[IMGCAP(1)]Companies planning for a merger or acquisition have various issues to consider as they prepare for the transaction. One of the issues is golden parachutes.
Known as the “Golden Parachute Rules,” Sections 280G and 4999 of the Internal Revenue Code were enacted by Congress in 1984. Final regulations were issued on Aug. 3, 2003.
Golden Parachute Rules
Golden parachute payments may be made to disqualified individuals contingent upon a change in control. A disqualified individual is a shareholder who owns more than 1 percent of the stock of a company, an officer of the corporation or a highly compensated individual.
A highly compensated individual is defined as a member of a group that constitutes the top 1 percent of compensated individuals within the corporation, or is compensated within the top 250 employees of the affiliated group. The threshold amount is $115,000, which is defined under Section 414(q) of the tax code and is indexed for inflation.
Parachute payments take many forms, including bonuses, retention bonuses, accelerated vesting of stock options, restricted stock, other equity compensation, fringe benefits, severance payments, life insurance and post-change in control arrangements.
Section 280G Tax Penalties
Section 280G imposes special tax penalties on employers. No deduction shall be allowed for any excess parachute payment. Excess parachute payments are defined as an amount equal to the excess over the base amount. The base amount is defined as average annual compensation (based on the previous five years of gross income received and reported by the individual). Golden parachute penalties do not apply if the parachute payments are less than three times the base amount (the “safe harbor” amount).
Section 4999 of the tax code imposes corresponding tax penalties on certain employees and independent contractors who receive such payments equal to an excise tax in the amount of 20 percent of such excess parachute payments. Examples of the tax consequences to a corporation and an individual are presented in the table below.
Fortunately, the Internal Revenue Code offers an exemption from the tax penalties to private companies that meet a number of requirements. Under Section 280G(b)(5), golden parachute provisions do not apply to any payment with respect to a corporation that, immediately before the change, either: (a) could have elected to be an S Corporation (known as the S Corp. exception), or (b) has no stock readily tradable on an established exchange and the payment was approved by a vote of the persons who owned more than 75 percent of the voting stock immediately before the change (known as the shareholder approval exception).
Excess parachute payments can be reduced or eliminated by demonstrating with clear and convincing evidence that a portion of the excess parachute payment is reasonable compensation for services performed before the change in control. If the disqualified individual was underpaid relative to similar executives at peer companies in years prior to the change in control, the corporation should demonstrate that all or a portion of the payment is a “catch-up” payment.
Opportunities to Reduce Excess Parachute Payments
Excess parachute payments can also be reduced or eliminated by demonstrating with clear and convincing evidence that the payment is reasonable compensation for services performed after the change in control. For example, a severance agreement or a non-competition agreement may constrain the disqualified individual’s ability to compete with the corporation for a certain period of time after employment is terminated.
Without the non-competition agreement in place, the corporation might suffer an economic loss equal to the reduced cash flow due to such competition. Thus, the valuation of a non-competition agreement can be an important consideration in the determination of excess parachute payments.
Valuation of Non-Competition Agreement
The method most often used to determine the value of a non-compete agreement is the discounted cash flow analysis in the form of a “with-without method.” This method values a non-compete by quantifying the economic harm that could occur to the business in the absence of the non-compete.
Typically, a DCF analysis is performed to determine the value of the business, assuming expected cash flows with the non-compete in place. This value is then compared to the indicated value of the business from the DCF, assuming expected cash flows without the non-compete in place. The difference in values represents the value of the non-compete after adjusting for an estimated probability of competition from the covenantor.
Important factors to consider in a reasonable and supportable valuation of a non-compete include plausible downside scenario without the non-compete in place and the ability, feasibility and likelihood of the covenantor to compete.
Doug Peterson is senior vice president of Valuation Research Corporation.
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