EXCESSIVE COMPENSATION?
Okay, so it is hard to tell these days what compensation is deductible
under Section 162 and what might be viewed as excessive. All of us are
now used to the rules of Section 162(m) which, when they were enacted,
might have seemed draconian. The real question is whether compensation
counts as performance-based, thus meeting the test of Section 162(m)(4).
A recent letter ruling, Letter Ruling 200016024, is useful confirmation
that compensation attributable to the exercise of stock options is performance-based.
Of course, the important qualifier is that the stock options in this ruling
were granted to a key employee at the time the business was formed. The
Service notes in the ruling that:
To begin with, there are now concerns about the timing of compensation.
Since last year’s Tax Court decision in Norwest Corp., et al. v. Commissioner,
112 T.C. No. 9 (1999), there has been concern about which salaries could
be treated as deductible and which were related to an acquisition. The
Tax Court in Norwest considered a target corporation that was a state bank.
The Tax Court required Norwest to capitalize employee salaries as well
as legal, investment banker and accounting fees, all of which related to
due diligence review and the investigation of a potential merger. The IRS
required this capitalization (and the Tax Court agreed) notwithstanding
the fact that these fees and expenses were incurred prior to the acquisition
of the target.
The holding in Norwest extends the application of the INDOPCO doctrine
to reach fees and expenses incurred before an acquisition. The $64,000
question in the case (actually it was a much bigger dollar figure than
this) was whether these costs were sufficiently related to an event that
produced a significant long-term benefit. The Tax Court admitted that the
costs were not direct costs of facilitating the event that produced the
long-term benefit (the merger). Nonetheless, the Tax Court held that the
costs were essential to achieving that benefit. This fine-tuning of words
extends the reach of INDOPCO even further. (For additional discussion,
see Muntean, “Tax Court Bloats INDOPCO in Norwest Corp. v. Commissioner,”
Vol. 7, No. 10, M&A Tax Report, May 19, 1999, p. 1.)
Golden Parachute Problems, Too
Of course, the golden parachute rules are a separate set of restrictions
on compensation deductibility. Not only is deductibility restricted, but
there is an excise tax, too. Section 280G of the Code makes payments of
“excess parachute payments” nondeductible to the paying corporation. This
nondeductible slap on the corporate wrist is coupled with a nondeductible
20% excise tax on the excess parachute payments (imposed by Section 4999(a)).
Between nondeductibility for the payment itself, and a 20% excise tax that
is also nondeductible, the cost of paying excess parachute payments is
severe.
Of course, one trick is to avoid the “excess” moniker. A parachute
payment is subject to the harsh regime only if it is “excess.” A parachute
payment is defined as any compensatory payment to or for the benefit of
a disqualified person (officer, shareholder, key employee or highly compensated
person performing personal services for the corporation) under the following
circumstances:
Since only excess parachute payments are sanctioned, the definition
of “excess” is crucial. A parachute payment is excess if: (1) it is made
to a “disqualified individual;” (2) the payment is contingent on a change
in the control or ownership of the corporation; and (3) the present value
of the payment is at least three times the individual’s base amount. This
base amount is essentially annualized compensation for the individual for
five-year period ending before the date of the change in control.
What About Restructuring?
Does a change in control occur in a corporate restructuring? Fortunately,
the answer seems to be no. In Letter Ruling 9847011, a parent’s sale of
its subsidiary stock was held not to be a change in ownership or control
of the parent, nor was it even considered an event closely associated with
a change in ownership or control. The parent and its wholly-owned subsidiary,
were members of an affiliated group. The subsidiary accounted for less
than 20% of the parent’s value. This subsidiary was sold to an independent
purchaser, thus triggering termination payments to the subsidiary’s executives.
In the same year that the subsidiary was sold, another purchaser acquired
all of the parent’s stock.
The question in the ruling was whether the payments made on termination
to the executives of the subsidiary were made because of a change in ownership
or control. The Service ruled that they were not. Even though the payments
made to the executives of the subsidiary were contingent on the sale of
the subsidiary, they were not held to be parachute payments under Section
280G.
Savings Clause
Despite such a favorable determination, it is becoming increasingly
common to see some type of savings clause in any significant executive
compensation package. A savings clause in a contract might say that, notwithstanding
any other arrangement or commitment, a company will have no liability to
pay an excess parachute payment that would incur the wrath of the nondeductible
excise tax. Although such clauses can dramatically limit the size of the
payment made to a departing executive, they can act as an effective reign
on the corporation’s liability both for large payments and for liability
for the golden parachute payment tax.
Section 162(m) Limits
Another example of planning around excess compensation problems is
Letter Ruling 200019010, just released a few weeks ago. There, the IRS
ruled that corporate officers who resign before the last day of the tax
year, with no intent to resume their duties, will not be covered employees
under Section 162(m). Thus, compensation paid to those individuals for
that year will not be subject to the Section 162(m) deduction limitation.
Just think of the possibilities this suggests.
In the letter ruling, the corporation was a publicly-held calendar
year tax period. Several of the officers had resigned (or intended to resign)
as officers, not intending to resume their duties. The question in the
ruling was whether, solely for the year of their resignation, their compensation
would not count under the limits of Section 162(m). Interestingly, the
ruling notes that it did not matter to this conclusion that the officers
were listed as the CEO or the four highest compensated officers during
the year.
Barbie’s Toys
Numbers seem ever to be climbing. Take, for example, the recent report
that Jill Barad, former CEO of Mattel, received an exit package valued
at close to $50 million. After all the flap over Barad’s three-year term
at Mattel’s helm, and her resignation in the face of mounting losses, it
staggers the imagination that the proxy statement now shows about $50 million
in exit pay (at least valued in current dollars). See Bannon, “Mattel Proxy
Says Jill Barad Received Severance Package of About $50 Million,” Wall
Street Journal, May 1, 2000, p. B9.
Excessive Compensation?, Vol. 8, No. 11, M&A Tax Report
(June 2000), p. 1.
In determining what constitutes excessive compensation, the facts won’t
always be this easy.
Determining whether a payment constitutes a parachute payment is typically
easy. Significantly, though, a parachute payment normally does not include
payments to or from qualified pension and profit-sharing plans, annuity
plans and simplified employee pensions. (See I.R.C. §280G(b)(6).)