Employers often want to provide extra benefits or security to key employees amidst the uncertainty caused by a change of control. These arrangements are often referred to as “golden parachute payments” because they help key employees land safely in a sale, merger, change in management or other corporate transaction. Examples of change of control agreements include accelerated vesting and accelerated payments of nonqualified deferred compensation plan benefits or stock options. Some employers also offer stay bonuses to encourage employees to remain employed pending sale negotiations, or sale bonuses to incentivize and reward key employees for a sale of the company. Without careful planning, these arrangements can trigger costly tax penalties for both the employer and the employee.

Benefits Constituting Parachute Payments

Extra benefits payable to key employees will constitute parachute payments if such payments: (a) are made to a “disqualified individual;” (b) are compensation for past services; (c) are contingent on a change of control; and (d) equal or exceed three times an individual’s base amount. Base amount means the individual’s average annual compensation for the five tax years ending before the change of control date. If the individual was not employed by the company for five years, then the individual’s base amount is the average compensation over the number of years he was employed with certain rules for annualizing compensation for a partial year.

Excess Parachute Payments

Once a parachute payment exceeds three times an individual’s base amount, then an excess parachute exists and penalties are imposed on all amounts which exceed one times an individual’s base amount. Not all employees who receive change of control benefits are subject to these rules. Only “disqualified individuals,” which include officers and the highest paid 1% of employees, are subject to the parachute payment rules. Excess parachute payments trigger two negative tax consequences. First, the employee is assessed a 20% excise tax on all amounts above the base amount. The excise tax is in addition to ordinary income taxes. Second, the employer is prohibited from deducting excess parachute payments.

The terminology can be confusing and the parachute excise tax calculations are complicated, so employers must use caution in designing and analyzing change of control agreements. In addition, important statutory exemptions, strategic planning and careful drafting can avoid or minimize costly tax penalties. Parachute payments and applicable excise taxes are governed by Internal Revenue Code Sections 280G and 4999.