Section 280G provides, in general, that the service provider receiving an excess parachute payment must incur a 20% nondeductible excise tax on the excess portion of the parachute payment which is usually associated with a payment triggered by virtue of "change of control" provision in an executive employment agreement. An executive for this purpose is generally a highly compensated employee (top 1%), a 1% or more employee-shareholder or an officer or director within a certain time frame before the change of control event.
While there are several methods to mitigate the imposition of the excise tax under section 280G, such exceptions have limited access for many public companies. Legal counsel for service providers have also negotiated for gross-up payments (including double-gross ups) for reducing the cost to the service provider. The tax gross-ups, which are a function of the incremental excise tax , have provided comfort to key executives whose parachute payments have an "excess" component and run outside of the less than three to one (average past years compensation).
In November 2008 RiskMetrics Group (RMG), formerly known as ISS, announced a policy that it would consider tax gross-up payment for golden parachute treatment a "poor pay practice." With this pronouncement it is speculated among commentators who specialize in executive compensation planning that shareholders will not be so willing to approve golden parachute payments particularly those with "excess" amount profiles. Indeed, on commentator recently reported a recent study by Pearl Meyer & Partners for the National Association of Corporate Directors found that 61 Fortune 500 companies made material alterations to change in control benefits from November 2008 to August 2009 and that more than 10 percent of these agreements eliminated excise tax gross-up provisions. If a tax gross-up payment is to be eliminated, a cap on payments may be beneficial in avoiding falling into the excess category.
Public companies are therefore evaluating whether payments triggered on a change of control can be deflected over to a noncompetition agreement. Still, the regulations provide for compliance with a covenant not to compete to be treated as the equivalent of providing services after a change in control. Post-control services generally fall outside of the section 280G provision where the value of the future services is substantial, the covenant not to compete is "real" and has a "reasonable likelihood" of being enforced. .
There are several other strategies that are available to public companies and their executives to increase the amount that may be paid under the tipping point. The base amount used to determine the tipping point can be increased by exercising stock options, electing not to defer amounts under a nonqualified deferred compensation plan, and paying bonuses during the five-year period ending before the year of a change in control.7 The value of payments for purposes of the tipping point calculation can also be reduced by cashing out options on a change in control, which limits the value to the cash-out amount (as opposed to a higher fair value associated with an unexercised option that could be exercised for a prolonged period after a change in control).28 Also, reasonable compensation for services to be rendered after a change in control includes payments received by an executive as bona fide damages for breach of contract because of an involuntary termination without cause.29 This exemption may apply when the payments do not exceed the present value of the compensation that would have been paid during the remainder of the contract term, the executive demonstrates a willingness to work that is rejected by the buyer, and the amounts to be paid as damages are reduced to the extent the executive has earned income from other sources during the remainder of the contract term.
Thus, the planning environment on highly compensated executives, officers and directors of public companies and other taxpayers subject to the excess parachute provisions may be tilting strongly towards dropping the gross-up concept in mitigating the service provider’s cost. This means that a more careful analytical and legal analysis must be made as to the package of compensation benefits a particular executive is presently receiving and what is required to be paid out on a change of control as defined in the regulations.