[Federal Register Volume 67, Number 34 (Wednesday, February 20, 2002)]
[Proposed Rules]
[Pages 7630-7656]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-3819]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-209114-90]
RIN 1545-AH49
Golden Parachute Payments
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to golden
parachute payments to provide guidance to taxpayers who must comply
with section 280G. Proposed regulations under section 280G were
previously published in the Federal Register on May 5, 1989 (the 1989
proposed regulations). These proposed regulations are proposed to apply
to any payments that are contingent on a change in ownership or control
occurring on or after January 1, 2004. Taxpayers may rely on these
proposed regulations until the effective date of the final regulations.
Alternatively, taxpayers may rely on the 1989 regulations for any
payment contingent on a change in ownership or control that occurs
prior to January 1, 2004.
DATES: Written or electronic comments must be received by June 5, 2002.
Requests to speak and outlines of topics to be discussed at the public
hearing scheduled for June 26, 2002, must be received by June 5, 2002.
ADDRESSES: Send submissions to CC:ITA:RU (REG-209114-90), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG-209114-90),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW,
Washington, DC or sent electronically, via the IRS Internet site
www.irs.gov/regs. The public hearing will be held in the IRS
Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Erinn
Madden at (202) 622-6030 (not a toll-free number). To be placed on the
attendance list for the hearing, please contact LaNita M. Vandyke at
(202) 622-7180.
SUPPLEMENTARY INFORMATION:
Background
This document contains proposed amendments to 26 CFR part 1 under
section 280G of the Internal Revenue Code (Code). Sections 280G and
4999 of the Code were added to the Code by sec. 67 of the Deficit
Reduction Act, Public Law 98-369 (98 Stat. 585). Section 280G was
amended by sec. 1804(j) of the Tax Reform Act of 1986, Public Law 99-
514 (100 Stat. 2807), sec. 1018(d) of the Technical and Miscellaneous
Revenue Act of 1988, Public Law 100-647 (102 Stat. 3581) and sec. 1421
of the Small Business Job Protection Act of 1996, Public Law 104-188
(110 Stat. 1755).
Section 280G denies a deduction to a corporation for any excess
parachute payment. Section 4999 imposes a 20-percent excise tax on the
recipient of any excess parachute payment. Related provisions include
section 275(a)(6), which denies the recipient a deduction for the
section 4999 excise tax, and section 3121(v)(2)(A), which relates to
Federal Insurance Contributions Act. Proposed regulations (PS-217-84)
under section 280G were previously published in the Federal Register at
54 FR 19390 on May 5, 1989 (the 1989 proposed regulations).
Explanation of Provisions
Overview
Section 280G denies a deduction to a corporation for any excess
parachute payment. Section 4999 imposes a 20-percent excise tax on the
recipient of any excess parachute payment. The disallowance of the
deduction under section 280G is not contingent on the imposition of the
excise tax under section 4999, and the imposition of the excise tax
under section 4999 is not contingent on the disallowance of the
deduction under section 280G. For example, an individual may be subject
to the 20-percent excise tax under section 4999 even though the payor
is a foreign corporation not subject to United States income tax.
Section 280G(b)(2)(A) defines a parachute payment as any payment
that meets all of the following four conditions: (a) The payment is in
the nature of compensation; (b) the payment is to, or for the benefit
of, a disqualified individual; (c) the payment is contingent on a
change in the ownership of a corporation, the effective control of a
corporation, or the ownership of a substantial portion of the assets of
a corporation (a change in ownership or control); and (d) the payment
has (together with other payments described in (a), (b), and (c) of
this paragraph with respect to the same individual) an aggregate
present value of at least 3 times the individual's base amount. Section
280G(b)(2)(B) provides that the term parachute payment also includes
any payment in the nature of compensation to, or for the benefit of, a
disqualified individual if the payment is pursuant to an agreement that
violates any generally enforced securities laws or regulations
(securities violation parachute payment).
Section 280G(b)(1) defines the term excess parachute payment as an
amount equal to the excess of any parachute payment over the portion of
the disqualified individual's base amount that is allocated to such
payment. For this purpose, the portion of the base amount allocated to
a parachute payment is the amount that bears the same ratio to the base
amount as the present value of the parachute payment bears to the
aggregate present value of all such payments to the same disqualified
individual.
Generally, excess parachute payments may be reduced by certain
amounts of reasonable compensation. Section 280G(b)(4)(B) provides
that, except in the case of securities violation parachute payments,
the amount of an excess parachute payment is reduced by any portion of
the payment that the taxpayer establishes by clear and convincing
evidence is reasonable compensation for personal services actually
rendered by the disqualified individual before the date of change in
ownership or control. Such reasonable compensation is first offset
against the portion of the base amount allocated to the payment.
[[Page 7631]]
The 1989 proposed regulations provided guidance regarding the
application of section 280G to corporations and individuals. Although
many aspects of the 1989 proposed regulations were well-received, the
IRS has received numerous comments requesting modification and
clarification of the 1989 proposed regulations. In response, these
proposed regulations clarify and revise, as described below, the 1989
proposed regulations. Many aspects of the 1989 proposed regulations are
preserved, and these proposed regulations retain the same
organizational structure as the 1989 proposed regulations. Major
modifications to the 1989 proposed regulations are described below.
Disqualified Individuals
A payment constitutes a parachute payment only if the payment is
made to (or for the benefit of) a disqualified individual. Section
280G(c) defines the term disqualified individual to include any
individual who (a) is an employee or independent contractor who
performs personal services for a corporation, and (b) is an officer,
shareholder, or highly-compensated individual.
The determination of whether an individual is a disqualified
individual under these proposed regulations is substantially the same
as under the 1989 proposed regulations, with three significant changes.
First, Q/A-17 of the 1989 regulations provides a de minimis rule for
purposes of identifying which shareholders of a corporation are
disqualified individuals. Under the 1989 proposed regulations, an
individual is a shareholder for purposes of section 280G if the
individual, at any time during the disqualified individual
determination period, owns stock of a corporation with a fair market
value exceeding the lesser of $1 million or 1 percent of the total fair
market value of the outstanding shares of all classes of the
corporation's stock. Since the issuance of the 1989 proposed
regulations, it has become apparent that this rule may include
individuals who do not possess significant influence over the
corporation. Therefore, under Q/A-17 of these proposed regulations, the
$1 million test is eliminated. Under these proposed regulations, an
individual is a shareholder only if, during the disqualified individual
determination period, the individual owns stock of a corporation with a
fair market value that exceeds 1 percent of the total fair market value
of the outstanding shares of all classes of the corporation's stock.
The constructive ownership rules of section 318(a) continue to apply
for purposes of determining the amount of stock owned by the
individual. Under these rules, for example, to determine the amount of
stock owned by an individual, the stock underlying vested stock options
is considered constructively owned by that individual.
Second, these proposed regulations modify the annualized
compensation method for determining who is a highly-compensated
individual under Q/A-19. Under the 1989 proposed regulations, no
individual whose annualized compensation during the disqualified
individual determination period is less than $75,000 is treated as a
highly-compensated individual, even if the individual otherwise
satisfies the definition of a highly-compensated individual. Q/A-19 is
modified to provide that an individual must have annualized
compensation equal to at least the amount described in section
414(q)(1)(B)(i). This amount for 2002 is $90,000 and is adjusted
periodically for cost-of-living increases. This modification both
updates the amount provided in the 1989 proposed regulations and
provides a mechanism to update this amount periodically without further
amendment of these regulations.
Finally, these proposed regulations change the disqualified
individual determination period under Q/A-20. Under the 1989 proposed
regulations, the disqualified individual determination period is the
portion of the year of the corporation ending on the date of the change
in ownership or control and the immediately preceding twelve months
(with an option to use the calendar year or the corporation's fiscal
year). Q/A-20 of these proposed regulations is modified to change this
period to the twelve months prior to and ending on the date of the
change in ownership or control of the corporation. Under this rule, the
disqualified individual determination period is the same length for any
change in ownership or control and is not affected by the date of the
change in ownership or control.
Payment in the Nature of Compensation
A payment may be a parachute payment only if it is a payment in the
nature of compensation. All payments, in whatever form, are payments in
the nature of compensation if the payments arise out of the employment
relationship or are associated with the performance of services. In Q/
A-11, these proposed regulations clarify that payments in the nature of
compensation include cash, the right to receive cash, or a transfer of
property.
Q/A-13 of the 1989 proposed regulations provides that the transfer
of a nonstatutory option is treated as a payment in the nature of
compensation (even if the option does not have a readily ascertainable
fair market value within the meaning of Sec. 1.83-7(b)). The 1989
proposed regulations reserve the issue of the treatment of statutory
options (i.e., options to which section 421 applies). These proposed
regulations revise Q/A-13 to address the treatment of statutory stock
options to provide that nonstatutory stock options and statutory stock
options are treated the same. Because both the transfer of a statutory
option and the transfer of a nonstatutory stock option are payments in
the nature of compensation, there is no basis for distinguishing
between these two types of options for purposes of section 280G.
In addition, these proposed regulations revise Q/A-13 with respect
to the valuation of both statutory and nonstatutory stock options.
Under the 1989 proposed regulations, the value of an option with an
ascertainable fair market value is determined under all the facts and
circumstances, including the difference between the option's exercise
price and the value of the property at the time of vesting, the
probability of an increase or decrease in the value of such property,
and the length of the option exercise period.
Since the issuance of the 1989 proposed regulations, commentators
have indicated that Q/A-13 does not provide sufficient guidance about
the determination of the value of a stock option. In particular,
commentators question whether the intrinsic value of the option (the
difference between the exercise price and the value of the property, or
spread) determined at the time of the change in ownership or control,
or a value determined under a valuation model such as Black-Scholes,
should be used for purposes of section 280G. Using the factors listed
in the 1989 proposed regulations results in a value different from the
value obtained from using only the difference between the exercise
price and the value of the property. Commentators have also noted that
valuation methods other than spread are often complicated and difficult
to apply in some circumstances, particularly when the stock underlying
the option is not publicly traded.
These proposed regulations continue to provide for the use of the
factors described in the 1989 proposed regulations. To provide further
guidance on acceptable and administrable methods for valuing stock
options, these proposed regulations delegate authority to the
Commissioner to provide methods for valuation of stock options
[[Page 7632]]
through published guidance. Rev. Proc. 2002-13, 2002-8 I.R.B. (February
25, 2002) published in conjunction with these proposed regulations,
provides several valuation methods. One of the methods permitted under
this revenue procedure is a simplified safe harbor approach modeled
after the Black-Scholes valuation method. The safe harbor allows a
corporation to establish a value for stock options based on spread at
the time of the change in ownership or control, the remaining term of
the option, and a basic assumption regarding the volatility of the
underlying stock. Other factors relevant to the Black-Scholes valuation
model, including a risk-free rate of return and dividend yield, are
addressed in the table contained in the revenue procedure. The safe
harbor valuation method provided in the revenue procedure may be used
without regard to whether the underlying stock is publicly traded.
Contingent on Change
To be a parachute payment, a payment in the nature of compensation
to a disqualified individual must be contingent on a change in
ownership or control. Q/A-22 of the 1989 proposed regulations provides
guidance on when a payment is contingent on a change in ownership or
control. Generally, a payment is treated as contingent on a change in
ownership or control if the payment would not in fact have been made
had no change in ownership or control occurred. A payment generally is
treated as one which would not in fact have been made in the absence of
a change in ownership or control unless it is substantially certain, at
the time of the change, that the payment would have been made whether
or not the change in ownership or control occurred.
These proposed regulations clarify in Q/A-22 that a payment is
contingent on a change in ownership or control if the payment would not
have been made absent the change in ownership or control, even if the
payment is also contingent on a second event, such as termination of
employment within a period following the change in ownership or
control. In addition, as under the 1989 proposed regulations, a payment
generally is treated as contingent on a change in ownership or control
if (a) the payment is contingent on an event that is closely associated
with such a change, (b) a change in ownership or control actually
occurs, and (c) the event is materially related to the change in
ownership or control. The fact that a payment that is contingent on an
event closely associated with a change in ownership or control is also
conditioned on the occurrence of a second event does not affect the
determination that the payment is contingent on a change in ownership
or control as the result of the occurrence of the first event.
Under Q/A-24 of the 1989 proposed regulations, the entire amount of
a payment is generally treated as contingent on a change in ownership
or control. These proposed regulations clarify that the general rule of
Q/A-24(a) (and not the special rules in either Q/A-24(b) or (c),
discussed below) applies to the payment of amounts due under an
employment agreement on a termination of employment or change in
ownership or control that, without regard to the change, would have
been paid for the performance of services after the termination of
employment or change in ownership or control, as applicable. Also, the
general rules of Q/A-24(a) apply to the accelerated payment of an
amount that is otherwise payable only on the attainment of a
performance goal or contingent on an event or condition other than the
continued performance of services for a specified period of time. In
situations governed by Q/A-24(a), the determination of whether a
portion of the payment is reasonable compensation for services rendered
before, on, or after the change in ownership or control is determined
under Q/As-38 through 44. With respect to amounts due under an
employment agreement, however, in most situations, a reduction for
reasonable compensation for services rendered before the change in
ownership or control is inappropriate, given the general expectation
that an individual is not under-compensated for services rendered
before a change in ownership or control. See Conf. Rep. No. 98-861, at
852 (1984).
Q/A-24(b) and (c) provide an objective method for determining the
portion of a payment that is treated as contingent on a change in
ownership or control for certain types of payments. These rules are not
appropriate in situations such as the acceleration of salary payments
under an employment agreement, when the periodic nature of the payments
for services means that there is no issue in determining the amount of
the payment that is accelerated, or in situations where a payment is
conditioned on achievement of a performance goal or other event.
As under the 1989 proposed regulations, these proposed regulations
provide that a payment is treated as contingent on a change in
ownership or control if the change accelerates the time at which the
payment is made or accelerates the vesting of a payment. Q/A-24(b) and
(c) provide rules for determining the portion of such payment that is
treated as contingent on the change in ownership or control. These
proposed regulations clarify when Q/A-24(b) and (c) apply to a
contingent payment.
These proposed regulations clarify that Q/A-24(b) applies if a
payment is vested, without regard to the change in ownership or
control, and is treated as contingent on a change in ownership or
control because the change accelerates the time the payment is made.
For example, if an individual has a vested right to a payment at normal
retirement age under a nonqualified deferred compensation plan, but
instead that payment is made immediately following a change in
ownership or control, Q/A-24(b) applies to determine the portion, if
any, of the payment that is treated as contingent on the change in
ownership or control.
These regulations clarify that Q/A-24(c) applies to a payment that
becomes vested as a result of a change in ownership or control to the
extent that (i) without regard to the change, the payment was
contingent only on the performance of services for the corporation for
a specified period of time and (ii) the payment is attributable, at
least in part, to the performance of services before the date the
payment is made or becomes certain to be made. For example, if an
individual will receive a bonus if employed at the end of a 3-year
period, but the bonus is paid immediately on the date of the change of
control, Q/A-24(c) applies to determine the portion of the payment that
is treated as contingent on the change in ownership or control.
Q/A-24(b) provides that, when a payment is accelerated, the portion
of the payment that is contingent on the change is the amount by which
the accelerated payment exceeds the present value of the payment absent
acceleration. Q/A-24(b) further provides that if the amount of a
payment without acceleration is not reasonably ascertainable, and the
acceleration does not significantly increase the value of the payment,
then the present value of the payment absent the acceleration is equal
to the amount of the accelerated payment. As a result, the value of the
accelerated payment is equal to the value of the payment absent
acceleration and no portion of the payment is treated as contingent on
a change in control. If the value of a payment absent acceleration is
not reasonably ascertainable and the acceleration significantly
increases the value of the payment, the future value of the payment is
equal to the amount
[[Page 7633]]
of the accelerated payment. When the future value (as opposed to the
present value) of the payment is deemed to be the amount of the
accelerated payment, then there is an excess and, therefore, a portion
of the payment is treated as contingent on the change.
Q/A-24(c) provides that the portion of the payment treated as
contingent on the change when both vesting and payment are accelerated
is the lesser of (1) the payment or (2) the amount determined under Q/
A-24(b) plus an additional amount to reflect the lapse of the
obligation to perform additional services. Q/A-24(c) provides that for
purposes of determining the amount under paragraph (b), the
acceleration of the vesting of a stock option or the lapse of a
restriction on restricted stock is considered to increase significantly
the value of the payment.
