Golden Parachutes

The term "golden parachute" is a wonderfully descriptive term for a defensive measure used by a company to prevent hostile takeovers. With golden parachutes, employers enter into agreements with key executives and agree to pay amounts in excess of their usual compensation in the event that control of the employer changes or there is a change in the ownership of a substantial portion of the employer's assets. Top executives are provided with a financial soft landing in the event that a takeover results in discharge. The company initiating the hostile takeover, on the other hand, will either have to pay the associated increased costs when acquiring the corporation or back down from the takeover.

Tip Golden parachute payments do not have to be made under a legally enforceable agreement or contract. A formal or informal understanding will suffice. For example, an oral agreement is enough even though such an agreement would not be legally enforceable under state contract law principles. Not having a written agreement, however, is a surefire invitation to be sued by a corporation's shareholders who may want a takeover to go through and don't want any obstacles (like the sudden appearance of such conveniently timed oral agreements) to stand in the way.

Parachute payment defined. If a payment meets all of the following conditions, it is generally treated as a parachute payment. The payment:

• is in the nature of compensation and is made or is to be made to or for the benefit of a "disqualified individual" (i.e., payments made to an employee, independent contractor, shareholder, officer, or highly compensated individual (i.e., one of the employer's top one percent or 250 employees in terms of compensation, whichever group is smaller) at any time during the 12-month period immediately before the date of ownership or control change)
• is contingent on a change in the ownership of a corporation, in the effective control of a corporation, or in the ownership of a substantial portion of the assets of a corporation
• has an aggregate present value of at least three times the individual's base amount of compensation

A parachute payment can be in the form of cash or property. Such payments can include the spread on the exercise of a stock option, pension proceeds, insurance or annuity proceeds, or payments made under a covenant not to compete.

Excess parachute payments. Golden parachute payments can reach the point where there is too much of a good thing. Congress viewed excessive golden parachute payments as detrimental to the interests of shareholders and a deterrent to corporate acquisitions. As a result, Congress enacted restrictions that limit the use of such payments.

If payments are determined to be excess parachute payments made to disqualified individuals, the excess payments are not tax deductible by the employer. Further, executives receiving such payments are subject to a 20 percent excise tax on the excess parachute payment. This is in addition to the usual income taxes that would be assessed. The excise tax is withheld by the employer in the case of payments that are considered wages, and the excise tax paid is not deductible for income tax purposes by the recipient of the parachute payments. As if that were not enough, excess payments are subject to Social Security (FICA) taxes when paid.

As in most cases, there are exceptions to the above penalty provisions. The following golden parachute payments are exempt from these penalty provisions:

• payments from certain small business corporations (i.e., S corporations)
• payments from corporations that, immediately before the change in control, have no stock that is readily tradable on an established securities market or otherwise
• payments to or from certain qualified plans, including pension, profit-sharing and stock bonus plans
• certain payments of reasonable compensation for personal services

Calculating the amount of excess payment. An excess parachute payment is the amount that exceeds an allocated portion of the base amount based upon the present value of the current and aggregate parachute payments. Huh?

The key is to determine the portion of the base amount to be allocated to each parachute payment. That portion is figured by multiplying the base amount by a fraction, the numerator of which is the present value of such parachute payment and the denominator of which is the aggregate present value of all such payments. This can also be expressed in the following formula:

The calculation of an excess parachute payment then becomes largely a matter of plugging in the appropriate numbers.

Example Executive Coca Iacoca, with a base amount of $100,000, expects two parachute payments, one of $200,000 at the time of the change in ownership and one of $400,000 at a future date. The present value of the $400,000 is $300,000 on the date ownership is changed. The portions of the base amount allocated to these base payments are $40,000 ($100,000 x $200,000/$500,000) and $60,000 ($100,000 x $300,000/$500,000), respectively. Therefore, the amounts of Coca's excess parachute payments are $160,000 ($200,000 - $40,000) and $340,000 ($400,000 - $60,000). Applying the 20 percent excise tax to those amounts, Coca must pay penalties of $32,000 and $68,000, respectively. Ouch.