Introduction
The golden parachute payment excise tax is a specialized IRS tax imposed on certain large severance packages awarded to top executives when a company undergoes a change in ownership or control. Designed to discourage excessively generous exit payments commonly known as golden parachutes, this tax serves to align executive compensation more closely with shareholder interests during mergers and acquisitions.
Background and History
The concept of golden parachutes originated in the 1960s and 1970s as a way to protect executives financially if they were terminated following a merger or acquisition. However, as severance packages grew increasingly large—sometimes reaching millions of dollars—Congress acted to regulate these payments. The Tax Reform Act of 1984 introduced the golden parachute payment excise tax, a 20% tax on amounts exceeding a set threshold, to deter disproportionately high severance benefits.
How the Excise Tax Works
The excise tax comes into effect when the total parachute payments to an executive exceed three times the average annual taxable compensation the executive earned in the five years preceding the ownership change. Parachute payments include a broad range of compensation tied to change-in-control events, such as severance pay, bonuses, accelerated stock options, and other benefits.
The IRS calculates the tax liability by:
- Adding all parachute payments made to the executive.
- Determining the average taxable compensation over the previous five years.
- Calculating the excess amount that exceeds three times this average.
- Imposing a 20% excise tax on this excess.
In addition to this excise tax, the entire parachute payment is subject to ordinary federal and state income taxes, often resulting in a significant total tax burden.
Real-World Example
Imagine a CEO with an average annual compensation of $1 million over the past five years. If the CEO receives a $4 million severance payment following an acquisition, the excise tax applies to the $1 million exceeding the $3 million threshold (3 times $1 million). The executive owes a 20% excise tax, or $200,000, on that excess amount, plus ordinary income tax on the full $4 million.
Who is Affected?
This tax primarily targets top executives and ‘disqualified individuals’ — a term defined by the IRS for those receiving substantial compensation related to a change in company control. It does not apply to all employees; only those receiving significant parachute payments tied to mergers, acquisitions, or similar business transactions.
Employers sometimes structure severance agreements to avoid or minimize this tax, for example, by keeping payments under the threshold or using payment forms not subject to excise tax.
Strategies and Considerations
- Careful Planning: Executives and companies can design compensation packages to stay below the excise tax thresholds.
- Tax Gross-Ups: Some contracts include a provision where the company covers the executive’s excise tax (a tax gross-up), though these provisions are less common due to higher employer costs.
- Professional Advice: Tax professionals can help navigate complex rules and reporting requirements to reduce unexpected tax liabilities.
- Contract Review: Review severance terms closely during mergers to understand potential tax impacts.
Common Misunderstandings
- The excise tax only applies when parachute payments exceed three times the executive’s average prior compensation, not on all severance payouts.
- It is an additional tax beyond regular income taxes owed on these payments.
- Various forms of compensation—including cash, stock options, and bonuses triggered by change-in-control events—count toward parachute payments.
Summary Table
| Aspect | Details |
|---|---|
| Excise Tax Rate | 20% on excess parachute payments over threshold |
| Threshold | Payments exceeding 3x average prior compensation |
| Affected Individuals | Top executives and disqualified individuals |
| Included Payment Types | Severance, bonuses, stock options, other benefits |
| Additional Taxes | Ordinary income tax on total payments |
| Purpose | Discourage excessive severance payments |
Frequently Asked Questions (FAQs)
Q: What counts as a golden parachute payment?
A: Severance, bonuses, stock options, and other benefits paid because of a change in company ownership.
Q: Who pays the excise tax?
A: The executive is responsible for the excise tax. Some employers may cover it through tax gross-up clauses.
Q: Can the excise tax be avoided?
A: While it can’t be entirely avoided, prudent tax planning and payment structuring can minimize or prevent triggering the tax.
Q: Does this tax apply to all severance payments?
A: No. It only applies to substantial payments made due to a change of control that exceed set thresholds.
References
- IRS Publication 535, Business Expenses: https://www.irs.gov/pub/irs-pdf/p535.pdf
- Investopedia, Golden Parachute: https://www.investopedia.com/terms/g/goldenparachute.asp
- Kiplinger: Golden Parachutes: What They Are and How They Are Taxed: https://www.kiplinger.com/taxes/601928/golden-parachutes-what-they-are-and-how-they-are-taxed
- Investopedia, Excise Tax: https://www.investopedia.com/terms/e/excisetax.asp
For executives facing change-of-control situations, understanding the golden parachute payment excise tax is essential for effective financial planning and avoiding unexpected tax bills during crucial transitions.