Montgomery Investment Technology has experience in the estimation of the likelihood of various payouts of a TSR for use in Change of Control situations where Internal Revenue Code Section 280G would apply.
An individual receiving payments when his or her company experiences a change in control may be subject to excise tax under Section 280G of the Internal Revenue Code. This section of the Code was enacted to discourage such payments, sometimes known as “golden parachutes,” in that the possibility of such payments may influence management to effect a merger or acquisition which may not be in the best interest of shareholders. Section 280G imposes a 20% excise tax on “excess parachute payments” made to “disqualified individuals” and further prevents the company from deducting the amount of any “excess parachute payments” as compensation. In order to avoid such punitive taxation, it is important for both companies and employees or contractors to understand how the Code defines “excess parachute payments.”
Without getting into excessive detail, “excess parachute payments” are defined as compensation paid to an individual because of a change in control which exceeds three times the individual’s “base amount.” The “base amount” is the average annual compensation over the five years immediately preceding the year in which the change in control takes place. The “disqualified individual” is defined as a shareholder who owns more than one percent of a corporation’s stock, an officer of the corporation, or a “highly compensated individual” whether that individual is an employee, director, or independent contractor.
Both corporations and individuals eligible for parachute payments should be concerned about Section 280G due to the severity of the consequences for receiving excess parachute payments. For the recipient, a 20% excise tax is applied to the excess parachute payments, in addition to the ordinary income tax. Further, the corporation making the excess payments cannot deduct the excess parachute payments as compensation expenses. There are also reporting and withholding requirements which affect the corporation making the payments. In addition, public corporations must report all parachute payments on their proxy statements.
Clearly, there is a great incentive on the part of both the corporation and the recipient to avoid excess parachute payments. There are, however, circumstances in which the amount of the parachute payment cannot be precisely known. For example, a corporation with a relative total shareholder return plan will not know the exact payout to participants until the performance period has been completed. If a change in control were to occur during the performance period, it could be argued that a part of the ultimate payout had been earned in the year prior to the year in which the change in control took place. If this is the case, the base amount would be increased while the parachute payment would be reduced.
Montgomery Investment Technology, Inc. has both the experience and the quantitative tools required to deal with such complex and subjective situations. While we recognize that each situation is unique, we have the intimate knowledge of the regulations and the broad overview of share-based compensation practice to assure you with a reasonable and supportable analysis which will present your situation to your greatest possible advantage. Please contact us to discuss your specific needs.