IRS Issues Proposed Regs in Connection with Golden Parachute Payments
Guidance Provided Relating to Golden Parachute Payments Contingent on Change in Ownership or Control (Rev. Proc. 2002-13; NPRM REG-209114-90)
The IRS has issued proposed regulations relating to golden parachute payments to provide guidance to taxpayers who must comply with Code Sec. 280G. The proposals would apply to any payments that are contingent on a change in ownership or control occurring on or after January 1, 2004, and may be relied on until the effective date of final regulations. Taxpayers may rely on regulations proposed on May 5, 1989, for any payment contingent on a change in ownership or control that occurs prior to January 1, 2004.
Code Sec. 280G denies a deduction to a corporation for any excess parachute payment and Code Sec. 4999 imposes a 20% excise tax on the recipient of any excess parachute payment. A payment constitutes a parachute payment only if it is made to, or for the benefit of, a disqualified individual, which is defined as an employee or independent contractor who performs personal services for a corporation and who is an officer, shareholder or highly compensated individual.
The determination of who is a disqualified individual under the new proposal is substantially the same as under the 1989 proposal, with three significant changes. First, the $1 million test for value of stock owned has been eliminated. Under the new proposal, an individual is a shareholder only if, during the disqualified individual determination period, the individual owns stock of a corporation with a fair market value that exceeds 1% of the total fair market value of the outstanding shares of all classes of the corporation's stock.
Second, the newly proposed regulations modify the annualized compensation method for determining who is a highly compensated individual to provide that, during the disqualified individual determination period, an individual must have annualized compensation at least equal to the amount described in Code Sec. 414(q)(1)(B)(i) to be treated as a highly compensated individual. This amount is $90,000 for 2002 and is to be adjusted periodically for cost-of- living increases. Third, the new regs change the disqualified individual determination period to the 12 months prior to and ending on the date of the change in ownership or control of the corporation.
Payment as Compensation
A payment may be a parachute payment only if it is a payment in the nature of compensation. The new proposals clarify that payments in the nature of compensation include cash, the right to receive cash or a transfer of property. Further, the transfer of either a statutory or a nonstatutory stock option would be a payment in the nature of compensation. The IRS has provided further guidance on acceptable and administrable methods for valuing stock options in Rev. Proc. 2002-13.
To be a parachute payment, a payment in the nature of compensation to a disqualified individual must be contingent on a change in ownership or control. The proposed regs clarify that a payment is contingent on a change in ownership or control if it would not have been made absent the change in ownership or control, even if it is also contingent on a second event. The general rule that the entire amount of a payment is treated as contingent on a change in ownership or control applies to the payment of amounts due under an employment agreement on a termination of employment or change in ownership or control that, without regard to the change, would have been paid for the performance of services after the termination or change.
In addition to the general rule, the 1989 proposal provided an objective method for determining the portion of a payment that is treated as contingent on a change in ownership or control for certain types of payments. The new proposal clarifies when the objective method would apply to a contingent payment.
Change in Ownership
The new proposals clarify that, for purposes of determining whether two or more persons acting as a group are considered to own more than 50% of the total fair market value or total voting power of the stock of a corporation on the date of a merger, acquisition or similar transaction involving that corporation, a person who owns stock in both corporations involved in the transaction is treated as acting as a group with respect to the other shareholders in a corporation only to the extent of such person's ownership of stock in that corporation prior to the transaction and not with respect to his or her ownership in the other corporation.
The proposed regulations clarify two issues with respect to reasonable compensation for services performed after a change in ownership or control. First, clear and convincing evidence that a payment is reasonable compensation for services rendered after a change in ownership or control exists if the individual's annual compensation after the change in ownership or control is not significantly greater than before the change, provided that his or her duties and responsibilities are substantially the same after the change as they were before the change.
Further, payments to an individual under an agreement that requires the individual to refrain from providing services may also constitute reasonable compensation for services to be rendered on or after the date of the change in ownership or control. Under the proposal, an agreement is treated as an agreement to refrain from services if it is demonstrated with clear and convincing evidence 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. If the agreement satisfies these criteria, it is treated as an agreement for the performance of services and the payments are exempt from the definition of parachute payments to the extent they are shown to be reasonable compensation.
The newly proposed regulations also address shareholder approval requirements, application to tax-exempt organizations, the definition of "corporation," the determination of excess parachute payments and the timing of the payment of the excise tax under Code Sec. 4999.
Comments & Hearing
A public hearing on the proposals has been scheduled for June 26, 2002, beginning at 10:00 a.m. in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Ave. NW., Washington, D.C. Comments on the proposals must be received by June 5, 2002. Written comments should be submitted to IRS, Attn: CC:ITA:RU (REG-209114-90), Room 5226, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.
Comments may also be submitted electronically via the Internet, by selecting "The Newsroom" option on the IRS website at www.irs.ustreas.gov, clicking on "IRS Guidance," then selecting "Tax Regulations."
Rev. Proc. 2002-13, issued in conjunction with the proposed regulations provides guidance for valuing stock options, including a safe harbor for valuing compensatory stock options for purposes of Code Secs. 280G and 4999. The IRS will treat the value of a compensatory stock option determined in accordance with the requirements of the revenue procedure as properly determined for purposes of those sections. In general, a taxpayer may value a compensatory stock option using any valuation method that is consistent with generally accepted accounting principles and that takes into account the factors provided in Reg. Sec. 1.280G-1.
If the stock option is one that could otherwise be valued under Rev. Proc. 98- 34, 1998-1 CB 983, because the stock option is one that satisfies the definition of "compensatory stock option" under section 3 of that procedure, then, for purposes of Code Secs. 280G and 4999 and the new revenue procedure, the valuation is not considered consistent with generally accepted accounting principles unless the valuation is made in accordance with Rev. Proc. 98-34 or the valuation safe harbor method provided in the new procedure.
The safe harbor valuation method is based on the Black-Scholes model and takes into account, as of the valuation date, the following factors: (1) the volatility of the underlying stock, (2) the exercise price of the option, (3) the value of the stock at the time of the valuation (the "spot price"), and (4) the term of the option on the valuation date. Rev. Proc. 2002-13 is effective as of April 26, 2002.
The IRS is requesting comments regarding the safe harbor valuation method. Comments must be submitted by June 5, 2002, to: IRS, CC:ITA:RU (Rev. Proc. 2002-13), Room 5226, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044. In the alternative, comments can be e-mailed to: Notice.Comments@irscounsel.treas.gov.