (Regs. Sec. 1.280G-1, Q&A-2).

##### 5. ExciseTaxes MayApply Prior to Income Recognition and the Employer’s Deduction

For instance, an option is subject to income tax in the year of exercise (or cashout), and the deduction is generally allowed at the time of the exercise or cashout. However, the Sec. 4999 excise tax applies in the year of vesting or grant (if the vesting or grant is the event related to a change in control) (see Rev. Proc. 2003-68; see generally Notice 2004-28).

##### 6. Consideration of Retention Payments and New Employment Agreements

In some instances, retention payments and payments made under employment agreements executed after a change in control may be considered parachute payments. In Square D Co., 121 T.C. 168 (2003), the Tax Court disallowed deductions for retention payments paid to certain executives under employment agreements entered into after a change in control. These executives forfeited substantial lump-sum parachute payments they were entitled to receive under prechange agreements; the prior agreements provided leverage in negotiating post-close employment or retention agreements.

While the company contended that, under Regs. Sec. 1.280G-1, Q&A-23, the retention payments were not contingent on a change in control because they were made pursuant to agreements made after the change, the Tax Court held that “pursuant to” in this context refers to the causal relationship between the pre- and post-change agreements. Because the terms of the post-change agreements were dictated by the parachute payment provisions of the prechange agreements, the Tax Court held that the retention payments were contingent on a change in control and fell under Sec. 280G.

##### 7. Consideration ofWhether PaymentsAre Pursuant to the Current Change in Control or a PriorTransaction

With increasing private equity investment, it is not uncommon for a portfolio company to change hands relatively quickly. In some instances, the payments to disqualified individuals on subsequent transactions may actually be considered parachute payments under the preceding transaction rather than the subsequent transaction.

For instance, a company has a change in control and accelerates an executive’s vesting of options, which generates an excess parachute payment. The executive also has an employment agreement providing for severance payments upon termination following a change in control; however, the executive continues to work for the company following the change in control so that severance does not occur. Suppose now that the company is quickly acquired in another transaction, triggering a second change in control that accelerates additional vesting of stock options, and the executive terminates employment shortly thereafter and receives severance benefits. In similar circumstances, the IRS concluded that the acceleration of the options was contingent on the first and second changes of control, respectively. The severance payment, however, was contingent only on the first change of control, not the second (see Letter Rulings 200046005, 200046006, and 200046007).

##### 8. Payments Made to an Executive as a Result of a Change in Control Are Not Always Fully Included in the Test

The value of change-in-control payments that are made solely due to accelerated time-based vesting or payout can be reduced for purposes of including the amount in the parachute calculation. The value included in the calculations is the lesser of the change-in-control payment or the total of the following two components: (1) the value of the acceleration of the payment, and (2) the value of the lapse of the obligation to continue to perform services (Regs. Sec. 1.280G-1, Q&A-24(c)(2)). Under this rule, if an amount was expected to vest in the near future, the value of the acceleration may be considerably smaller than the actual amount included in the individual’s income.

##### 9. Determining the Base Amount of a Disqualified Individual Who Has Provided Services Only in theYear of the Change in Control

If an individual did not provide services to the company for the entire five-year period preceding the change in control, the individual’s base amount is the individual’s annualized compensation that is, or could have been, includible in gross income and is not contingent on a change in control. Compensation to the executive in any short year is annualized, with the exception of one-time payments such as sign-on bonuses (Regs. Sec. 1.280G-1, Q&A-34(b), Q&A-36).

##### 10. Consideration of Covenants Not to Compete

Amounts that can be allocated to a covenant not to compete are characterized as reasonable compensation for services rendered after a change in control and are not change-in-control payments includible in the calculation, if certain conditions are satisfied (Regs. Sec. 1.280G-1, Q&A-42(b)).

EditorNotes

Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.