One of the biggest mistakes businesses can make about change-in-control events is to believe they won’t ever face one. That lack of preparation can cost company and executive alike dearly.

Even if they don’t expect a change in control (usually a merger) to occur, companies must ensure that all their executive compensation plans and employment agreements account for such events. Otherwise, any “golden parachute” payments to departing top executives might run afoul of the tax code, specifically Section 280G for companies and Section 4999 for employees. Errors there can cause companies to lose valuable tax deductions and employees to face 20 percent excise taxes.

Drigotas

“The message is change-in-control can happen,” says Elizabeth Drigotas, a principal in Deloitte & Touche’s national tax office, who recently co-hosted a Webcast on the subject. “So it’s better to be prepared and be safe now rather than sorry later.”

An excess parachute payment is the amount of the payment that exceeds the base amount allowed under Section 280G. It is calculated as the average compensation over the five years prior to the year in which a change-in-control occurs. Drigotas says advance planning can save some companies and executives millions of dollars.

Ari Benjamin, a director in the global employer services group at Deloitte, says another reason to prepare early is that once a change-in-control event has begun with a buyer, the company can’t make changes to any compensation plans without consent from the buyer.

Too often, Benjamin says, companies dismiss change-in-control payments as unimportant because they assume—wrongly—that there will be no extra costs. For example, he says, a common misconception is that by setting payouts at 2.99 times base salary, companies can avoid the extra taxes that kick above that number. That’s not always true, Benjamin warns.

The 2.99 multiple “almost always creates golden parachute issues” because the change in control also hits vesting of stock options, health benefits, or accelerated bonuses, he says. That total then pushes executives over the 3X multiple and socks them with higher taxes.

Another misconception is that an executive is always better off reducing his payout to the safe harbor limit rather than paying an excise tax. In many cases, Benjamin says, the executive may be better off taking higher payments and paying his own excise tax, even though the company still loses the Section 280G tax deduction.

Without proper planning, an executive could even end up forfeiting payments. For instance, an executive with in-the-money stock options valued at $1 million and due to vest in six months could actually forfeit that $1 million if his compensation plan didn’t address a change in control, because the options would no longer vest.

Just as bad, Drigotas says, is that companies might know how a change in control will affect its payout to top employees, but not understand how many employees might be swept up in the event. There are “often surprises as to who may be affected,” she says, with adverse consequences for lower-level workers.

Preparing for Change

For all those reasons, Benjamin says it’s a mistake to wait until the company is in discussions about a change in control to look at the potential issues around executive compensation payments. Instead, companies should review the effect of a change in control any time they have significant changes to their executive pay plans or employment agreements. At the least, they should revisit the issue “every few years,” he says.

IRS CODE

Below is an excerpt of IRS guidance explaining how Section 280G of the tax code treats parachute payments.

Section 280G denies a deduction for any excess parachute payment. Section 4999 imposes a nondeductible 20 percent excise tax on the recipient of any excess parachute payment, within the meaning of § 280G(b).

An excess parachute payment is defined in § 280G(b)(1) as an amount equal to the excess of any parachute payment over the portion of the disqualified individual’s base amount that is allocated to such payment.

Section 280G(b)(2)(A) defines a parachute payment as any payment in the nature of compensation to (or for the benefit of) a disqualified individual if (i) such payment is contingent on a change in the ownership of a corporation, the effective control of a corporation, or the ownership of a substantial portion of the assets of a corporation (a change in ownership or control), and (ii) the aggregate present value of the payments in the nature of compensation which are contingent on such change equals or exceeds an amount equal to 3 times the base amount …

For purposes of determining when a payment in the nature of compensation under § 280G(b)(2)(A) has been made, § 1.280G-1, Q/A-12(b), provides that an election made by a disqualified individual under § 83(b) with respect to the transferred property does not apply. A payment in the nature of compensation for purposes of that determination is generally considered made (or to be made) when the property is transferred to, and becomes substantially vested in, such individual. The § 280G regulations, however, are silent for purposes of determining whether restricted stock subject to an election under§ 83(b) is outstanding when determining whether there has been a change in ownership or control.

Source

Internal Revenue Service.

Experts note that new final Section 409A regulations related to deferred compensation and new proxy disclosure rules have forced companies to look more closely at the effect of a change in control on their plans. That’s leading companies to look at the cumulative effect of all of the compensation policies they’ve put in place over time, giving them the chance to fix unintended consequences, Drigotas says.

Fackler

Stephen Fackler, co-chair of the executive compensation practice at the law firm Gibson Dunn & Crutcher, says most companies he sees do consider the consequences of a change in control on executive pay. But, he says, they “may not have a good ongoing sense as to the potential aggregate cost of such programs” to the company, largely because of stock price volatility over time.

With the required quantitative disclosure under the new executive compensation disclosure rules, “they have a better sense” at least for the named executive officers, says Fackler. Still, so far he hasn’t seen the new proxy disclosure rules trigger a reassessment of a company’s change-in-control programs.

Jonathan Ocker of the law firm Orrick Herrington & Sutcliffe, however, says that because of Section 409A, the new proxy rules, media coverage, and institutional investor pressures, “the whole area of post-termination payments, severance, and change-in-control is being looked at and modified around the edges to address concerns.”

Ocker

Some companies are scaling back severance multiples down from triple base salary and bonus to double, or from double to one year’s payout. Others are limiting or eliminating excise tax gross ups, Ocker says.

It’s common for companies to have change-in-control arrangements “pretty far down the organization,” Ocker says. In the context of a merger or acquisition, “They can almost be poison pill, the costs and excise taxes are so great. Often payments get ratcheted back to get the deal done.”