Golden Parachute Payments (Part 1)
by Thomas D. Terry
All section references are to the Internal Revenue Code (“IRC”) unless otherwise indicated. “DEFRA” refers to the Deficit Reduction Act of 1984, Pub. L. No. 98369, 98 Stat. 494; and “IRS,” to the IRS. A. Background 1. Golden Parachute Problem. The U.S. Treasury Department’s initial position on golden parachute tax sanctions (circa 1983) was that the Federal securities laws or state corporate law limitations on corporate waste would be the most effective way of dealing with the problem a. Representative Stark (California) and Senator Chaffee (Rhode Island) both introduced golden parachute tax bills characterized as sanctions on “management protection agreements.” b. In March, 1984, Treasury Assistant Secretary Chapoton wrote to Senator Chaffee saying the Treasury could live with a tax sanction on golden paraThomas D. Terry is of counsel to Groom Law Group, Chartered, in Washington, D.C. He is former chair of the ABA’s Section of Taxation and former chair of the IRS’s Advisory Council. This outline updates an outline that was originally prepared by the author and Carolyn E. Smith after the enactment of the golden parachute provisions in 1984 and then updated by Ms. Smith following the issuance of the proposed regulations in 1989. The assistance of C. Duncan MacRae in the preparation of this version of the outline is gratefully acknowledged. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call 1-800-CLE-NEWS, ext. 7000, and ask for SE92. 31
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chutes; he rationalized this position by acknowledging that the income tax laws historically denied corporate deductions for “unreasonable compensation” under section 162. He then endorsed a presumption of unreasonableness in the case of certain management protection agreements. c. Nevertheless, the Treasury continued to oppose golden parachute tax sanctions at hearings held in the Spring of 1984 leading up to DEFRA. 2. Tax Provisions Response. However, new sections 280G and 4999, imposing tax sanctions on certain parachute payments were included in section 67 of DEFRA. The legislative history gives three reasons for the golden parachute provisions. a. First, the Congress was concerned that, in some situations, golden parachute agreements could hinder acquisitions by increasing the cost of the acquisition. b. Second, the Congress was concerned that, in other situations, golden parachute arrangements could encourage key personnel to support a takeover that might not be in the best interests of the shareholders because they would be rewarded if a takeover did occur. c. Third, the existence of golden parachute arrangements may reduce the amount payable to the shareholders of a target company. H. R. Conf. Rep. 98-861, 98th Cong., 2d Sess. (June 23, 1984) (“Conference Report”). Further explanation of the provision is also in the General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 prepared by the staff of the Joint Committee on Taxation (the “Blue Book ”). 3. Tax Provision Amendments. Changes to section 280G were made in: a. Section 102(c)(4) of the Imputed Interest Simplification Act of 1985; b. Section 1804(j) of the technical corrections provisions of the Tax Reform Act of 1986; c. Section 1018(d) of the Technical and Miscellaneous Revenue Act of 1988; and d. Section 1421(b) of the Small Business Job Protection Act of 1996. For legislative history to the 1986 provisions, see H. R. Rep. No. 99-426, at 899-903 (1985). S. Rep. No. 99-313, at 915-922 (1986). See also the Explanation of Tech-
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nical Corrections to the Tax Reform Act of 1984 and other Recent Tax Legislation prepared by the staff of the Joint Committee on Taxation (May 13, 1987) (the “Technical Corrections Blue Book”). 4. Proposed Treasury Regulations. Proposed regulations interpreting the golden parachute rules were issued on May 5, 1989. 54 Fed. Reg. 19,390. The regulations are in question and answer form, “Q&A”s. They have yet to be finalized. Post-1989 legislation is not reflected in the regulations, e.g., Prop. Treas. Reg. §1.280G-1 Q&A 8 does not reflect the addition in 1996 of simple retirement accounts described in section 408(p) to the list of qualified plan under which payments are exempt from the definition of “parachute payment.” B. Overview of Provisions 1. Section 280G(a) disallows any corporate deduction for “excess parachute payments” and section 4999(a) imposes a 20 per cent excise tax on their recipients. Q&A 1. The excise tax is not deductible by the payor for federal income tax purposes. See §275(a)(6). 2. Employers are required to withhold the excise tax if the excess parachute payments are “wages.” §§4999(c)(1) and 3121(v)(2)(A). Also, the Blue Book (at p. 200) provides: “if any [excess parachute payment] is made by the acquiring company, or a shareholder of the acquired or the acquiring company, Congress did not intend that it be treated as part of the acquiring company’s purchase price for the acquired company, or as increasing the shareholder’s basis in his stock in the acquired or acquiring company.” C. Definitions 1. Parachute Payments. Generally, a parachute payment is a payment that is made to or for the benefit of a “disqualified individual” and which is in the nature of compensation, is contingent on a change in ownership or effective control of a corporation or in the ownership of a substantial portion of its assets, and has (together with other such payments) an aggregate present value of at least three times the individual’s “base amount,” which is the individual’s average taxable compensation over the five taxable years ending before such change in ownership or control. For this purpose, the present value of the payments is determined as of the date of change of control. §§280G(b)(2), (b)(3), (d)(1), and (d)(2); Q&A 2(a).
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a. Securities Violation Parachute Payments. A payment in the nature of compensation made to or for the benefit of a disqualified individual is also a parachute payment (regardless of the amount) if it violates any generally enforced securities laws or regulations. The IRS has the burden of establishing the occurrence of a violation of such a law or regulation. §280G(b)(2)(B); Q&A 2(b). b. Exempt Payments. The term “parachute payment” does not include: i. Payments with respect to a small business corporation or a corporation whose stock is not publicly traded if the payment is approved by the corporation’s shareholders (§280G(b)(5); Q&A 6); ii. Payments to or from a qualified plan (§280G(b)(6); Q&A 8); or
iii. Payments that are reasonable compensation for services to be rendered on or after the change in ownership or control (§280G(b)(4)(A); Q&A 9). See also Q&A 5. c. Payor of Parachute Payment. A parachute payment may be paid by the target company or the acquiring entity. Q&A 10; Hemingway v. United States, 81 F. Supp.2d 1163 (D. Utah 1999) (agreement by acquiring corporation with target company officer can be parachute payment contract). See also Blue Book (at p. 201), quoted infra. 2. Excess Parachute Payments. Parachute payments are excess parachute payments, and therefore nondeductible and subject to the excise tax, to the extent that the amount of the parachute payments exceeds the base amount or any larger amount that constitutes reasonable compensation for personal services actually rendered before the change in ownership or control. §§280G(b)(1), and 4999(a) and (b); Q&A 3. a. Example. Assume an executive with a base amount of $100,000 receives payments with an aggregate present value of $300,000 that are contingent on a change of ownership or control. All of the payments would be parachute payments because their $300,000 present value equals three times $100,000. If the actual amount of those payments exceeds $100,000, they may be considered nondeductible excess parachute payments subject to the excise tax. If the executive’s payments were one dollar less or if they were postponed and paid later in time, they would all be deductible and no excise tax would be due because the “three times” test would not be satisfied.