United States: Removal Of Tax Gross-Ups Results In Heightened Sensitivity To Golden Parachute Rules In Corporate Transactions

A sensitive issue in many corporate transactions is whether amounts to be paid to a target's executives will be treated as golden parachute payments for tax purposes. Golden parachute payments result in adverse tax consequences for both the executive and the employer: the executive must pay a 20 percent nondeductible excise tax on the excess portion of the golden parachute payments (as discussed below), and the payor loses its deduction on the excess portion of the golden parachute payments. (For purposes of this article, an executive is an employee or director of a public company who was an officer, a one percent or more shareholder, or one of the top one percent highest paid individuals within the 12-month period immediately preceding the change in control.) For several years, many public companies have included tax gross-ups for this excise tax in order to reduce the risk of executives becoming distracted by this issue. Although quite small in relationship to the overall size of the corporate transaction, tax gross-ups provided an important level of assurance to executives that benefits promised under severance and equity compensation plans would be provided as expected.

Tax gross-ups for golden parachute treatment at public companies have recently come under heavy attack. In November 2008, RiskMetrics Group (RMG), formerly known as ISS, announced a policy that, going forward, it would consider tax gross-up payment for golden parachute treatment to be a "poor pay practice." RMG is an influential shareholder advisory service that determines whether to recommend for or against approval of proposed equity compensation plans, and/or to withhold votes for a director on the compensation committee. It is reasonable to expect that shareholder proposals to eliminate golden parachute payments and the threat to withhold votes by shareholders will result in fewer tax gross-ups in the future. A recent study by Pearl Meyer & Partners for the National Association of Corporate Directors found that 61 Fortune 500 companies made material changes to change in control benefits from November 2008 to August 2009 and that more than 10 percent of these agreements eliminated excise tax gross-up provisions.

Restricting payments that are contingent upon a change in control to amounts that will not trigger golden parachute treatment may result in a significant loss of benefits to executives. Golden parachute treatment results when the present value of payments that are contingent upon a change in control exceeds a tipping point. In general, this occurs when payments are at least three times the executive's average annual taxable compensation during the five-year period ending before the year of the change in control (the base amount). Assume that an executive's employment agreement provides for $3 million in payments contingent upon a change in control and that the executive's base amount was $500,000. The payments in this case would need to be limited to just less than $1.5 million to avoid golden parachute treatment even though the executive might otherwise be expecting twice that amount.

The tipping point calculation does not provide as much room to make payments without triggering golden parachute protection as might appear at first glance. The base amount does not take into account payments that would be made in the year of the change in control. It also includes earlier years in which taxable compensation might have been significantly lower than the value of the payments upon a change in control. This is quite likely to happen when an executive is paid heavily with equity compensation that has not previously been taxed (e.g., no earlier exercise of stock options) or when there have been years without bonuses and/or with salary freezes in exchange for long-term compensation. It is not uncommon to see situations in which the tipping point is between one and one-half and two times the current rate of salary.

Recent changes in equity compensation plan design exacerbate this problem. Until recently, executives often received all or a substantial portion of their long-term incentive in the form of time-vested stock options or restricted stock. Internal Revenue Service (IRS) regulations provide a taxpayer-friendly method for valuing the golden parachute payment that results from the accelerated vesting of these awards. When calculating the tipping point, the golden parachute payment is not the total amount received by the executive. Instead, the golden parachute payment will only reflect the time value of money (i.e., getting paid now instead of at the normal scheduled vesting date) and one percent of the equity award's value for each month of waived vesting service. Depending upon how much time remains until vesting, the valuation discounts could be quite significant. Recently, however, public companies have increasingly been using performance-based vesting conditions. No matter how likely it is that these conditions will be satisfied, a discount cannot be applied when valuing these awards for purposes of the tipping point calculation.

If there is no tax gross-up, allowing payments in excess of the tipping point can result in a lose-lose situation for the parties that only benefits the IRS. The 20 percent golden parachute excise tax is based on the amount by which the payments contingent upon a change in control exceed the base amount, and not the amount by which the tipping point is exceeded. Consider an executive who has a base amount of $100,000. If the payments contingent upon a change in control are $299,999, then there is no excise tax. However, if just one additional dollar is paid, a 20 percent nondeductible excise tax applies to the executive not just on $1, but instead on the entire amount above the base amount, thereby resulting in a $40,000 excise tax ($300,000 - $100,000 * 20 percent). If a tax gross-up payment is to be eliminated, it should be replaced with either a cap on payments so as to avoid the tipping point, or a provision that allows for contingent payments to be made only when doing so would provide a better after-tax net benefit for the executive (at some pre-determined level) after considering all of the executive's taxes.

So, what is an executive to do? In renegotiating executive pay packages, public companies increasingly are considering a technique that conditions payments that are contingent upon a change in control upon compliance with a non-competition covenant. Any payment that is considered reasonable compensation for services rendered after a change in control is ignored for purposes of calculating the tipping point. IRS regulations provide for compliance with a non-compete to be treated as the equivalent of providing services after a change in control. As a result, post-termination cash payments and equity vesting that would otherwise be subject to a 20 percent excise tax could be exempt from golden parachute treatment.

Achieving this result depends upon the specific circumstances and requires careful advance planning. The non-compete will only have value for future services if it "substantially constrains the individual's ability to perform services," and there is a "reasonable likelihood that the agreement will be enforced." In addition, this standard must be met by "clear and convincing evidence." As a practical matter, taking advantage of this rule often requires the following:

A good valuation report will evaluate in detail the potential harm that could result from competition by the executive and the executive's personal circumstances.

There are several other strategies that are available to public companies and their executives to increase the amount that may be paid under the tipping point. The base amount used to determine the tipping point can be increased by exercising stock options, electing not to defer amounts under a nonqualified deferred compensation plan and paying bonuses during the five- year period ending prior to the year of a change in control. The value of payments for purposes of the tipping point calculation can also be reduced by cashing out options, which limits the value to the cash-out amount (as opposed to a higher Black-Scholes value due to holding the options for a prolonged period of time after a change in control). In addition, reasonable compensation for services to be rendered after a change in control includes payments received by an executive as bona fide damages for breach of contract due to an involuntary termination without cause. This exemption may apply when the payments do not exceed the present value of the compensation that would have been paid during the remainder of the contract term, the executive demonstrates a willingness to work that is rejected by the buyer and the amounts to be paid as damages are reduced to the extent the executive has earned income from other sources during the remainder of the contract term.

It will usually be quite difficult and distracting to grapple with these issues for the first time upon a change in control. A purchase and sale agreement will typically call for a representation by the seller that no agreement or arrangement will result in golden parachute treatment (except as disclosed in a schedule). Calculating the amount of golden parachute payments is quite complicated and often can involve judgment calls, such as whether a payment is truly contingent upon a change in control and, if so, when payment is certain enough to count toward the tipping point. There will also be the procedural issue of who determines whether the tipping point has been exceeded and how the executive's benefits will be reduced if under the contract, the benefits must be limited to an amount under the tipping point. In addition, a 20 percent addition to tax under Section 409A may apply in certain cases when either the executive has the ability to direct how benefits are to be reduced or if the manner of reduction is unclear.

Further complicating matters is that a well-represented buyer will request evidence from the target that payments contingent upon the change in control do not equal or exceed the tipping point. The executive compensation audit initiative by the IRS is an often-cited reason for requiring more than just a representation by the seller. Audit technique guidelines now provide IRS agents with step-by-step instructions for examining whether buyers are deducting amounts that should be nondeductible due to golden parachute treatment. Because audits often occur years after a corporate transaction, and the information to evaluate golden parachutes may not then be readily accessible, it would normally be a daunting task for the buyer to document its tax position from scratch upon audit.

The shift away from tax gross-up payments will make it more important than ever for public companies and executives to plan ahead and to understand the interplay between golden parachute rules and change in control protection. Failure to do so can result in an executive's compensation package becoming a significant distraction in completing a corporate transaction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.