Golden Parachute Taxes in Corporate Transactions

Transcription

1 Golden Parachute Taxes in Corporate Transactions Donald S. Kohla Laura M. Nolen Heather C. Moore Tuesday, October 18, :30 1:30 p.m. EDT If you have not downloaded the program materials, please do so now at learn/handout To connect to the audio part of the program, please call: A customer service representative will connect you to the seminar. For technical assistance at any time during the presentation, please call:

2 Speaker Biographies Don Kohla is a partner in the Employee Benefits & Executive Compensation Practice Group in the Atlanta office. He joined King & Spalding in Donald S. Kohla dkohla@kslaw.com Mr. Kohla s practice has focused primarily on ERISA and ERISA-related matters since ERISA was enacted in He represents plan sponsors in designing, preparing, implementing and administering all types of employee benefit plans and executive compensation arrangements and the related funding vehicles. He represents clients who provide employee benefit plan related fiduciary and non-fiduciary products and services to plans and to plan sponsors, including insurance companies, brokerage firms, investment managers, actuarial and consulting firms and banks and trust companies. He represents clients in connection with mergers and acquisitions and, he represents private equity funds in fund formation and related activities and represents employee benefits plan investors in such funds. Finally, Mr. Kohla represents clients before the Internal Revenue Service, the Department of Labor and the PBGC. Mr. Kohla is a member of the Southern Employee Benefits Conference (Steering Committee, and President, 1984), the Atlanta and American Bar Associations, the State Bar of Georgia and the Florida Bar. He is admitted to practice in both Georgia and Florida. He has been listed in The Best Lawyers in America since 1987, which was the first year lawyers practicing in his area were listed, and he has been named one of Georgia s super lawyers for 2004 and for 2005, which were the first two years that super lawyers were named in Georgia. Mr. Kohla received his A.B., cum laude, from Harvard University in 1964 and his J.D., with honors, in 1972 from the University of Florida. He was the Executive Editor of the University of Florida Law Review. He received his LL.M (Taxation) from New York University in Speaker Biographies Laura Nolen is an associate with King & Spalding's Employee Benefits & Executive Compensation Practice Group. Her practice consists of a broad range of employee benefits matters, including assisting clients with mergers, acquisitions, and other corporate transactions and advising clients regarding executive compensation arrangements, welfare benefit plans and 401(k) plans. Laura M. Nolen lnolen@kslaw.com Ms. Nolen graduated, cum laude, from Trinity University in San Antonio, Texas. Ms. Nolen earned her J.D. degree, with honors, from the University of Chicago in She is a member of the State Bars of Georgia and Texas and is admitted to practice in the U.S. District Court for the Northern District of Texas.

3 Speaker Biographies Heather Moore is an Employee Benefits Specialist. She joined the Employee Benefits & Executive Compensation Practice Group in Ms. Moore has 16 years of legal and consulting experience in the design, communication and administration of all types of employee benefit plans and in addressing compliance issues with respect to such plans. Ms. Moore received her B.A. in History from Emory University and her Paralegal Certificate from The National Center for Paralegal Training. Heather C. Moore Golden Parachute Taxes in Corporate Transactions Donald S. Kohla Laura M. Nolen Heather C. Moore Tuesday, October 18, :30 1:30 p.m. EDT 1

4 What is the golden parachute tax? 20% excise tax imposed by 280G and 4999 of the Internal Revenue Code On payments made to certain disqualified individuals Contingent on a change in the ownership or control of a corporation or in the ownership of a substantial portion of the assets of a corporation 2 Whose issue is this? Executives and others care because they could owe the tax. Corporations care because parachute payments are not deductible and corporations are required to report parachute payments on Form W-2 and to withhold. If the corporation fails to withhold and executive does not pay, the government may try to collect the tax from the corporation. 3

