Parachute Strategies Save Employee Taxes, Employer Deduction, Practitioners Say

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By Mary Hughes

Aug. 15 — Caps, cutbacks and other strategies may be used to avoid triggering a 20 percent golden parachute excise tax to executives and costing employers their tax deductions, speakers said during an Aug. 14 webcast.

Tax code § 280G on golden parachute payments comes into play when payments are made to certain executives, contingent on a change in control, that equal or exceed three times the executive's base amount, generally defined as the individual's average compensation for the last five years preceding the change in control, said Andrew C. Liazos, a partner with McDermott Will & Emery LLP in Boston.

In determining whether an amount is subject to § 280G, it is important to know what counts in the calculation of the base amount and why, what doesn't count and how you calculate it, said Pamela Baker, a partner at Dentons US LLP in Chicago.

Baker and Liazos spoke during a program sponsored by American Law Institute.

Safe Harbor

Liazos said that ways to meet the three-times safe harbor include capping the payment at the statutory level to avoid triggering the excise tax or cutting back the payment to save taxes for the executive and to save the company a significant tax deduction.

In a cutback, the employee is required to reduce parachute payments until he or she is under the safe harbor, he said. A cap that eliminates the excess payment can be a good approach, but not necessarily in every situation, Liazos said.

“Best-after-tax” provisions in plans and agreements allow for a cutback to avoid the 20 percent tax, but only if the employee would be better off after-tax with a cutback instead of receiving the full amount, he said.

In recent years, shareholder advisory firms have urged companies to shift to performance-based equity vehicles, Baker said. Performance-vested equity doesn't receive favorable parachute treatment, so performance-based awards “are going to use up your three-times safe harbor amount faster than options or time-vested restricted stock,” she said.

Pressure on Companies

The shift to more types of performance-based compensation puts more pressure on companies to avoid triggering §280G, and the pressure is further intensified because tax gross-up payments have disappeared, Liazos said. A gross-up payment that would make the executive whole for the § 4999 excise tax is considered a poor corporate governance practice by advisory firms, he said.

“You have to look at equity awards before you can estimate if there is going to be a parachute tax,” Baker said. This is because time-vested options, time-vested restricted stock and time-vested restricted stock units whose vesting is triggered by a change in control receive favorable treatment under § 280G, she said.

One way to address exceeding the safe harbor limit is to add a noncompete agreement, which can be subtracted from the parachute calculation as reasonable compensation for performing or refraining from performing services, Baker said. However, “it is tricky,” because it has to be demonstrated by clear and convincing evidence that the noncompete actually works, that the company will enforce it and that it is enforceable under state law, she said.

There is no clear guidance on how to value a noncompete, whether by what harm would come to the employer if the executive goes to work for a competitor or hires away employees, or in terms of income replacement, Baker said. It is something to think about when you are valuing parachute amounts, she said.

Deferred Compensation

Change in control is one of the distribution events permitted under § 409A, Baker said. The definition of what constitutes a change in control isn't the same as the definition under § 280G, however, and neither match the definition that may appear in traditional plans, she said.

Because the definitions don't line up, employers need to think about whether they have a definition of change in control in their plan document that will require a payment of deferred compensation that won't meet the § 409A definition of a payment event, Liazos said.

“That is a more common experience than you might anticipate,” he said.

One safeguard is to include language that says, with respect to compensation subject to § 409A, that a change-in-control provision requiring accelerated payment will only apply if the change in control is § 409A-compliant, he said.

“That is not a substitute for carefully thinking through the issues, but it is something to think about in terms of a fail-safe,” Liazos said.

Section 409A prohibits acceleration of payments and substitutions of one form of deferred compensation for another, Baker said. When deferred compensation is reduced or foregone in a § 280G cutback, it may be considered an acceleration or substitution that violates § 409A, she said.

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