Minimize Parachute Penalties

EXECUTIVE SUMMARY

COMPANIES SHOULD NOT ENTER into golden parachute plans without careful consideration. CPAs called in to help draft these agreements can, through prudent planning, save their employers and clients significant sums. GOLDEN PARACHUTES CAN ENCOMPASS A VARIETY of benefits, including not just extended salaries and cash payouts but also early vesting of stock options, bonuses, pensions and other benefits. Because of the complexity of rules governing parachutes and their tax treatment, most parachutes generate attest work for CPAs when they are triggered. THE DEFICIT REDUCTION ACT OF 1984 led to the proliferation of so-called “299%” deals in which an executive losing his or her job due to a change in corporate control got a payout that fell just under the excise tax trigger. A GROSS-UP PROVISION LAYERS an additional payment on top of the golden parachute to reimburse the recipient for the excise tax he or she will owe. ONE OF THE MOST POPULAR TECHNIQUES to mitigate the cost of a parachute payment is to take advantage of an IRS provision that says payments made to executives for services they provide after a change in control are not part of the golden parachute.

RANDY MYERS is a freelance financial writer who lives in Dover, Pennsylvania. His e-mail address is randy@randymyers.net .

hen executives at United Airlines began calculating what they would have to pay to acquire rival US Airways if the merger had been completed, due diligence took them on an eye-opening ride beyond the balance sheet. Detailed in the employment contracts between US Airways and its senior executives were severance provisions for the top five managers that would add approximately $165 million to the cost of United’s takeover deal. Even in a merger valued at more than $11 billion, that was no small sum.

The proposed payout didn’t scare away United Airlines, which was convinced that it needed to complete the deal for competitive reasons. As it happens, the company never made those payments because it abandoned the merger in July, right after the U.S. Justice Department said it would sue to stop the deal on antitrust grounds. But as the size of its potential severance expense illustrated, so-called golden parachutes—big compensation packages paid out to executives due to a change in control of the company—shouldn’t be overlooked by companies contemplating a merger or acquisition.

Nor should companies enter into parachute plans without careful consideration. CPAs called in to help draft these agreements can, through prudent planning, save their employers and clients significant sums of money (see “Planning for Parachutes,” below).

Because of the unusual federal tax treatment parachute plans receive, including a 20% excise tax on payments exceeding a complexly calculated threshold, poor planning can lead to unexpected and exorbitant costs. In worst-case scenarios, companies can find themselves spending more than $3 for every $1 of benefits received by the departing executive. In other cases, poorly worded documents can trigger payments in circumstances where none were intended. “Companies absolutely do not spend enough time thinking about these things,” insists Alan Johnson, a managing director with the New York City-based executive compensation firm Johnson Associates. “The issue isn’t just how you calculate the parachute payment, but what should trigger it. A lot of companies just copied what everybody else was doing 5 or 10 years ago and haven’t thought about it since. But we’ve been involved in change of control transactions twice where these things became a huge barrier to the deal.”

“They can present some thorny issues,” agrees Gregory Sneddon, cofounder and senior managing director of Consilium Partners, a boutique mergers-and-acquisitions firm based in Boston. “If the management team of the selling company is asking for usurious levels of financial compensation, it can cause a fair amount of friction.”

REIN IN GENEROSITY

Golden parachutes became popular in the early 1980s, the heyday of corporate raiders such as Carl Icahn and T. Boone Pickens. The payout agreements were presented to shareholders as a tool for keeping senior managers focused on the company’s interests, rather than on saving their own skin, during a hostile takeover attempt. (For more about types of parachutes, see “Golden Parachutes…Plus Silver, Tin and Platinum,” below.)

It wasn’t long before Congress began to worry that the severance packages could be so generous they would actually divorce senior management’s interests from those of other shareholders. Their response was a provision in the Deficit Reduction Act of 1984 creating tax penalties for companies awarding excessive severance packages, or what had come to be called golden parachutes. Wags called the legislation the “Bill Agee bill” because it was prompted in part by Congressional indignation over a severance package awarded to the Bendix Corp. chairman during a hostile takeover attempt by Martin Marietta Corp. Bendix’s Agee-led board approved golden parachutes for the company’s top executives totaling $15.7 million, including a salary for Agee of $800,000 per year for five years.

