The following is a brief summary of some of the tax laws regarding reasonable compensation, golden parachute payments, and limitations on compensation deductions.
Reasonable Compensation In General
Section 162 of the Internal Revenue Code allows a deduction for ordinary and necessary business expenses, including reasonable compensation expenses for personal services. As might be expected, the concept of "reasonableness" is somewhat nebulous. In making this determination, courts have applied two tests:
- the amount test, which analyzes whether the amount of compensation is reasonable in relation to the services performed, and
- the intent test, which analyzes whether the money paid was intended as compensation.
Generally, the amount test is more important. A variety of factors are used to analyze whether the amount is reasonable:
- salary history of the individual,
- dividend history of the corporation,
- salary scale for employees generally,
- salary scale in the industry,
- qualifications of the employee,
- contribution to the success of the business, and
- formality and timing of corporate action.
Golden Parachutes: Sections 280G and 4999
Section 280G denies a corporation a deduction for any excess parachute payment, and Section 4999 imposes on the recipient a nondeductible 20% excise tax, in addition to regular income and Social Security taxes. If an acquiring company makes the excess parachute payment, it is not added to the acquiring company's tax basis.
A parachute payment is defined as a payment which violates any generally enforced federal or state securities laws, or which;
- is in the nature of compensation (including stock options valued at their present fair market value at the time of vesting, as well as noncompetition covenants, but excluding certain types of qualified pension plans),
- is made to "disqualified individuals," and
- is contingent on a change in corporate ownership or effective control (or ownership of a substantial portion of the corporate assets). A parachute payment is treated as "excess" and hence nondeductible and subject to the excise tax
- if it exceeds three times the "base amount" and
- to the extent it exceeds the greater of "the base amount" (note this is not three times the base amount) or "reasonable compensation." In general, "base amount" equals the disqualified individual's average annualized compensation, which was includable as gross income ("annual includable compensation") for the five years preceding the tax year at issue.
The statute defines the term "disqualified individual" as an individual;
- who is an employee, independent contractor, or other person specified in regulations, who performs personal services for any corporation, and
- who is an officer, shareholder, or highly compensated individual of the corporation.
Officers are determined by examining the facts and circumstances. There is a limit of 50 officers or if less, the greater of 10% of employees or 3 employees. A shareholder must own the lesser of 1% of the value of the corporation's outstanding stock or $1 million of stock. A "highly compensated" individual is defined as one of the highest paid 1% of employees, or, if less, is one of the highest paid 250 employees. However, an employee whose compensation is less than $75,000 is not treated as highly compensated.
The payment must be contingent on the change of control. Numerous issues abound as to what constitutes a change of control.
Section 280G does not apply to private companies without readily tradable securities or to payments from qualified plans. However, private companies must either meet the requirements to be taxed under subchapter S or must have shareholder approval (either prospectively or retrospectively ) of the parachute payment to qualify for this exemption. Shareholder approval is defined as the approval by 75% of the voting power of the corporation. If the person receiving the payment is a shareholder, then his stock is removed from the shareholder base in making this determination.
Section 162(m)'s $1 Million Limit on Deductions
A public corporation's deduction for compensation with regard to a "covered employee" is limited to $1 million per year. This does not modify the reasonableness requirement which continues to apply. A "covered employee" is:
- the corporation’s CEO or someone else acting in that capacity as of the close of the taxable year; or
- the employee's total compensation must be reported for the taxable year under the Securities Act of 1934 because he or she is one of the four highest compensated officers for that year (other than the CEO).
Unless specifically excluded, the deduction limit applies to all remuneration for services, including cash and in-kind compensation. The limit applies regardless of whether the payment is for services as a covered employee and regardless of when the compensation was earned. The $1 million cap is reduced by any excess parachute payments that the corporation may not deduct.
The limit applies to the year in which the deduction would otherwise be taken. Thus, for example, for nonqualified stock options, the deduction is normally taken in the year the option is exercised.
Certain types of performance based compensation and contributions to qualified plans are excluded from the $1 million limit. Performance goals must be based on objective standards, a compensation committee must approve the goals and certify they have been met, and there must be shareholder approval of the performance based compensation before payment. Stock options are treated as performance based compensation if the requirements for outside director and shareholder approval have been met, because the amount of compensation attributable to the options or other rights would be based solely on an increase in the price of the corporation's stock. Grants of stock options below market value and downside protection for an executive in the event of a decline in the stock price are not covered.