Understanding the Nuances of New Golden Parachute Rules –

In the midst of a reenergized mergers and acquisitions market, the Internal Revenue Service recently issued new proposed golden parachute regulations. Company executives and their advisors should give careful attention to these new tax rules and the impact they may have on pending transactions where a change in corporate control is involved.

Golden parachute treatment applies when the value of payments contingent on a change in control to a “disqualified individual” (defined below) is three times or more than the individual’s prior average compensation over a period of up to five years. If this limit is exceeded, all contingent payments referred to as “parachute payments” in excess of the individual’s prior average compensation are subject to a 20% nondeductible excise tax. In addition, tax rules prohibit the buyer from deducting parachute payments subject to the excise tax.

The 2002 regulations, while not providing as many improvements as had been desired and suggested by practitioners following the original 1989 proposed rules, may allow for corporations to reduce or eliminate exposure to golden parachute treatment. The 2002 regulations also clarify important exemption provisions.

Disqualified

Three of the more significant changes under the 2002 regulations affecting the venture capital community include a narrower definition of a “disqualified individual,” revised stockholder approval requirements and guidance for valuing options.

Taxpayers may elect to apply the 2002 regulations to pending transactions so long as the change in control occurs before 2004. Alternatively, taxpayers may continue to rely on the 1989 regulations before final golden parachute regulations become effective.

Only “disqualified individuals” may be subject to golden parachute taxes. This category consists of employees and independent contractors who are officers, shareholders or highly compensated individuals within a corporation. In other words, the definition of “disqualified individuals” is intended to identify those individuals wielding significant influence over the corporation.

The 2002 regulations provide important relief for employees below the executive level that hold significant option positions. The 1989 regulations treat employees holding vested options to acquire more than $1 million of company stock as “disqualified individuals.” In response to comments made by tax attorneys, the 2002 regulations narrow the shareholder definition by providing that an individual will not be subject to the golden parachute provisions just because he holds vested stock options, unless the underlying option stock is worth more than 1% of the corporation’s value.

Other changes to the definition of a highly compensated individual may not be as helpful. The 1989 regulations generally provide that an employee in the highest paid 1% of employees who earns more than $75,000 will be treated as highly compensated. The 2002 regulations increase the minimum compensation limit to $90,000 and provide for future cost-of-living adjustments. This increased limit will still result in disqualified individual status for certain managers at large high-tech companies.

Privately held companies receiving venture financing often seek shareholder approval to avoid golden parachute treatment. In general, a private company exemption from the golden parachute rules is provided for shareholder approval under the following circumstances: when approval is provided by a separate vote by persons (excluding disqualified individuals) who own more than 75% of the corporation’s voting power immediately prior to the change in control; when adequate disclosure is made to shareholders; and when rights to payment are contingent upon 75% shareholder approval.

A Delicate Matter

Obtaining shareholder approval has proved to be a delicate matter. The 1989 regulations make no allowance to reflect that corporations don’t design contingent payments to be subject to shareholder approval immediately before a change in control. Corporations and executives often agree to rescind benefits immediately prior to a change in control in order to obtain the required shareholder approval for a replacement compensation package. Practical issues, such as how to treat option holders, how to structure voting approvals and what payments must be subject to the approval process, were not addressed in the 1989 regulations. As a result, corporate transactions often involved lengthy negotiations over how to qualify for the exemption due to the uncertainty under the 1989 regulations.

The 2002 regulations provide well intended but modest changes to shareholder approval requirements. Flexibility is provided in determining who the corporation’s shareholders are for purposes of the required approval. The proposed rules allow corporations to obtain a vote of the shareholders of record at any time within the three months prior to the change in control transaction. In addition, the new proposed rules do not require that all potential parachute payments be subject to shareholder approval. Instead, only the payments to a disqualified individual that would trigger golden parachute payment treatment need be subject to shareholder approval.

Unfortunately, the shareholder approval rules in the 2002 regulations fall short in several respects. The timing for obtaining required shareholder approval remains an issue. The proposed rules also require that material information regarding all contingent payments be provided to all shareholders, even though tax rules only require 75% approval. Making detailed disclosure of executive pay in private companies that have broad-based stock plans will continue to be a very sensitive issue. In addition, a corporation receiving services from a disqualified individual who is also a partner of a shareholder may face special approval difficulties.

Trigger Happy

Stock option valuation is a very important issue if the corporation cannot qualify for the shareholder approval exception. As noted above, accelerated vesting of equity compensation on a change in control is treated as compensation subject to the golden parachute rules. Stock options are often vested, in whole or in part, upon a change in control or a termination of employment following a change in control. The accelerated value of stock options often triggers golden parachute treatment by itself.

The 1989 regulations did not provide clear guidance on how to value options for purposes of the golden parachute rules. Some companies valued options based on their spread (that is, the difference between the stock value and the exercise price) at the time of the change in control. That’s referred to as the “intrinsic value approach.” Other companies employed methods such as the “Black-Scholes valuation model.”

Selecting one valuation method over another can result in significantly different valuation amounts. For example, consider an option that is underwater at the time of the change in control. There would be no value under the intrinsic value approach. However, the parachute value might be quite significant using a Black-Scholes valuation model, depending on the stock’s volatility and the expected term of the option. Determining which valuation model to use has been contentious when change-in-control agreements require that contingent payments be limited to avoid golden parachute treatment.

It will become even more important to determine the most desirable and acceptable valuation approach under the 2002 regulations. The IRS has suggested that the intrinsic value approach by itself cannot be used for option valuation. Companion guidance to the 2002 regulations provides for different valuation methods consistent with generally accepted accounting principles to be used going forward. (Those valuation methods are subject to special restrictions for publicly held corporations.) Safe harbor valuation rules provided in the guidance will have limited usefulness, as holders of stock options with large spreads on a change in control often will be unable to use the safe harbor.

The interplay of the golden parachute rules and change in control protection will continue to be important. It is advisable to address these issues well in advance of an acquisition. Failure to do so may result in an executive’s pay package becoming an obstacle to completing a transaction.

Andrew Liazos and John Egan are partners in the Boston office of McDermott, Will & Emery. Liazos is head of the firm’s Executive Compensation Group, while Egan runs the Private Equity/Emerging Companies Group.