3531 / How is the nondeductible amount of a parachute payment calculated?

The amount of a parachute payment that is nondeductible and subject to the excise tax (i.e., the “excess parachute payment,” see Q 3530) is the amount of the payment in excess of the portion of the base amount allocable to that payment.

The “base amount” is the average of the individual’s annual compensation paid by the corporation undergoing the change in ownership and includable in the gross income of the individual in the most recent five taxable years ending before the date on which the change in ownership or control occurs. If the individual has been employed by the corporation for fewer than five years, then the base amount is figured using the annual compensation for the years actually employed. Compensation of individuals employed for a portion of a taxable year should be annualized (i.e., $30,000 in compensation for four months of employment with the corporation would be $90,000 on an annual basis).

To determine the “excess parachute payment,” the base amount is multiplied by the ratio of the present value of the parachute payment to the present value of all parachute payments expected; the result is then subtracted from the amount of the parachute payment.

excess parachute payment	=	parachute payment	–	present value of the parachute payment	×	base amount
				present value of all parachute payments expected

The present value is to be determined at the time the contingency occurs, using a discount rate of 120 percent of the applicable federal rate.

Any amount the taxpayer can prove is “reasonable compensation” will not be treated as a parachute payment.¹ See Q 3519 for a general discussion on standards for “reasonable compensation.”

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Planning Point: The original documentation should allow the sponsor the option to pay the maximum amount payable (2.99 x average annual compensation) without equaling or exceeding the total amount that would make some portion “excess compensation,” which would cause loss of a portion of the deduction. This option often may result in the participant ultimately receiving a larger dollar amount than if the participant had received “excessive compensation,” after consideration for income taxes in both cases. In addition, the sponsor will have retained its compensation deduction for the payment.

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