Revenue Ruling 2004-87: How Golden Parachute Rules Apply in Bankruptcy
July 28, 2004 To Our Friends and Clients: On July 19, the Internal Revenue Service (the “IRS”) issued Revenue Ruling 2004-87, [1] which addresses whether a change in ownership or control under Section 280G occurs when creditors acquire a corporation’s stock in a bankruptcy reorganization. [2] The ruling also addresses how a company in bankruptcy may satisfy the shareholder approval requirements for a special exception to the golden parachute rules that is available to corporations whose shares are not readily tradeable on an established securities market, and whether a company in bankruptcy will be treated as having stock that is “readily tradeable” where the stock is traded on an “over-the-counter” market. I. Background of Section 280G Section 280G was enacted to discourage a corporation from making large “golden parachute” payments to key personnel in the event that control of the corporation changes. Excess parachute payments have adverse tax consequences for both the paying corporation and the recipient. For the corporation, such payments are not deductible as compensation [3] and cause a dollar-for-dollar reduction in the one million dollar cap on the deductibility of certain executive compensation paid by publicly held corporations. [4] The recipient is subject to a nondeductible 20-percent excise tax on the amount of the excess parachute payment. [5] A parachute payment is defined as a payment in the nature of compensation to (or for the benefit of) a disqualified individual [6] if (i) such payment is contingent on a change in the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation and (ii) the aggregate present value of such payments equals or exceeds an amount equal to three times the base amount. [7] An excess parachute payment is an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment. [8] In general terms, a change in the ownership of the stock of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires ownership of stock of a corporation that, together with stock already held by such person or persons, possesses more than 50 percent of the total fair market value or voting power of the stock of such corporation. [9] A change in effective control of a corporation is presumed to occur on the date that either (i) any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 20 percent or more of the total voting power of the stock of such corporation or (ii) a majority of the members of the corporation’s board of directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation’s board of directors prior to the date of the appointment or election. [10]
A change in the ownership of a substantial portion of a corporation’s assets occurs on the date that any person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation that have a total gross fair market value equal to or more than one-third of the total gross fair market value of all the assets of the corporation immediately prior to such acquisition or acquisitions. [11] Section 280G(b)(5)(A)(ii) provides an exception (the “shareholder approval exception”) for payments by certain corporations that, immediately before the change in ownership or control, had no readily tradeable stock, if the shareholders of the corporation approved the payments. [12] Shareholder approval requires that (i) a payment be approved by a vote of the persons who owned, immediately before the change in ownership or control, more than 75 percent of the outstanding stock of a corporation (excluding certain interested parties) and (ii) there was adequate disclosure to shareholders of all material facts concerning all payments which would be parachute payments but for this exception. [13] II. The Revenue Ruling In Revenue Ruling 2004-87, the IRS addressed four situations that deal with how the golden parachute rules apply in bankruptcy. The question is whether there has been a change in ownership or control for purposes of Sections 280G and 4999 and, if so, whether any potential parachute payments qualify for the shareholder approval exception available to certain non-publicly traded corporations. Situation 1 A corporation (“Corporation A”), which files a voluntary petition for relief under Chapter 11, has a single class of stock that is widely held and actively traded on the New York Stock Exchange. Under the plan of reorganization, all of the existing shares of the corporation’s common stock are cancelled and new shares are authorized. Corporation A’s unsecured creditors will receive 75 percent of the new common stock, with no single unsecured creditor receiving 20 percent or more of the outstanding shares of the corporation. Certain shareholders will receive the remaining 25 percent of the new common stock. Analysis. The IRS held that the creditors are not acting as a group to acquire the stock of Corporation A. The fact that the unsecured creditors are represented by a committee and that the plan of reorganization provides for the creditors to receive stock instead of cash is normally a function of the company’s financial problems and is not an indication that the creditors (who typically would prefer to receive cash rather than stock) intend to act as a group in order to acquire control of the company. The ruling emphasizes the fact that the filing was voluntary. As a result, the creditors did not act together to force the corporation into bankruptcy. The extent to which a filing forced by creditors may be viewed as the creditors acting as a group is left open. Situation 2 The facts are the same as in Situation 1 except that after the reorganization, the largest creditor of the corporation will receive 25 percent of the outstanding stock of Corporation A. Analysis. The IRS held that, because the creditor acquired 20 percent or more of Corporation A’s stock within a 12-month period, Corporation A will be presumed to have experienced a change in effective control. However, the presumption may be rebutted by a showing that the largest creditor will not act to control the management and policies of Corporation A. [14] Revenue Ruling 2004-87 confirms the analysis of PLR 200236006, in which the IRS concluded that a corporation’s bankruptcy reorganization did not constitute a change in