Today, golden parachutes can encompass a wide variety of benefits, including not just extended salaries and cash payouts but also early vesting of stock options, bonuses, pensions and other benefits such as health and life insurance policies, says Marianne Heard, CPA, a manager at American Express Tax and Business Services. Because of the complexity of the rules that govern them and their tax treatment, most golden parachutes generate attest work for accountants when they are triggered. The IRS published proposed regulations for golden parachutes in 1989 in Section 280G of the tax code specifying that companies could offer the payments without penalty if they totaled less than three times the executive’s average annual compensation for the prior five years, with that base salary including bonuses and any stock options the executives might have exercised during that period. Once that threshold was exceeded, however, the recipient would owe a 20% excise tax on any portion of the severance package that exceeded one times his or her base salary. In addition, the company would not be able to claim that portion of the severance payment as a corporate tax deduction.

“As far as I am aware, this is the only income tax in America that isn’t calculated at the margin,” observes Johnson. “Let’s say I’m an executive getting a parachute payment and my five-year average annual pay is $1 million. If my severance package is worth $2,999,999.99, I pay no excise tax and my company gets a full deduction for that amount. But if my severance is $3 million exactly—one penny over the line—I owe a 20% excise tax on $2 million, which means that penny cost me almost $400,000 in extra income taxes at the federal level alone. My company also loses a $2 million tax deduction.”

The IRS did specify four types of payments that would not be considered part of a golden parachute and would not be subject to penalty, regardless of their size. They include payments made to executives of companies that, immediately before a change in control or ownership, were (a) considered small businesses under IRC Section 1361(b) without regard to paragraph (1)(C); or (b) had not issued stock that was readily tradable as long as certain shareholder approvals of the payment had been met. Other exemptions included payments made from a qualified retirement plan, a section 403(a) annuity plan or a simplified employee pension (SEP) under section 408(k) of the tax code, or payments that could be shown to be reasonable compensation for personal services performed after the change in ownership or control of the company.

Far from discouraging lucrative severance plans, the Deficit Reduction Act of 1984 led to the proliferation of so-called “299%” deals in which an ousted executive got a payout that fell just under the excise tax trigger, because Congress had “authorized” payments of that amount. Still, some companies concluded that to attract and retain the best possible talent, especially at the CEO level, they needed to offer more than a 299% package. That’s when golden parachutes really got expensive.

“Companies recognized their executives didn’t want to get an enormous excise tax bill for going over the threshold, so one of the solutions they devised was the gross-up,” says Bill Coleman, vice-president of compensation for Salary.com, a Wellesley, Massachusetts company that conducts research on pay practices. “Depending upon what state you are in, it can be the most expensive corporate cost associated with an individual executive’s compensation package.”

As its name implies, a gross-up provision layers an additional payment on top of the golden parachute to reimburse the recipient for the excise tax he or she will owe. According to the 2001 Golden Parachute Report by Executive Compensation Advisory Services, 52% of the Fortune 1000 golden parachute agreements include gross-up provisions.

It isn’t hard to see how those provisions can quickly become expensive. Most senior executives are in the highest federal tax bracket of 39.1% (under the newly enacted tax legislation), and after the phase-out or disallowance of various itemized deductions that apply to high wage-earners, plus the addition of the 1.45% Medicare tax, they typically labor under a maximum marginal rate of about 42.5%, explains attorney Roger Siske, a partner at Sonnenschein Nath & Rosenthal in Chicago and chair of its national employee benefits and executive compensation practice. Throw on a 20% federal excise tax plus state income taxes, and the total tax burden on gross-ups in some states can exceed 70%. “For every dollar the company gives you for the gross-up, you spend 70 cents on an additional tax on the gross-up. As you increase the gross-up to keep the executive even, it can end up taking about $3.33 to pay $1 of excise tax,” Siske says. “And while that’s significant, it understates the real cost because the employer can’t deduct any of the dollars subjected to the excise tax.” (see “Golden Parachute Costs Can Skyrocket,” below.)

Those numbers also don’t address the soft costs a company incurs, notes Heard, such as time spent by legal staff, human resources, payroll, tax and other executives in managing the severance agreement.