5 Exemptions Payments made by tax exempt entities. Payments made by a corporation which, immediately before the change in control, was a small business corporation. Payments made by a corporation which has no stock that is readily tradeable on an established securities market or otherwise and shareholder approval requirements have been met. 4 Small Business Corporation Does not have more than 100 shareholders; Does not have as a shareholder a person (other than certain estates or trusts) who is not an individual; and Does not have more than 1 class of stock. No parachute issue where the corporation is an S-Corporation. 5

6 Shareholder Approval No stock is readily tradeable. Payment is approved by more than 75% of voting power of all outstanding stock entitled to vote immediately before the change in control. There is adequate disclosure to all persons entitled to vote of all material facts concerning all material payments which would otherwise be parachute payments. 6 Shareholder Approval Payments must be contingent on the vote! ALL shareholders have to receive the disclosure. The vote can be on less than the full amount of all payments. Stock held by a disqualified person is treated as if it is not outstanding in calculating 75%. 7

7 Who is a disqualified individual? An employee or independent contractor who performs personal services for the corporation AND Is an officer, shareholder, or other highly compensated individual 8 Who is a disqualified individual? Disqualified individual is not limited to employees. Directors are disqualified individuals. A personal service corporation will also be treated as an individual and can be subject to parachute tax. 9

8 Who is a shareholder? Not all shareholders are shareholders for purposes of 280G. Must own stock that exceeds 1% of the fair market value of all classes of the corporation s stock. 10 Who is an officer? Determination is based on all the facts and circumstances in the particular case. An individual with an officer title is presumed to be an officer. Generally means an administrative executive who is in regular and continued service. 11

9 Who is an officer? Executives hired for a single transaction are excluded. No more than 50 employees (or, if less, the greater of 3 employees or 10% of employees rounded up to the nearest whole number) are officers. 12 How is 10% of employees calculated? Number of employees is the greatest number of employees during the 12 months ending on the change in control. Employees who normally work less than 17.5 hours per week or who work for 6 or fewer months per year are not counted. However, employees who are not counted can still be officers. 13

10 Who is a highly compensated individual? An individual who is (or would be if he or she were an employee) one of the highest paid 1% of employees OR Highest paid 250 employees when ranked on the basis of compensation 14 Who is a highly compensated individual? The 1% calculation for determining who is a highly compensated individual is the same as the 10% calculation for determining who is an officer. Employees who do not earn at least $95,000 (adjusted for inflation) will not be highly compensated individuals. 15

11 Which transactions trigger parachute tax? A change in the ownership of a corporation, A change in the effective control of a corporation, OR A change in the ownership of a substantial portion of the assets of a corporation. 16 What is a change in corporate ownership? One person or a group acquires more than 50% of the total fair market value or the total voting power of the stock of the corporation Stock underlying vested options is considered owned 17

12 What is a change in effective control? One person or a group acquires more than 20% of the total voting power of the stock of the corporation A majority of the corporation s directors is replaced in a 12 month period by directors whose appointment is not endorsed by a majority of the current board 18 What is a change in effective control? Acquisition of 20% vote or replacement of majority of directors is presumed to be a change in effective control Presumption may be rebutted by establishing that there has been no transfer of power to control the management or policies of the corporation from one person or group to another person or group. 19

13 One Change Rule Transaction where one company undergoes a change in ownership and the second undergoes a change in effective control is possible. If one corporation has a change in ownership or control, the other corporation in the transaction does not. 20 Transfer of substantial portion of assets Any person or group acquires assets that have a total fair market value equal to more than 1/3 of the gross fair market value of all of the corporation s assets. Transfer to a subsidiary or to an entity controlled by shareholders of the corporation is not a change in control. Transfer to a shareholder of the corporation in exchange for its stock is not a change in control. 21

14 Contingent on a Change of Control Payment is contingent on a change in control if it would not have been made absent the change in control. If it is substantially certain, at the time of the change, that a payment would be made, it is not contingent on the change in control. Payments that become vested on a change in control are not treated as substantially certain to be made. 22 Types of Payments Which payments to a disqualified person count as parachute payments? Severance cash severance continued health and dental benefits outplacement services Option vesting Restricted stock vesting Accelerated payment of deferred compensation 23

