Excess "Golden Parachute" Payments--Nondeductible and Penalty Tax

By Alison Stemler, J.D. *

The golden parachute rules in IRC Section 280G state that if an employee or contractor receives or will receive compensation that is triggered by or closely related to a change in control, and that change in control compensation is in total more than three times the employee or contractor's average taxable pay, the compensation that exceeds one times average taxable pay is not deductible by the employer, and is subject to a 20% excise tax payable by the employee or contractor under IRC Section 4999. For this purpose, a change in control occurs when a person (which includes an entity and persons acting as a group) acquires stock that results in the person becoming a more than 50% owner of the fair market value or total voting power of the stock of the corporation, when there is a change in effective control of a corporation, or when there is a sale or disposition of one-third or more of the assets of the corporation.

Businesses often enter into agreements with their important executives to provide for a substantial payment of severance compensation if the executive's services are terminated following a change in control, and sometimes even to provide for a payment at a change in control even if services are not terminating. The purpose of these "golden parachute" payments is to retain an executive in a time of uncertainty, such as when a sale is or is expected to be considered or pursued. At one time it was not unusual for the golden parachute to provide for a cash payment of five years' worth of the executive's current compensation. As a result of perceived abuses in the scope of golden parachute contracts, IRC Sections 280G and 4999 were enacted. Parachute payments have also been attacked by shareholders and have become much more modest. However, vesting in significant equity compensation and parachute payments at start-up companies where executives and directors have been paid little or nothing, can still frequently give rise to excess parachute payments.

Under IRC Section 280G(a), a corporation may not take a federal income tax deduction for any "excess parachute payment." Under IRC Section 4999(a), any individual who receives an "excess parachute payment" is subject to a 20% excise tax on the amount of the excess parachute payment.

The parachute rules do not apply to payments by partnerships, payments by entities taxed as an S corporation, or to entities that meet the qualifications to elect to be taxed as an S corporation even if the election has not been made. In addition, for a non-public company, a payment is exempt if 75% of shareholders approve the payments after the payments are made contingent on shareholder approval, and after 100% of shareholders have been provided with a detailed notice of the payment amounts and all relevant circumstances of the payments and request for shareholder approval. If an employer determines that there are excess payments, and another exception does not apply, the employer may want to seek shareholder approval if a private corporation is involved.

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*Alison Stemler is a Member of the Kentucky Bar.

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 RELATED LINKS: For additional insight into this topic, see:

• 1-3 Taxation of Executive Compensation § 3.11