Help Your Company Mitigate Tax Consequences by Proactively Reviewing Change-in-Control Agreements

It can often prove beneficial to understand the tax consequences of change-in-control (CIC) payments, commonly known as parachute payments, prior to a business combination.

Doing so can help companies address potential tax issues and unintended consequences, which in turn may provide more clarity for executives as well as mitigate any potentially adverse results for individuals and banks.

Excess Parachute Payments

The golden-parachute rules outlined under Internal Revenue Code Section 280G and Section 4999 impose penalties on excess parachute payments made to disqualified individuals by corporations undergoing a COC. Generally, these rules do the following:

  • Impose on recipients a 20% excise tax in addition to regular income taxes
  • Deny a corporation a tax deduction

A parachute payment is generally defined as compensation that’s contingent on a change in ownership or in the ownership of a substantial portion of a corporation’s assets where the aggregate present value of the payment equals or exceeds an amount equal to three times the base amount. The base amount is generally calculated as the average compensation for the most recent five years.

Payments Exceeding the Limitation

If payments are made that equal or exceed the three-times base amount—by even $1—all payments made above the base amount are then subject to the excise tax and disallowed deductions. This makes understanding where things stand in the years prior to a potential transaction essential, as it may provide the ability to mitigate the impact of the limitation.

Last-Minute Employment Agreements

It’s important to note that any employment agreement entered into or an amendment made to an existing agreement less than one year before a change in ownership is presumed contingent on the change in control that’s included in the computation of parachute payments. To circumvent that presumption, the contrary must be established with clear and convincing evidence.

Key Issues

Clawback Language

Most CICs and employment agreements provide for a reduction to reduce the payments to below the 280G limitation to avoid excise taxes and nondeductible payments.

Contract language providing for a payment of 299% of current salary or base amount may be problematic if additional items are included in an employee’s compensation package, such as:

  • Medical insurance
  • Supplemental executive retirement plan (SERP)
  • Acceleration of equity-award vesting
  • Acceleration of bonus payments

In these cases, a clawback provision may be appropriate to avoid excise taxes. This has the potential to significantly impact the net amounts received.

Supplemental Employee Retirement Plan (SERP) Payments

To the extent there’s accelerated vesting with respect to a SERP, this may result in a lower calculation than a set-dollar or lump-sum payout, affecting certain SERP payments because acceleration generally results in a lower inclusion amount.

Stock Options and Voluntary Salary Deferrals

Base amount is based on Box 1 W-2 wages, which means any increase in compensation during the years prior to a COC effectively reduces excess parachute payments. Because of this, individuals may want to exercise stock options or reduce voluntary salary deferrals in the years prior to a transaction to increase their base amount.

Representations and Warranties

Generally, a purchase or merger agreement requires a target corporation to make representations and warranties with respect to golden parachute payments. The acquiring corporation is then subject to payroll-withholding obligations for any excess parachute payments.

Post-Transaction Employment Agreements

Entering into any new employment agreements for either transitional or continued employment after a transaction closes instead of before may help to avoid issues associated with the one-year presumption rule discussed above.

Proactive Planning

The impact of excess parachute payments is often magnified because exceeding the golden-parachute payment limit by $1 taints all payments over the base amount. And relying on a high-level calculation of the appropriate amount can create issues for the following:

  • Closing process
  • Payroll withholding
  • Executives receiving the parachute payments

By reviewing agreements and understanding the impact to executives well in advance of any potential transaction, the unintended consequences of excess parachute payments may be better mitigated—resulting in a smoother business combination.

We’re Here to Help

For more information on how to approach parachute payments prior to an M&A transaction, contact your Moss Adams professional.