Excess parachute payments: Overview, definition, and example
What are excess parachute payments?
Excess parachute payments refer to compensation or benefits provided to executives or key employees in the event of a change of control within a company, such as a merger or acquisition, that exceed legally allowed limits. These payments are often in the form of severance, bonuses, stock options, or other benefits. The U.S. Internal Revenue Code places limits on how much an executive can receive in parachute payments before those payments are subject to heavy taxes. Payments that exceed these limits are considered "excess parachute payments" and are subject to a 20% excise tax on both the employee receiving the payment and the company making it.
For example, if an executive receives a $10 million payout as part of a merger, but the limit under the tax code is $5 million, the $5 million above the threshold would be considered an excess parachute payment.
Why are excess parachute payments important?
Excess parachute payments are important because they have significant tax implications for both the recipient and the company making the payments. The law aims to discourage overly generous payments to executives that may not be in line with the interests of the shareholders or the company’s financial health. By imposing an excise tax on these excess payments, the government seeks to ensure that corporate executives are not overly rewarded in situations such as mergers or takeovers, which could lead to conflicts of interest.
For companies, understanding and managing parachute payments is crucial to avoid unnecessary tax penalties and ensure compliance with tax regulations. For executives, understanding the limits of parachute payments helps avoid unexpected tax burdens.
Understanding excess parachute payments through an example
Imagine a company, XYZ Corp., that is acquired by a larger corporation. As part of the acquisition, the CEO of XYZ Corp. receives a severance package worth $12 million, which includes bonuses and stock options. However, the IRS limit for parachute payments in this case is $6 million. The $6 million above the threshold is considered an excess parachute payment and is subject to a 20% excise tax, meaning both the CEO and XYZ Corp. will face additional taxes on this portion of the payout.
In another example, a company, TechCo, is undergoing a merger, and its CFO is offered a $5 million severance package. This amount falls within the allowed limit, so no excess parachute payment tax is incurred. However, if the severance package were $8 million, $3 million of that would be considered an excess parachute payment and would be taxed at the 20% rate.
An example of an "excess parachute payment" clause
Here’s how a clause like this might appear in a contract:
“In the event of a Change of Control, the Company agrees to provide severance benefits to the Executive; however, if such benefits exceed the thresholds set forth under the U.S. Internal Revenue Code Section 280G, the Executive acknowledges that any excess parachute payments will be subject to excise taxes as required by law.”
Conclusion
Excess parachute payments are compensatory payments made to executives or key employees that exceed the legal limits established under U.S. tax law, and they are subject to a heavy excise tax. These payments often arise in the context of mergers, acquisitions, or other corporate restructuring, and understanding the limits and tax consequences of such payments is essential for both businesses and executives. Companies need to carefully manage parachute payments to avoid costly penalties, while executives should be aware of the tax implications of any severance or change-of-control benefits they receive.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.