Tax Traps for the Unwary
TAX TRAPS FOR THE UNWARY – EXECUTIVE COMPENSATION ISSUES IN M&A TRANSACTIONS (PART I: SECTION 280G)
By Charles E. Wern, JD, LLM and D. Laird Blue, JD, LLM, Shareholders, Jones & Keller, PC
Changes to the U.S. regulatory landscape and corporate tax law structure could spark increased M&A deal activity and strategic partnering in the banking industry. Various provisions of the Internal Revenue Code (“IRC”) can have a significant adverse impact on the recipients of compensation triggered upon a “Change in Control” (“CIC”) in an M&A transaction, as well as on the companies paying out such compensation. As a result, boards, compensation committees, and executives within the banking industry should consider reviewing all CIC-related agreements governing executive and director compensation arrangements and equity award plans for tax traps, including employment agreements, severance or retention agreements, deferred compensation plans, and plans governing stock options, stock appreciation rights (“SARs”), restricted stock, restricted stock units (“RSUs”), and phantom stock. This article discusses the potential impact of IRC Section 280G parachute payments, while a subsequent article will discuss IRC Section 409A.
280G Parachute Payments
The golden parachute payment rules under IRC Section 280G and Section 4999 (“280G”) can impose harsh penalties on “excess” parachute payments made to “disqualified individuals” by corporations undergoing a CIC. Disqualified individuals are generally officers, 1% shareholders, and certain highly compensated employees or independent contractors. 280G works to both deny the corporation a tax deduction on the “excess” parachute payment and to charge the recipient of such payments a 20% excise tax (in addition to regular taxes).
“Excess” Parachute Payments
So what are “excess” parachute payments? Excess parachute payments are generally all payments contingent on a CIC (“parachute payments”) that exceed, in present value dollars, 3 times the disqualified individual’s “base amount” (i.e., their average W-2 compensation for the 5 calendar years preceding the CIC). If the total parachute payments don’t exceed the 3x safe harbor amount, then 280G doesn’t apply. If the total parachute payments do exceed the 3x safe harbor amount, then all payments over the 1x base amount are “excess” parachute payments subject to the 20% excise tax and deduction loss. The corporation is also required to withhold the 20% excise tax owed by the recipient (in addition to all other required tax withholdings).
Accordingly, the 280G penalty is essentially a cliff over the 1x base amount so long as total parachute payments exceed the 3x safe harbor amount. This harsh rule can result in significant adverse tax consequences to both the recipient and the corporation. In addition, since throughout the financial crisis salaries, bonuses, and equity awards were significantly pared back and may not have caught back up with the industry’s rising profit margins, these economics could result in an artificially low 3x safe harbor amount (based on the calculation of the average 1x base amount for the 5-year look back period), which in turn would result in high “excess” parachute payments subject to excise taxes and deduction losses in M&A transactions.
Types of Payments Subject to 280G
280G captures a wide array of CIC-related payments. Transaction bonuses, severance payments and retention bonuses are subject to 280G, as well as various time and performance based incentive equity compensation that accelerates upon a CIC (including stock options, restricted stock, RSUs, SARs, and phantom stock). Given the inclusion of equity accelerations, the 3x safe harbor amount is more likely to be exceeded, resulting in excess parachute payments.
280G golden parachute payment rules can be complicated to navigate, but there are some opportunities to ameliorate the adverse impact of 280G on both the recipient and the corporation with advance planning. Boards and key personnel should review all CIC-related agreements and compensation plans to ensure they do not contain any unintended tax consequences and that the treatment of 280G across all applicable documents is consistently applied. In addition, there are various 280G rules of which banks should be aware that apply to public and private companies differently and that may be a benefit or detriment to your bank’s executive compensation planning.
Please look in the next issue to Part II of this series governing IRC Section 409A Non-Qualified Deferred Compensation Plans.