Section 280G Excise Tax Planning and Mitigation

Change in control (“CIC”) arrangements have become an effective way to attract qualified candidates and to reward top performers for their success. CIC arrangements are commonly put in place to ensure that executives evaluate every opportunity (including a merger or acquisition) with an eye toward maximizing shareholder value, without worrying about how such an event will affect their personal circumstances.
When a CIC does occur, the CIC arrangements will trigger payments which could subject both the corporation and key executives to significant adverse tax consequences under the Golden Parachute provisions of the Internal Revenue Code (Sections 280G and 4999).

Overview of Golden Parachute Rules

Golden Parachute payments to an executive[1] that exceed a “safe harbor” limit could trigger significant tax consequences to both the corporation and the executive. Depending on the circumstances and the number of executives affected, the cost to the corporation and the executives could be substantial.

• Golden Parachute payments can include severance payments, deal bonuses, accelerated vesting and payment of equity awards (such as stock options or restricted stock), fringe benefits, and excise tax gross-up payments.
• The “safe harbor” limit that determines whether the company or executives will be impacted by the Golden Parachute rules is equal to 300% of the executive’s Base Amount. Base Amount is calculated as the average gross compensation over the 5 most recent calendar years ending before the CIC date.
• When an executive receives payments exceeding the “safe harbor” limit, the Golden Parachute rules impose a 20% excise tax on the executive and disallow a deduction to the corporation for the related compensation.
• The excise tax and loss of deduction is imposed on any “excess parachute” amount. The excess parachute amount is determined based on the value of the executive’s parachute payments, less 100% of the executive’s Base Amount.

The most common situations where the Golden Parachute penalties could be triggered include:

• A company that has a significant amount of equity-based compensation awards outstanding (e.g., stock options, restricted shares, performance shares) that accelerate upon a CIC and/or termination;
• Severance payments triggered in connection with a CIC, which typically pay 2x – 3x annual salary and bonus; and
• New hires or newly promoted executives whose historical compensation amounts do not yet reflect their current position, which results in a lower “safe harbor” limit.

The illustration below shows a scenario where parachute payments to an executive can cost the corporation and the executive a significant amount of money:

Excise Tax Mitigation Alternatives

With the use of excise tax gross-ups waning over the past several years, fewer executives are fully protected from the potential impact of the excise tax levied under the Golden Parachute rules. Coupled with the increasing popularity of performance-based equity vehicles (which are generally costlier under Section 280G), more executives have the potential to be hit with a large and unexpected tax bill. Accordingly, it is now more important than ever to consider excise tax mitigation alternatives.

Change in Control Planning Considerations

Although there are a few excise tax mitigation alternatives that can be utilized around the time of a CIC, it is prudent to ensure that an executive’s CIC arrangement is designed for success. Many pitfalls can be avoided through compensation plan design that considers tax implications, regulatory hurdles, and shareholder concerns. With respect to the design and implementation of CIC arrangements, companies should consider the following:

• Benchmarking existing plans to the current market allows public company boards, their compensation committees and management to validate existing CIC benefits or identify opportunities for change. Severance multiples, equity acceleration triggers, and other CIC benefits should be reviewed to ensure alignment with the market. Please see the A&M 2019/2020 Executive Change in Control Report for more information.
• Accelerated vesting of equity awards upon a CIC could have a significant Golden Parachute impact, depending on the normal-course vesting criteria of the awards. The Golden Parachute rules favor time-vesting awards, which are typically valued at less than their economic value when calculating their Golden Parachute impact. Performance-vesting awards are not eligible for this reduced valuation and tend to have a greater Golden Parachute impact. Potential excise tax implications of the Golden Parachute rules should be considered, among various other factors, when granting equity awards.
• The Securities and Exchange Commission (SEC) requires public companies to quantify any parachute payments the CEO and other NEOs would receive upon a hypothetical CIC at year-end and must disclose those amounts in the annual proxy statement. This provides transparency so that shareholders can weigh in on the company’s pay practices through their say-on-pay votes. Management and Boards should consider how shareholders and advisory firms might view the company’s current Golden Parachute arrangements.
• There are various excise tax protections that companies can utilize, such as gross-ups, “best-net” provisions, or cutbacks. Gross-ups have fallen out of favor and significantly declined in prevalence over the past several years, while “best-net” provisions have gained popularity. These excise tax protections help reduce the impacts of the Golden Parachute rules, but even with these provisions the Golden Parachute rules oftentimes still prove costly to executives and corporations.

Alvarez & Marsal’s 280G Calculation and Mitigation Process

Prior to or in anticipation of an actual CIC, it is critical to calculate the value of an executive’s parachute payments and whether or not the payments would trigger excise tax consequences under various scenarios.

• A&M can identify planning opportunities and implement proven techniques to help mitigate the excise tax impact on affected individuals and reduce the lost tax deduction for the company by taking the following steps:

Conclusion

Boards of directors and compensation committees need to remain attentive to changing market trends and be ready to respond when challenges arise regarding the benefits provided to executives. When designing compensation programs, the potential impact of the Golden Parachute rules should be considered. As soon as it is determined that a CIC may be on the horizon, the company should take steps to understand the impact of the Golden Parachute rules to both the company and the executives.

• Officer – no more than 50 employees (or, if less, the greater of 3 employees or 10 percent of all employees).
• Shareholder – only individuals who own stock of a corporation with a fair market value exceeding 1 percent of all outstanding stock.  Constructive ownership rules apply.
• Highly compensated individual – limited to highest-paid 1 percent of all employees, not to exceed 250 in total.  Minimum annual compensation of $130K.

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