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New tools for auditors in updated golden parachute payments audit techniques guide

Golden parachute payments given to top executives after a takeover have been controversial with shareholders and regulators over the years because they typically far exceed severance payments given to other departing employees. They also are a target for IRS auditors, who have been given new guidance in an updated audit techniques guide (ATG) on how to ferret out information on golden parachute payments, which are subject to deduction disallowance and an extra 20% tax if deemed “excessive” under Code Sec. 280G.

Background . No deduction is allowed for an excess parachute payment, which is the amount by which a parachute payment exceeds the base amount allocated to it. (Code Sec. 280G(b)(1)) In addition, Code Sec. 4999 imposes a nondeductible 20% excise tax on the recipient of an excess parachute payment.

A parachute payment is any payment in the nature of compensation to (or for the benefit of) a disqualified individual if :

1. the payment is contingent on a change (a) in the ownership or effective control of the corporation, or (b) in the ownership of a substantial part of the corporation’s assets, and
2. the aggregate present value of all such contingent compensation payments equals, or exceeds, three times the base amount. (Code Sec. 280G(b)) This base amount is the average annualized compensation income includible in a disqualified individual’s gross income in the 5-tax-year period preceding the tax year in which the change of ownership or control of the corporation occurs. (Code Sec. 280G(b), Code Sec. 280G(d))

A disqualified individual is a person who is: (1) an employee, independent contractor, or other person specified in regs who performs personal services for a corporation, and (2) is an officer, shareholder or “highly compensated individual.” (Code Sec. 280G(c); Reg. § 1.280G-1, Q&As 15 to 20) A highly compensated individual means one of the highest paid 1% of employees or, if less, one of the highest paid 250 employees. (Code Sec. 280G(c))

A parachute payment doesn’t include an amount that the taxpayer can establish, by clear and convincing evidence, is reasonable compensation for services to be rendered on, or after, the date of change in ownership or control. (Code Sec. 280G(b)(4)(A)) And, the amount of an excess parachute payment can be reduced to the extent that the taxpayer can establish by clear and convincing evidence that the payment is reasonable compensation for personal services actually rendered before the date of change of ownership or control. (Code Sec. 280G(b)(4)(B))

The parachute payment rules don’t apply to a corporation (1) that was (immediately before the change in control or assets) a “small business corporation,” i.e., a corporation that qualifies under the S corporation rules without regard to whether it has a nonresident alien shareholder or (2) whose stock isn’t readily tradeable if shareholder approval for the payment was obtained. (Code Sec. 280G(b)(5)) A corporation that meets the requirements to elect to be treated as an S corporation, but does not elect S status, may nevertheless use the small business exemption. (Reg. § 1.280G-1, Q&A 6(a)(1))

Payments to or from a qualified pension or profit-sharing plan, Code Sec. 403(a) annuity, simplified employee pension, or SIMPLE plan aren’t parachute payments. (Code Sec. 280G(b)(6); Reg. § 1.280G-1, Q&A 8)

A publicly held corporation can’t deduct applicable employee remuneration in excess of $1 million per year paid to a covered employee (Code Sec. 162(m)(1)) The dollar limit is reduced to $500,000 for certain covered executives by a recipient of financial assistance under the Troubled Asset Relief Program (TARP), and for certain applicable individuals if the employer is a “covered health insurance provider.” (Code Sec. 162(m)(5), Code Sec. 162(m)(6)) The dollar limit is reduced (but not below zero) by the amount, if any, paid to the executive but not deductible under the golden parachute rules. (Code Sec. 162(m)(4)(F), Code Sec. 162(m)(5)(G), Code Sec. 162(m)(6)(G); Reg. § 1.162-27(g))

Updated audit techniques guide. The newly updated ATG on golden parachutes provides an expanded and updated list of documents for auditors to review in connection with a golden parachute examination, including the following:

  • Form 10-K: This document provides information for equity compensation plans using a table format setting forth the (a) number of securities to be issued, (b) weighted-average exercise price, and (c) additional shares available for future grants. Any compensation plans adopted in the applicable year without stockholder approval are provided as an exhibit. Also, Form 10-K often references additional compensation plans that were previously filed with the SEC. These compensation plans frequently include stock options, restricted stock, and other types of equity-based compensation for executives. Form 10-K may discuss the vesting provisions of such equity-based compensation especially in the event of a change in control.
  • DEF 14A, Proxy Statement Pursuant to Section 14A of the SEC, better known as the Definitive Proxy Statement, or the annual proxy statement: The ATG says this is the easiest place to look up information on executive compensation. This proxy statement is sent to the shareholders of record before the Annual Meeting and may contain information about specific stock options and compensation plans for executives. It is more detailed than Form 10-K and provides specific detail as to the number of options granted and the total exercise price under the various plans.
  • Schedule 14A, Information Statement Pursuant to Section 14(a) of the SEC and Schedule 14C, Information Statement pursuant to Section 14(c) of the SEC:These schedules disclose information about golden parachute payments in connection with the solicitation for shareholders’ approval as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act requires a shareholder advisory vote, commonly referred to as “vote on golden parachute payments” for any new executive compensation arrangements in connection with a merger, acquisition, consolidation, proposed sale, or disposition of all or substantially all assets of a public company. The company must disclose all parachute payments that may be made if a change in control occur. It also must reveal in a “Golden Parachute Compensation” table quantitative information about the components of the parachute payments based the per share price, and describe conditions for payment, how payments are made, who makes payments, and how long the payments are made. Additionally, any parachute payments actually made upon a change in control must be reported.
  • Forms S-4 and F-4: These forms, used when registering securities under the Securities Act of 1933, provide information to investors related to mergers, acquisitions, or when securities are exchanged between companies. Form F-4 is specifically used to register securities offered by foreign issuers.

Other, more common sources of information for auditors include board of directors and compensation committee minutes, merger and acquisition agreements, employment contracts, deferred compensation arrangements, and the corporation’s Form 1120 and Form 851 (Affiliations Schedule). Auditors also are told that if a change in ownership or control has occurred, they should review the appropriate executives’ (at both the target and acquiring company) Forms W-2 for large increases in compensation from one year to the next. Form 1099 may need to be examined for former executives and/or independent contractors.

The updated audit guide features, as did the 2005 version, a nine-step guide and flowchart to performing a parachute examination.

References: For the golden parachute rules, see FTC 2d/FIN ¶  H-3825; United States Tax Reporter ¶  280G4.

Golden Parachute Payments, Audit Techniques Guide, 1/20/17.

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