The IRS' golden parachute payment rules can result in severe adverse tax consequences to both corporations that make, and an executive who receives, parachute payments. It is important therefore for corporations and their executives to understand how these rules work.
This article will discuss the final golden parachute payment regulations published by the Internal Revenue Service in August of 2003. The final regulations clarify and modify proposed regulations that were published by the Internal Revenue Service in early 2002.
Introduction - Golden Parachute payments
The Internal Revenue Code ("Code") denies a corporation a deduction for "excess parachute payments" made by a corporation. In addition, it imposes on the recipient of such payments an excise tax equal to 20% of the payment. A "parachute payment" is generally a payment to a "disqualified individual" that (1) is in the nature of compensation, (2) is contingent on a change in ownership or control of the corporation, and (3) equals or exceeds three times the individual's "base amount." An "excess parachute payment" is the excess of the amount of any parachute payment over one times the individual's base amount. A "disqualified individual" is any officer, shareholder or highly compensated employee of the corporation. A disqualified individual's "base amount" is generally the average annualized compensation of the individual includible in gross income over the five taxable years ending immediately before the year in which the change in ownership or control occurs.
The final regulations make a number of important changes to the 2002 proposed regulations, including the following:
Accelerated Vesting of Options. The final regulations provide that accelerating the vesting of a compensatory stock option could result in a parachute payment. The IRS had previously issued two revenue procedures that set forth methodologies for valuing the accelerated vesting of options. In coordination with the issuance of the final regulations, the IRS has issued a revenue procedure (Rev. Proc. 2003-68) restating the previous revenue procedures and addressing certain additional issues raised by various commentators.
- Under the Rev. Proc. 2003-68, any valuation method permitted by generally accepted accounting principals may be used for valuation purposes, without regard to whether the option relates to publicly or nonpublicly traded stock. In addition, the revenue procedure provides a safe harbor valuation method based on the Black-Scholes valuation model, taking into account the volatility of the stock subject to the option, the exercise price of the option, the value of the stock on the valuation date, and the remaining term of the option. The valuation of an option may not be based solely on the spread between the exercise price and the value of the stock at the time of the change in ownership or control.
- Rev. Proc. 2003-68 provides that the value of options can be redetermined during an 18-month redetermination period that begins on the date of a change in ownership or control if during such period there is a change in the term of an option resulting from a termination of employment or if there is a change in the volatility of the underlying stock.
Accelerated Vesting Without Payment. The 2002 proposed regulations provided that the lapse (due to a change in ownership or control) of a restriction on a disqualified individual's rights to payment results in a parachute payment, regardless of whether the actual payment is accelerated. They also provided that the amount attributable to the lapse of the obligation to perform services is 1 percent of the present value of the future payment multiplied by the number of full months between the date that the individual's right to receive the payment is vested and the date that, absent acceleration, the payment would have vested. The final regulations contain the same rule. However, the IRS recognizes that the accelerated vested amount, as calculated under the regulations, may in fact result in more income being reported than the amount that will actually be paid to the disqualified individual (e.g., if the vesting is accelerated by more than 100 months). The final regulations therefore provide that a parachute payment resulting from accelerated vesting without accelerated payment will not exceed the present value of the accelerated payment.
Presumption of Status as Officer. A disqualified individual includes an officer of the corporation. The final regulations provide that a person who holds the title of an officer is presumed to be an officer unless the facts and circumstances demonstrate that the person does not have the authority of an officer. Conversely, a person who does not have the title of officer may nevertheless be considered an officer if the facts and circumstances demonstrate that the person should be considered an officer.
Qualification for Small Corporation Exemption. The Code provides an exemption from the golden parachute payment rules for payments made by a "small business corporation." It defines small business corporation by reference to the definition of that term under the S corporation provisions of the Code (except that for purposes of the golden parachute rules the presence of a nonresident alien shareholder will not disqualify a corporation as a small business corporation). Commentators have indicated that it is unclear whether a corporation qualifies for the small business corporation exemption if the corporation could have made an S corporation election, but does not. The final regulations clarify that such a corporation does qualify for the exemption.
Shareholder Approval. In certain circumstances, payments that are approved by a vote of persons who own more than 75% of the voting power of all outstanding stock of the corporation payments will not be subject to the golden parachute payment rules.
- In response to comments to the 2002 proposed regulations, the final regulations clarify that only stock that would otherwise be entitled to vote is considered outstanding and entitled to vote for these purposes. For example, an individual who holds options is not considered to hold outstanding stock entitled to vote.
- The 2002 proposed regulations allowed the corporation to identify shareholders eligible to vote using the shareholders of record at the time of any vote taken in connection with a transaction or event giving rise to the change in ownership or control within the three-month period ending on the date of the change in ownership or control. The final regulations expand, clarify and simply this provision by allowing a corporation to determine the shareholders of record on any day during the six-month period ending on the date of the change in ownership or control, regardless of whether there was a vote on that day.
- The final regulations clarify that stock held (directly or indirectly) by a disqualified individual who would receive a parachute payment if the shareholder approval requirements are not met is not entitled to vote with respect to a payment made to any disqualified individual.
- An entity shareholder (e.g., a partnership that owns shares of the corporation) cannot vote shares constructively owned by a disqualified individual (e.g. a disqualified individual who is a partner of the partnership) who would receive parachute payments in connection with a change in ownership or control, but the entity shareholder can designate another equity interest owner (e.g., another partner in the partnership) to vote the shares not constructively owned by the disqualified individual.
Definition of Change in Ownership Or Control. The 2002 proposed regulations provided three different definitions of a change in ownership or control: (i) a person or group of persons acquires more than 50% of the total fair market value or voting power of the stock of a corporation (i.e., a change in ownership of stock), (ii) a person or group of persons acquires one-third or more of the fair market value of the assets of a corporation (i.e., a change in ownership of assets), or (iii) a person or group of persons acquires effective control of a corporation by acquiring 20% or more of the total voting power of the stock of the corporation or by replacing a majority of the directors of the corporation during an 12-month period with individuals whose appointment or election is not endorsed by the current board (i.e., a change in effective control). Commentators have suggested that these definitions can result in more than one change in ownership or control occurring in a single transaction. The final regulations adopt the proposed definitions of change in ownership or control, but also provide a "one change" rule. Under that rule, if there is a change in ownership of stock or assets of a corporation, the other corporation that is a party to the transaction would not experience a change in ownership of stock or assets. In addition, a change in effective control of a corporation would not occur if the other corporation that is a party to the transaction experienced a change in ownership of stock or assets.
Prepayment of Excise Tax. The 2002 proposed regulations provided a mechanism to allow a disqualified individual to prepay the 20% excise tax. The final regulations clarify that the prepayment of the excise tax is based on the present value of the excise tax that would be due in the year the excess parachute payment would actually be paid and allow prepayment of the excise tax in the year of the change in ownership or control or any later year.
Conclusion
Corporations and executives need to be aware of the IRS' newly adopted golden parachute payment regulations. It is important that parties are familiar with the key aspects of the regulations in their compensation and severance planning efforts. In our experience, corporations and executives are often unpleasantly surprised by the impact of these regulations as well as the effects of the alternative minimum tax on unexercised incentive stock options, at the time of a change in control. Careful planning can help avoid unintended consequences to both companies and their executives.