The Golden Parachute and the Tax Man

When Robert Nardelli and the board of directors of Home Depot mutually agreed to his resignation, he left with nearly $210 million in parachute payments. A part of the payments included excise tax payments and gross-up provisions. Until recently, shareholders had little idea about the size and scope of these payments. Companies were not required to elaborate on golden parachutes in proxy statements. That is clearly changing. Another relatively new IRS statute (280G) is also wreaking havoc with these payments as well. 280G was enacted to control excessive payments to executives in the event of a Change-In-Control by imposing negative tax consequences on the company and the individual. The rule states that, “if the present value of a CIC payment exceeds the safe harbor (three times the average taxable compensation over the five most recent calendar years preceding the CIC, less $1), the company loses tax deductions for the amounts considered excess parachute payment. Additionally, the executive is required to pay a 20% excise tax on the excess payment”.

The 280G regulation has made it significantly more expensive for a CIC. Interestingly, it has done little to curb golden parachutes and simply made CIC transactions more expensive. Most acquiring companies see the golden parachute, as a transaction cost that will be passed on to shareholders. The IRS as with most governmental agencies has tried unsuccessfully to regulate business pay practice. The 280G rule also has some costly fine print when it comes to calculating the penalties. Penalties are calculated based on amounts paid in excess of one times the executive’s five year average taxable compensation, rather than the amount in excess of the safe harbor.

For example, where a CEO’s average five-year compensation was $750,000 and the CIC payment was three times the average one year compensation less $1, and where the executive is reimbursed for excise tax and gross-up (gross up = 65%):

^{Note: $ in ‘000s}

You will notice that the CIC payment of three times the average one-year compensation less $1 still did not meet the safe harbor. Many companies mistakenly believe they are within the safe harbor, not knowing the accelerated stock, deferred compensation and other perquisites are included in the calculation. In our example, the penalty cost is nearly $1.3 million on top of the $2.3 million parachute. Shareholders need to pay attention to these punitive policies and maybe its time to convince government to stay out of the pay regulation business.