Because Q/A-24(b) and (c) operate to provide an objective basis for
determining the portion of a payment that is earned as of the date of a
change in ownership or control, and therefore, not contingent on a
change in ownership or control, these proposed regulations clarify that
the rules in
Q/As-38 through 44 (which provide rules related to reasonable
compensation for services rendered), are inapplicable if the special
rules in Q/A-24(b) or (c) apply to a payment.
Change in Ownership or Control
These proposed regulations follow the same approach as the 1989
proposed regulations for determining when a change in ownership or
control occurs. However, these proposed regulations clarify that, for
purposes of determining whether two or more persons acting as a group
are considered to own more than 50 percent of the total fair market
value or total voting power of the stock of a corporation on the date
of a merger, acquisition, or similar transaction involving that
corporation, a person who owns stock in both corporations involved in
the transaction is treated as acting as a group with respect to the
other shareholders in a corporation only to the extent of such person's
ownership of stock in that corporation prior to the transaction, and
not with respect to his or her ownership in the other corporation. For
example, assume individual A owns stock in both corporations X and Y
when corporation X acquires stock in Y in exchange for X stock. In
determining whether corporation Y has undergone a change in ownership
or control, individual A is considered to be acting as a group with
other shareholders in corporation Y only to the extent of A's holdings
in corporation Y prior to the transaction, and not with respect to A's
ownership in X. In determining whether Corporation X has undergone a
change in ownership or control, individual A is considered to be acting
as a group with other shareholders in Corporation X only to the extent
of individual A's holdings in Corporation X prior to the transaction,
and not with respect to individual A's ownership interest in
Corporation Y. This rule applies without regard to the type of
shareholder involved (i.e., whether the shareholder is an individual or
an institutional shareholder, such as a corporation, mutual fund, or
trust).
Comments are requested with respect to whether the change in
ownership or control rules in these proposed regulations should be
further revised. Comments are also requested with respect to whether
additional guidance is necessary regarding the application of the
change in ownership or control provisions, and these proposed
regulations in general, in the context of specific business situations
such as bankruptcy.
Shareholder Approval Requirements
Section 280G specifically exempts from the definition of the term
parachute payment several types of payments that would otherwise
constitute parachute payments. Deductions for payments exempt from the
definition of parachute payment are not disallowed by section 280G, and
such exempt payments are not subject to the 20-percent excise tax of
section 4999. In addition, such exempt payments are not taken into
account in applying the 3-times-base-amount test of section
280G(b)(2)(A)(ii).
The most significant revisions made by these proposed regulations
with respect to exempt payments are clarifications to the shareholder
approval requirements which must be met for payments with respect to a
corporation in which no stock is readily tradeable on an established
securities market or otherwise immediately before the change in
ownership or control.
Section 280G(b)(5)(B) provides that the shareholder approval
requirements are met if two conditions are satisfied. First, the
payment is approved by a vote of the persons who owned, immediately
before the change in ownership or control, more than 75% of the voting
power of all outstanding stock of the corporation. Second, there is
adequate disclosure to shareholders of all material facts concerning
all payments which (but for this rule) would be parachute payments with
respect to a disqualified individual. Since the issuance of the 1989
proposed regulations, commentators have indicated that the 1989
proposed regulations do not fully explain how the shareholder approval
requirements operate or accurately reflect business practices connected
with a change in ownership or control.
The proposed regulations clarify the process of obtaining
shareholder approval within the structure provided by section
280G(b)(5)(B). Under this section, a shareholder approval vote is valid
only if (1) it is a vote of more than 75% of the shareholders entitled
to vote based on ownership in the corporation immediately before the
change in ownership or control, and (2) disclosure is made with respect
to all payments that would otherwise be parachute payments for an
individual.
The first step in obtaining shareholder approval is to identify the
shareholders entitled to vote. Q/A-7 is revised to clarify that stock
held by a disqualified individual (or by certain entity shareholders)
is not entitled to vote with respect to a payment to be made to any
disqualified individual and that this stock is disregarded in
determining whether the more than 75% approval requirement has been
met. Once the stock entitled to vote is determined, more than 75% of
the voting power of such stock must approve the payment. Q/A-7 also
includes a rule of administrative convenience providing that a vote to
approve the payment does not fail to be a vote of the shareholders who
own stock immediately before the change in ownership or control if
eligibility to vote is based on the shareholders of record at the time
of any vote taken in connection with a transaction or event giving rise
to the change in ownership or control within the three-month period
ending on the date of the change in ownership or control. This rule
only applies if the disclosure requirements are also met.
These proposed regulations further clarify that not all parachute
payments must be subject to a shareholder vote to satisfy the
shareholder approval requirements with respect to a payment. It is
permissible for only a portion of the payments that would otherwise be
made to a disqualified individual to be subject to vote. For example,
assume that a disqualified individual with a base amount of $150,000
would receive payments that (but for the exemption for a corporation
with no readily tradeable stock) would be parachute payments including
(i) a bonus payment of $200,000, (ii) vesting in stock options with a
fair market value of $500,000, $200,000 of which is contingent on the
change in ownership or control, and (iii) severance payments of
$100,000. In this
[[Page 7634]]
situation, assuming all of the payments are disclosed, the corporation
may submit to the shareholders for approval (1) all of the payments,
(2) any one of the three payments, or (3) $50,001 of any one of the
payments (e.g., options with a value of $50,001). The issue submitted
to a shareholder vote must be whether the payment will be made to the
disqualified individual, not whether the corporation will be able to
deduct the payment. In addition, the vote must be a separate vote of
the shareholders. Therefore, the merger, acquisition, or other
transaction cannot be conditioned on the shareholders' approval of the
payment.
These proposed regulations also clarify that the shareholder
approval requirements are met by a single vote on all payments
submitted to the vote, including payments to more than one disqualified
individual (assuming the disclosure requirements, described below, are
also met).
The shareholder approval requirements also require adequate
disclosure of all material facts concerning the amount of all parachute
payments. For this purpose, the proposed regulations clarify that the
amount of all parachute payments to be made to each disqualified
individual, and not just the amount of the payments subject to vote, is
a material fact. These proposed regulations also clarify that
shareholders should be provided with basic information about the type
of payments involved (e.g., vesting of stock options or severance
payments). This disclosure of information must be made to all
shareholders entitled to vote, not just to shareholders with 75% of the
voting power entitled to vote.
Reasonable Compensation
The determination of whether amounts are reasonable compensation is
relevant for two purposes. First, an excess parachute payment is
reduced by any portion of the payment that constitutes reasonable
compensation for services actually rendered before a change in
ownership or control. Second, amounts that are reasonable compensation
for services to be rendered after a change in ownership or control are
exempt from the definition of parachute payment. In both situations,
reasonable compensation for services must be demonstrated by clear and
convincing evidence.
These proposed regulations clarify two issues with respect to
reasonable compensation for services performed after a change in
ownership or control. The proposed regulations clarify that clear and
convincing evidence that a payment is reasonable compensation for
services rendered after a change in ownership or control exists if the
individual's annual compensation after the change in ownership or
control (apart from normal increases) is not significantly greater then
the individual's annual compensation before the change in ownership or
control, provided that the individual's duties and responsibilities are
substantially the same after the change in ownership or control as they
were before the change in ownership or control. If the individual's
duties and responsibilities have changed, then the clear and convincing
evidence must demonstrate that the individual's annual compensation
after the change in ownership or control is not significantly greater
than the compensation customarily paid by the employer, or by
comparable employers, to persons performing comparable services.
Payments to an individual under an agreement that requires the
individual to refrain from providing services (such as under a covenant
not to compete) may also constitute reasonable compensation for
services to be rendered on or after the date of the change in ownership
or control. Under Q/A-42 of these proposed regulations, an agreement is
treated as an agreement to refrain from services (rather than an
agreement for severance pay) if it is demonstrated with clear and
convincing evidence that the agreement substantially constrains the
individual's ability to perform services and there is a reasonable
likelihood that the agreement will be enforced against the individual.
If, under the facts and circumstances, the agreement does not satisfy
these criteria, the payments under the agreement are instead treated as
severance payments under Q/A-44. If the agreement does satisfy these
criteria, then the agreement is treated as an agreement for the
performance of services, and the payment are exempt from the definition
of parachute payment to the extent the payments are show to be
reasonable compensation under Q/A-42(a)(2).
Application to Tax-Exempt Organizations
Commentators have asked whether a payment with respect to a tax-
exempt entity is exempt from the definition of the term parachute
payment. These proposed regulations clarify that a payment with respect
to a tax-exempt entity that would otherwise constitute a parachute
payment is exempt from the definition of the term parachute payment if
the following two conditions are satisfied.
First, the payment must be made by a corporation undergoing a
change in ownership or control that is a tax-exempt organization, as
defined in these proposed regulations. A tax-exempt organization is
defined as any organization described in section 501(c) that is subject
to an express statutory prohibition against inurement of net earnings
to the benefit of any private shareholder or individual, an
organization described in subsections 501(c)(1) or 501(c)(21), any
religious or apostolic organization described in section 501(d), or any
qualified tuition program described in section 529.
Second, the organization must meet the definition of tax-exempt
organization, as defined in these regulations, both immediately before
and immediately after the change in ownership or control. If this
second condition is not met, a payment made by a tax-exempt
organization is not exempt from the definition of parachute payment.
As noted above, the term tax-exempt organizations includes
organizations that are described in section 501(c) that already are
subject to express statutory rules that prohibit the inurement of the
net earnings of such organizations to the benefit of ``any private
shareholder or individual.'' Organizations described in the following
subsections of 501(c) are tax-exempt organizations under application of
this rule: 501(c)(3) (including any organization described in
subsections 501(e), (f), or (k)), 501(c)(4), 501(c)(6), 501(c)(9),
501(c)(11), 501(c)(13) (but only with respect to those organizations
subject to the express anti-inurement provision), 501(c)(19), and
501(c)(26). In light of the existing restrictions on these
organizations, the Service and the Treasury Department believe the
additional protections of section 280G are unnecessary. In addition,
the term tax-exempt organization in the proposed regulations includes
federal instrumentalities organized under Act of Congress (described in
section 501(c)(1)), black lung trusts (described in section
501(c)(21)), certain religious and apostolic organizations (described
in section 501(d)) and qualified tuition programs (described in section
529). The Service and the Treasury Department recognize that it may be
appropriate to exempt payments made by other types of tax-exempt
organizations. Comments are requested on whether any additional
categories of organizations should be included in the definition of
tax-exempt organization for purposes of section 280G.
[[Page 7635]]
Definition of Corporation
Under the 1989 proposed regulations, corporation is defined by
reference to section 7701(a)(3) of the Code. These proposed regulations
clarify that the term corporation, for purposes of section 280G and the
regulations thereunder, includes any entity described in Sec. 301.7701-
2(b) such as, for example, a real estate investment trust under section
856(a), a corporation that has mutual or cooperative (rather than
stock) ownership, such as a mutual insurance company, a mutual savings
bank, or a cooperative bank (as defined in section 7701(a)(32)), and a
foreign corporation (as defined in section 7701(a)(5)).
Accordingly, the term corporation also includes any entity
described in Sec. 301.7701-3(c)(1)(v)(A). That regulation provides, in
general, that an entity that claims to be, or is determined to be, an
entity that is exempt from taxation under section 501(a) is treated as
an association for purposes of the Code. Because the definition of
corporation includes an association, any entity described in
Sec. 301.7701-3(c)(1)(v)(A) is a corporation for purposes of sections
7701 and 280G.
Determination of Excess Parachute Payments
Once all parachute payments are identified, the determination of
what portion, if any, of each parachute payment is an excess parachute
payment is made. This determination is based on the aggregate present
value of all parachute payments. These proposed regulations modify the
method described in Q/A-33 of the 1989 proposed regulations for
determining the present value of a payment contingent on an uncertain
future event or condition. Under Q/A-33 of these proposed regulations,
if there is at least a 50-percent probability that the payment will be
made, the entire present value of a contingent payment should be
included for purposes of determining if there are excess parachute
payments. If there is less than a 50-percent probability, then the
present value of the contingent payment is not included. Once it is
certain whether or not the payment will be made, the 3-times-base
amount test in Q/A-30 is reapplied if the initial determination as to
whether to include the payment was incorrect. If the inclusion or
exclusion of the payment for purposes of Q/A-30 at the time of the
change in ownership or control was correct, there is no need to reapply
the 3-times-base-amount test. In addition, if it is reasonably
estimated that there is a less than 50-percent probability that the
payment will be made and the payment is not included in the 3-times-
base-amount test, but the payment is later made, the 3-times-base-
amount test is not reapplied if the test without regard to the
contingent payment resulted in a determination that the individual
received (or would receive) excess parachute payments and no base
amount is allocated to the contingent payment.
Finally, Q/A-31 provides guidance on determining the present value
of an obligation to provide health care over a period of years. Under
these proposed regulations, the determination of the present value of
this obligation should be calculated in accordance with generally
accepted accounting principles. For purposes of Q/A-31, it is
permissible for the obligation to provide health care to be measured by
projecting the cost of premiums for purchased health care insurance,
even if no health care insurance is actually purchased. If the
obligation to provide health care is made in coordination with a health
care plan that the corporation makes available to a group, then the
premiums used for this purpose may be group premiums. This method only
applies for purposes of determining present value. Premiums for health
care insurance can be used for purposes of determining a corporation's
loss of deduction or the excise tax obligation for a disqualified
individual only to the extent such premiums are actually paid for
health care insurance used to satisfy the corporation's obligation to
provide health care.
Timing of the Payment of Tax under Section 4999
In general, the excise tax under section 4999 is due at the time
that the payment is considered made under Q/A-11 through 13. Q/A-11(b)
of these proposed regulations clarifies that, except as provided in Q/
A-12 or 13, a payment is considered made in the taxable year that it is
includible in the disqualified individual's gross income, or for
benefits excludible from income, in the year the benefit is received.
Q/A-11(c) of these proposed regulations permits a disqualified
individual, for purposes of section 4999, to treat certain payments as
made in the year of the change in ownership or control (or the first
year for which a payment contingent on a change in ownership or control
is certain to be made), even though the payment is not yet includible
in income (or otherwise received). This treatment is not available,
however, for a payment if the present value is not reasonably
ascertainable within the meaning of section 3121(v) and Sec. 1.3121(v)-
1(e)(4) or for a payment related to health benefits or coverage. These
proposed regulations indicate in Q/A-11(c) that the Commissioner may
provide through published guidance that Q/A-11(c) is or is not
available with respect to other types of payments.
According to Q/A-11(c) of these proposed regulations, the payment
of the excise tax under section 4999 must be made based on the amount
calculated for purposes of determining excess parachute payments.
Therefore, to the extent that the determination of whether there is an
excess parachute payment is based on an incorrect valuation of the
payment, the excise tax payment under this provision is also incorrect.
Proposed Effective Date
These regulations are proposed to apply to any payments that are
contingent on a change in ownership or control occurring on or after
January 1, 2004. Taxpayers may rely on these proposed regulations until
the effective date of the final regulations. Alternatively, taxpayers
may rely on the 1989 proposed regulations for any payment contingent on
a change in ownership or control that occurs prior to January 1, 2004.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It has also
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and, because
the regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f), this notice of proposed rulemaking
will be submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written or electronic comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. All comments will be available for public inspection and copying.
A public hearing has been scheduled for June 26, 2002, beginning at
10 a.m. in the IRS Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW, Washington, DC. All
[[Page 7636]]
visitors must present photo identification to enter the building.
Because of access restrictions, visitors will not be admitted beyond
the immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the building
access list to attend the hearing, see the FOR FURTHER INFORMATION
CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written
comments and an outline of the topics to be discussed and the time to
be devoted to each topic (signed original and eight (8) copies) by June
5, 2002. A period of 10 minutes will be allotted to each person for
making comments. An agenda showing the schedule of speakers will be
prepared after the deadline for receiving outlines has passed. Copies
of the agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these proposed regulations is Erinn Madden,
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities). However, other personnel from the IRS and
Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
The proposed amendments to 26 CFR part 1 are as follows:
PART I--INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1986
1. The authority citation for part 1 is amended by adding the
following entry in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.280G-1 also issued under 26 U.S.C. 280G (b) and (e). *
* *
2. Section Sec. 1.280G-1 is added to read as follows:
Sec. 1.280G-1 Golden parachute payments.
The following questions and answers relate to the treatment of
golden parachute payments under section 280G of the Internal Revenue
Code of 1986, as added by section 67 of the Tax Reform Act of 1984
(Pub. L. 98-369; 98 Stat. 585) and amended by section 1804(j) of the
Tax Reform Act of 1986 (Pub. L. 99-514; 100 Stat. 2807), section
1018(d) (6)-(8) of the Technical and Miscellaneous Revenue Act of 1988
(Pub. L. 100-647; 102 Stat. 3581), and section 1421 of the Small
Business Job Protection Act of 1996 (Pub. L. 104-188, 110 Stat. 1755).
