“Golden parachute payments” are an often-scrutinized mechanism that provides a monetary bonus to executives and key employees should the company be acquired. Think of it as a protection policy of sorts for highly compensated employees who may have an uncertain future if the company is sold during their tenure. Golden parachutes can also involve certain payments made to an executive after the change in control occurs, to help ensure a smooth transition between buyer and seller.
Although these types of payments can be controversial, they continue to be common among most mergers and acquisition deals. However, the tax rules surrounding a golden parachute can be harsh. Understanding a vital exception in the tax code can help make these payments more beneficial to all involved.
What Exactly Constitutes a Golden Parachute Payment?
Golden parachute payments, also called “excess parachute payments,” generally mean any payment in which all of the following apply:
- The payment occurs due to a change in control of a corporation, or substantially all a corporation’s assets;
- The aggregate value of the payment is greater than or equal to three times that individual’s average annual salary for the previous five years; and
- The payment is made to an employee or contractor who is also a shareholder, officer or other highly compensated individual.
How is a Golden Parachute Payment Taxed?
Corporations cannot deduct golden parachute payments, and recipients of the payments will have to pay a 20% excise tax in addition to any ordinary income taxes. This is a punishing tax law that can adversely affect both the buyer and seller involved in the acquisition. Fortunately, there are some exceptions that allow certain companies to deduct parachute payments and recipients to not pay the additional excise tax:
- Payments that are made under qualified plans or deemed “reasonable compensation” that are made on or after the change date are not considered golden parachute payments.
- Companies that qualify as an S corporation, even if taxed as a C corporation, are not subject to the golden parachute payment rules.
- Additionally, there is a notable exception for private companies that allows shareholders to vote on the matter.
The “Small Business Corporation” Shareholder Vote Exception
If a corporation is not publicly traded, shareholders can vote to approve the golden parachute payments and, therefore, not be subject to the harsh tax penalties mentioned above. At least 75% of shares by vote must approve the payments. The vote must occur based on ownership before the change of control event, and the transaction cannot be contingent upon the golden parachute vote passing. The shareholders must have received adequate disclosure of all material facts and circumstances surrounding the payments. The adequate disclosure requirements include, but are not limited to, the following:
- The event triggering the payments
- The amount that would be considered golden parachute payments if the vote does not pass
- A brief description of each payment, whether it is salary, accelerated vesting of options, bonus, etc.
- Any other material facts “if there is a substantial likelihood that a reasonable shareholder would consider it important”
- Disclosure of information must be made to every shareholder of the corporation entitled to vote
It is important to involve your advisers in the process, as the golden parachute rules contain many complexities. Certain shareholder votes can be excluded, present value calculations may be required, and determining the base amount and other complications could misstate the amount calculated for golden parachute payments. If the shareholders are told the golden parachute payments are $1 million but they are in fact $3 million, it is likely an IRS examination would rule the vote null and void.
The moral of the story is to bring your tax advisers into the conversation early, depending on the materiality of the payments, to avoid running afoul of the potentially costly golden parachute payment rules.
Contact Dennis Grady at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.