15 What doesn t t count? Payments for stock owned by a disqualified person Reasonable Compensation Salary Consulting fees Payments for restrictive covenants Noncompete covenants Nonsolicitation of customers and employees Must be enforceable 24 Calculating the Excise Tax If an executive receives a payment on a change in control that equals or exceeds 3x his base amount, then 20% excise tax is due on all amounts in excess of 1x the executive s base amount. Note: the excise tax is not just due on the amount over 3x base amount, it s due on everything over 1x base amount. 25

16 What is the Base Amount? Base amount is the average of the annual compensation for services performed for the corporation included in income for the years in the base period. The base period is the most recent 5 years ending before the change in control or the portion of the 5-year period during which the executive worked for the corporation. Generally, the 5 year average of compensation shown in Box 1 of an executive s W Base Amount Example Executive A has worked for a corporation for 5 years and has W-2 comp as follows: 2000 $90, $105, $130, $225, $250,000 Executive A s base amount is $160,

17 Base Amount Less than 5 Years What if Executive A started working for the corporation July 1, 2000? 2000 $ 45, $105, $130, $225, $250,000 Annualize partial year for 2000 (to $90,000). Executive A s base amount is still $160, Excise Tax 3x Executive A s Base Amount is $480,000. If Executive A has an employment agreement that pays him 2x salary and bonus ($500,000) after termination following a change in control, he will have a parachute problem if he is terminated. 29

18 Excise Tax Everything over 1x base amount ($160,000) is subject to 20% excise tax. $500,000 - $160,000 = $340, % of $340,000 = $68,000. So after payment of excise tax, Executive A ends up with $432, Rollback Strategy Executive A is better off if he gives up $20,001 of his severance. Executive A then receives $479,999, which is less than 3x his base amount, and he owes no excise tax. $479,999 > $432,000, which is what Executive A would have received without the rollback. 31

19 Excise Tax What if Executive A is entitled to 3x his salary and bonus as severance? $750,000 - $160,000 = $590, % of $590,000 = $118,000. Executive A would rather receive the whole $750,000 and pay the tax because he would end up with $632,000, which exceeds 3x his base amount. 32 Better Off Strategy Executive A s employment agreement can be drafted to provide that he will receive either the rollback amount or the full amount depending on which will give him the most money. 33

20 Gross-Up Strategy Executive A receives a gross-up payment to pay the excise tax and the additional income tax on the gross-up amount and leave him in the same position as if he were not subject to excise tax. Gross-up payments are expensive for the corporation. Because the additional amounts are parachute payments, they are not deductible. 34 Gross-Up Payment Total gross-up payment generally equals the amount of excise tax divided by 43.55% Executive A receives: $ 750,000 severance $ 118,000 excise tax $ 152,953 additional excise + income tax $1,020,953 Total payment 35

21 Things are never so simple Executives receives a number of other payments in a change in control such as Accelerated payment of deferred compensation, Accelerated vesting of restricted stock, Accelerated vesting of options, Health insurance continuation, and Outplacement. 36 Speeding Things Up Part 1 The value of the acceleration in payment timing or vesting must be determined. The calculations generally involve comparing the amount that would have been paid in the future if there had not been a change in control to the present value (PV) of the payment as of the date of the change in control. Regulations require PV to be determined using a discount rate equal to 120% of the Applicable Federal Rate (AFR) compounded semiannually. 37

22 Speeding Things Up Part 2 AFR is published monthly in Revenue Rulings available on the IRS website. Short-term AFR applies to periods of 3 years or less. Mid-term AFR applies to periods between 3 and 9 years. Long-term AFR applies to periods greater than 9 years. 120% AFRs compounded semiannually for October 2005 are: Short-term Mid-term Long-term 4.62% 4.85% 5.22% 38 Accelerated Payment If Executive A has vested deferred compensation which entitles him to $100,000 in 10 years, the amount included in the parachute calculation is $100, Accelerated payment $ 59, Present value of payment $ 40, Total 39

