The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 6, January 2001, Panel Publishers, New York, NY.

HOLES IN GOLDEN PARACHUTES

By Robert W. Wood

In the continuing controversy over the interpretation of Section 280G governing golden parachutes, a significant number of letter rulings are being issued dealing with the topic of how to calculate the amount of excess parachute payments resulting from accelerated vesting of stock options, especially when there are two changes of control. To a lesser extent, the treatment of severance payments arising from two changes of control is also causing taxpayer consternation sufficient to rise up the letter ruling barometer. In the latter case, the main question is how to allocate base amounts to excess parachute payments.

Rather than focus on one particular letter ruling, let's look at a typical fact pattern.

Case Study

Suppose a company enters into a change of control agreement with an executive calling for accelerated vesting of options. Plus, the agreement calls for accelerated vesting of nonqualified retirement plans, severance payments, and pro-rated bonus payments. The change of control occurs, and afterwards, the executive elects to continue employment with the second company. The accelerated vesting of options also occurs, but not the acceleration of other payments. The value of the accelerated options was more than three times the executive's base amount, generating an excess parachute payment.

Suppose now that the second company was acquired by a third company, triggering a second change of control. This, in turn, accelerated the executive's vesting in the second company's options. The executive later terminated employment with the third company, and received a severance payment and pro-rated bonuses. The original agreement did not provide for accelerated vesting of the second company's stock options.

What Color Is Your Parachute?

In this circumstance, the IRS concluded that the acceleration of the first and second company's options were contingent on the first and second changes of control, respectively. The severance payment, however, was contingent only on the first change of control, not the second. Finally, the Service outlined how to attribute the executive's base amount to excess parachute payments attributable to the accelerated vesting and the severance payment.

For full text of these letter rulings, see Letter Ruling 200046005, Tax Analysts Doc. No. 2000-29545, 2000 TNT 224-20 (Nov. 27, 2000); Letter Ruling 200046006, Tax Analysts Doc. No. 2000-29546, 2000 TNT 224-21 (Nov. 27, 2000); and Letter Ruling 200046007, Tax Analysts Doc. No. 2000-29547, 2000 TNT 224-22 (Nov. 27, 2000).

Parachute Paranoia

Despite recent market frost, there has probably been no greater time for preeminence of the stock option, both qualified and nonqualified. The question may arise whether a rich option deal will result in a triggering of the golden parachute payment rules, thus spelling nondeductibility to the payor, and even an excise tax. In Letter Ruling 200032017, Tax Analysts Doc. No. 2000-21137, 2000 TNT 158-5, the IRS ruled that the exchange of vested, nonqualified stock options in an acquiring company for vested options in a target company is not a parachute payment under Section 280G. The Service also ruled that for non qualified options that become vested as a result of the merger of the target into the acquiring company, the parachute is determined under Proposed Regulation Section 1.280G-1, Q&A 24(c).

The acquiring company in the deal merged with the target and, as part of the merger, nonqualified stock options held by target employees were converted into nonqualified options in the acquiring company. The differential between the value of the target's options and the acquirer's options was based on the exchange ratio for the merger (and that was arrived at in an arms'-length negotiation between the companies and their respective advisors). The only outstanding target options that were not fully vested became fully vested when the target shareholders voted to approve a merger.

Under these circumstances the IRS concluded that the payments made for vested non-qualified options were not parachute payments because they were not in the nature of compensation under Section 280G. The payments in the nature of compensation for the vested options occurred when the options vested (which was before the merger and not contingent on the change in control).

As far as the unvested options were concerned, options that became vested as a result of the ownership change, these were payments in the nature of compensation when they became substantially vested. Thus, these payments were contingent on the change in control because the payments were accelerated. A contingent portion, however, according to the IRS maybe reduced under Proposed Regulation Section 1.280G-1, Q&A 24(c), because it was substantially certain at the time of the ownership change that the options would have vested if the employees had continued to perform services.

One big question is what happens when options are not exchanged (as they were in Letter Ruling 200032017), but rather accelerated as a result of a change in ownership or control. The proposed regulations under the golden parachute rules expressly deal with this situation. These rules provide that where a payment is accelerated by a change in ownership or control, and that payment was substantially certain at the time of the change to have been made without regard to the change, the portion of the payment that is treated as contingent on the change in ownership for control is the lesser of:

This formula may sound a bit threatening, particularly the latter part. In fact, though, it is designed, at least in somewhat simplified terms, so that only the accelerated portion of the payment is treated as a golden parachute payment. Although this example is somewhat complex, it is worth running through at least one example contained in the proposed regulations regarding the treatment of stock options:

Example: (i) on January 15, 1996, a corporation grants to a disqualified individual nonqualified stock options to purchase 30,000 shares of the corporation's stock. The options do not have a readily ascertainable fair market value at the time of grant. The options will be forfeited by the individual if he fails to perform personal services for the corporation until January 15, 1999. The options will, however, substantially vest in the individual at an earlier date if there is a change in ownership or control of the corporation. On January 16, 1998, a change in the ownership of the corporation occurs and the options become substantially vested in the individual. On January 16, 1998, the options have an ascertainable fair market value of $600,000.

(ii) At the time of the change, it is substantially certain that the payment of the options to purchase 30,000 shares would have been made in the absence of the change if the individual had continued to perform services for the corporation until January 15, 1999. Therefore, only a portion of the payment is treated as contingent on the change. The portion of the payment that is treated as contingent on the change is the amount by which the amount of the accelerated payment on January 16, 1998 ($600,000) exceeds the present value on January 16, 1998, of the payment that was expected to have been made on January 15, 1999, absent the acceleration, plus an amount reflecting the lapse of the obligation to continue to perform services. Assuming that, at the time of the change, it cannot be reasonably ascertained what the value of the options would have been on January 15, 1999, the value of such options on January 16, 1998, is deemed to be $600,000, the amount of the accelerated payment. The present value on January 16, 1998, of a $600,000 payment to be made on January 15, 1999, is $549,964.13. Thus, the portion of the payment treated as contingent on the change is $50,035.87 ($600,000 — $549,964.13), plus an amount reflecting the lapse of the obligation to continue to perform services. Such amount will depend on all the facts and circumstances but in no event will such amount be less than $66,000 (1% x 11 months x $600,000). (Prop. Reg. §1.280G-1(c), Example (7).

Watch Out

With options, or any other consideration, beware of payments contingent on a change in ownership or control.

Holes in Golden Parachutes, Vol. 9, No. 6, The M&A Tax Report (January 2001), p. 1.