MITIGATING THE COSTS

Although the IRS has yet to finalize its Section 280G rules on golden parachutes, practical application of the proposed regulations, buttressed in some cases by letter rulings from the IRS, have led to the development of several common techniques for mitigating their cost. CPAs can build cost-savings into the design of a golden parachute agreement, while they can use other techniques retroactively once a parachute payment has been triggered.
One of the most popular techniques takes advantage of the provision in the proposed regulations exempting from golden parachutes payments made to executives for services they provide after a change in control. Accordingly, companies that temporarily retain an executive to assist with the merger transition have argued that some of the money he or she receives is just that type of compensation. Even executives who know they will be losing their jobs can sometimes find these short-term assignments agreeable if it helps them avoid the onerous 20% excise tax on their parachute payments.

A more novel application of the same rule, endorsed by the IRS in a letter ruling to KPMG last year, is to designate some portion of the executives’ compensation after the change of control as payment for entering into a noncompete agreement with the acquiring company. The challenge for CPAs, of course, is to affix a defensible value to the noncompete agreement. That value can vary tremendously based on the size of the company and its industry, the executive’s prominence within that industry and the impact he or she could have as a competitor. Because of rules governing when an accounting firm can conduct appraisals for an audit client, it is not uncommon to bring in a third-party appraiser to do the job.

“A consulting arrangement for specific expertise is the most used vehicle to mitigate tax consequences,” notes Heard. “But again, the issue of reasonable compensation must be addressed. Showing up for a few meetings and a lunch may be questioned. A retainer that states the amount is being paid for advice and expertise ‘as needed’ is the most aggressive approach.”

One way to avoid the onerous tax consequences of a golden parachute is to implement what some compensation experts refer to as a “claw-back” clause, which says that if the net proceeds to the executive meet or exceed the three-times-base-salary threshold, the parachute payment will be capped to stay below it. Suppose, Heard notes, that an executive’s base salary for purposes of calculating his golden parachute is $100,000. If his all-inclusive severance is $300,000, $200,000 of that amount would be subject to the penalty. By cutting the payout to $299,999, none of the severance package would be subject to the penalty.

Yet another option is to boost the salaries of executives slated to receive golden parachutes in the year before the change of control, so that their base salaries are higher. The executives can receive larger parachute payments without triggering the excise tax, but it’s not easy to do this. In its enabling legislation, Congress specified that a parachute payment is one based on a change in control of the company. To prevent companies from doling out huge bonuses or stock awards immediately before a change in control—a blatant attempt, in other words, to avoid the tax consequences of a large parachute—Congress said any such payment made within a year of the change of control would be presumed to be attributable to the change in control unless the company could prove otherwise (for example, if it had awarded similar payments in prior years).

“Our members have not seen this put into play that often, as it would take sufficient advance warning and adequate time for adjustment,” concedes Heard, who is also president of the American Woman’s Society of CPAs.

Still, if competitive conditions allow for it and the sums of money justify it, companies can make this strategy work. Salary.com’s Coleman notes that in a previous job with a large benefits consulting firm, he saw two companies renegotiate the closing of their merger into another calendar year so that the departing CEO could first exercise stock options and increase his base salary.

Alternatively, says Peter I. Elinsky, CPA and national partner-in-charge of compensation and benefits at KPMG, LLP in McLean, Virginia, companies with the flexibility to do so can accelerate into December 31 of the year before the change of control one-time payments they would have made anyway to the departing executive after the change. In that case, the payment is considered a parachute, but it will also count toward the executive’s average base salary for the five years before to the change in control. The net effect increases the average base salary by 20 cents for every dollar of the bonus. Since parachutes are not penalized below the three-times-base-salary cap, 60 cents of each bonus dollar will avoid the parachute tax (see “How to Make Tax Sense of the Parachute Bonus,” below).

In some circumstances, Elinsky adds, companies can successfully argue only a portion of a bonus paid out within a year of a change of control should be deemed part of the parachute. Suppose, for example, an executive had a contract calling for him or her to receive a $1 million bonus after five years of service, payable immediately if there was a change of control. If such a change does take place—after four years, let’s say—the company can argue that 80% of the payment should be credited against the four years of service already performed, so that only the remaining 20% would be part of the parachute.

“People often have stock options or restricted stock that vests over five years, but vests immediately if there is a change of control,” Elinsky observes. “In those cases, the one-year rule gives us the right to treat some of that compensation as not being part of the parachute payment. It helps to mitigate the tax consequences.”

Mitigation, not elimination, is often the most that any CPA can offer a client or employer seeking to soften the impact of a golden parachute payout. Given the sums at stake, though, even that relief can be material.