The term "golden parachute" is a wonderfully descriptive term for a defensive measure used by a company to prevent hostile takeovers. With golden parachutes, employers enter into agreements with key executives and agree to pay amounts in excess of their usual compensation in the event that control of the employer changes or there is a change in the ownership of a substantial portion of the employer's assets. Top executives are provided with a financial soft landing in the event that a takeover results in discharge. The company initiating the hostile takeover, on the other hand, will either have to pay this associated increased costs when acquiring the corporation or back down from the takeover
Please note: Golden parachute payments do not have to be made under a legally enforceable agreement or contract. A formal or informal understanding will suffice. For example, an oral agreement is enough even though such an agreement would not be legally enforceable under state contract law principles. Not having a written agreement, however, is a surefire invitation to be sued by a corporation's shareholders who may want a takeover to go through and don't want any obstacles (like the sudden appearance of such conveniently timed oral agreements) to stand in the way.
What is a "Golden Parachute"?
Golden parachutes are payments made to "disqualified individuals" that are contingent upon a change in the employer's ownership. "Disqualified individuals" are any of the employer's employees or independent contractors who are shareholders, officers, or highly-compensated individuals (i.e., one of the employer's top one percent or 250 employees in terms of compensation, whichever group is smaller)
If a payment meets all of the following conditions, it is generally treated as a golden parachute payment. The payment:
is in the nature of compensation and is made or is to be made to or for the benefit of a "disqualified individual" at any time during the 12-month period immediately before the date of ownership or control change
is contingent on a change in the ownership of a corporation, in the effective control of a corporation, or in the ownership of a substantial portion of the assets of a corporation
has an aggregate present value of at least three times the individual's base amount of compensation.
A parachute payment can be in the form of cash or property. Such payments can include the spread on the exercise of a stock option, pension proceeds, insurance or annuity proceeds, or payments made under a covenant not to compete.
Excess parachute payments.
Golden parachute payments can reach the point when there is too much of a good thing. Congress viewed excessive golden parachute payments as detrimental to the interests of shareholders and a deterrent to corporate acquisitions. As a result, Congress enacted restrictions that limit the use of such payments.
If payments are determined to be excess parachute payments made to disqualified individuals, the excess payments are not tax deductible by the employer. Further, executives receiving such payments are subject to a 20 percent excise tax on the excess parachute payment. This is in addition to the usual income taxes that would be assessed. The excise tax is withheld by the employer in the case of payments that are considered wages, and the excise tax paid is not deductible for income tax purposes by the recipient of the parachute payments. As if that were not enough, excess payments are subject to Social Security (FICA) taxes when paid.
As in most cases, there are exceptions to the above penalty provisions. The following golden parachute payments are exempt from these penalty provisions:
payments from certain small business corporations (i.e., S corporations)
payments from corporations that, immediately before the change in control, have no stock that is readily tradable on an established securities market or otherwise
payments to or from certain qualified plans, including pension, profit-sharing and stock bonus plan
certain payments of reasonable compensation for personal services
Given the complexity of many executive compensation packages, it can be difficult to determine exactly how much of the parachute payment is "excess" — for example, valuing existing stock options. Executives at companies that are considering a golden parachute defense, should examine their personal situation (ownership interests, current compensation packages, proposed parachute payments, etc.) and obtain expert advice on how the plan may affect them. Golden parachute payments up to three time annual compensation fall under "safe harbor" rules — plans that exceed that level are subject to the 20% excise tax.
Silver, Tin and Pension Parachutes
These types of nonqualified deferred compensation arrangements are not as well publicized as their golden counterparts.
Golden parachutes are primarily used to shelter top executives in the event of a hostile takeover. Similarly, "silver," "tin," and "pension" parachutes are used to provide benefits to employees, except that a more broadly based group of employees is usually affected.
Silver parachutes provide benefits to a broad base of employees in the event of a hostile takeover.
Pension parachutes increase retirement payments to employees participating in an employer's defined benefit pension plan. Pension parachutes become activated only after a change of corporate control, resulting in the automatic termination of the company's retirement plan. The excess assets are then used to provide additional benefits for all active and retired participants.
Tin parachutes are basically severance payments for rank-and-file employees that kick in if a hostile takeover costs employees their jobs. Many see these plans as an even better takeover defense than golden parachutes because having greater numbers can add up to a larger total package, even if individual payments are less.
Rules and tax consequences. The same rules and tax consequences that apply to golden parachute payments also apply to silver, tin, and pension parachutes. An important difference, though, is that silver, tin, and pension parachute payments are not subject to the 20 percent excise tax on excess parachute payments. This is because the payments are made to rank-and-file employees instead of to disqualified individuals.