23 Accelerated Restricted Stock Vesting Consists of 2 parts Value of Acceleration Value of Lapse Value of Acceleration the excess of the fair market value of the restricted stock over the present value of the stock. The lapse value is a value the IRS assigns because the executive does not have to work the additional period to receive the stock. 40 Restricted Stock Acceleration Works like acceleration of deferred compensation Executive A has restricted stock worth $100,000. Half of the stock will vest in 1 year and half will vest in 2 years. $100, Fair market value of stock $ 93, Present value $ 6, Total 41

24 Restricted Stock Lapse IRS regulations attribute 1% value per full month of acceleration for lapse of obligation to continue performing services. 1% x 12 months = 12% x $50,000 = $6,000 1% x 24 months = 24% x $50,000 = $12,000 $18,000 is included in calculating Executive A s parachute amount. 42 Accelerated Option Vesting Executive A has options to purchase 20,000 shares of stock for $1 per share. Options expire in 6 years and stock has low volatility. Fair market value is $3 per share. May use any valuation method for valuation of options that is consistent with generally accepted accounting principles (such as FAS 123) and which takes into account factors listed by IRS in regulations. IRS has provided a safe harbor method for valuation of options. 43

25 Accelerated Option Vesting IRS safe harbor method considers: (1) the volatility of the underlying stock, (2) the exercise price of the option, (3) the value of the stock at the time of the valuation (the spot price ), and (4) the amount of time remaining to exercise the option on the valuation date. 44 Option Acceleration Safe harbor value of the option is calculated as: Number of Options x Spot Price x Valuation Factor 20,000 x $3 x.699 = $41,940 The valuation factor comes from a table provided by the IRS in Rev. Proc , attached. 45

