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:: Goldeng Parachute Audit Techniques (02-2005)
NOTE: This
guide is current through the publication
date. Since changes may have occurred after
the publication date that would affect the
accuracy of this document, no guarantees are
made concerning the technical accuracy after
the publication date.
The parachute examination
can occur during the examination of either
the corporation's or the individual's
return. As the examination begins and
throughout its course, the following items
should be considered :
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The Code requires
that the excise tax payable under §
4999 be administered as an income
tax. See § 4999(c)(2). Accordingly,
the three-year statute of
limitations of § 6501 will apply
because, in most cases, there has
not been a substantial
understatement of income.
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The outcome of the
parachute examination may affect the
tax return of a taxpayer (i.e., a
current or former employee or
independent contractor) in another
part of the country so steps should
be taken to keep the statute open
for the affected taxpayer.
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Final regulations
concerning golden parachute payments
were issued on August 4, 2003, and
are effective for any payment
contingent on a change in ownership
or control if the change occurs on
or after January 1, 2004. For
payments contingent on a change
occurring prior to January 1, 2004,
taxpayers may rely on the 1989
proposed regulations, 2002 proposed
regulations, or the final
regulations.
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The Regulations
1.280G-1 were issued in question and
answer format. Any
reference to questions and answers
(Q/A) in this ATG relate to the
final regulations. The key code and
regulations for Golden Parachutes
are IRC 280G; IRC 4999 and Treas.
Reg. 1.280G-1.
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Potential
Adjustments in a Parachute
Examination
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If a payment is
determined to be an excess
parachute payment the
corporation is not allowed a
deduction for that payment under
§ 280G
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An excise tax
of 20% is imposed on the
recipient of such a payment
under § 4999
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The payor of
the parachute payment must
withhold the excise tax if the
payment is wages.
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Golden Parachute
Reporting Requirements
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Employees: Generally,
golden parachute payments, any
taxes withheld, and the total
excise tax are reported to
employee on Form W-2. The
employee must include the 20%
excise tax in total taxes on
Form 1040.
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Non-Employees: Total
golden parachute payments made
to non-employees are reported on
Form 1099-Misc in Box 7,
Non-employee compensation. Any
excess parachute payment is
reported in box 13, “Excess
Golden Parachute Payments”.
Documents to review
in a golden parachute examination:
The Board of
Director’s and Compensation Committee
Minutes: Identify activities
relating to shareholder approval of mergers,
consolidations, or liquidations of the
corporation. Also look for discussions of
executive compensation due to change in
control. The minutes may help identify
change in control triggers and payments to
be
made on a change in ownership or control.
Merger and
Acquisition Agreements: These
agreements may contain important
information in determining if there was a
change in control and may contain
information
about payments that may be made in
connection with a change in control. Not all
mergers involve a change in control so be
alert to the type of merger in which your
taxpayer is involved.
The Employment
Contracts, Employment Security Agreements
and Executive Benefit Plans: The
employment agreements and benefit plans may
contain additional
information about any payments that will be
made on a change in control and any
change in control triggers.
Deferred
Compensation Arrangements: Review
the deferred compensation
arrangements for payments (including
accelerated payments) and/or change in
control
triggers.
Stock Option and
Restricted Stock Plans : These
plans may have change in control triggers
and may contain additional information about
payments that will be made on a change in
control (including accelerated vesting or
cash out of options).
The 10-K document
is the annual report filed with the SEC and
provides a complete
listing of the Directors a nd executive
officers, executive compensation, and the
security ownership of certain beneficial
owners and management. There is also a
description at the back of the 10-K
containing additional exhibits filed with
the SEC, which may contain additional
compensation plans for executives.
Generally, these compensation plans are
option oriented and discuss vesting of the
options, especially if there is a change in
control. See
www.sec.gov.
The 14A, Proxy
Statement Pursuant to Section 14A of the SEC,
better known as the Definitive Proxy
Statement, is sent to the shareholders of
record prior to the Annual Meeting and
contains a wealth of information on specific
stock options and
compensation plans for the executives. It
provides details on the types and amount o f
compensation provided to the key executives.
See
www.sec.gov.