The following is a table of contents for this section:
Overview:
Effect of section 280G................................. Q/A-1
Meaning of ``parachute payment''....................... Q/A-2
Meaning of ``excess parachute payment''................ Q/A-3
Effective date of section 280G......................... Q/A-4
Exempt Payments:
Exempt payments generally.............................. Q/A-5
Exempt payments with respect to certain corporations... Q/A-6
Shareholder approval requirements...................... Q/A-7
Exempt payments under a qualified plan................. Q/A-8
Exempt payments of reasonable compensation............. Q/A-9
Payor of Parachute Payments................................ Q/A-10
Payments in the Nature of Compensation:
The nature of compensation............................. Q/A-11
Property transfers..................................... Q/A-12
Stock options.......................................... Q/A-13
Reduction of amount of payment by consideration paid... Q/A-14
Disqualified Individuals:
Meaning of ``disqualified individual''................. Q/A-15
Personal service corporation treated as individual..... Q/A-16
Meaning of ``shareholder''............................. Q/A-17
Meaning of ``officer''................................. Q/A-18
Meaning of ``highly-compensated individual''........... Q/A-19
Meaning of ``disqualified individual determination Q/A-20
period''..............................................
Meaning of ``compensation''............................ Q/A-21
Contingent on Change in Ownership or Control:
General rules for determining payments contingent on Q/A-22
change................................................
Payments under agreement entered into after change..... Q/A-23
Amount of payment contingent on change................. Q/A-24
Presumption that payment is contingent on change....... Q/A-25, 26
Change in ownership or control......................... Q/A-27, 28,
29
Three-Times-Base-Amount Test for Parachute Payments:
Three-times-base-amount test........................... Q/A-30
Determination of present value......................... Q/A-31, 32,
33
Meaning of ``base amount''............................. Q/A-34
Meaning of ``base period''............................. Q/A-35
Special rule for determining base amount............... Q/A-36
Securities Violation Parachute Payments.................... Q/A-37
Computation and Reduction of Excess Parachute Payments:
Computation of excess parachute payments............... Q/A-38
Reduction by reasonable compensation................... Q/A-39
Determination of Reasonable Compensation:
General criteria for determining reasonable Q/A-40
compensation..........................................
Types of payments generally considered reasonable Q/A-41, 42,
compensation.......................................... 43
[[Page 7637]]
Treatment of severance payments........................ Q/A-44
Miscellaneous rules:
Definition of corporation.............................. Q/A-45
Treatment of affiliated group as one corporation....... Q/A-46
Effective date:
General effective date of section 280G................. Q/A-47
Effective date of regulations.......................... Q/A-48
Overview
Q-1: What is the effect of Internal Revenue Code section 280G?
A-1: (a) Section 280G disallows a deduction for any excess
parachute payment paid or accrued. For rules relating to the imposition
of a nondeductible 20-percent excise tax on the recipient of any excess
parachute payment, see Internal Revenue Code sections 4999, 275(a)(6),
and 3121(v)(2)(A).
(b) The disallowance of a deduction under section 280G is not
contingent on the imposition of the excise tax under section 4999. The
imposition of the excise tax under section 4999 is not contingent on
the disallowance of a deduction under section 280G. Thus, for example,
because the imposition of the excise tax under section 4999 is not
contingent on the disallowance of a deduction under section 280G, a
payee may be subject to the 20-percent excise tax under section 4999
even though the disallowance of the deduction for the excess parachute
payment may not directly affect the federal taxable income of the
payor.
Q-2: What is a parachute payment for purposes of section 280G?
A-2: (a) The term parachute payment means any payment (other than
an exempt payment described in Q/A-5) that--
(1) Is in the nature of compensation;
(2) Is made or is to be made to (or for the benefit of) a
disqualified individual;
(3) Is contingent on a change--
(i) In the ownership of a corporation;
(ii) In the effective control of a corporation; or
(iii) In the ownership of a substantial portion of the assets of a
corporation; and
(4) Has (together with other payments described in paragraphs
(a)(1), (2), and (3) of this A-2 with respect to the same disqualified
individual) an aggregate present value of at least 3 times the
individual's base amount.
(b) Hereinafter, a change referred to in paragraph (a)(3) of this
A-2 is referred to as a change in ownership or control. For a
discussion of the application of paragraph (a)(1), see Q/A-11 through
Q/A-14; paragraph (a)(2), Q/A-15 through Q/A-21; paragraph (a)(3), Q/A-
22 through Q/A-29; and paragraph (a)(4), Q/A-30 through Q/A-36.
(c) The term parachute payment also includes any payment in the
nature of compensation to (or for the benefit of) a disqualified
individual that is pursuant to an agreement that violates a generally
enforced securities law or regulation. This type of parachute payment
is referred to in this section as a securities violation parachute
payment. See Q/A-37 for the definition and treatment of securities
violation parachute payments.
Q-3: What is an excess parachute payment for purposes of section
280G?
A-3: The term excess parachute payment means an amount equal to the
excess of any parachute payment over the portion of the base amount
allocated to such payment. Subject to certain exceptions and
limitations, an excess parachute payment is reduced by any portion of
the payment which the taxpayer establishes by clear and convincing
evidence is reasonable compensation for personal services actually
rendered by the disqualified individual before the date of the change
in ownership or control. For a discussion of the nonreduction of a
securities violation parachute payment by reasonable compensation, see
Q/A-37. For a discussion of the computation of excess parachute
payments and their reduction by reasonable compensation, see Q/A-38
through Q/A-44.
Q-4: What is the effective date of section 280G and this section?
A-4: In general, section 280G applies to payments under agreements
entered into or renewed after June 14, 1984. Section 280G also applies
to certain payments under agreements entered into on or before June 14,
1984, and amended or supplemented in significant relevant respect after
that date. This section applies to any payment contingent on a change
in ownership or control which occurs on or after January 1, 2004. For a
discussion of the application of the effective date, see
Q/A-47 and Q/A-48.
Exempt Payments
Q-5: Are some types of payments exempt from the definition of the
term parachute payment?
A-5: (a) Yes, the following five types of payments are exempt from
the definition of parachute payment--
(1) Payments with respect to a small business corporation
(described in Q/A-6 of this section);
(2) Certain payments with respect to a corporation no stock in
which is readily tradeable on an established securities market (or
otherwise) (described in Q/A-6 of this section);
(3) Payments to or from a qualified plan (described in Q/A-8 of
this section);
(4) Certain payments made by a corporation undergoing a change in
ownership or control that is described in any of the following sections
of the Internal Revenue Code: section 501(c) (but only if such
organization is subject to an express statutory prohibition against
inurement of net earnings to the benefit of any private shareholder or
individual, or if the organization is described in section 501(c)(1) or
section 501(c)(21)), section 501(d), or section 529, collectively
referred to as tax-exempt organizations (described in
Q/A-6 of this section); and
(5) Certain payments of reasonable compensation for services to be
rendered on or after the change in ownership or control (described in
Q/A-9 of this section).
(b) Deductions for payments exempt from the definition of parachute
payment are not disallowed by section 280G, and such exempt payments
are not subject to the 20-percent excise tax of section 4999. In
addition, such exempt payments are not taken into account in applying
the 3-times-base-amount test of Q/A-30 of this section.
Q-6: Which payments with respect to a corporation referred to in
paragraph (a)(1), (a)(2), or (a)(4) of Q/A-5 of this section are exempt
from the definition of parachute payment?
A-6: (a) The term parachute payment does not include--
(1) Any payment to a disqualified individual with respect to a
corporation which (immediately before the change in ownership or
control) was a small business corporation (as defined in section
1361(b) but without regard to section 1361(b)(1)(C) thereof),
(2) Any payment to a disqualified individual with respect to a
corporation (other than a small business corporation described in
paragraph (a)(1) of this A-6) if--
(i) Immediately before the change in ownership or control, no stock
in such
[[Page 7638]]
corporation was readily tradeable on an established securities market
or otherwise; and
(ii) The shareholder approval requirements described in Q/A-7 of
this section are met with respect to such payment; or
(3) Any payment to a disqualified individual made by a corporation
which is a tax-exempt organization (as defined in paragraph (a)(4) of
Q/A-5 of this section), but only if the corporation meets the
definition of a tax-exempt organization both immediately before and
immediately after the change in ownership or control.
(b) For purposes of paragraph (a)(1) of this A-6, the members of an
affiliated group are not treated as one corporation.
(c) The requirements of paragraph (a)(2)(i) of this A-6 are not met
if a substantial portion of the assets of a corporation undergoing a
change in ownership or control consists (directly or indirectly) of
stock in another entity (or any ownership interest in such entity) and
stock of such entity (or any ownership interest in such entity) is
readily tradeable on an established securities market or otherwise. For
this purpose, such stock constitutes a substantial portion of the
assets of an entity if the total fair market value of the stock is
equal to or exceeds one third of the total gross fair market value of
all of the assets of the entity. If a corporation is a member of an
affiliated group (which group is treated as one corporation under A-46
of this section), the requirements of paragraph (a)(2)(i) of this A-6
are not met if any stock in any member of such group is readily
tradeable on an established securities market or otherwise.
(d) For purposes of paragraph (a)(2)(i) of this A-6, the term stock
does not include stock described in section 1504(a)(4) if the payment
does not adversely affect the redemption and liquidation rights of any
shareholder owning such stock.
(e) For purposes of paragraph (a)(2)(i) of this A-6, stock is
treated as readily tradeable if it is regularly quoted by brokers or
dealers making a market in such stock.
(f) For purposes of paragraph (a)(2)(i) of this A-6, the term
established securities market means an established securities market as
defined in Sec. 1.897-1(m).
(g) The following examples illustrate the application of this
exemption:
Example 1. A small business corporation (within the meaning of
paragraph (a)(1) of this A-6) operates two businesses. The
corporation sells the assets of one of its businesses, and these
assets represent a substantial portion of the assets of the
corporation. Because of the sale, the corporation terminates its
employment relationship with persons employed in the business the
assets of which are sold. Several of these employees are highly-
compensated individuals to whom the owners of the corporation make
severance payments in excess of 3 times each employee's base amount.
Since the corporation is a small business corporation immediately
before the change in ownership or control, the payments are not
parachute payments.
Example 2. Assume the same facts as in Example 1, except that
the corporation is not a small business corporation within the
meaning of paragraph (a)(1) of this A-6. If no stock in the
corporation is readily tradeable on an established securities market
(or otherwise) immediately before the change in ownership or control
and the shareholder approval requirements described in Q/A-7 of this
section are met, the payments are not parachute payments.
Example 3. Stock of Corporation S is wholly owned by
Corporation P, stock in which is readily tradeable on an established
securities market. The Corporation S stock equals or exceeds one
third of the total gross fair market value of Corporation P, and
thus, represents a substantial portion of the assets of Corporation
P. Corporation S makes severance payments to several of its highly-
compensated individuals that are parachute payments under section
280G and Q/A-2 of this section. Because stock in Corporation P is
readily tradeable on an established securities market, the payments
are not exempt from the definition of parachute payments under this
A-6.
Example 4. A is a corporation described in section 501(c)(3),
and accordingly, its net earnings are prohibited from inuring to the
benefit of any private shareholder or individual. A transfers
substantially all of its assets to another corporation resulting in
a change in ownership or control. Contingent on the change in
ownership or control, A makes a payment that, but for the potential
application of the excemption described in A-5(a)(4), would
constitute a parachute payment. However, one or more aspects of the
transaction that constitutes the change in ownership or control
causes A to fail to be described in section 501(c)(3). Accordingly,
A fails to meet the definition of a tax-exempt organization both
immediately before and immediately after the change in ownership or
control, as required by this A-6. As a result, the payment made by A
that was contingent on the change in ownership or control is not
exempt from the definition of parachute payment under this A-6.
Example 5. B is a corporation described in section 501(c)(15).
B does not meet the definition of a tax-exempt organization because
section 501(c)(15) does not expressly prohibit inurement of B's net
earnings to the benefit of any private shareholder or individual.
Accordingly, if B has a change in ownership or control and makes a
payment pays or accrues a payment that would otherwise meet the
definition of a parachute payment, such payment is not exempt from
the definition of the term parachute payment for purposes of this A-
6.
Q-7: How are the shareholder approval requirements referred to in
paragraph (a)(2)(ii) of Q/A-6 of this section met?
A-7: (a) General rule. The shareholder approval requirements
referred to in paragraph (a)(2)(ii) of Q/A-6 of this section are met
with respect to any payment if--
(1) Such payment was approved by more than 75 percent of the voting
power of all outstanding stock of the corporation entitled to vote (as
described in this A-7) immediately before the change in ownership or
control; and
(2) There was adequate disclosure to all persons entitled to vote
(as described in this A-7) of all material facts concerning all
material payments which (but for Q/A-6 of this section) would be
parachute payments with respect to a disqualified individual.
(b) Voting requirements--(1) General rule. The vote described in
paragraph (a)(1) of this A-7 must determine the right of the
disqualified individual to receive the payment, or, in the case of a
payment made before the vote, the right of the disqualified individual
to retain the payment. For purposes of this A-7, the vote can be no
less than the full amount of the payment(s) to be made. The total
payment(s) submitted for shareholder approval must be separately
approved by the shareholders. Shareholder approval can be a single vote
on all payments submitted to vote, including payments to more than one
disqualified individual. The requirements of this paragraph (b)(1) are
not satisfied if approval of the change in ownership or control is
contingent on the approval of any payment that would be a parachute
payment but for Q/A-6 of this section to a disqualified individual.
(2) Special rule for vote within 3 months before change. A vote to
approve the payment does not fail to be a vote of the outstanding stock
of the corporation entitled to vote immediately before the change in
ownership or control merely because the determination of the
shareholders entitled to vote on the payment is based on the
shareholders of record at the time of any shareholder vote taken in
connection with a transaction or event giving rise to such change in
ownership or control and within the three-month period ending on date
of the change in ownership or control, provided the disclosure
requirements described in paragraph (c) of this A-7 are met.
(3) Entity shareholder. Approval of a payment by any shareholder
that is not an individual (an entity shareholder) generally must be
made by the person
[[Page 7639]]
authorized by the entity shareholder to approve the payment. However,
if a substantial portion of the assets of an entity shareholder
consists (directly or indirectly) of stock in the corporation
undergoing the change in ownership or control, approval of the payment
by that entity shareholder must be made by a separate vote of the
persons who hold, immediately before the change in ownership or
control, more than 75 percent of the voting power of the entity
shareholder. The preceding sentence does not apply if the value of the
stock of the corporation owned, directly or indirectly, by or for the
entity shareholder does not exceed 1 percent of the total value of the
outstanding stock of the corporation. Where approval of a payment by an
entity shareholder must be made by a separate vote of the owners of the
entity shareholder, the normal voting rights of the entity shareholder
determine which owners shall vote. For purposes of this A-7, stock
represents a substantial portion of the assets of an entity shareholder
if the total fair market value of the stock held by the entity
shareholder in the corporation undergoing the change in ownership or
control is equal to or exceeds one third of the total fair market value
of all of the assets of the entity shareholder.
(4) Attribution of stock ownership. In determining the persons who
comprise the ``more than 75 percent'' group referred to in paragraph
(a)(1) or (b)(3) of this A-7, stock is not counted as outstanding stock
if the stock is actually owned or constructively owned under section
318(a) by or for a disqualified individual who receives (or is to
receive) payments that would be parachute payments if the shareholder
approval requirements described in paragraph (a) of this A-7 were not
met. Likewise, stock is not counted as outstanding stock if the owner
is considered under section 318(a) to own any part of the stock owned
directly or indirectly by or for a disqualified individual described in
the preceding sentence. In addition, if a partner authorized by a
partnership to approve a payment is a disqualified individual with
respect to the corporation undergoing a change in ownership or control,
none of the stock held by the partnership is considered outstanding
stock. However, if all persons who hold voting power in the corporation
are disqualified individuals or related persons described in either of
the two preceding sentences, then stock owned by such persons is
counted as outstanding stock.
(5) Disqualified individuals. To satisfy the approval requirements
of paragraph (a) of this A-7, the vote of a disqualified individual who
receives (or is to receive) a payment that would be a parachute payment
if the shareholder approval requirements described in paragraph (a) of
this A-7 were not met is not considered in determining whether the more
than 75 percent vote has been obtained for purposes of any vote under
paragraph (a) of this A-7. However, if all persons who hold voting
power in the corporation are disqualified individuals or related
persons, then votes by such persons are considered in determining
whether the more than 75% vote has been obtained.