26 Rev. Proc from Internal Revenue Bulletin August 25, 2003 Table of Valuation of Stock Options Term (months) Spread Volatility Factor* 200% 66.8% 67.3% 67.9% 68.4% 69.0% 69.5% 69.9% 70.3% 70.7% 71.0% 71.2% 180% 64.5% 65.0% 65.7% 66.4% 67.1% 67.7% 68.3% 68.8% 69.3% 69.6% 69.9% 160% 61.8% 62.4% 63.3% 64.1% 65.0% 65.8% 66.5% 67.1% 67.7% 68.1% 68.5% 140% 58.6% 59.4% 60.4% 61.5% 62.5% 63.5% 64.4% 65.1% 65.8% 66.4% 66.9% 120% 54.9% 55.8% 57.1% 58.4% 59.7% 60.9% 62.0% 62.9% 63.7% 64.5% 65.1% 100% 50.4% 51.5% 53.2% 54.8% 56.4% 57.9% 59.1% 60.3% 61.3% 62.2% 63.0% 80% 44.9% 46.3% 48.5% 50.6% 52.6% 54.3% 55.9% 57.3% 58.5% 59.6% 60.5% 60% 38.0% 40.0% 42.9% 45.6% 48.0% 50.1% 52.0% 53.7% 55.2% 56.5% 57.6% 40% 29.3% 32.3% 36.3% 39.7% 42.6% 45.2% 47.4% 49.4% 51.2% 52.7% 54.1% 20% 18.1% 23.3% 28.5% 32.7% 36.2% 39.3% 41.9% 44.3% 46.4% 48.2% 49.9% 0% 6.4% 13.6% 19.9% 24.7% 28.8% 32.3% 35.4% 38.1% 40.5% 42.7% 44.7% -20% 0.6% 5.4% 11.2% 16.1% 20.4% 24.2% 27.6% 30.6% 33.4% 35.9% 38.1% -40% 0% 0.9% 4.1% 7.9% 11.6% 15.2% 18.5% 21.7% 24.6% 27.3% 29.9% Low -60% 0% 0.0% 0.6% 2.0% 4.0% 6.4% 9.0% 11.6% 14.3% 16.8% 19.3% 200% 66.8% 67.4% 68.6% 69.9% 71.1% 72.2% 73.1% 73.9% 74.5% 75.0% 75.4% 180% 64.5% 65.2% 66.7% 68.2% 69.6% 70.9% 71.9% 72.8% 73.5% 74.1% 74.6% 160% 61.8% 62.7% 64.5% 66.3% 68.0% 69.4% 70.6% 71.6% 72.5% 73.2% 73.7% 140% 58.6% 59.8% 62.0% 64.2% 66.1% 67.7% 69.1% 70.3% 71.2% 72.0% 72.7% 120% 54.9% 56.4% 59.2% 61.7% 63.9% 65.8% 67.4% 68.8% 69.9% 70.8% 71.6% 100% 50.4% 52.5% 55.9% 58.9% 61.5% 63.7% 65.5% 67.0% 68.3% 69.4% 70.3% 80% 44.9% 47.9% 52.2% 55.7% 58.7% 61.2% 63.2% 65.0% 66.5% 67.7% 68.8% 60% 38.2% 42.6% 47.8% 52.0% 55.4% 58.3% 60.6% 62.7% 64.3% 65.8% 67.0% 40% 30.0% 36.3% 42.7% 47.6% 51.6% 54.8% 57.6% 59.9% 61.8% 63.5% 64.9% 20% 20.3% 29.1% 36.8% 42.5% 47.0% 50.8% 53.9% 56.5% 58.8% 60.7% 62.3% 0% 10.4% 21.2% 30.0% 36.4% 41.6% 45.8% 49.4% 52.4% 55.0% 57.2% 59.1% -20% 3.0% 13.0% 22.2% 29.2% 34.9% 39.7% 43.7% 47.2% 50.2% 52.8% 55.0% -40% 0.3% 5.7% 13.8% 20.8% 26.8% 32.0% 36.4% 40.4% 43.8% 46.8% 49.5% Medium -60% 0% 1.2% 5.9% 11.4% 16.9% 22.1% 26.7% 31.0% 34.8% 38.3% 41.4% 200% 66.8% 68.1% 70.7% 73.1% 75.0% 76.6% 77.8% 78.8% 79.5% 80.0% 80.4% 180% 64.5% 66.1% 69.1% 71.7% 73.9% 75.6% 77.0% 78.1% 78.9% 79.5% 79.9% 160% 61.8% 63.8% 67.3% 70.3% 72.7% 74.6% 76.1% 77.3% 78.2% 78.9% 79.4% 140% 58.6% 61.3% 65.3% 68.6% 71.3% 73.4% 75.1% 76.4% 77.4% 78.2% 78.8% 120% 54.9% 58.3% 63.0% 66.8% 69.7% 72.1% 73.9% 75.4% 76.6% 77.4% 78.1% 100% 50.6% 55.0% 60.4% 64.6% 67.9% 70.6% 72.6% 74.3% 75.6% 76.6% 77.3% 80% 45.3% 51.1% 57.4% 62.2% 65.9% 68.8% 71.1% 73.0% 74.4% 75.6% 76.5% 60% 39.1% 46.6% 54.0% 59.4% 63.5% 66.8% 69.4% 71.4% 73.1% 74.4% 75.4% 40% 31.7% 41.4% 50.0% 56.1% 60.7% 64.4% 67.3% 69.6% 71.5% 73.0% 74.2% 20% 23.2% 35.4% 45.3% 52.1% 57.4% 61.5% 64.8% 67.4% 69.6% 71.3% 72.7% 0% 14.3% 28.5% 39.6% 47.4% 53.3% 57.9% 61.6% 64.7% 67.1% 69.1% 70.8% -20% 6.4% 20.8% 32.9% 41.5% 48.1% 53.4% 57.6% 61.1% 64.0% 66.4% 68.3% -40% 1.5% 12.7% 24.8% 34.0% 41.4% 47.3% 52.2% 56.3% 59.7% 62.5% 64.8% High -60% 0.1% 5.2% 15.2% 24.3% 32.1% 38.8% 44.4% 49.1% 53.2% 56.6% 59.5% [a] [a] * Spot (market) Price/Exercise Price 1 or (S/X-1)