Website:
Review the parent company's website for
information on corporate
acquisitions and mergers.
Internet Research:
Research internet sources for information on
the corporation for the years under audit.
Use search engines such as Google.com.
Tax Returns:
Review the corporation's Form 1120 and Form
851, Affiliations Schedule, for newly added
or omitted subsidiary companies. Analyze M-1
adjustments to determine whether the
corporation has reduced its compensation
deduction for excess parachute payments.
This should appear as a deduction taken for
book purposes but not for tax purposes.
Form W-2’s and Form
1099’s: If a change in ownership or
control has occurred,
examine the appropriate executive Forms W-2
for large increases in compensation from one
year to the next. This should be done for
employees of both the target company and the
acquiring company. Form 1099 may need to be
examined for former executives and/or
independent contractors.
Nine Steps to
Follow in a Parachute Examination.
(Refer to examination steps flow chart)
Step 1: Determine whether
there has been a change in ownership or
control.
Step 2: Establish who are
"disqualified individuals."
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A "disqualified
individual" is any individual (or
any personal service corporation or
similar entity) who is both an
employee or an independent
contractor and
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A shareholder. This
is an individual who owns stock with
a fair market value
that exceeds 1% of the fair market
value of all outstanding stock of
the
corporation. See Q/A-17.
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An officer. Whether
an individual is an officer is based
on the facts and
circumstances. See Q/A-18.
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A highly
compensated individual. This is
someone whose annual
compensation is $90,000 (adjusted
under §414(a)(1)(B)(k)) and who is
among a group consisting of the
lesser of the highest paid 1% of the
corporation or highest 250 employees
of the corporation. See Q/A-19.
Step 3: Determine each
disqualified individual's "base amount" and
multiply it by 3 to
establish the "safe harbor amount."
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In general, the
base amount is the average annual
compensation that was includible in
gross income by the disqualified
individual, for the individual's
most recent five taxable years
ending before a cha nge of ownership
or control.
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The "safe harbor
amount" is the "base amount" times
three. If the present value of all
the potential parachute payments
equals or exceeds this amount, the
payments are "parachute payments."
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Look closely at
what is included in the base pay. A
company could have plans in place
that are more sensitive “change in
control” triggers then those by
statute. The company may treat these
early payments as part of the base
pay. Check to see if these payments
might fall under the “closely
associated” standard in the
regulations Q/A -22(b). Any payment
pursuant to a contract or an
amendment to a pre-existing contract
entered into within one year before
a change of control is presumed to
be contingent on the change, unless
the taxpayer establishes the
contrary by clear and convincing
evidence. (IRC 280G(b)(2)(C) and
Q/A-25 and 26).
Step 4: Determine what
payments in the nature of compensation were
made to each
disqualified individual that were contingent
on the change in ownership or control.
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Only payments in
the nature of compensation may be
parachute payments. (See
IRC §280G(b)(2)(A)). In general, all
payments are in the nature of
compensation if they arise from an
employment relationship or are
associated with the performance of
services. Wages, bonuses, severance
pay, fringe benefits, pension
benefits, transfer of property, the
accelerated vesting or granting of
stock options, and other deferred
compensation are characterized as
payments in the nature of
compensation. Elective or salary
reduction contributions to a
cafeteria plan, cash or deferred
arrangement, or tax-sheltered
annuity are also payments in the
nature of compensation. (Q/A-11).
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Under IRC 280G, a
stock option is treated as property
that is transferred at the time it
becomes substantially vested. Thus,
the vesting of an option is treated
as a payment in the nature of
compensation. (Q/A-13(a)). For
information on the
valuation of stock options, see Rev.
Proc. 2003-68, 2003-34 I.R.B. 398.
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If golden parachute
payments are treated as exempt,
review the source of the
payments to determine if the
exemption requirements are met. See
the list of
exempt payments in Q/A-5. If these
exempt payments are from tax
qualified plans then these payments
are not subject to the golden
parachute tax and do not count
toward the three-times-base limit.
Step 5: Determine whether
any of the payments that were contingent on
the change of
ownership or control due to acceleration can
have the contingent portion reduced under
Q/A-24.