the corporation’s ownership or control, despite the fact that the company’s creditors acquired most of the company’s stock in the reorganization (with one creditor receiving more than 20 percent of the stock). The private ruling held that the facts indicated that the reorganization would not transfer to such creditor the power to control the management and policies of the company. Situation 3 A corporation (“Corporation B”) in bankruptcy has its stock de-listed from the New York Stock Exchange and is thereafter no longer tradeable on any established securities market. No trading occurred with respect to the corporation’s stock on any other market, including any over-the-counter market (including the pink sheets, the over-the-counterbulletin board and the automated confirmation transaction service). Corporation C proposes to purchase more than one-third of the total gross fair market value of the assets of Corporation B, which potentially could cause Section 280G to apply. The sale would trigger payments to Executive E, a disqualified individual with respect to Corporation B. E files a request with the bankruptcy court to allow Corporation B to make the payments to E as administrative expenses. The request provides (i) that the payments will be made because of the sale of assets, (ii) the total amount of the payments and (iii) a brief description of each payment. After notice and hearing, the bankruptcy court approves the sale of assets and the payments to E. Analysis. Corporation B meets the “not readily tradeable” requirement of the shareholder approval exception, because it was de-listed from an established securities market and was not otherwise readily tradeable on the date of the change in control. Further, the revenue ruling holds that bankruptcy court approval serves to protect the estate and the ultimate owner from unnecessary or excessive payments made to executives and, therefore, the shareholder approval and disclosure requirements are deemed to be satisfied. Situation 4 The facts are the same as in Situation 3, except that the stock of Corporation B is tradeable on an over-the-counter market after de-listing from the New York Stock Exchange. Analysis. The ruling holds that Corporation B can qualify for the shareholder approval exception, notwithstanding the over-the-counter market trading, because the trading of stock on an over-the-counter market when the corporation is a debtor in bankruptcy is, in the IRS’s view, necessarily impaired. Therefore, the stock is not considered “readily tradeable” for purposes of Section 280G and the payments to E are not parachute payments. Revenue Ruling 2004-87 is consistent with the analysis of PLR 200212013, which held that a company whose stock was de-listed by a stock exchange was no longer readily tradeable on an established securities market or otherwise. * * * * *
This memorandum provides only a summary of Revenue Ruling 2004-87. If you have any questions or would like more information regarding the revenue ruling or Section 280G, please call one of the attorneys listed below or any other member of our tax practice group. Stephen Mills – New York Office Tel.: (212) 556-2353 E-mail: sgmills@kslaw.com Peter Genz – Atlanta Office Tel.: (404) 572-4935 E-mail: pgenz@kslaw.com
Megan Davenport – New York Office Tel.: (212) 556-2158 E-mail: mdavenport@kslaw.com
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2004-32 I.R.B. Unless otherwise indicated, all Section references are to the Internal Revenue Code of 1986, as amended (the “Code”). Section 280G(a). Section 162(m)(4)(F). Section 4999. A disqualified individual is an individual who is an employee or independent contractor who performs personal services for any corporation and who is an officer, shareholder or highly-compensated individual. For these purposes, a personal service corporation will be treated as an individual. Section 280G(c). Section 280G(b)(2). The term “base amount” means the individual’s annualized includible compensation for the “base period,” which consists of the individual’s most recent 5 taxable years ending before the date of the change in ownership or control (or such portion of such period during which the individual performed personal services for the corporation). Section 280G(b)(3), (d)(2). Section 280G(b)(1). Treas. Reg. § 1.280G-1, Q/A-27(a). Persons will not be considered to be acting as a group merely because they happen to purchase or own stock of the same corporation at the same time, or as a result of the same public offering. Treas. Reg. § 1.280G-1, Q/A-28(a). Treas. Reg. § 1.280G-1, Q/A-29(a). For this purpose, gross fair market value means the value of the assets of the corporation, or the value of the assets being disposed of, determined without regard to any liabilities associated with such assets. Section 280G(b)(5)(A)(ii). Section 280G(b)(5)(B). Treas. Reg. § 1.280G-1, Q/A-28(a).
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