As the pace of bank mergers begins to accelerate, poorly understood IRS regulations governing golden parachutes for top executives are sure to create agony on both sides of the table. Misunderstanding the regulations, which have been in effect for about five years, can be painfully expensive to outgoing executives while slapping unexpected costs on acquiring companies.
And when golden parachutes suddenly tarnish under the application of these regulations, the potential for ill will and snarled negotiations is tremendous.
The parachute rules, found in Sections 280G and 4999 of the Internal Revenue Code of 1986, were first passed by Congress in 1984 in reaction to extremely rich severance arrangements for outgoing executives after corporate takeovers. The IRS issued its regulations interpreting these rules, still technically in the "proposed" stage, in 1989.
These rules affect only a handful of highly paid employees: the five to ten top executive officers who usually have specially written employment contracts, compensation arrangements, and severance packages. They do not affect companywide severance programs, no matter how generous.
This is what the law now states: A penalty will be applied if the aggregate amount of an executive's parachute payments in a change-of-control situation is equal to or greater than three times the annualized average of the executive's W-2 income (typically salary and bonus) for the preceding five calendar years. The calculation begins with the calendar year before the change in control occurs.
Once the package reaches the 300% level, the executive must pay a 20% tax on all amounts over 100% of the five-year average. And the acquiring company may not deduct from its income tax any amount it pays that exceeds the five-year average.
Thus, an outgoing bank CEO whose five-year W-2 income averaged $300,000 could theoretically receive a severance package. of $899,999 and pay no penalty. One dollar more and the executive pays an excise tax of $120,000 (20 percent of $600,000, the excess over the five-year average). And the acquiring company loses a deduction of $600,000.
While the basic formula cited above is fairy straightforward, the process of valuing a severance package. is quite the opposite.
For example, any benefits that continue following the executive's termination must be valued and counted as part of the package,
So must certain accelerated vesting of stock options and retirement plan payments.
Exclusions are few. Sometimes a strategy of deferring payments can produce a more generous settlement over the long term.
Sometimes, when the merger is scheduled to take place during the next calendar year, it may be possible to accelerate income into the current year and thus increase the five-year average on which the limitations are based.
You can see that the options are complex. Finding the right formula for a given executive often requires developing several scenarios.
Don't assume that existing employment agreements are in compliance with the law or are satisfactory to executives who will have to leave.
Managers departing with millions have thrown mergers into chaos arguing over thousands. A great deal more than money is involved.
Over time, companies have tended to take one of three broad approaches to structuring golden parachutes:
* Payment Cap. Here, the decision-makers stipulate that the parachutes will be limited by the IRS regulations.
* No Cap. This let-the-chipsfall-where-they-may approach essentially ignores the IRS regulations and grants severance solely according to existing arrangements or the judgment of those who decide compensation matters. The drawbacks are obvious.
* No Cap with Gross Up. Here the IRS limit is again ignored, but with the provision that any resulting penalties and taxes will be paid by the company.
It's a safe bet that bankers, like their counterparts in other industries, will find these regulations technically perplexing and emotionally charged. Exactly the reasons for addressing them now, while there's still time for reason.