(c) Adequate disclosure. To be adequate disclosure for purposes of
paragraph (a)(2) of this A-7, disclosure must be full and truthful
disclosure of the material facts and such additional information as is
necessary to make the disclosure not materially misleading at the time
the disclosure was made. Disclosure of such information must be made to
every shareholder of the corporation entitled to vote under this A-7.
For each disqualified individual, material facts that must be disclosed
include the total amount of the payments that would be parachute
payments if the shareholder approval requirements described in
paragraph (a) of this A-7 were not met and a brief description of each
payment (e.g., accelerated vesting of options, bonus, or salary). An
omitted fact is considered a material fact if there is a substantial
likelihood that a reasonable shareholder would consider it important.
(d) Corporation without shareholders. If a corporation does not
have shareholders, the exemption described in Q/A-6(a)(2) of this
section and the shareholder approval requirements described in this A-7
do not apply. For purposes of this paragraph (d), a shareholder does
not include a member in an association, joint stock company, or
insurance company.
(e) Examples. The following examples illustrate the application of
this A-7:
Example 1. Corporation S has two shareholders--Corporation P,
which owns 76 percent of the stock of Corporation S, and A, a
disqualified individual. No stock of Corporation P or S is readily
tradeable on an established securities market (or otherwise). Stock
of Corporation S equals or exceeds one third of the assets of
Corporation P, and thus, represents a substantial portion of the
assets of Corporation P. All of the stock of Corporation S is sold
to Corporation M. Contingent on the change in ownership of
Corporation S, severance payments are made to the officers of
Corporation S in excess of 3 times each officer's base amount. If
the payments are approved by a separate vote of the persons who
hold, immediately before the sale, more than 75 percent of the
voting power of the outstanding stock of Corporation P and the
disclosure rules of paragraph (a)(2) of this A-7 are complied with,
the shareholder approval requirements of this A-7 are met, and the
payments are exempt from the definition of parachute payment
pursuant to A-6 of this section.
Example 2. Corporation M is wholly owned by Partnership P. No
interest in either M or P is readily tradeable on an established
securities market (or otherwise). Stock of Corporation M equals or
exceeds one third of the assets of Partnership P, and thus,
represents a substantial portion of the assets of Partnership P.
Corporation M undergoes a change in ownership or control.
Partnership P has one general partner and 200 limited partners. None
of the limited partners are entitled to vote on issues involving the
management of the partnership investments. If the payments that
would be parachute payments if the shareholder approval requirements
of this A-7 are not met are approved by the general partner and the
disclosure rules of paragraph (a)(2) of this A-7 are complied with,
the shareholder approval requirements of this A-7 are met, and the
payments are exempt from the definition of parachute payment
pursuant to A-6 of this section.
Example 3. Corporation A has several shareholders including X
and Y, who are disqualified individuals with respect to Corporation
A. No stock of Corporation A is readily tradeable on an established
securities market (or otherwise). Corporation A undergoes a change
in ownership or control. Contingent on the change, severance
payments are payable to X and Y that are in excess of 3 times each
individual's base amount. To determine whether the approval
requirements of paragraph (a)(1) of this A-7 are satisfied regarding
the payments to X and Y, the stock of X and Y is not considered
outstanding, and X and Y are not eligible to vote.
Example 4. Assume the same facts as in Example 3 except that
after adequate disclosure (within the meaning of paragraph (a)(2) of
this A-7) to all shareholders entitled to vote, 60 percent of the
shareholders who are entitled to vote approve the payments to X and
Y. Because more than 75 percent of the shareholders did not approve
the payments to X and Y, the shareholder approval requirements of
paragraph (a)(1) of this A-7 are not satisfied, and the payments are
not made to X and Y.
Example 5. Assume the same facts as in Example 3 except that
disclosure of all the material facts regarding the payments to X and
Y is made to two of Corporation A's shareholders, who collectively
own 80 percent of Corporation A's stock entitled to vote and approve
the payment. Assume further that no disclosure of the material facts
regarding the payments to X and Y is made to other Corporation A
shareholders who are entitled to vote within the meaning of this A-
7. Because disclosure regarding the payments to X and Y is not made
to all of Corporation A's shareholders who were entitled to vote,
the disclosure requirements of paragraph (a)(2) of this A-7 are not
met, and the payments are not exempt from the definition of
parachute payment pursuant to Q/A-6.
[[Page 7640]]
Example 6. Corporation C has three shareholders--Partnership,
which owns 20 percent of the stock of Corporation C; A, an
individual who owns 60 percent of the stock of Corporation C; and B,
an individual who owns 20 percent of Corporation C. Stock of
Corporation C does not represent a substantial portion of the assets
of Partnership. No interest in either Partnership or Corporation C
is readily tradeable on an established securities market (or
otherwise). P, a one-third partner in Partnership, is a disqualified
individual with respect to Corporation C. Corporation C undergoes a
change in ownership or control. Contingent on the change, a
severance payment is payable to P in excess of 3 times P's base
amount. To determine the persons who comprise the ``more than 75
percent group'' referred to in paragraph (a)(1) of this A-7 who must
approve the payment to P, one third of the stock held by Partnership
is not considered outstanding stock. If, however, P is the person
authorized by Partnership to approve the payment, none of the shares
of Partnership are considered outstanding stock.
Example 7. X, an employee of Corporation E, is a disqualified
individual with respect to Corporation E. No stock in Corporation E
is readily tradeable on an established securities market (or
otherwise). X, Y, and Z are all employees and disqualified
individuals with respect to Corporation E. Each individual has a
base amount of $100,000. Corporation E undergoes a change in
ownership or control. Contingent on the change, a severance payment
of $400,000 is payable to X; $600,000 is payable to Y; and
$1,000,000 is payable to Z. Corporation E provides a ballot to each
Corporation E shareholder entitled to vote under paragraph(a)(1) of
this A-7 listing the payments of $400,000 to X; $600,000 to Y; and
$1,000,000 to Z. Next to each name and corresponding amount on the
ballot, Corporation E requests approval (with a ``yes'' and ``no''
box) of each total payment to be made to each individual and states
that if the payment is not approved the payment will not be made.
Adequate disclosure, within the meaning of this A-7 is made to each
shareholder entitled to vote under this A-7. More than 75 percent of
the Corporation E shareholders who are entitled to vote under
paragraph (a)(1) of this A-7, approve each payment to each
individual. The shareholder approval requirements of this A-7 are
met, and the payments are exempt from the definition of parachute
payment pursuant to A-6 of this section.
Example 8. Assume the same facts as in Example 7 except that the
ballot does not request approval of each total payment to each
individual separately. Instead, the ballot states that $2,000,000 in
payments will be made to X, Y, and Z and requests approval of all of
the $2,000,000 payments. Assuming the nature of the payments to X,
Y, and Z are separately described to the shareholders entitled to
vote under this A-7, the shareholder approval requirements of
paragraph (a)(1) of this A-7 are met, and the payments are exempt
from the definition of parachute payment pursuant to A-6 of this
section.
Example 9. B, an employee of Corporation X, is a disqualified
individual with respect to Corporation X. Stock of Corporation X is
not readily tradeable on an established securities market (or
otherwise). Corporation X undergoes a change in ownership or
control. B's base amount is $205,000. Under B's employment agreement
with Corporation X, in the event of a change in ownership or
control, B's stock options will vest and B will receive a severance
and bonus payment. Contingent on the change, B's stock options
immediately vest with a fair market value of $500,000, $200,000 of
which is contingent on the change, and B will receive a $200,000
bonus payment and a $400,000 severance payment. Corporation X
distributes a ballot to every shareholder of Corporation X who
immediately before the change is entitled to vote. The ballot lists
the following payments to be made to B: the contingent payment of
$200,000 attributable to options, a $200,000 bonus payment, and a
$400,000 severance payment. The ballot requests shareholder approval
of the $200,000 bonus payment to B and states that whether or not
the $200,000 bonus payment is approved, B will receive $200,000
attributable to options and a $400,000 severance payment. More than
75 percent of the shareholders entitled to vote approve the $200,000
bonus payment to B. The shareholder approval requirements of this A-
7 are met, and the $200,000 payment is exempt from the definition of
parachute payment pursuant to A-6 of this section.
Q-8: Which payments under a qualified plan are exempt from the
definition of parachute payment?
A-8: The term parachute payment does not include any payment to or
from--
(a) A plan described in section 401(a) which includes a trust
exempt from tax under section 501(a);
(b) An annuity plan described in section 403(a);
(c) A simplified employee pension (as defined in section 408(k));
or
(d) A simple retirement account (as defined in section 408(p)).
Q-9: Which payments of reasonable compensation are exempt from the
definition of parachute payment?
A-9: Except in the case of securities violation parachute payments,
the term parachute payment does not include any payment (or portion
thereof) which the taxpayer establishes by clear and convincing
evidence is reasonable compensation for personal services to be
rendered by the disqualified individual on or after the date of the
change in ownership or control. See Q/A-37 of this section for the
definition and treatment of securities violation parachute payments.
See Q/A-38 through Q/A-44 of this section for rules on determining
amounts of reasonable compensation.
Payor of Parachute Payments
Q-10: Who may be the payor of parachute payments?
A-10: Parachute payments within the meaning of Q/A-2 of this
section may be paid, directly or indirectly, by--
(a) The corporation referred to in paragraph (a)(3) of Q/A-2 of
this section,
(b) A person acquiring ownership or effective control of that
corporation or ownership of a substantial portion of that corporation's
assets, or
(c) Any person whose relationship to such corporation or other
person is such as to require attribution of stock ownership between the
parties under section 318(a).
Payments in the Nature of Compensation
Q-11: What types of payments are in the nature of compensation?
A-11: (a) General rule. For purposes of this section, all
payments--in whatever form--are payments in the nature of compensation
if they arise out of an employment relationship or are associated with
the performance of services. For this purpose, the performance of
services includes holding oneself out as available to perform services
and refraining from performing services (such as under a covenant not
to compete or similar arrangement). Payments in the nature of
compensation include (but are not limited to) wages and salary,
bonuses, severance pay, fringe benefits, and pension benefits and other
deferred compensation (including any amount characterized by the
parties as interest thereon). A payment in the nature of compensation
also includes cash when paid, the value of the right to receive cash,
or a transfer of property. However, payments in the nature of
compensation do not include attorney's fees or court costs paid or
incurred in connection with the payment of any amount described in
paragraphs (a)(1), (2), and (3) of Q/A-2 of this section or a
reasonable rate of interest accrued on any amount during the period the
parties contest whether a payment will be made.
(b) When payment is considered to be made. Except as otherwise
provided in A-11 through Q/A-13 of this section, a payment in the
nature of compensation is considered made (and is subject to the excise
tax under section 4999) in the taxable year in which it is includible
in the disqualified individual's gross income or, in the case of fringe
benefits and other benefits excludible from income, in the taxable year
the benefits are received.
(c) Pre-payment rule. Notwithstanding the general rule described in
paragraph (b) of this A-11, for purposes of section 4999, a
disqualified individual is
[[Page 7641]]
permitted to treat a payment as received in the year of the change in
ownership or control or, if later, the first year in which the payment
(or payments) is certain to be made without regard to the year in which
the payment (or payments) is includible in income (or otherwise
received). The payment of the excise tax for purposes of section 4999
must be based on the amount calculated for purposes of determining any
excess parachute payments. However, a disqualified individual may not
apply this paragraph (c) of this A-11 to a payment to be made in cash
if the present value of the payment would be considered not reasonably
ascertainable under section 3121(v) and Sec. 1.3121(v)-1(e)(4) or a
payment related to health benefits or coverage. The Commissioner is
permitted to provide that this paragraph (c) is or is not available for
certain types of payments.
(d) Transfers of property. Transfers of property are treated as
payments for purposes of this A-11. See Q/A-12 of this section for
rules on determining when such payments are considered made and the
amount of such payments. See Q/A-13 of this section for special rules
on transfers of statutory and nonstatutory stock options.
Q-12: If a property transfer to a disqualified individual is a
payment in the nature of compensation, when is the payment considered
made (or to be made), and how is the amount of the payment determined?
A-12: (a) Except as provided in this A-12 and Q/A-13 of this
section, a transfer of property is considered a payment made (or to be
made) in the taxable year in which the property transferred is
includible in the gross income of the disqualified individual under
section 83 and the regulations thereunder. Thus, in general, such a
payment is considered made (or to be made) when the property is
transferred (as defined in Sec. 1.83-3(a)) to the disqualified
individual and becomes substantially vested (as defined in Sec. 1.83-
3(b) and (j)) in such individual. In such case, the amount of the
payment is determined under section 83 and the regulations thereunder.
Thus, in general, the amount of the payment is equal to the excess of
the fair market value of the transferred property (determined without
regard to any lapse restriction, as defined in Sec. 1.83-3(i)) at the
time that the property becomes substantially vested, over the amount
(if any) paid for the property.
(b) An election made by a disqualified individual under section
83(b) with respect to transferred property will not apply for purposes
of this A-12. Thus, even if such an election is made with respect to a
property transfer that is a payment in the nature of compensation, the
payment is generally considered made (or to be made) when the property
is transferred to and becomes substantially vested in such individual.
(c) See Q/A-13 of this section for rules on applying this A-12 to
transfers of stock options.
(d) The following example illustrates the principles of this A-12:
Example. On January 1, 2006, Corporation M gives to A, a
disqualified individual, a bonus of 100 shares of Corporation M
stock in connection with the performance of services to Corporation
M. Under the terms of the bonus arrangement A is obligated to return
the Corporation M stock to Corporation M unless the earnings of
Corporation M double by January 1, 2009, or there is a change in
ownership or control of Corporation M before that date. A's rights
in the stock are treated as substantially nonvested (within the
meaning of Sec. 1.83-3(b)) during that period because A's rights in
the stock are subject to a substantial risk of forfeiture (within
the meaning of Sec. 1.83-3(c)) and are nontransferable (within the
meaning of Sec. 1.83-3(d)). On January 1, 2008, a change in
ownership or control of Corporation M occurs. On that day, the fair
market value of the Corporation M stock is $250 per share. Because
A's rights in the Corporation M stock become substantially vested
(within the meaning of Sec. 1.83-3(b)) on that day, the payment is
considered made on that day, and the amount of the payment for
purposes of this section is equal to $25,000 (100 x $250). See Q/
A-38 through 41 for rules relating to the reduction of the excess
parachute payment by the portion of the payment which is established
to be reasonable compensation for personal services actually
rendered before the date of a change in ownership or control.
Q-13: How are transfers of statutory and nonstatutory stock options
treated?
A-13: (a) For purposes of this section, an option (including an
option to which section 421 applies) is treated as property that is
transferred not later than the time at which the option becomes
substantially vested (whether or not the option has a readily
ascertainable fair market value as defined in Sec. 1.83-7(b)). Thus,
for purposes of this section, the vesting of such an option is treated
as a payment in the nature of compensation. The value of an option with
an ascertainable fair market value at the time the option vests is
determined under all the facts and circumstances in the particular
case. Factors relevant to such a determination include, but are not
limited to: the difference between the option's exercise price and the
value of the property subject to the option at the time of vesting; the
probability of the value of such property increasing or decreasing; and
the length of the period during which the option can be exercised.
Valuation may be determined by any method prescribed by the
Commissioner in published guidance for purposes of this A-13. See
Q/A-33 of this section for the treatment of options the granting or
vesting of which is contingent on a change in ownership or control and
that do not have an ascertainable fair market value at the time of
granting or vesting.
(b) Any money or other property transferred to the disqualified
individual on the exercise, or as consideration on the sale or other
disposition, of an option described in paragraph (a) of this A-13 after
the time such option vests is not treated as a payment in the nature of
compensation to the disqualified individual under Q/A-11 of this
section. Nonetheless, the amount of the otherwise allowable deduction
under section 162 or 212 with respect to such transfer is reduced by
the amount of the payment described in paragraph (a) of this A-13
treated as an excess parachute payment.
Q-14: Are payments in the nature of compensation reduced by
consideration paid by the disqualified individual?
A-14: Yes, to the extent not otherwise taken into account under Q/
A-12 and Q/A-13 of this section, the amount of any payment in the
nature of compensation is reduced by the amount of any money or the
fair market value of any property (owned by the disqualified individual
without restriction) that is (or will be) transferred by the
disqualified individual in exchange for the payment. For purposes of
the preceding sentence, the fair market value of property is determined
as of the date the property is transferred by the disqualified
individual.
