Plan Before a Change in Control to Avoid Excess Golden Parachute Payments

Golden parachute payments often occur when a company undergoes a change in control.

In the case of a sale of a corporation or a sale of a substantial portion of a corporation's assets, certain key employees may receive so-called golden parachute payments, (i.e., payments that are contingent on the sale such as bonuses, vesting of equity compensation, severance, etc.). If the aggregate value of such payments equals or exceeds a threshold amount, then the employee is subject to a 20% excise tax on a portion of the golden parachute (not just the excess above the threshold amount) and the employer is not entitled to an income tax deduction for such excess. A pre-sale golden parachute payment study can assist the company in determining the extent to which the company has exposure to these rules. If there is exposure, there may be planning opportunities to reduce or eliminate negative tax results.

Golden Parachute Rules and Penalties

The golden parachute rules are detailed in Internal Revenue Code Secs. 280G and 4999. Excess parachute payments are defined under Sec. 280G as an amount equal to the excess over the base amount (Base Amount). Base Amount is defined as the individual’s average annual taxable compensation for the base period. The base period is then defined as the most recent five years ending before the date of the change in ownership or control in which the individual was an employee or independent contactor. Golden parachute penalties do not apply if the parachute payments are less than three times the Base Amount (Safe Harbor). If the payments equal or exceed the Safe Harbor, the penalty is calculated on the total value of the payments in excess of the Base Amount. For example, if the Base Amount is $100,000, then the individual cannot receive contingent payments of $300,000 or more and avoid the excise tax. If the individual receives $300,000 the penalty would be $40,000 (($300,000 - $100,000) x 20%). On the other hand, if the individual only receives $299,999 there would be no penalty to the individual and the company could take the full amount as a deduction.

Pre-Sale Study to Reduce Excess Parachute Payments

A pre-sale golden parachute payments study can assist in determining the extent to which the company and the individual have exposure to these rules. Excess parachute payments can be reduced by demonstrating with clear and convincing evidence that a portion of the parachute payment is reasonable compensation for services performed before the change in control. For example, if the individual was underpaid relative to similar executives at peer companies in years prior to the change in control, the corporation could demonstrate that all or a portion of the payment is a catch-up payment.

Non-Competition Agreements and the Importance of Valuation

Parachute payments can also be reduced or eliminated by demonstrating that a portion of the payment is reasonable compensation for services to be performed after the change in control. For example, a non-competition agreement may restrict the individual's ability to compete with the company for a certain period of time after employment is terminated. Without the non-competition agreement in place, the company could experience an economic loss due to such competition. As a result, the value of a non-competition agreement can be an important factor in the determination of excess parachute payments.

In valuing the non-competition agreement, IRS valuation guidelines must be followed closely. In Rev. Rul. 77-403, IRS stated that in order to place value on a non-competition agreement, one must demonstrate that a person bound by a non-competition agreement (the Covenantor) would, under normal circumstances, have the ability, feasibility and desire to compete absent any explicit arrangement.

The courts have ruled that the ability of a Covenantor to compete is evidenced by the individual’s experience in and knowledge of the transferred business. Specifically, such ability can be indicated by the Covenantor’s thorough knowledge of the company’s operations, markets and strategies. Ability is also evidenced by the Covenantor’s leadership and stature in the industry and the community, as well as by his or her financial wherewithal and entrepreneurial ability.

The question of feasibility is normally associated with endogenous factors such as barriers to entry. Such barriers might include time to start a competing operation, procurement of necessary licenses, availability of labor and amount of capital investment required in light of returns expected.

The desire to compete can be demonstrated by showing that there are no factors, such as age and health of the Covenantor, or the attractiveness of the returns expected, that would diminish the desire to compete.

The method most often used to determine the value of a non-competition agreement is the discounted cash flow (DCF) analysis in the form of a with-without method. This method values a non-competition agreement by quantifying the economic harm that could occur to the business in the absence of the agreement. Generally, a probability adjusted DCF analysis is performed to determine the value of the business assuming expected cash flows with the non-competition agreement in place (the with scenario). This value is then compared to the indicated value of the business from the DCF assuming expected cash flows without the non-competition agreement in place (the without scenario). The difference represents the value of the non-compete agreement.

It is extremely important that the appraisal of the non-competition agreement follows IRS requirements. Further, it is critical that the assumptions used in both the with and the without scenarios are supported by sound and supportable assumptions. The valuation process includes interviews with company management as well as independent related research to quantify the parameters utilized to quantify the economic impact on the company if the Covenantor were to compete.

Plan Before a Change in Control Occurs

Golden parachute payments have the potential to yield significant tax consequences for both a company and the individual employees involved. Planning before a change in control or sale of a substantial portion of corporate assets can help mitigate the tax consequences by examining ways to reduce excess parachute payments and by strategically using non-competition agreements.