Golden parachute excise tax: Overview, definition, and example
What is a golden parachute excise tax?
A golden parachute excise tax is a tax imposed on large severance payments or benefits that are provided to executives or key employees when they leave a company, typically in connection with a change in control, such as a merger or acquisition. These payments are known as "golden parachutes" and often include generous compensation packages such as cash bonuses, stock options, and other financial incentives designed to retain top executives or encourage their departure during a corporate transaction.
The excise tax is intended to discourage excessive compensation arrangements that could result in unfairly large payouts to executives when their employment is terminated in connection with a company takeover. In the United States, under the Internal Revenue Code (IRC) Section 4999, this tax applies when the total amount of severance pay or other benefits exceeds a certain threshold, which is typically three times the executive's base salary and bonus.
Why is the golden parachute excise tax important?
The golden parachute excise tax is important because it helps regulate executive compensation, particularly in situations where executives stand to receive large payouts that may not be in the best interest of the company’s shareholders. By imposing a tax on excessive severance packages, the government aims to curb potentially excessive or unreasonable payments that could occur during mergers, acquisitions, or other corporate transactions.
For companies, the excise tax can act as a deterrent to offering overly generous golden parachute packages that could be considered wasteful or unjustifiable. For executives, it serves as a reminder that large payouts may have tax consequences and that the terms of their employment contracts should be structured accordingly.
Understanding golden parachute excise tax through an example
Imagine an executive at a large corporation is entitled to a severance package worth $15 million, which includes a mix of salary, bonuses, and stock options. If the company is acquired, and the executive's departure qualifies as a "change of control," the total severance package may trigger the golden parachute excise tax. If the total payment exceeds a threshold (usually three times the executive's average compensation over the previous five years), the executive would be subject to a 20% excise tax on the excess amount.
For example, if the executive's base salary and bonus were $5 million, and the severance package exceeds the threshold by $3 million, the excise tax would apply to that excess $3 million, resulting in an additional tax burden of $600,000 (20% of $3 million).
In another example, a company may provide a more modest severance package, but if a merger triggers a change of control, the payments to executives could result in the golden parachute excise tax, depending on the structure and size of the package.
An example of a golden parachute excise tax clause
Here’s how a clause related to the golden parachute excise tax might appear in an executive employment agreement:
“In the event that the Executive’s employment is terminated following a Change of Control, the Executive shall be entitled to receive severance benefits, subject to applicable laws. If the severance benefits exceed the threshold under IRC Section 4999 and result in the imposition of the golden parachute excise tax, the Company agrees to gross up the Executive’s severance payment to cover the excise tax liability.”
Conclusion
The golden parachute excise tax serves as a regulatory tool designed to curb excessive executive compensation in the context of corporate mergers, acquisitions, or changes in control. By imposing a tax on large severance payouts, the tax discourages the offering of disproportionately high benefits to executives, ensuring that such packages are reasonable and aligned with the interests of shareholders. For companies and executives alike, understanding this tax is crucial when negotiating severance terms and ensuring compliance with tax laws.
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.