Human Capital Advisory Services
Quantifying Change-in-Control Payments under Proxy Disclosure Rules
More completed and detailed disclosure of executive compensation programs under the SEC’s proxy disclosure rules requires that companies report the value of payments in the event of a Change-in-Control (CIC) to Named Executive Officers (NEOs).
With very few exceptions, such payments will be covered by the “golden parachute
” rules under IRC Section 280G.
This memo discuses some not-so-obvious aspects of calculating these values, including a look at how even a miniscule increase in a CIC payment may, under the highly complex and tax-driven calculations required, end up generating millions of dollars in additional reportable compensation.
Golden Parachutes – An Overview
The golden parachute
rules are intended to discourage excessive compensation payments to executives in the event of a CIC by imposing negative tax consequences to both the company and the recipient. Under the rules, if the present value of a CIC payment to an executive exceeds his/her “safe harbor” (that is, three times the executive’s average taxable compensation over the five most recent calendar years preceding the CIC, less $1), the company loses tax deductions for the amounts considered “excess parachute payments.” Additionally, the executive is required to pay a 20% excise tax on the excess payment. Commonly misunderstood, the penalties resulting from excess parachute payments are calculated based on amounts paid in excess of one times the executive’s five year average taxable compensation (base amount), rather than the amount in excess of the safe harbor.
Common CIC Contract Designs
Many employment and CIC contracts require companies to “gross-up” the executive for any excise taxes owed on golden parachutes. These payments are often substantial, given that payment of the gross-up is also subject to income and excise taxes. Alternatively, some executive contracts stipulate that the CIC benefits are cut back if the payments exceed the safe harbor limitations or if the executive is in a better tax position by scaling the payments back to the safe harbor amount.
Implications for Disclosure – An Example
Given the disproportionate impact of even very minor changes in expected CIC payments and the numerous complexities and assumptions involved, calculations must be as accurate as possible. As shown in the illustration below, boosting the calculated value of a CIC payment by as little as $1 would translate into an approximately $4,700,000 increase in the total CIC payments that must be disclosed to shareholders and, under the new rules, certified by the Chief Executive Officer and the Chief Financial Officer.
Golden Parachute Rules – A Simplified Example
CIC Payments in Excess of 280G Safe Harbor with Excise Tax Gross-UP
CIC Payments at 280G Safe Harbor
Total CIC Payments
Based Amount (Average Compensation over prior 5 years) 2. $5,000,000 $5,000,000
Safe Harbor ((2) X 3 less $1) 3. $14,999,999 $14,999,999
Are CIC payments in Excess of Safe Harbor? 4. YES NO
Calculate Excess Parachute Payments ((1) – (2)) $10,000,000 $0
Executive Excise Taxes @ 20% $2,000,000 $0
Excise Tax gross-Up *A $4,667,445 $0
Total CIC Payments $19,667,445 $14,999,999 $4,667,446
*A Based on a 57.15% marginal tax rate (37.15% income and employment taxes, plus the 20% excise tax).