3530 / What are “excess parachute payments” and how are they taxed?

Agreements providing a generous package of severance and benefits to top executives and key personnel in the event of a takeover or merger are commonly referred to as “golden parachutes.” “Excess parachute payments,” as defined in IRC Section 280G, are subject to the following two tax sanctions: (1) no employer deduction is allowed; and (2) the recipient is subject to a 20 percent penalty tax.¹ Note that this tax penalty is not the same 20 percent penalty imposed by plans covered by and failing IRC Section 409A requirements ( Q 3540).

A “parachute payment” is defined in the IRC as any payment in the nature of compensation to a disqualified individual that is (1) contingent on a change in the ownership or effective control of the corporation or a substantial portion of its assets and the present value of the payments contingent on such change equals or exceeds three times the individual’s average annual compensation from the corporation in the five taxable years ending before the date of the change, or (2) pursuant to an agreement that violates any generally enforced securities laws or regulations.² The present value of the payments contingent on the change in ownership or control is to be determined as of the date of the change, using a discount rate equal to 120 percent of the applicable federal rate.³ A transfer of property will be treated as a payment and taken into account at its fair market value.⁴

A “disqualified individual” is any employee, independent contractor, or other person specified in the regulations who performs personal services for a corporation and who is an officer, shareholder, or highly compensated individual of the corporation. For this purpose, “highly compensated individual” only includes an individual who is a member of the group consisting of the highest paid 1 percent of the employees of the corporation or, if less, the highest paid 250 employees of the corporation.

A payment generally will not be considered contingent if it is substantially certain at the time of the change that the payment would have been made whether or not the change occurred. If a payment is made under a contract entered into or amended within one year of a change in ownership or control, it is presumed to be a parachute payment, unless it can be shown “by clear and convincing evidence” that the payment was not contingent on the change in ownership or control.⁵

The term “parachute payment” does not include:

(1)   any payment to a disqualified individual with respect to a “small business corporation” as defined in IRC Section 1361(b) (which does not have more than one class of stock and not more than 100 stockholders, all of whom are generally individuals but none of whom are nonresident aliens),

(2)   any payment to a disqualified individual with respect to a corporation if, immediately before the change, no stock was readily tradable on an established securities market or otherwise and shareholder approval of the payment was obtained after adequate and informed disclosure by a vote of persons, who, immediately before the change, owned more than 75 percent of the voting power of all outstanding stock of the corporation, or

(3)   any payment to or from a qualified pension, profit sharing or stock bonus plan, a tax sheltered annuity plan, or a simplified employee pension plan.⁶

IRC Section 280G applies to agreements entered into or amended after June 14, 1984.⁷

See Q 3531 for a discussion of how to calculate the nondeductible portion of a parachute payment.

Section 409A Impact

Because Section 280G and Section 409A both can cover a plan providing severance/separation benefits in the case of a change in control, and Section 280G and Section 409A have separate definitions of what constitutes a change in control (Section 409A imposing a narrower definition), it is necessary to carefully coordinate the plan provisions when both IRC sections might apply ( Q 537).