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Generally, a
payment is contingent unless it is
substantially certain, at the time
of the change that it would have
been made whether or not the change
of control occurred. (Q/A-22(a).) A
payment is also treated as
contingent on a change if it is
contingent on an event that is
closely related to a change (e.g.,
onset of a tender offer or
termination of employment), the
change actually occurs, and the
event is materially related to the
change. A material relationship is
presumed to exist if the event
occurs within one year before or
after the change. (Q/A-22(b)).
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Whether or not the
disqualified individual is
terminated as a result of the change
in ownership or control has no
bearing on whether the payment is
contingent on the change. A payment
may be contingent on the change
whether the disqualified individual
continues employment or is either
involuntarily or voluntarily
terminated.
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Generally, if a
payment is contingent on a change in
ownership or control, the full
amount of the contingent payment is
treated as contingent on the change.
However, in certain circumstances
only a portion of the payment is
treated as contingent (see the next
2 bullets).
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If a payment is
vested (without regard to the
change) and the change accelerates
the time at which the payment is
made, Q/A-24(b) applies to determine
the portion of the payment that is
treated as contingent on the
change.
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If a payment
becomes vested as a result of the
change (assuming that absent the
change the payment was contingent
only on the continued performance of
services for a certain time period
and the payment is attributable, in
part, to services performed before
the date the payment vested),
Q/A-24(c) applies to determine the
portion of the payment that is
treated as contingent on the change.
The payout of the remaining salary
due under an employment agreement is
a severance payment and is not
reduced under Q/A-24(c). Instead,
the full amount of the payment is
treated as contingent on the change.
Also, if the payment would vest due
to an event other than the
performance of services (such as
attainment of a performance goal)
and the event does not occur prior
to the change, neither Q/A-24(b) or
(c) applies to reduce the payment.
Instead, the full amount of the
payment is treated as contingent on
the change.
Step 6: Reduce each
parachute payment by whatever portion the
taxpayer establishes
with "clear and convincing evidence" is
reasonable compensation for services to be
rendered on or after the change of ownership
or control. (IRC §280G(b)(4)(A)).
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This reduction
generally applies when a
disqualified individual continues to
render services for the corporation
after it has experienced a change in
control, but the amounts paid for
those services are contingent on the
change.
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Refraining from the
performance of services, such as in
compliance with a covenant not to
compete, may be considered
reasonable compensation for services
to the extent it is demonstrated
that the agreement substantially
constrains the individual’s ability
to perform services and there is a
reasonable likelihood that the
agreement will be enforced against
the individual. (Q/A-42(b)).
Step 7: Determine the
present value of the contingent payment, as
reduced by Steps 5
and 6, to determine whether the aggregate
present value of all the payments equals
or exceeds the "safe harbor amount."
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At this point, the
contingent payments are reduced by
steps 5 and 6, and the result is
merely potential parachute payments.
The next step is to determine the
present value of all these potential
parachute payments. If the aggregate
present value is less than the “safe
harbor amount,” they are not
parachute payments. If the aggregate
present value equals or exceeds the
“safe harbor amount,” they are
parachute payments.
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The present value
of a payment is determined as of the
date of the change of
ownership or control, or, if the
payment is made prior to that date,
the date on which the payment is
made. (Q/A-31). Present value is
generally determined by using
a discount rate equal to 120 percent
of the applicable Federal Rate
(determined under IRC §1274(d))
compounded semiannually. (Q/A-32).
This rate is published in the
Cumulative Bulletin and in the tax
services.
Step 8: If the safe harbor
amount of Step 7 is exceeded, determine
whether the
taxpayer has shown with clear and convincing
evidence that a portion of the payment is
reasonable compensation for services
actually rendered before the change in
ownership or control.
Step 9: Calculate the
“excess parachute payment” by subtracting
from each parachute
payment the greater of the allocable base
amount or the reasonable compensation of
Step 8.
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Some companies will
gross up payments to cover the
excise tax. This gross up
amount should also be treated as
part of the golden parachute
payment.
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Whatever excess
parachute payment is attributable to
an option is subject to income tax
in the year of exercise, excise tax
in the year of vesting or grant (if
the grant is the event that
determines that the payment is
contingent), and the deduction is
disallowed when the option is
exercised.
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