27 Putting All the Pieces Together Executive B has a change in control package that includes: $600,000 lump sum severance 2 yrs. of family health and dental insurance coverage, worth $30,000 accelerated vesting on 1,500 shares of restricted stock with an original vesting date of June 30, 2007 accelerated vesting on two sets of 5,000 options, each of which can be exercised through December 31, 2009 for $10 per share. The original vesting dates for the options are August 15, 2006 and August 15, Facts Current stock price is $25 per share. Common stock has medium volatility. October 31, 2005 is date of change in control (and accelerated vesting). Executive B s base amount is $200,000. Employment agreement provides for tax gross-up payment. An expert has determined that the non-compete provision in Executive B s employment agreement is worth $20,000. Refer to attached spreadsheet for sample calculation. 47

28 Executive B - Accelerated Vesting CIC Date= 10/31/2005 Short-term discount rate for Oct = 4.62% [Use the appropriate rate based on the number of years of acceleration. In this example, the short-term rate applies because the acceleration period is 3 years. Note : The rate is based on semi-annual compounding. Units in Present Value formula must be consistent.] Stock Options Expiration # of Options Original Vesting Date Acceleration Period (semi-annual) Exercise Price Current Price Spread Factor Term (months) Safe Harbor Factor (Medium Volatility) 12/31/2009 5,000 8/15/ $10 $ % % 12/31/2009 5,000 8/15/ $10 $ % % Total Shares = 10,000 [This is difference between the original vesting date and the CIC date. It is expressed in terms of semi-annual ( i.e., 6 mos.) periods to facilitate calculation of present value.] [This is Current Price divided by Exercise Price, minus 1. If the Spread Factor is more than 220%, the Rev. Proc safe harbor valuation method cannot be used.] [This is difference between CIC Date and Expiration Date.] [Use the chart in Rev. Proc to determine this amount. It is permissible to round down the Spread Factor to the next lower multiple of 20% and to round down the Term to the next lower multiple of 12 months. Here, 150% was rounded down to 140% and 50 months was rounded down to 48 months. In the medium volatility section of the chart, the row for 140% and the column for 48 months intersect to give a Safe Harbor Factor of 66.1%.] Safe Harbor Value Present Value Difference # Full Months of Acceleration Lapse Amount Total $82, $79, $2, $7, $10, $82, $76, $6, $17, $23, $34, [# Options x [1% x Safe Current Price x Harbor Value x Safe Harbor Full Months of [Difference + Lapse] Factor] Acceleration] Restricted Stock Original Vesting Date Acceleration Period (semi-annual) Current Price Current Value Present Value Difference # Full Months of Acceleration Lapse Amount [1% x Current Value x Full Months of Acceleration] # of Shares 1,500 06/30/ $25 $37, $34, $2, $7, Total [Difference + Lapse] $10,242.91

29 The Final Tally The total value of Executive B s change in control package is: Severance = $600,000 Insurance = $ 30,000 Restricted Stock = $ 10,243 (rounded) Stock Options = $ 34,195 (rounded) $674,438 - $ 20,000 non-compete $654,438 Because the total is more than 3x Executive B s base amount of $200,000, the portion above $200,000 is an excess parachute payment subject to the 20% excise tax. Excess parachute payment = $454,438 Excise tax = $90, Total Gross Up Amount Federal income tax of 35% and Medicare tax of 1.45% apply to the entire amount that Executive B receives. FICA tax won t apply because Executive B has already earned more than the taxable wage base ($90,000 for 2005) % x $654,438 = $238, Federal Taxes Federal Taxes + Excise Tax = $329, Gross-up amount = Excise Tax / 43.55% = $208, Executive B will receive $654,438 parachute payment + $208, gross-up payment, for a total of $863,

30 Questions Self Study Code: