Payments to executives that are triggered by a change in control can involve a big tax bite if they exceed 3x an executive’s “base amount” of comp as determined under IRC Section 280G’s “Golden Parachute” provisions. This Andrews Kurth Kenyon memo highlights mitigation strategies to address those tax issues for disqualified individuals.
This excerpt provides a summary of the alternatives involving cutbacks & gross-ups:
Straight cutback – compensation that equals or exceeds the 280G threshold is automatically forfeited. No 280G consequences.
“Better-off” cutback – the disqualified individual retains the greater, on an after-tax basis, of the amount resulting from (i) payment of the full amount (taking into account the 20% excise tax) and (ii) application of a straight cutback.
Full gross-up – the corporation pays the disqualified individual a gross-up payment sufficient to place him or her in the same after-tax position as if the 20% excise tax had not applied. Note that such a gross-up costs more than just the 20% excise tax because the gross-up payment is also subject income taxation (and, because it is connected compensation, also the 20% excise tax). Loss of deduction and the 20% excise tax will apply.
Modified gross-up – the full gross-up, described above, applies only if the connected compensation exceeds the 280G threshold by a particular amount (e.g., 110%), otherwise a straight cutback is applied.
Payments established by clear and convincing evidence to constitute reasonable compensation for services on or after the change in control (including refraining from performing services under a non-competition agreement) are exempt from 280G.
In addition, a disqualified individual or the corporation may take actions to increase the base amount in the years before a potential transaction – such as exercising vested options or paying bonuses earlier than usual. These actions will have the effect of increasing the relevant “base amount” under 280G, thus reducing the chances of exceeding the 280G threshold.
The memo also notes that private companies may avoid application of 280G by obtaining shareholder approval of the compensation in question – subject to certain conditions.
– John Jenkins