Disqualified Individuals
Q-15: Who is a disqualified individual?
A-15: (a) For purposes of this section, an individual is a
disqualified individual with respect to a corporation if, at any time
during the disqualified individual determination period (as defined in
Q/A-20 of this section), the individual is an employee or independent
contractor of the corporation and is, with respect to the corporation--
(1) A shareholder (but see Q/A-17 of this section);
(2) An officer (see Q/A-18 of this section); or
(3) A highly-compensated individual (see Q/A-19 of this section).
(b) A director is a disqualified individual with respect to a
corporation if, at any time during the disqualified
[[Page 7642]]
individual determination period (as defined in Q/A-20 of this section),
the director is an employee or independent contractor and is, with
respect to the corporation, either a shareholder (see Q/A-17 of this
section) or a highly-compensated individual (see Q/A-19 of this
section).
Q-16: Is a personal service corporation treated as an individual?
A-16: (a) Yes. For purposes of this section, a personal service
corporation (as defined in section 269A(b)(1)), or a noncorporate
entity that would be a personal service corporation if it were a
corporation, is treated as an individual.
(b) The following example illustrates the principles of this A-16:
Example. Corporation N, a personal service corporation (as
defined in section 269A(b)(1)), has a single individual as its sole
shareholder and employee. Corporation N performs personal services
for Corporation M. The compensation paid to Corporation N by
Corporation M puts Corporation N within the group of the highly-
compensated individuals of Corporation M as determined under A-19 of
this section. Thus, Corporation N is treated as a highly-compensated
individual with respect to Corporation M.
Q-17: Are all shareholders of a corporation considered shareholders
for purposes of paragraph (a)(1) of Q/A-15 of this section?
A-17: (a) No, only an individual who owns stock of a corporation
with a fair market value that exceeds 1 percent of the fair market
value of the outstanding shares of all classes of the corporation's
stock is treated as a disqualified individual with respect to the
corporation by reason of stock ownership. An individual who owns a
lesser amount of stock may, however, be a disqualified individual with
respect to the corporation if such individual is an officer or highly-
compensated individual with respect to the corporation. For purposes of
determining the amount of stock owned by an individual, the
constructive ownership rules of section 318(a) apply.
(b) The following examples illustrates the principles of this A-17:
Example 1. E, an employee of Corporation A, received options
under Corporation A's Stock Option Plan. E's stock options vest
three years after the date of grant. E is not an officer or highly
compensated individual during the disqualified individual
determination period and does not own any other Corporation A stock.
Two years after the options are granted to E, all of Corporation A's
stock is acquired by Corporation B. Under Corporation A's Stock
Option Plan, E's options are converted to Corporation B options and
the vesting schedule remains the same. To determine whether E is a
disqualified individual based on E's stock ownership, the stock
underlying the unvested options held by E on the date of the change
in ownership or control is not considered constructively owned by E
under section 318(a). Because E does not own, or constructively own,
Corporation A stock with a fair market value exceeding 1 percent of
the total fair market value of all of the outstanding shares of all
classes of Corporation A and E is not an officer or highly-
compensated individual during the disqualified individual
determination period, E is not a disqualified individual within the
meaning of A-15 of this section with respect to Corporation A.
Example 2. Assume the same facts as in Example 1 except that
Corporation A's Stock Option Plan provides that all unvested options
will vest immediately on a change in ownership or control. To
determine whether E is a disqualified individual based on E's stock
ownership, the stock underlying the options that vest on the change
in ownership or control is considered constructively owned by E
under section 318(a). If the stock constructively held by E exceeds
1 percent of the total fair market value of all of the outstanding
shares of all classes of Corporation A stock, E is a disqualified
individual within the meaning of this A-15 of this section with
respect to Corporation A.
Example 3. Assume the same facts as in Example 1 except that E
received nonstatutory stock options that are exercisable for stock
subject to a substantial risk of forfeiture under section 83. Assume
further that under Corporation A's Stock Option Plan, the
nonstatutory options will vest on a change in ownership or control.
To determine whether E is a disqualified individual based on E's
stock ownership, the stock underlying the options that vest on the
change in ownership or control is not considered constructively
owned by E under section 318(a) because the options are exercisable
for stock subject to a substantial risk of forfeiture within the
meaning of section 83. Because E does not own, or constructively
own, Corporation A stock with a fair market value exceeding 1
percent of the total fair market value of all of the outstanding
shares of all classes of Corporation A stock and E is not an officer
or highly compensated individual during the disqualified individual
determination period, E is not a disqualified individual within the
meaning of A-15 of this section with respect to Corporation A.
Q-18: Who is an officer?
A-18: (a) For purposes of this section, whether an individual is an
officer with respect to a corporation is determined on the basis of all
the facts and circumstances in the particular case (such as the source
of the individual's authority, the term for which the individual is
elected or appointed, and the nature and extent of the individual's
duties). Generally, the term officer means an administrative executive
who is in regular and continued service. The term officer implies
continuity of service and excludes those employed for a special and
single transaction. An individual who merely has the title of officer
but not the authority of an officer is not considered an officer for
purposes of this section. Similarly, an individual who does not have
the title of officer but has the authority of an officer is considered
an officer for purposes of this section.
(b) An individual who is an officer with respect to any member of
an affiliated group that is treated as one corporation pursuant to Q/A-
46 of this section is treated as an officer of such one corporation.
(c) No more than 50 employees (or, if less, the greater of 3
employees, or 10 percent of the employees (rounded up to the nearest
integer)) of the corporation (in the case of an affiliated group
treated as one corporation, each member of the affiliated group) are
treated as disqualified individuals with respect to a corporation by
reason of being an officer of the corporation. For purposes of the
preceding sentence, the number of employees of the corporation is the
greatest number of employees the corporation has during the
disqualified individual determination period (as defined in Q/A-20 of
this section). If the number of officers of the corporation exceeds the
number of employees who may be treated as officers under the first
sentence of this paragraph (c), then the employees who are treated as
officers for purposes of this section are the highest paid 50 employees
(or, if less, the greater of 3 employees, or 10 percent of the
employees (rounded up to the nearest integer)) of the corporation when
ranked on the basis of compensation (as determined under Q/A-21 of this
section) paid during the disqualified individual determination period.
Q-19: Who is a highly-compensated individual?
A-19: (a) For purposes of this section, a highly-compensated
individual with respect to a corporation is any individual who is, or
would be if the individual were an employee, a member of the group
consisting of the lesser of the highest paid 1 percent of the employees
of the corporation (rounded up to the nearest integer), or the highest
paid 250 employees of the corporation, when ranked on the basis of
compensation (as determined under Q/A-21 of this section) paid during
the disqualified individual determination period (as defined in Q/A-20
of this section). For purposes of the preceding sentence, the number of
employees of the corporation is the greatest number of employees the
corporation has during the disqualified individual determination period
(as defined in Q/A-20 of this section). However, no individual whose
annualized
[[Page 7643]]
compensation during the disqualified individual determination period is
less than the amount described in section 414(q)(1)(B)(i) for the year
in which the change in ownership or control occurs will be treated as a
highly-compensated individual.
(b) An individual who is not an employee of the corporation is not
treated as a highly-compensated individual with respect to the
corporation on account of compensation received for performing services
(such as brokerage, legal, or investment banking services) in
connection with a change in ownership or control of the corporation, if
the services are performed in the ordinary course of the individual's
trade or business and the individual performs similar services for a
significant number of clients unrelated to the corporation.
(c) In determining the total number of employees of a corporation
for purposes of this A-19, employees are not counted if they normally
work less than 17\1/2\ hours per week (as defined in section
414(q)(5)(B) and the regulations thereunder) or if they normally work
during not more than 6 months during any year (as defined in section
414(q)(5)(C) and the regulations thereunder). However, an employee who
is not counted for purposes of the preceding sentence may still be a
highly-compensated individual.
Q-20: What is the disqualified individual determination period?
A-20: The disqualified individual determination period is the
twelve-month period prior to and ending on the date of the change in
ownership or control of the corporation.
Q-21: How is compensation defined for purposes of determining who
is a disqualified individual?
A-21: (a) For purposes of determining who is a disqualified
individual, the term compensation is the compensation which was earned
by the individual for services performed for the corporation with
respect to which the change in ownership or control occurs (changed
corporation), for a predecessor entity, or for a related entity. Such
compensation is determined without regard to sections 125, 132(f)(4),
402(e)(3), and 402(h)(1)(B). Thus, for example, compensation includes
elective or salary reduction contributions to a cafeteria plan, cash or
deferred arrangement or tax-sheltered annuity and amounts credited
under a nonqualified deferred compensation plan.
(b) For purposes of this A-21, a predecessor entity is any entity
which, as a result of a merger, consolidation, purchase or acquisition
of property or stock, corporate separation, or other similar business
transaction transfers some or all of its employees to the changed
corporation or to a related entity or to a predecessor entity of the
changed corporation. The term related entity include--
(1) All members of a controlled group of corporations (as defined
in section 414(b)) that includes the changed corporation or a
predecessor entity;
(2) All trades or business (whether or not incorporated) that are
under common control (as defined in section 414(c)) if such group
includes the changed corporation or a predecessor entity;
(3) All members of an affiliated service group (as defined in
section 414(m)) that includes the changed corporation or a predecessor
entity; and
(4) Any other entities required to be aggregated with the changed
corporation or a predecessor entity pursuant to section 414(o) and the
regulations thereunder (except leasing organizations as defined in
section 414(n)).
(c) For purposes of Q/A-18 and Q/A-19 of this section, compensation
that was contingent on the change in ownership or control and that was
payable in the year of the change is not treated as compensation.
Contingent on Change in Ownership or Control
Q-22: When is a payment contingent on a change in ownership or
control?
A-22: (a) In general, a payment is treated as contingent on a
change in ownership or control if the payment would not, in fact, have
been made had no change in ownership or control occurred, even if the
payment is also conditioned on the occurrence of another event. A
payment generally is treated as one which would not, in fact, have been
made in the absence of a change in ownership or control unless it is
substantially certain, at the time of the change, that the payment
would have been made whether or not the change occurred. (But see Q/A-
23 of this section regarding payments under agreements entered into
after a change in ownership or control.) A payment that becomes vested
as a result of a change in ownership or control is not treated as a
payment which was substantially certain to have been made whether or
not the change occurred. For purposes of this A-22, vested means the
payment is substantially vested within the meaning of Sec. 1.83-3(b)
and (j) or the right to the payment is not otherwise subject to a
substantial risk of forfeiture.
(b)(1) For purposes of paragraph (a), a payment is treated as
contingent on a change in ownership or control if--
(i) The payment is contingent on an event that is closely
associated with a change in ownership or control;
(ii) A change in ownership or control actually occurs; and
(iii) The event is materially related to the change in ownership or
control.
(2) For purposes of paragraph (b)(1)(i) of this A-22, a payment is
treated as contingent on an event that is closely associated with a
change in ownership or control unless it is substantially certain, at
the time of the event, that the payment would have been made whether or
not the event occurred. An event is considered closely associated with
a change in ownership or control if the event is of a type often
preliminary or subsequent to, or otherwise closely associated with, a
change in ownership or control. For example, the following events are
considered closely associated with a change in the ownership or control
of a corporation: The onset of a tender offer with respect to the
corporation; a substantial increase in the market price of the
corporation's stock that occurs within a short period (but only if such
increase occurs prior to a change in ownership or control); the
cessation of the listing of the corporation's stock on an established
securities market; the acquisition of more than 5 percent of the
corporation's stock by a person (or more than one person acting as a
group) not in control of the corporation; the voluntary or involuntary
termination of the disqualified individual's employment; a significant
reduction in the disqualified individual's job responsibilities; and a
change in ownership or control as defined in the disqualified
individual's employment agreement (or elsewhere) that does not meet the
definition of a change in ownership or control described in Q/A-27, 28,
or 29 of this section. Whether other events are treated as closely
associated with a change in ownership or control is based on all the
facts and circumstances of the particular case.
(3) For purposes of determining whether an event (as described in
paragraph (b)(2) of this A-22) is materially related to a change in
ownership or control, the event is presumed to be materially related to
a change in ownership or control if such event occurs within the period
beginning one year before and ending one year after the date of change
in ownership or control. If such event occurs outside of the period
beginning one year before and ending one year after the date of change
in ownership or control, the event is presumed not materially related
to the change in ownership or control. A payment does
[[Page 7644]]
not fail to be contingent on a change in ownership or control merely
because it is also contingent on the occurrence of a second event
(without regard to whether the second event is closely associated with
or materially related to a change in ownership or control). Similarly,
a payment that is treated as contingent on a change because it is
contingent on a closely associated event does not fail to be treated as
contingent on a change in ownership or control merely because it is
also contingent on the occurrence of a second event (without regard to
whether the second event is closely associated with or materially
related to a change in ownership or control).
(c) A payment that would in fact have been made had no change in
ownership or control occurred is treated as contingent on a change in
ownership or control if the change in ownership or control (or the
occurrence of an event that is closely associated and materially
related to a change in ownership or control within the meaning of
paragraph (b)(1) of this A-22), accelerates the time at which the
payment is made. Thus, for example, if a change in ownership or control
accelerates the time of payment of deferred compensation that is vested
without regard to the change in ownership or control, the payment may
be treated as contingent on the change. See Q/A-24 of this section
regarding the portion of a payment that is so treated. See also Q/A-8
of this section regarding the exemption for certain payments under
qualified plans and Q/A-40 of this section regarding the treatment of a
payment as reasonable compensation.
(d) A payment is treated as contingent on a change in ownership or
control even if the employment or independent contractor relationship
of the disqualified individual is not terminated (voluntarily or
involuntarily) as a result of the change.
(e) The following examples illustrate the principles of this A-22:
Example 1. A corporation grants a stock appreciation right to a
disqualified individual, A, more than one year before a change in
ownership or control. After the stock appreciation right vests and
becomes exercisable, a change in ownership or control of the
corporation occurs, and A exercises the right. Assuming neither the
granting nor the vesting of the stock appreciation right is
contingent on a change in ownership or control, the payment made on
exercise is not contingent on the change in ownership or control.
Example 2. A contract between a corporation and B, a
disqualified individual, provides that a payment will be made to B
if the corporation undergoes a change in ownership or control and
B's employment with the corporation is terminated at any time over
the succeeding 5 years. Eighteen months later, a change in the
ownership of the corporation occurs. Two years after the change in
ownership, B's employment is terminated and the payment is made to
B. Because it was not substantially certain that the corporation
would have made the payment to B on B's termination of employment if
there had not been a change in ownership, the payment is treated as
contingent on the change in ownership under paragraph (a) of this A-
22. This is true even though B's termination of employment is
presumed not to be, and in fact may not be, materially related to
the change in ownership or control.
Example 3. A contract between a corporation and C, a
disqualified individual, provides that a payment will be made to C
if C's employment is terminated at any time over the succeeding 3
years (without regard to whether or not there is a change in
ownership or control). Eighteen months after the contract is entered
into, a change in the ownership of the corporation occurs. Six
months after the change in ownership, C's employment is terminated
and the payment is made to C. Termination of employment is
considered an event closely associated with a change in ownership or
control. Because the termination occurred within one year after the
date of the change in ownership, the termination of C's employment
is presumed to be materially related to the change in ownership
under paragraph (b)(3) of this A-22. If this presumption is not
successfully rebutted, the payment will be treated as contingent on
the change in ownership under paragraph (b) of this A-22.
Example 4. A contract between a corporation and a disqualified
individual, D, provides that a payment will be made to D upon the
onset of a tender offer for shares of the corporation's stock. A
tender offer is made on December 1, 2008, and the payment is made to
D. Although the tender offer is unsuccessful, it leads to a
negotiated merger with another entity on June 1, 2009, which results
in a change in the ownership of the corporation. It was not
substantially certain, at the time of the onset of the tender offer,
that the payment would have been made had no tender offer taken
place. The onset of a tender offer is considered closely associated
with a change in ownership or control. Because the tender offer
occurred within one year before the date of the change in ownership
of the corporation, the onset of the tender offer is presumed to be
materially related to the change in ownership. If this presumption
is not rebutted, the payment will be treated as contingent on the
change in ownership. If no change in ownership or control had
occurred, the payment would not be treated as contingent on a change
in ownership or control; however, the payment still could be a
parachute payment under Q/A-37 of this section if the contract
violated a generally enforced securities law or regulation.
Example 5. A contract between a corporation and a disqualified
individual, E, provides that a payment will be made to E if the
corporation's level of product sales or profits reaches a specified
level. At the time the contract was entered into, the parties had no
reason to believe that such an increase in the corporation's level
of product sales or profits would be preliminary or subsequent to,
or otherwise closely associated with, a change in ownership or
control of the corporation. Eighteen months later, a change in the
ownership of the corporation occurs and within one year after the
date of the change, the corporation's level of product sales or
profits reaches the specified level. Under these facts and
circumstances (and in the absence of contradictory evidence), the
increase in product sales or profits of the corporation is not an
event closely associated with the change in ownership or control of
the corporation. Accordingly, even if the increase is materially
related to the change, the payment will not be treated as contingent
on a change in ownership or control.
Q-23: May a payment be treated as contingent on a change in
ownership or control if the payment is made under an agreement entered
into after the change?
A-23: (a) No., payments are not treated as contingent on a change
in ownership or control if they are made (or to be made) pursuant to an
agreement entered into after the change (a post-change agreement). For
this purpose, an agreement that is executed after a change in ownership
or control pursuant to a legally enforceable agreement that was entered
into before the change is considered to have been entered into before
the change. (See Q/A-9 of this section regarding the exemption for
reasonable compensation for services rendered on or after a change in
ownership or control.) If an individual has a right to receive a
parachute payment under an agreement entered into prior to a change in
ownership or control (pre-change agreement) and gives up that right as
bargained-for consideration for benefits under a post-change agreement,
the agreement is treated as a post-change agreement only to the extent
the value of the payments under the agreement exceed the value of the
payments under the pre-change agreement. To the extent payments under
the agreement have the same value as the parachute payments under the
pre-change agreement, such payments retain their character as parachute
payments subject to this section.
(b) The following examples illustrate the principles of this A-23:
Example 1. Assume that a disqualified individual is an employee
of a corporation. A change in ownership or control of the
corporation occurs, and thereafter the individual enters into an
employment agreement with the acquiring company. Because the
agreement is entered into after the change in ownership or control
occurs, payments to be made under the agreement are not treated as
contingent on the change.
Example 2. Assume the same facts as in Example 1, except that
the agreement
[[Page 7645]]
between the disqualified individual and the acquiring company is
executed after the change in ownership or control, pursuant to a
legally enforceable agreement entered into before the change.
Payments to be made under the agreement may be treated as contingent
on the change in ownership or control pursuant to Q/A-22 of this
section. However, see Q/A-9 of this section regarding the exemption
from the definition of parachute payment for certain amounts of
reasonable compensation.
Example 3. Assume the same facts as in Example 1 except that
prior to the change in ownership or control, the individual and
corporation enter into an agreement under which the individual will
receive parachute payments in the event of a change in ownership or
control of the corporation. After the change, the individual agrees
to give up the right to parachute payments under the pre-change
agreement in exchange for compensation under a new agreement with
the acquiring corporation. Because the individual gave up the right
to parachute payments under the pre-change agreement in exchange for
other payments under the post-change agreement, payments in an
amount equal to the parachute payments under the pre-change
agreement are treated as contingent on the change in ownership or
control under this A-23. Because the post-change agreement was
entered into after the change, payments in excess of this amount are
not treated as parachute payments.
Q-24: If a payment is treated as contingent on a change in
ownership or control, is the full amount of the payment so treated?
A-24: (a)(1) General rule. Yes, if the payment is a transfer of
property, the amount of the payment is determined under Q/A-12 or Q/A-
13 of this section. For all other payments, the amount of the payment
is determined under Q/A-11 of this section. However, in certain
circumstances, described in paragraphs (b) and (c) of this A-24, only a
portion of the payment is treated as contingent on the change.
Paragraph (b) of this A-24 applies to a payment that is vested, without
regard to the change in ownership or control, and is treated as
contingent on the change in ownership or control because the change
accelerates the time at which the payment is made. Paragraph (c) of
this A-24 applies to a payment that becomes vested as a result of the
change in ownership or control if, without regard to the change in
ownership or control, the payment was contingent only on the continued
performance of services for the corporation for a specified period of
time and if the payment is attributable, at least in part, to services
performed before the date the payment becomes vested. For purposes of
this A-24, for the definition of vested see
Q/A-22(a).
(2) Reduction by reasonable compensation. The amount of a payment
under paragraph (a)(1) of this A-24 is reduced by any portion of such
payment that the taxpayer establishes by clear and convincing evidence
is reasonable compensation for personal services rendered by the
disqualified individual on or after the date of the change of control.
See Q/A-9 and Q/A-38 through 44 of this section for rules concerning
reasonable compensation. The portion of an amount treated as contingent
under paragraph (b) or (c) of this A-24 may not be reduced by
reasonable compensation.
(b) Vested payments. This paragraph (b) applies if a payment is
vested, without regard to the change in ownership or control, and is
treated as contingent on the change in ownership or control because the
change accelerates the time at which the payment is made. In such case,
the portion of the payment, if any, that is treated as contingent on
the change in ownership or control is the amount by which the amount of
the accelerated payment exceeds the present value of the payment absent
the acceleration. If the value of such a payment absent the
acceleration is not reasonably ascertainable, and the acceleration of
the payment does not significantly increase the present value of the
payment absent the acceleration, the present value of the payment
absent the acceleration is treated as equal to the amount of the
accelerated payment. If the value of the payment absent the
acceleration is not reasonably ascertainable, but the acceleration
significantly increases the present value of the payment, the future
value of such payment is treated as equal to the amount of the
accelerated payment. For rules on determining present value, see
paragraph (e) of this A-24, Q/A-32, and Q/A-33 of this section.
(c)(1) Nonvested payments. This paragraph (c) applies to a payment
that becomes vested as a result of the change in ownership or control
to the extent that--
(i) Without regard to the change in ownership or control, the
payment was contingent only on the continued performance of services
for the corporation for a specified period of time; and
(ii) The payment is attributable, at least in part, to the
performance of services before the date the payment is made or becomes
certain to be made.
(2) The portion of the payment subject to paragraph (c) of this A-
24 that is treated as contingent on the change in ownership or control
is the lesser of--
(i) The amount of the accelerated payment; or
(ii) The amount described in paragraph (b) of this A-24, plus an
amount, as determined in paragraph (c)(4) of this A-24, to reflect the
lapse of the obligation to continue to perform services.
(3) For purposes of this paragraph (c) of this A-24, the
acceleration of the vesting of a stock option or the lapse of a
restriction on restricted stock is considered to significantly increase
the value of a payment.
(4) The amount reflecting the lapse of the obligation to continue
to perform services (described in paragraph (c)(2)(ii) of this A-24) is
1 percent of the amount of the accelerated payment multiplied by the
number of full months between the date that the individual's right to
receive the payment is vested and the date that, absent the
acceleration, the payment would have been vested. This paragraph (c)(4)
applies to the accelerated vesting of a payment in the nature of
compensation even if the time at which the payment is made is not
accelerated.
(d) Application of this A-24 to certain payments.--(1) Benefits
under a nonqualified deferred compensation plan. In the case of a
payment of benefits under a nonqualified deferred compensation plan,
paragraph (b) of this A-24 applies to the extent benefits under the
plan are vested without regard to the change in ownership or control.
Paragraph (c) of this A-24 applies to the extent benefits under the
plan become vested as a result of the change in ownership or control
and are attributable, at least in part, to the performance of services
prior to vesting. Any other payment of benefits under a nonqualified
deferred compensation plan is a payment in the nature of compensation
subject to the general rule of paragraph (a) of this A-24 and the rules
in Q/A-11 of this section.
(2) Employment agreements. The general rule of paragraph (a) of
this A-24 applies to the payment of amounts due under an employment
agreement on a termination of employment or a change in ownership or
control that otherwise would be attributable to the performance of
services (or refraining from the performance of services) during any
period that begins after the date of termination of employment or
change in ownership or control, as applicable. For purposes of this
paragraph (d)(2) of this A-24, an employment agreement means an
agreement between an employee or independent contractor and employer or
service recipient which describes, among other things, the amount of
compensation or remuneration payable to the employee or independent
[[Page 7646]]
contractor. See Q/A-42(b) and 44 of this section for the treatment of
the remaining amounts of salary under an employment agreement.
(3) Vesting due to an event other than services. Neither paragraph
(b) nor (c) of this A-24 applies to a payment if (without regard to the
change in ownership or control) vesting of the payment depends on an
event other than the performance of services, such as the attainment of
a performance goal, and the event does not occur prior to the change in
ownership or control. In such circumstances, the full amount of the
accelerated payment is treated as contingent on the change in ownership
or control under paragraph (a) of this A-24. However, see Q/A-39 of
this section for rules relating to the reduction of the excess
parachute payment by the portion of the payment which is established to
be reasonable compensation for personal services actually rendered
before the date of a change in ownership or control.
(e) Present value. For purposes of this A-24, the present value of
a payment is determined as of the date on which the accelerated payment
is made.
(f) Examples. The following examples illustrate the principles of
this A-24:
Example 1. (i) Corporation maintains a qualified plan and a
nonqualified supplemental retirement plan (SERP) for its executives.
Benefits under the SERP are not paid to participants until
retirement. E, a disqualified individual with respect to
Corporation, has a vested account balance of $500,000 under the
SERP. A change in ownership or control of Corporation occurs. The
SERP provides that in the event of a change in ownership or control,
all vested accounts will be paid to SERP participants.
(ii) Because E was vested in $500,000 of benefits under the SERP
prior to the change in ownership or control and the change merely
accelerated the time at which the payment was made to E, only a
portion of the payment, as determined under paragraph (b) of this A-
24, is treated as contingent on the change. Thus, the portion of the
payment that is treated as contingent on the change is the amount by
which the amount of the accelerated payment ($500,000) exceeds the
present value of the payment absent the acceleration.
(iii) Assume that instead of having a vested account balance of
$500,000 on the date of the change in ownership or control, E will
vest in his account balance of $500,000 in 2 years if E continues to
perform services for the next 2 years. Assume further that the SERP
provides that all unvested SERP benefits vest immediately on a
change in ownership or control and are paid to the participants.
Because the vesting of the SERP payment, without regard to the
change, depends only on the performance of services for a specified
period of time and the payment is attributable, in part, to the
performance of services before the change in ownership or control,
only a portion of the $500,000 payment, as determined under
paragraph (c) of this A-24, is treated as contingent on the change.
The portion of the payment that is treated as contingent on the
change is the lesser of the amount of the accelerated payment or the
amount by which the accelerated payment exceeds the present value of
the payment absent the acceleration, plus an amount to reflect the
lapse of the obligation to continue to perform services.
(iv) Assume further that under the SERP E's vested account
balance of $500,000 will be paid to E on the change in ownership or
control and an additional $70,000 will be credited to E's account.
Because the $500,000 was vested without regard to the change in
ownership or control, paragraph (b) of this A-24 applies to the
$500,000 payment. Because the $70,000 is not vested, without regard
to the change, and is not attributable to the performance of
services prior to the change, the entire $70,000 payment is
contingent on the change in ownership or control under paragraph (a)
of this A-24.
Example 2. As a result of a change in the effective control of a
corporation, a disqualified individual with respect to the
corporation, D, receives accelerated payment of D's vested account
balance in a nonqualified deferred compensation account plan. Actual
interest and other earnings on the plan assets are credited to each
account as earned before distribution. Investment of the plan assets
is not restricted in such a manner as would prevent the earning of a
market rate of return on the plan assets. The date on which D would
have received D's vested account balance absent the change in
ownership or control is uncertain, and the rate of earnings on the
plan assets is not fixed. Thus, the amount of the payment absent the
acceleration is not reasonably ascertainable. Under these facts,
acceleration of the payment does not significantly increase the
present value of the payment absent the acceleration, and the
present value of the payment absent the acceleration is treated as
equal to the amount of the accelerated payment. Accordingly, no
portion of the payment is treated as contingent on the change.
Example 3. (i) On January 15, 2006, a corporation and a
disqualified individual, F, enter into a contract providing for a
retention bonus of $500,000 to be paid to F on January 15, 2011. The
payment of the bonus will be forfeited by F if F does not remain
employed by the corporation for the entire 5-year period. However,
the contract provides that the full amount of the payment will be
made immediately on a change in ownership or control of the
corporation during the 5-year period. On January 15, 2009, a change
in ownership or control of the corporation occurs and the full
amount of the payment ($500,000) is made on that date to F. Under
these facts, the payment of $500,000 was contingent only on F's
performance of services for a specified period and is attributable,
in part, to the performance of services before the change in
ownership or control. Therefore, only a portion of the payment is
treated as contingent on the change. The portion of the payment that
is treated as contingent on the change is the amount by which the
amount of the accelerated payment (i.e., $500,000, the amount paid
to the individual because of the change in ownership) exceeds the
present value of the payment that was expected to have been made
absent the acceleration (i.e., $406,838, the present value on
January 15, 2009, of a $500,000 payment on January 15, 2011), plus
$115,000 (1% x 23 months x $500,000) which is the amount
reflecting the lapse of the obligation to continue to perform
services. Accordingly, the amount of the payment treated as
contingent on the change in ownership or control is $208,162, the
sum of $93,162 ($500,000 - $406,838) - $115,000). This result is not
changed if F actually remains employed until the end of the 5-year
period.
(ii) Assume that the contract provides that the retention bonus
will vest on a change in ownership or control, but will not be paid
until January 15, 2011 (the original date in the contract). Because
the payment of $500,000 was contingent only on F's performance of
services for a specified period and is attributable, in part, to the
performance of services before the change in ownership or control,
only a portion of the $500,000 payment is treated as contingent on
the change. Because there is no accelerated payment, the portion of
the payment treated as contingent on the change is an amount
reflecting the lapse of the obligation to continue to perform
services which is $115,000 (1% x 23 months x $500,000).
Example 4. (i) On January 15, 2006, a corporation gives to a
disqualified individual, in connection with her performance of
services to the corporation, a bonus of 1,000 shares of the
corporation's stock. Under the terms of the bonus arrangement, the
individual is obligated to return the stock to the corporation if
she terminates her employment for any reason prior to January 15,
2011. However, if there is a change in the ownership or effective
control of the corporation prior to January 15, 2011, she ceases to
be obligated to return the stock. The individual's rights in the
stock are treated as substantially nonvested (within the meaning of
Sec. 1.83-3(b) and (j)) during that period. On January 15, 2008, a
change in the ownership of the corporation occurs. On that day, the
fair market value of the stock is $500,000.
(ii) Under these facts, the payment was contingent only on
performance of services for a specified period and is attributable,
in part, to the performance of services before the change in
ownership or control. Thus, only a portion of the payment is treated
as contingent on the change in ownership or control. The portion of
the payment that is treated as contingent on the change is the
amount by which the present value of the accelerated payment on
January 15, 2009 ($500,000), exceeds the present value of the
payment that was expected to have been made on January 15, 2011,
plus an amount reflecting the lapse of the obligation to continue to
perform services. At the time of the change, it cannot be reasonably
ascertained what the value of the stock would been on January 15,
2011. The acceleration of the lapse of a restriction on stock is
treated as significantly increasing the
[[Page 7647]]
value of the payment. Therefore, the value of such stock on January
15, 2011, is deemed to be $500,000, the amount of the accelerated
payment. The present value on January 15, 2009, of a $500,000
payment to be made on January 15, 2011, is $406,838. Thus, the
portion of the payment treated as contingent on the change is
$208,162, the sum of $93,162 ($500,000 - $406,838), plus $115,000
[1% x 23 months x $500,000], the amount reflecting the lapse of
the obligation to continue to perform services.
Example 5. (i) On January 15, 2006, a corporation grants to a
disqualified individual nonqualified stock options to purchase
30,000 shares of the corporation's stock. The options do not have a
readily ascertainable fair market value at the time of grant. The
options will be forfeited by the individual if he fails to perform
personal services for the corporation until January 15, 2009. The
options will, however, vest in the individual at an earlier date if
there is a change in ownership or control of the corporation. On
January 16, 2008, a change in the ownership of the corporation
occurs and the options become vested in the individual. On January
16, 2008, the options have an ascertainable fair market value of
$600,000.
(ii) The payment of the options to purchase 30,000 shares was
contingent only on performance of services for the corporation until
January 15, 2009, and is attributable, in part, to the performance
of services before the change in ownership or control. Therefore,
only a portion of the payment is treated as contingent on the
change. The portion of the payment that is treated as contingent on
the change is the amount by which the accelerated payment on January
16, 2008 ($600,000) exceeds the present value on January 16, 2008,
of the payment that was expected to have been made on January 15,
2009, absent the acceleration, plus an amount reflecting the lapse
of the obligation to continue to perform services. At the time of
the change, it cannot be reasonably ascertained what the value of
the options would have been on January 15, 2009. The acceleration of
vesting in the options is treated as significantly increasing the
value of the payment. Therefore, the value of such options on
January 15, 2009, is deemed to be $600,000, the amount of the
accelerated payment. The present value on January 16, 2008 of a
$600,000 payment to be made on January 15, 2009, is $549,964.13.
Thus, the portion of the payment treated as contingent on the change
is $116,035.87, the sum of $50,035.87 ($600,000 - $549,964.13), plus
an amount reflecting the lapse of the obligation to continue to
perform services which is $66,000 (1% x 11 months x $600,000).
Example 6. (i) The facts are the same as in Example 5, except
that the options become vested periodically (absent a change in
ownership of control), with one-third of the options vesting on
January 15, 2007, 2008, and 2009, respectively. Thus, options to
purchase 20,000 shares vest independently of the January 16, 2008,
change in ownership and the options to purchase the remaining 10,000
shares vest as a result of the change.
(ii) The payment of the options to purchase 10,000 shares was
contingent only on performance of services for the corporation until
January 15, 2009, and is attributable, in part, to the performance
of services before the change in ownership or control. Therefore,
only a portion of the payment is treated as contingent on the
change. The portion of the payment that is treated as contingent on
the change is the amount by which the accelerated payment on January
16, 2008 ($200,000) exceeds the present value on January 16, 2008,
of the payment that was expected to have been made on January 15,
2009, absent the acceleration, plus an amount reflecting the lapse
of the obligation to perform services. At the time of the change, it
cannot be reasonably ascertained what the value of the options would
have been on January 15, 2009. The acceleration of vesting in the
options is treated as significantly increasing the value of the
payment. Therefore, the value of such options on January 15, 2009,
is deemed to be $200,000, the amount of the accelerated payment. The
present value on January 16, 2008, of a $200,000 payment to be made
on January 15, 2009, is $183,328.38. Thus, the portion of the
payment treated as contingent on the change is $38,671.62, the sum
of $16,671.62 ($200,000 - $183,328.38), plus an amount reflecting
the lapse of the obligation to continue to perform services which is
$22,000 (1% x 11 months x $200,000).
Example 7. Assume the same facts as in Example 5, except that
the option agreement provides that the options will vest either on
the corporation's level of profits reaching a specified level, or if
earlier, on the date on which there is a change in ownership or
control of the corporation. The corporation's level of profits do
not reach the specified level prior to January 16, 2008. In such
case, the full amount of the payment, $600,000, is treated as
contingent on the change because it was not contingent only on
performance of services for the corporation for a specified period.
See Q/A-39 of this section for rules relating to the reduction of
the excess parachute payment by the portion of the payment which is
established to be reasonable compensation for personal services
actually rendered before the date of a change in ownership or
control.
Example 8. On January 1, 2002, E, a disqualified individual with
respect to Corporation X, enters into an employment agreement with
Corporation X under which E will be paid wages of $200,000 each year
during the 5-year employment agreement. The employment agreement
provides that if a change in ownership or control of Corporation X
occurs, E will be paid the present value of the remaining salary
under the employment agreement. On January 1, 2003, a change in
ownership or control of Corporation X occurs, E is terminated, and E
receives a payment of the present value of $200,000 for each of the
4 years remaining under the employment agreement. Because the
payment represents future salary under an employment agreement
(i.e., amounts otherwise attributable to the performance of services
for periods that begin after the termination of employment), the
general rule of paragraph (a) of this A-24 applies to the payment.
See Q/A-42(c) and 44 of this section for the treatment of the
remaining payments under an employment agreement.
Presumption That Payment Is Contingent on Change
Q-25: Is there a presumption that certain payments are contingent
on a change in ownership or control?
A-25: Yes, for purposes of this section, any payment is presumed to
be contingent on such change unless the contrary is established by
clear and convincing evidence if the payment is made pursuant to--
(a) An agreement entered into within one year before the date of a
change in ownership or control; or
(b) An amendment that modifies a previous agreement in any
significant respect, if the amendment is made within one year before
the date of a change in ownership or control. In the case of an
amendment described in paragraph (b) of this A-25, only the portion of
any payment that exceeds the amount of such payment that would have
been made in the absence of the amendment is presumed, by reason of the
amendment, to be contingent on the change in ownership or control.
Q-26: How may the presumption described in Q/A-25 of this section
be rebutted?
A-26: (a) To rebut the presumption described in Q/A-25 of this
section, the taxpayer must establish by clear and convincing evidence
that the payment is not contingent on the change in ownership or
control. Whether the payment is contingent on such change is determined
on the basis of all the facts and circumstances of the particular case.
Factors relevant to such a determination include, but are not limited
to, the content of the agreement or amendment and the circumstances
surrounding the execution of the agreement or amendment, such as
whether it was entered into at a time when a takeover attempt had
commenced and the degree of likelihood that a change in ownership or
control would actually occur. However, even if the presumption is
rebutted with respect to an agreement, some or all of the payments
under the agreement may still be contingent on the change in ownership
or control pursuant to Q/A-22 of this section.
(b) In the case of an agreement described in paragraph (a) of Q/A-
25 of this section, clear and convincing evidence that the agreement is
one of the three following types will generally rebut the presumption
that payments under the agreement are contingent on the change in
ownership or control--
(1) A nondiscriminatory employee plan or program as defined in
paragraph (c) of this A-26;
(2) A contract between a corporation and an individual that
replaces a prior
[[Page 7648]]
contract entered into by the same parties more than one year before the
change in ownership or control, if the new contract does not provide
for increased payments (apart from normal increases attributable to
increased responsibilities or cost of living adjustments), accelerate
the payment of amounts due at a future time, or modify (to the
individual's benefit) the terms or conditions under which payments will
be made; or
(3) A contract between a corporation and an individual who did not
perform services for the corporation prior to the one year period
before the change in ownership or control occurs, if the contract does
not provide for payments that are significantly different in amount,
timing, terms, or conditions from those provided under contracts
entered into by the corporation (other than contracts that themselves
were entered into within one year before the change in ownership or
control and in contemplation of the change) with individuals performing
comparable services.
(c) For purposes of this section, the term nondiscriminatory
employee plan or program means: a group term life insurance plan that
meets the requirements of section 79(d); a self insured medical
reimbursement plan that meets the requirements of section 105(h); a
cafeteria plan (within the meaning of section 125); an educational
assistance program (within the meaning of section 127); a dependent
care assistance program (within the meaning of section 129); or a no-
additional-cost service (within the meaning of section 132(b)) or
qualified employee discount (within the meaning of section 132(c)); and
an adoption assistance program (within the meaning of section 137).
Payments under certain other plans are exempt from the definition of
parachute payment under Q/A-8 of this section.
(d) The following examples illustrate the application of the
presumption:
Example 1. A corporation and a disqualified individual who is an
employee of the corporation enter into an employment contract. The
contract replaces a prior contract entered into by the same parties
more than one year before the change and the new contract does not
provide for any increased payments other than a cost of living
adjustment, does not accelerate the payment of amounts due at a
future time, and does not modify (to the individual's benefit) the
terms or conditions under which payments will be made. Clear and
convincing evidence of these facts rebuts the presumption described
in A-25 of this section. However, payments under the contract still
may be contingent on the change in ownership or control pursuant to
Q/A-22 of this section.
Example 2. Assume the same facts as in Example 1, except that
the contract is entered into after a tender offer for the
corporation's stock had commenced and it was likely that a change in
ownership would occur and the contract provides for a substantial
bonus payment to the individual upon his signing the contract. The
individual has performed services for the corporation for many
years, but previous employment contracts between the corporation and
the individual did not provide for a similar signing bonus. One
month after the contract is entered into, a change in the ownership
of the corporation occurs. All payments under the contract are
presumed to be contingent on the change in ownership even though the
bonus payment would have been legally required even if no change had
occurred. Clear and convincing evidence of these facts rebuts the
presumption described in A-25 of this section with respect to all of
the payments under the contract with the exception of the bonus
payment (which is treated as contingent on the change). However,
payments other than the bonus under the contract still may be
contingent on the change in ownership or control pursuant to Q/A-22
of this section.
Example 3. A corporation and a disqualified individual, who is
an employee of the corporation, enter into an employment contract
within one year of a change in ownership of the corporation. Under
the contract, in the event of a change in ownership or control and
subsequent termination of employment, certain payments will be made
to the individual. A change in ownership occurs, but the individual
is not terminated until 2 years after the change. If clear and
convincing evidence does not rebut the presumption described in A-25
of this section, because the payment is made pursuant to an
agreement entered into within one year of the date of the change in
ownership, the payment is presumed contingent on the change under
A-25 of this section. This is true even though A's termination of
employment is presumed not to be materially related to the change in
ownership or control under Q/A-22 of this section.
Change in Ownership or Control
Q-27: When does a change in the ownership of a corporation occur?
A-27: (a) For purposes of this section, a change in the ownership
or control of a corporation occurs on the date that any one person, or
more than one person acting as a group, acquires ownership of stock of
the corporation that, together with stock held by such person or group,
owns more than 50 percent of the total fair market value or total
voting power of the stock of such corporation. However, if any one
person, or more than one person acting as a group, is considered to own
more than 50 percent of the total fair market value or total voting
power of the stock of a corporation, the acquisition of additional
stock by the same person or persons is not considered to cause a change
in the ownership of the corporation (or to cause a change in the
effective control of the corporation (within the meaning of Q/A-28 of
this section)). An increase in the percentage of stock owned by any one
person, or persons acting as a group, as a result of a transaction in
which the corporation acquires its stock in exchange for property will
be treated as an acquisition of stock for purposes of this section.
(b) For purposes of paragraph (a) of this A-27, persons will not be
considered to be acting as a group merely because they happen to
purchase or own stock of the same corporation at the same time, or as a
result of the same public offering. However, persons will be considered
to be acting as a group if they are owners of an entity that enters
into a merger, consolidation, purchase or acquisition of stock, or
similar business transaction with the corporation. If a person,
including an entity shareholder, owns stock in both entities that enter
into a merger, consolidation, purchase or acquisition of stock, or
similar transaction, such shareholder is considered to be acting as a
group with other shareholders in an entity only to the extent of his
ownership in that entity prior to the transaction giving rise to the
change and not with respect to his ownership interest in the other
entity.
(c) For purposes of this A-27, section 318(a) applies to determine
stock ownership.
(d) The following examples illustrate the principles of this A-27:
Example 1. Corporation M has owned stock with a fair market
value equal to 19 percent of the value of the stock of Corporation N
(an otherwise unrelated corporation) for many years prior to 2006.
Corporation M acquires additional stock with a fair market value
equal to 15 percent of the value of the stock of Corporation N on
January 1, 2006, and an additional 18 percent on February 21, 2007.
As of February 21, 2007, Corporation M has acquired stock with a
fair market value greater than 50 percent of the value of the stock
of Corporation N. Thus, a change in the ownership of Corporation N
is considered to occur on February 21, 2007 (assuming that
Corporation M did not have effective control of Corporation N
immediately prior to the acquisition on that date).
Example 2. All of the corporation's stock is owned by the
founders of the corporation. The board of directors of the
corporation decides to offer shares of the corporation to the
public. After the public offering, the founders of the corporation
own a total of 40 percent of the corporation's stock, and members of
the public own 60 percent. If no one person (or more than one person
acting as a group) owns more than 50 percent of the corporation's
stock (by value or voting power) after the public offering, there is
no change in the ownership of the corporation.
[[Page 7649]]
Example 3. Corporation P merges into Corporation O (a previously
unrelated corporation). In the merger, the shareholders of
Corporation P receive Corporation O stock in exchange for their
Corporation P stock. Immediately after the merger, the former
shareholders of Corporation P own stock with a fair market value
equal to 60 percent of the value of the stock of Corporation O, and
the former shareholders of Corporation O own stock with a fair
market value equal to 40 percent of the value of the stock of
Corporation O. The former shareholders of Corporation P will be
treated as acting as a group in their acquisition of Corporation O
stock. Thus, a change in the ownership of Corporation O occurs on
the date of the merger.
Example 4. Assume the same facts as in Example 3 except that
immediately after the change, the former shareholders of Corporation
P own stock with a fair market value of 51 percent of the value of
Corporation O stock and the former shareholders of Corporation O own
stock with a fair market value equal to 49 percent of the value of
Corporation O stock. Assume further that prior to the merger several
Corporation P shareholders also owned Corporation O stock
(overlapping shareholders) with a fair market value of 5 percent of
the value of Corporation O stock. The overlapping shareholders
consist of Mutual Company A Growth Fund, which prior to the
transaction owns 3 percent of the value of Corporation O stock,
Mutual Company A Income Fund, which prior to the transaction owns 1
percent of the value of Corporation O stock, and B, an individual
who prior to the transaction owns 1 percent of the value of
Corporation O stock. Growth Fund and Income Fund are treated as
separate shareholders with respect to their ownership interests in
Corporation O and Corporation P. The overlapping shareholders are
not treated as acting as a group with the Corporation P shareholders
with respect to the Corporation O stock each overlapping shareholder
held before the transaction. Instead, the overlapping shareholders
are treated as acting as a group separately with respect to
Corporation O and Corporation P. Because the former shareholders of
Corporation O are treated as acting as a group with respect to other
Corporation O shareholders only to the extent of their ownership
interest in Corporation O and not with respect to their ownership
interest in Corporation P, a change in the ownership of Corporation
O occurs on the date of the merger.
Example 5. A, an individual, owns stock with a fair market value
equal to 20 percent of the value of the stock of Corporation Q. On
January 1, 2007, Corporation Q acquires in a redemption for cash all
of the stock held by shareholders other than A. Thus, A is left as
the sole shareholder of Corporation O. A change in ownership of
Corporation O is considered to occur on January 1, 2007 (assuming
that A did not have effective control of Corporation Q immediately
prior to the redemption).
Example 6. Assume the same facts as in Example 5, except that A
owns stock with a fair market value equal to 51 percent of the value
of all the stock of Corporation Q immediately prior to the
redemption. There is no change in the ownership of Corporation Q as
a result of the redemption.
Q-28: When does a change in the effective control of a corporation
occur?
A-28: (a) For purposes of this section, a change in the effective
control of a corporation is presumed to occur on the date that either--
(1) Any one person, or more than one person acting as a group,
acquires (or has acquired during the 12-month period ending on the date
of the most recent acquisition by such person or persons) ownership of
stock of the corporation possessing 20 percent or more of the total
voting power of the stock of such corporation; or
(2) A majority of members of the corporation's board of directors
is replaced during any 12-month period by directors whose appointment
or election is not endorsed by a majority of the members of the
corporation's board of directors prior to the date of the appointment
or election.
(b) The presumption of paragraph (a) of this A-28 may be rebutted
by establishing that such acquisition or acquisitions of the
corporation's stock, or such replacement of the majority of the members
of the corporation's board of directors, does not transfer the power to
control (directly or indirectly) the management and policies of the
corporation from any one person (or more than one person acting as a
group) to another person (or group). For purposes of this section, in
the absence of an event described in paragraph (a) (1) or (2) of this
A-28, a change in the effective control of a corporation is presumed
not to have occurred.
(c) If any one person, or more than one person acting as a group,
is considered to effectively control a corporation (within the meaning
of this A-28), the acquisition of additional control of the corporation
by the same person or persons is not considered to cause a change in
the effective control of the corporation (or to cause a change in the
ownership of the corporation within the meaning of Q/A-27 of this
section).
(d) For purposes of this A-28, persons will not be considered to be
acting as a group merely because they happen to purchase or own stock
of the same corporation at the same time, or as a result of the same
public offering. However, persons will be considered to be acting as a
group if they are owners of an entity that enters into a merger,
consolidation, purchase or acquisition of stock, or similar business
transaction with the corporation. If a person, including an entity
shareholder, owns stock in both entities that enter into a merger,
consolidation, purchase or acquisition of stock, or similar
transaction, such shareholder is considered to be acting as a group
with other shareholders in an entity only to the extent of his
ownership in that entity prior to the transaction giving rise to the
change and not with respect to his ownership interest in the other
entity.
(e) Section 318(a) applies to determine stock ownership for
purposes of this A-28.
(f) The following examples illustrate the principles of this A-28:
Example 1. Shareholder A acquired the following percentages of
the voting stock of Corporation M (an otherwise unrelated
corporation) on the following dates: 16 percent on January 1, 2005;
10 percent on January 10, 2006; 8 percent on February 10, 2006; 11
percent on March 1, 2007; and 8 percent on March 10, 2007. Thus, on
March 10, 2007, A owns a total of 53 percent of M's voting stock.
Because A did not acquire 20 percent or more of M's voting stock
during any 12-month period, there is no presumption of a change in
effective control pursuant to paragraph (a)(1) of this A-28. In
addition, under these facts there is a presumption that no change in
the effective control of Corporation M occurred. If this presumption
is not rebutted (and thus no change in effective control of
Corporation M is treated as occurring prior to March 10, 2007), a
change in the ownership of Corporation M is treated as having
occurred on March 10, 2007 (pursuant to Q/A-27 of this section)
because A had acquired more than 50 percent of Corporation M's
voting stock as of that date.
Example 2. A minority group of shareholders of a corporation
opposes the practices and policies of the corporation's current
board of directors. A proxy contest ensues. The minority group
presents its own slate of candidates for the board at the next
annual meeting of the corporation's shareholders, and candidates of
the minority group are elected to replace a majority of the current
members of the board. A change in the effective control of the
corporation is presumed to have occurred on the date the election of
the new board of directors becomes effective.
Q-29: When does a change in the ownership of a substantial portion
of a corporation's assets occur?
A-29: (a) For purposes of this section, a change in the ownership
of a substantial portion of a corporation's assets occurs on the date
that any one person, or more than one person acting as a group,
acquires (or has acquired during the 12-month period ending on the date
of the most recent acquisition by such person or persons) assets from
the corporation that have a total gross fair market value equal to or
more than one third of the total gross fair market value of all of the
assets of the
[[Page 7650]]
corporation immediately prior to such acquisition or acquisitions.
(b) A transfer of assets by a corporation is not treated as a
change in the ownership of such assets if the assets are transferred
to--
(1) A shareholder of the corporation (immediately before the asset
transfer) in exchange for or with respect to its stock;
(2) An entity, 50 percent or more of the total value or voting
power of which is owned, directly or indirectly, by the corporation;
(3) A person, or more than one person acting as a group, that owns,
directly or indirectly, 50 percent or more of the total value or voting
power of all the outstanding stock of the corporation; or
(4) An entity, at least 50 percent of the total value or voting
power is owned, directly or indirectly, by a person described in
paragraph (b)(3) of this A-29.
(c) For purposes of paragraph (b) and except as otherwise provided,
a person's status is determined immediately after the transfer of the
assets. For example, a transfer of assets pursuant to a complete
liquidation of a corporation, a redemption of a shareholder's interest,
or a transfer to a majority-owned subsidiary of the corporation is not
treated as a change in the ownership of the assets of the transferor
corporation.
(d) For purposes of this A-29, persons will not be considered to be
acting as a group merely because they happen to purchase or own stock
of the same corporation at the same time, or as a result of the same
public offering. However, persons will be considered to be acting as a
group if they are owners of an entity that enters into a merger,
consolidation, purchase or acquisition of stock, or similar business
transaction with the corporation. If a person, including an entity
shareholder, owns stock in both entities that enter into a merger,
consolidation, purchase or acquisition of stock, or similar
transaction, such shareholder is considered to be acting as a group
with other shareholders in an entity only to the extent of his
ownership in that entity prior to the transaction giving rise to the
change and not with respect to his ownership interest in the other
entity.
(e) For purposes of this A-29, section 318(a) applies in
determining stock ownership.
(f) The following examples illustrate the principles of this A-29:
Example 1. Corporation M acquires assets having a gross fair
market value of $500,000 from Corporation N (an unrelated
corporation) on January 1, 2006. The total gross fair market value
of Corporation N's assets immediately prior to the acquisition was
$3 million. Since the value of the assets acquired by Corporation M
is less than one-third of the fair market value of Corporation N's
total assets immediately prior to the acquisition, the acquisition
does not represent a change in the ownership of a substantial
portion of Corporation N's assets.
Example 2. Assume the same facts as in Example 1. Also assume
that on November 1, 2006, Corporation M acquires from Corporation N
additional assets having a fair market value of $700,000. Thus,
Corporation M has acquired from Corporation N assets worth a total
of $1.2 million during the 12-month period ending on November 1,
2006. Since $1.2 million is more than one-third of the total gross
fair market value of all of Corporation N's assets immediately prior
to the earlier of these acquisitions ($3 million), a change in the
ownership of a substantial portion of Corporation N's assets is
considered to have occurred on November 1, 2006.
Example 3. All of the assets of Corporation P are transferred
to Corporation O (an unrelated corporation). In exchange, the
shareholders of Corporation P receive Corporation O stock.
Immediately after the transfer, the former shareholders of
Corporation P own 60 percent of the fair market value of the
outstanding stock of Corporation O and the former shareholders of
Corporation O own 40 percent of the fair market value of the
outstanding stock of Corporation O. Because Corporation O is an
entity more than 50 percent of the fair market value of the
outstanding stock of which is owned by the former shareholders of
Corporation P (based on ownership of Corporation P prior the
change), the transfer of assets is not treated as a change in
ownership of a substantial portion of the assets of Corporation P.
However, a change in the ownership (within the meaning of Q/A-27) of
Corporation O occurs.
Three-Times-Base-Amount Test for Parachute Payments
Q-30: Are all payments that are in the nature of compensation, are
made to a disqualified individual, and are contingent on a change in
ownership or control, parachute payments?
A-30: (a) No, to determine whether such payments are parachute
payments, they must be tested against the individual's base amount (as
defined in Q/A-34 of this section). To do this, the aggregate present
value of all payments in the nature of compensation that are made or to
be made to (or for the benefit of) the same disqualified individual and
are contingent on the change in ownership or control must be
determined. If this aggregate present value equals or exceeds the
amount equal to 3 times the individual's base amount, the payments are
parachute payments. If this aggregate present value is less than the
amount equal to 3 times the individual's base amount, no portion of the
payment is a parachute payment. See Q/A-31, Q/A-32, and Q/A-33 of this
section for rules on determining present value. Parachute payments that
are securities violation parachute payments are not included in the
foregoing computation if they are not contingent on a change in
ownership or control. See Q/A-37 of this section for the definition and
treatment of securities violation parachute payments.
(b) The following examples illustrate the principles of this A-30:
Example 1. A is a disqualified individual with respect to
Corporation M. A's base amount is $100,000. Payments in the nature
of compensation that are contingent on a change in the ownership of
Corporation M totaling $400,000 are made to A on the date of the
change. The payments are parachute payments since they have an
aggregate present value at least equal to 3 times A's base amount of
$100,000 (3 x $100,000 = $300,000).
Example 2. Assume the same facts as in Example 1, except that
the payments contingent on the change in the ownership of
Corporation M total $290,000. Since the payments do not have an
aggregate present value at least equal to 3 times A's base amount,
no portion of the payments is a parachute payment.
Q-31: As of what date is the present value of a payment determined?
A-31: (a) Except as provided in this section, the present value of
a payment is determined as of the date on which the change in ownership
or control occurs, or, if a payment is made prior to such date, the
date on which the payment is made.
(b)(1) For purposes of determining whether a payment is a parachute
payment, if a payment in the nature of compensation is the right to
receive payments in a year (or years) subsequent to the year of the
change in ownership or control, the value of the payment is the present
value of such payment (or payments) calculated in accordance with Q/A-
32 of this section and based on reasonable actuarial assumptions.
(2) If the payment in the nature of compensation is an obligation
to provide health care, then for purposes of this A-31 and for applying
the 3-times-base-amount test under Q/A-30 of this section, the present
value of such obligation should be calculated in accordance with
generally accepted accounting principles. For purposes of Q/A-30 and
this A-31, the obligation to provide health care is permitted to be
measured by projecting the cost of premiums for purchased health care
insurance, even if no health care insurance is actually purchased. If
the obligation to provide health care is made in coordination with a
health care plan that the corporation makes available to a group, then
the premiums
[[Page 7651]]
used for this purpose may be group premiums.
Q-32: What discount rate is to be used to determine present value?
A-32: For purposes of this section, present value generally is
determined by using a discount rate equal to 120 percent of the
applicable Federal rate (determined under section 1274(d) and the
regulations thereunder) compounded semiannually. The applicable Federal
rate to be used for this purpose is the Federal rate that is in effect
on the date as of which the present value is determined. See Q/A-24 and
35 of this section. However, for any payment, the corporation and the
disqualified individual may elect to use the applicable Federal rate
that is in effect on the date that the contract which provides for the
payment is entered into, if such election is made in the contract.
Q-33: If the present value of a payment to be made in the future is
contingent on an uncertain future event or condition, how is the
present value of the payment determined?
A-33: (a) In certain cases, it may be necessary to apply the 3-
times-base-amount test of Q/A-30 of this section or to allocate a
portion of the base amount to a payment described in paragraphs (a)(1),
(2), and (3) of Q/A-2 of this section at a time when the aggregate
present value of all such payments cannot be determined with certainty
because the time, amount, or right to receive one or more such payments
is contingent on the occurrence of an uncertain future event or
condition. For example, a disqualified individual's right to receive a
payment may be contingent on the involuntary termination of such
individual's employment with the corporation. In such a case, it must
be reasonably estimated whether the payment will be made. If it is
reasonably estimated that there is a 50-percent or greater probability
that the payment will be made, the full amount of the payment is
considered for purposes of the 3-times-base-amount test and the
allocation of the base amount. Conversely, if it is reasonably
estimated that there is a less than 50-percent probability that the
payment will be made, the payment is not considered for either purpose.
(b) If the estimate made under paragraph (a) of this A-33 is later
determined to be incorrect, the 3-times-base-amount test described in
Q/A-30 of this section must be reapplied (and the portion of the base
amount allocated to previous payments must be reallocated (if
necessary) to such payments) to reflect the actual time and amount of
the payment. Whenever the 3-times-base-amount test is applied (or
whenever the base amount is allocated), the aggregate present value of
the payments received or to be received by the disqualified individual
is redetermined as of the date described in A-31 of this section, using
the discount rate described in A-32 of this section. This
redetermination may affect the amount of any excess parachute payment
for a prior taxable year. Alternatively, if, based on the application
of the 3-times-base-amount test without regard to the payment described
in paragraph (a) of this A-33, a disqualified individual is determined
to have an excess parachute payment or payments, then the 3-times-base-
amount test does not have to be reapplied when a payment described in
paragraph (a) of this A-33 is made (or becomes certain to be made) if
no base amount is allocated to such payment.
(c) The following examples illustrate the principles of this A-33:
Example 1. A, a disqualified individual with respect to
Corporation M, has a base amount of $100,000. Under A's employment
agreement with Corporation M, A is entitled to receive a payment in
the nature of compensation in the amount of $250,000 contingent on a
change in ownership or control of Corporation M. In addition, the
agreement provides that if A's employment is terminated within 1
year after the change in ownership or control, A will receive an
additional payment in the nature of compensation in the amount of
$150,000, payable 1 year after the date of the change in ownership
or control. A change in ownership or control of Corporation M occurs
and A receives the first payment of $250,000. Corporation M
reasonably estimates that there is a 50-percent probability that, as
a result of the change, A's employment will be terminated within 1
year of the date of the change. For purposes of applying the 3-
times-base-amount test (and if the first payment is determined to be
a parachute payment, for purposes of allocating a portion of A's
base amount to that payment), because M reasonably estimates that
there is a 50-percent or greater probability that, as a result of
the change, A's employment will be terminated within 1 year of the
date of the change, Corporation M must assume that the $150,000
payment will be made to A as a result of the change in ownership or
control. The present value of the additional payment is determined
under Q/A-31 and Q/A-32 of this section.
Example 2. Assume the same facts as in Example 1 except that
Corporation M reasonably estimates that there is a less than 50-
percent probability that, as a result of the change, A's employment
will be terminated within 1 year of the date of the change. For
purposes of applying the 3-times-base-amount test, because
Corporation M reasonably estimates that there is a less than 50-
percent probability that, as a result of the change, A's employment
will be terminated within 1 year of the date of the change,
Corporation M must assume that the $150,000 payment will not be made
to A as a result of the change in ownership or control.
Example 3. B, a disqualified individual with respect to
Corporation P, has a base amount of $200,000. Under B's employment
agreement with Corporation P, if there is a change in ownership or
control of Corporation P, B will receive a severance payment of
$600,000 and a bonus payment of $400,000. In addition, the agreement
provides that if B's employment is terminated within 1 year after
the change, B will receive an additional payment in the nature of
compensation of $500,000. A change in ownership or control of
Corporation P occurs, and B receives the $600,000 and $400,000
payments. At the time of the change in ownership or control,
Corporation P reasonably estimates that there is a less than 50-
percent probability that B's employment will be terminated within 1
year of the change. For purposes of applying the 3-times-base-amount
test, because Corporation P reasonably estimates that there is a
less than 50-percent probability that B's employment will be
terminated within 1 year of the date of the change, Corporation P
assumes that the $500,000 payment will not be made to B. Eleven
months after the change in ownership or control, B's employment is
terminated, and the $500,000 payment is made to B. Because B was
determined to have excess parachute payments without regard to the
$500,000 payment, the 3-times-base-amount test is not reapplied and
the base amount is not reallocated to include the $500,000 payment.
The entire $500,000 payment is treated as an excess parachute
payment.
Q-34: What is the base amount?
A-34: (a) The base amount of a disqualified individual is the
average annual compensation for services performed for the corporation
with respect to which the change in ownership or control occurs (or for
a predecessor entity or a related entity) which was includible in the
gross income of such individual for taxable years in the base period
(including amounts that were excluded under section 911), or which
would have been includible in such gross income if such person had been
a United States citizen or resident. See Q/A-35 of this section for the
definition of base period and for examples of base amount computations.
(b) If the base period of a disqualified individual includes a
short taxable year or less than all of a taxable year, compensation for
such short or incomplete taxable year must be annualized before
determining the average annual compensation for the base period. In
annualizing compensation, the frequency with which payments are
expected to be made over an annual period must be taken into account.
Thus, any amount of compensation for such a short or
[[Page 7652]]
incomplete taxable year that represents a payment that will not be made
more often than once per year is not annualized.
(c) Because the base amount includes only compensation that is
includible in gross income, the base amount does not include certain
items that constitute parachute payments. For example, payments in the
form of excludible fringe benefits are not included in the base amount
but may be treated as parachute payments.
(d) The base amount includes the amount of compensation included in
income under section 83(b) during the base period.
(e) The following example illustrates the principles of this A-34:
Example. A disqualified individual, D, receives an annual salary
of $500,000 per year during the 5-year base period. D defers
$100,000 of D's salary each year under the corporation's
nonqualified deferred compensation plan. D's base amount is $400,000
($400,000 x (5/5)).
Q-35: What is the base period?
A-35: (a) The base period of a disqualified individual is the most
recent 5 taxable years of the individual ending before the date of the
change in ownership or control. For this purpose, the date of the
change in ownership or control is the date the corporation experiences
one of the events described in Q/A-27, Q/A-28, or Q/A-29 of this
section. However, if the disqualified individual was not an employee or
independent contractor of the corporation with respect to which the
change in ownership or control occurs (or a predecessor entity or a
related entity as defined in Q/A-21 of this section) for this entire 5-
year period, the individual's base period is the portion of such 5-year
period during which the individual performed personal services for the
corporation or predecessor entity or related entity.
(b) The following examples illustrate the principles of Q/A-34 of
this section and this Q/A-35:
Example 1. A disqualified individual, D, was employed by a
corporation for 2 years and 4 months preceding the taxable year in
which a change in ownership or control of the corporation occurs.
D's includible compensation income from the corporation was $30,000
for the 4-month period, $120,000 for the first full year, and
$150,000 for the second full year. D's base amount is $120,000, ((3
x $30,000) + $120,000 + $150,000)/ 3.
Example 2. Assume the same facts as in Example 1, except that D
also received a $60,000 signing bonus when D's employment with the
corporation commenced at the beginning of the 4-month period. D's
base amount is $140,000, (($60,000 + (3 x $30,000)) + $120,000 +
$150,000) / 3. Since the bonus will not be paid more often than once
per year, the amount of the bonus is not increased in annualizing
D's compensation for the 4-month period.
Q-36: How is the base amount determined in the case of a
disqualified individual who did not perform services for the
corporation (or a predecessor entity or a related entity as defined in
Q/A-21 of this section), prior to the individual's taxable year in
which the change in ownership or control occurs?
A-36: (a) In such a case, the individual's base amount is the
annualized compensation for services performed for the corporation (or
a predecessor entity or related entity) which--
(1) Was includible in the individual's gross income for that
portion, prior to such change, of the individual's taxable year in
which the change occurred (including amounts that were excluded under
section 911), or would have been includible in such gross income if
such person had been a United States citizen or resident;
(2) