Golden Parachute

A golden parachute is a package of payments an executive receives because their employer is sold or otherwise changes hands, typically cash severance, accelerated equity and continued benefits. The phrase is the everyday name and it is also the caption Congress gave to both sections of the Internal Revenue Code that deal with the subject.

The Code works in two defined steps. A parachute payment is compensation to a disqualified individual that is contingent on a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of its assets, where the aggregate present value of all such change-contingent payments to that individual equals or exceeds three times the base amount. An excess parachute payment is then the parachute payment minus the portion of the base amount allocated to it. The base amount is the individual's annualized includible compensation over a base period of the five most recent taxable years ending before the change, so it is roughly their average annual pay.

Two consequences attach to the excess. Section 280G(a) denies the corporation any deduction for it. Section 4999(a) imposes on "any person who receives an excess parachute payment" a tax equal to 20 percent of that amount, which the executive pays in addition to ordinary income tax, and which the employer must add to its withholding. Those are separate penalties on separate taxpayers, and conflating them is the most common mistake in describing the regime.

The gap between the trigger and the tax base is the whole design. Three times the base amount decides whether any of the payments count at all. Cross it and the entire change-contingent package becomes parachute payments, and the amount penalized is what exceeds one times the allocated base amount. That is a cliff, not a slope: an executive whose payments come to a dollar under three times their base amount owes nothing under section 4999, and one who crosses it by a dollar is taxed on a little over two years' worth of pay. Deal lawyers call the space just under the line the safe harbor, and payments are frequently cut back to stay inside it precisely because a small increase can cost far more than it delivers.

Who is exposed. A disqualified individual under section 280G(c) is a person who performs personal services for the corporation as an employee, independent contractor or other person specified in regulations, and who is an officer, a shareholder, or a highly compensated individual. The last of those is bounded: it reaches only someone in the group consisting of the highest paid 1 percent of the corporation's employees, or the highest paid 250 employees, whichever group is smaller. A personal service corporation is treated as an individual for this purpose, and all members of an affiliated group are treated as one corporation, with an officer of any member treated as an officer of the whole.

How the arithmetic is actually built. The base amount is the average annual compensation that was payable by the corporation and includible in the individual's gross income over the base period, or over so much of it as they worked there, so a recent hire has a smaller base amount and is easier to push over the line. Property transfers, including accelerated equity, are treated as payments at fair market value. Present value is computed using a discount rate of 120 percent of the applicable federal rate under section 1274(d), compounded semiannually. And the base amount is allocated across the payments in proportion to their present values, which is what makes each individual payment have its own excess.

Four ways payments come out of the calculation. First, the taxpayer may establish by clear and convincing evidence that part of a payment is reasonable compensation for services to be performed on or after the change, and that part is not a parachute payment at all. Second, reasonable compensation for services actually rendered before the change reduces the excess, and is offset first against the base amount. Third, payments to or from a qualified plan under section 401(a), a 403(a) annuity plan, a simplified employee pension or a SIMPLE retirement account are excluded outright. Fourth, and most useful in practice, section 280G(b)(5) exempts payments made by a small business corporation as defined in section 1361(b), read without its bar on nonresident alien shareholders, and payments by any other corporation whose stock was not readily tradable immediately before the change, provided the payments were approved by holders of more than 75 percent of the voting power after adequate disclosure of all material facts. That vote is why a private-company sale often comes with a 280G cleansing consent and a public one does not.

Two anti-avoidance rules worth knowing. A payment made under an agreement entered into within one year before the change, or under an amendment made in that window to an earlier agreement, is presumed to be contingent on the change, and the presumption can be overcome only by clear and convincing evidence. And a payment made under an agreement violating generally enforced securities laws or regulations is a parachute payment regardless of the three times test, though there the burden of proving the violation is on the government.

The separate securities-law layer. Since the Dodd-Frank Act, Exchange Act Rule 14a-21(c) requires a registrant soliciting shareholder approval of an acquisition, merger, consolidation or a proposed sale or other disposition of all or substantially all its assets to include a separate resolution, subject to a shareholder advisory vote, approving the golden parachute compensation disclosed under Item 402(t) of Regulation S-K, unless those arrangements have already been voted on at an annual meeting. The vote is advisory, so it does not stop a payment. It makes the numbers public and attributable, which is a different kind of constraint. Emerging growth companies are outside the requirement.

1. Identify the disqualified individuals: officers, shareholders, and the highly compensated group capped at the top 1 percent of employees or the top 250, whichever is fewer.

2. Compute each person's base amount, the annualized compensation includible in their income over the five taxable years ending before the change.

3. Total the change-contingent payments at present value, discounted at 120 percent of the applicable federal rate compounded semiannually, counting property transfers at fair market value and applying the one-year presumption to recent agreements.

4. Apply the trigger. If that total is at least three times the base amount, every one of those payments is a parachute payment. If it is not, none of them is.

5. Subtract the allocated base amount from each parachute payment to get the excess parachute payment, after removing anything established as reasonable compensation and anything covered by the qualified-plan or small-corporation exemptions.

6. Apply both penalties. The corporation's deduction for the excess is denied, and the recipient owes a 20 percent excise tax on it, withheld along with ordinary income tax.

An example, with invented figures. Yusuf has been an officer of the company for well over five years and his base amount, his average annual includible compensation over the base period, is $400,000. On the sale he is due severance, accelerated equity and a pro-rated bonus with an aggregate present value of $1,500,000, all contingent on the change.

Three times the base amount is 3 x $400,000 = $1,200,000. Because $1,500,000 is at least that, the trigger is met and the whole $1,500,000 is a parachute payment. The excess parachute payment is then $1,500,000 - $400,000 = $1,100,000. Yusuf owes a section 4999 excise tax of 20 percent of that, which is 0.20 x $1,100,000 = $220,000, on top of the ordinary income tax on the full $1,500,000. The company loses its deduction for the $1,100,000.

Now change one number. Had the package come to $1,199,000, it would have fallen short of the $1,200,000 trigger, nothing would have been a parachute payment, and the excise tax would have been zero. The last $301,000 of the real package therefore carried $220,000 of excise tax with it, which is why deal documents so often contain a cutback clause reducing payments to just under the line.

What the regime achieves

• It puts a real price on the largest change-of-control packages without forbidding them, leaving the decision with the parties.
• The penalties land on both sides of the arrangement, so neither the company nor the executive can be indifferent to the number.
• Payments to qualified retirement plans are carved out, so ordinary retirement benefits are not swept in.
• Private companies have a genuine exit through the more-than-75-percent shareholder approval route, which also forces disclosure to owners.
• The advisory vote under Rule 14a-21(c) makes public-company parachutes visible to shareholders at the moment they matter.

Where it is blunt or costly

• The trigger is a cliff. A small increase in a package can create a very large excise tax, which distorts negotiation near the line.
• The excise tax is on the individual, and companies frequently respond by grossing it up, which increases the total cost and the excess in a loop.
• Base amount is backward-looking over five years, so a recently promoted or recently hired executive is far more exposed than a long-tenured one at the same salary.
• Valuing accelerated equity and computing present value are technical exercises under the section's regulations, so nobody can estimate exposure from the face of an award.
• The public-company vote is advisory only and does not prevent any payment.
• The one-year presumption can pull in an agreement negotiated for ordinary reasons shortly before a deal nobody was expecting.