IRS Proposes New Golden Parachute Regs

In 1989, the Internal Revenue Service proposed several changes to a section of the tax code dealing with golden parachute payouts to certain outgoing employees and insiders of companies that had been merged or acquired. Many tax attorneys came to find the amended language cumbersome in its imprecision and excessively punitive in its treatment of option-laden middle managers, but they nonetheless adopted it as law even though the regulations were never finalized.

Following 13 years of commentary, the IRS late Tuesday night issued a brand new set of proposed regulations that likely will spark yet another round of debates. In the meantime, the IRS said that either the 1989 or 2002 proposed regulations (related to Code Sec. 280G) could be used going forward until any final decisions are made.

“It?s not unusual to see something like this fall onto the back burner,” explains Colleen McIntosh, a New York-based partner with Morrison and Foerster.

Lightening The Load

A golden parachute is generally defined as a compensatory payment in which the payment is contingent on a change in ownership, effective control of the company or ownership of substantial company assets.

Rather than covering all corporate severance packages, however, golden parachutes only apply to employees or independent contract service providers who are also company officers, shareholders or highly compensated individuals. The IRS terms such people to be “disqualified individuals.”

The reason such categories are important is that being disqualified is a double-edged sword. If a disqualified individual?s golden parachute is deemed to be an “excess golden parachute” (i.e. compensation worth more than 3 times the individual?s average compensation over the preceding five years), then he is subject to a 20% excise tax and his former employer cannot take the excess payout as a tax deduction.

Under the 1989 proposed rules, an employee holding either in excess of 1% of his company?s stock or $1 million of his company?s stock was considered disqualified. The former regulation is kept in the 2002 version, but the latter one is dropped.

“These regulations make it clear that if you have vested stock options and are otherwise not highly compensated, you won?t be subject to the excise tax unless you own more than 1% of the company,” explains Andrew Liazos, a Boston-based partner with McDermott, Will & Emery.

The framework of the highly compensated employee category was also reworked to reflect cost of living increases.

Approval Kinks Remain

Under both the new and old proposals, unlisted companies can avoid potential golden parachute penalties so long as the parachute in question is approved by 75% of the company?s stockholders. Moreover, the new rules give unlisted companies additional flexibility in slipping under the excess parachute threshold by allowing supermajority approval of just a portion of a proposed package.

“It is helpful that [the IRS] has clarified that this is not an all-or-nothing test,” McIntosh says. “If shareholders look at a parachute payment and discover that $50,000 will throw it into excess, they can now just go ahead and approve just that piece.”

Also included in that loophole was a clarification that such votes had to occur within three months prior to the close of the M&A deal. Moreover, disqualified individuals would not be allowed to vote and their shares will not be counted against the supermajority.

One issue not adequately addressed, however, is the status of payments to employees of merged or acquired companies who stick around through transition periods.

“If a CFO knows he will probably lose his job as part of an M&A deal, but stays around to help complete the deal and picks up extra duties and a bump in pay along the way, does that raise count as a parachute payment?” Liazos asks. “It?s fair to say that there are still some areas like this where commentators will have some problems.”

Everyone Has Options

One of the chief criticisms of the 1989 proposed rule was that it provided little guidance on the issue of valuing stock options. This was especially true when the underlying stock was in a private company.

In the 13 years between proposed rule offerings, tax attorneys addressed the matter through a variety of valuation methods spun off of the Black-Scholes one suggested in the 1989 regulations. The new IRS proposal basically endorses a continuation of such methods, and also for the first time explicitly permits a safe harbor rule when valuing stock options.

According to the proposal: “The safe harbor approach allows a corporation to establish a value for stock options based on the spread [ed. Difference between exercise price and the value of the property] at the time of the change of ownership or control, the remaining term of the option, and a basic assumption regarding the volatility of the underlying stock.”The safe harbor method is applicable whether or not a stock is publicly traded.

Does It Count?

The proposed rule changes would apply to any parachute payments made contingent on a management change made on or after Jan. 1, 2004. Either the 1989 or 2002 rules can be used until a final ruling is reached.

A public hearing is scheduled for June 26.

Click here for the full text of the new proposed 280G rules.Dan Primack can be contacted at: Daniel.Primack@tfn.com

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