Is Your Change-in-Control Protection Safe?

Removal of tax gross-ups can result in a significant loss of benefits.
Andrew LiazosJuly 25, 2011

Tax gross-ups provided to public-company executives under “golden-parachute” deals payable upon a change in control have recently come under heavy attack. Some large investors have submitted shareholder resolutions to ban this type of gross-up, and Institutional Shareholder Services considers it a “poor pay practice.”

Golden-parachute payments result in adverse tax consequences for both executive and employer. The executive must pay a 20% nondeductible excise tax on the excess portion of the payment (as defined below), and the employer loses its deduction on that excess. For several years, it was common for employers to provide tax gross-ups that covered the excise tax. Although quite small in relationship to the overall size of the corporate transaction, tax gross-ups assured that executives would get the targeted level of after-tax benefits under severance and equity-compensation plans.

But this proxy season, in order to secure favorable “say on pay” votes from shareholders, many public companies eliminated or committed to discontinue golden-parachute tax gross-ups. Without this protection, the amount a public-company executive receives when a change in control occurs might be much less than expected, and different from year to year based on changes in compensation. (Note: For purposes of this article, an “executive” is an employee of a public company who was an officer, a 1%-or-more shareholder, or one of the top 1% highest-paid individuals within the 12-month period immediately preceding the change in control.)

Golden-parachute treatment results when the present value of payments that are contingent upon a change in control exceeds a tipping point. In general, that occurs when payments are at least three times the executive’s average annual taxable compensation during the five-year period ending before the year of the change in control, which is the so-called base amount. Payments above the base amount constitute the excess portion referred to above that is subject to the 20% excise tax.

Say an executive has an employment agreement calling for payments of $3 million, and that his or her base amount is $500,000. In order to avoid golden-parachute treatment, such payments would be restricted to $1.5 million, half of what the executive otherwise would expect to get. Even if an agreement allows for parachute payments to be made — when doing so, after considering the 20% excise tax, results in a larger after-tax benefit — the net amount being provided after tax will be significantly reduced.

This calculation provides even less room to make payments without triggering golden-parachute protection than one might first think. The base amount used for the calculation generally does not take into account payments made in the year of the change in control. At the same time, it includes earlier years in which taxable compensation might have been significantly lower than the value of the payments upon a change in control. That is quite likely to happen when an executive is paid heavily with equity compensation that has not previously been taxed (e.g., there was no earlier exercise of stock options), when large amounts of compensation are contributed to nonqualified deferred-compensation plans, or when there have been years without bonuses and/or with salary freezes in exchange for long-term compensation. It is not uncommon for golden-parachute treatment to be triggered at less than two times the current annual cash compensation.

Recent changes in equity compensation plan design exacerbate this problem. Until recently, executives often received all or a substantial portion of their long-term incentives in the form of time-vested stock options or restricted stock. Internal Revenue Service regulations provide a favorable method for determining the value of accelerated vesting for these awards. The value is not the total amount received by the executive; instead, it is based solely on the time value of money (i.e., being paid now instead of at the normal scheduled vesting date) and 1% of the equity award’s value for each month of waived vesting service. Depending on how much time remains until vesting, the valuation discounts can be quite significant. Recently, however, public companies have increasingly been using performance-based vesting conditions, and no matter how likely it is that these conditions will be satisfied, the same type of valuation discount cannot be applied.

So, what are executives to do? For one thing, when negotiating new pay packages, consideration is increasingly being given to tying post-termination payments to compliance with noncompetition covenants. Any payment that is considered reasonable compensation for services rendered after a change in control is ignored for purposes of the golden-parachute rules (i.e., it is not counted for purposes of the three-times-base-amount test). IRS regulations provide that reasonable payments in exchange for compliance with a noncompetition restriction can be treated as post-change-in-control compensation. A noncompete will be treated as bona fide for this purpose only if it substantially constrains the individual’s ability to perform services and there is a reasonable likelihood that the agreement will be enforced. Successfully structuring this type of provision depends on the specific circumstances and requires careful advance planning.

Other remedial possibilities include accelerating taxable compensation into the year prior to the year of the change in control, such as by exercising stock options, and avoiding large deferrals of compensation into later years.

What is certain is that grappling with these issues for the first time upon a change in control is usually quite difficult and distracting for the executive team. The shift away from tax gross-up payments will make it more important than ever for public companies and executives to plan ahead and to understand the interplay between golden-parachute rules and change-in-control protection.

Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.