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The Internal Revenue Service’s latest attempt to “clarify” the “golden parachutes” rules falls short of addressing the real issues underlying the improvident 1984 legislation that imposes tax burdens on excess parachute payments. The blunt instrument of tax law has failed to curb the perceived corporate abuses of over a decade ago and taxpayers’ recourse now is to beseech the IRS for more meaningful “clarifications” before the newly proposed regulations become final. “Excess parachute payments” can be non-deductible to the payor and can subject the recipient to a 20 percent excise tax. The test for whether an excess parachute payment exists is deceptively simple to articulate, but can be devilish to calculate. If a payment is: (a) in the nature of compensation and contingent upon a change-in-control; and (b) the aggregate present value of all such contingent payments exceeds three times the disqualified person’s five year average taxable compensation income (the “Base Amount”); then (c) the “excess parachute payments” are all amounts in excess of the Base Amount, less (d) amounts deemed “reasonable compensation” for services rendered or to be rendered (or forborne from) by the disqualified person. The deduction is lost and the excise tax is imposed under �� 280G and 4999 of the Internal Revenue Code, respectively. The IRS originally issued proposed regulations in 1989 in a question-and-answer format (the “1989 Q&As”). With time, the 1989 Q&As have garnered a certain aura of permanence, though final regulations were never issued. Tax practitioners have tested, and often stretched, the boundaries of the 1989 Q&As. The new proposed regulations (the “2002 Proposals”) are aimed at “clarifying” the 1989 Q&As in a number of areas. THE 2002 PROPOSALS The 2002 Proposals clarify that a shareholder of both parties to a merger is treated as a separate shareholder of each in determining whether a 50 percent change-in-control has occurred for purposes of determining whether shareholders acting as a group controlled a corporation. The proposals also eliminate the rule that would treat a shareholder owning $1,000,000 of stock as a “disqualified” person, leaving the rule that so designates one owning 1 percent or more of the corporation’s stock and confirming that shares subject to vested options — including those that vest as a result of the change-in-control — are deemed owned. In addition, the 2002 Proposals “clarify” that the full amount of severance payments, accelerated payments of amounts otherwise payable on attainment of performance goals, and accelerated salary payments are included in determining parachute payments. The proposals confirm that payments in exchange for a covenant not to compete may constitute exempt reasonable compensation for post change-in-control services; but clear and convincing evidence must demonstrate that the covenant in fact substantially constrains the person’s ability to perform services and there must be a reasonable likelihood of enforcement. Similarly, under the proposals if an executive’s salary goes up after the change-in-control, but his or her duties do not change, the increase may not be reasonable compensation or that portion that exceeds amounts paid to persons performing comparable services may not be reasonable compensation. Moreover, the 2002 Proposals substantially limit the scope of an exception provided for under the 1989 Q&As that excludes payments under a post-change agreement. Under the new proposals, if a pre-change agreement is replaced after the change, then payments under the new agreement are nonetheless deemed contingent on the change-in-control to the extent of the amounts that would have been paid under the old agreement. TOSSING A BONE Excess parachute payments do not include payments made by a non-public corporation approved by a 75 percent vote of persons holding the stock of the corporation immediately before the change-in-control, without regard to how long before the vote took place. However, under the 1989 Q&As, the shareholder vote has to determine the employee’s right to receive or retain the parachute payment. Significant shareholder changes may have occurred between the date of the grant and the date of the change-in-control. The 2002 Proposals toss a relatively insignificant bone by allowing shareholder approval based upon shareholders of record within three months of the actual change-in-control. However, the intrinsic problem of shifting ownership percentages over time for venture-financed companies is not addressed, which continues to render the safe-harbor of little help in a large number of cases. The proposals do provide that shareholder approval may be limited to the portion of the payments that would cause the disqualified person to have excess parachute payments absent the approval. This change may assist those shareholders who receive grants of stock or options in a series. The 2002 Proposals are effective for payments related to changes in control occurring after Dec. 31, 2003. In the interim, taxpayers may rely on either the 1989 Q&As or the 2002 Proposals. Sabino Rodiguez is chair of Day, Berry & Howard‘s business law department and a member of its M&A and Tax Groups. Derek Gilman is counsel at the firm and a member of its M&A and Tax Groups.

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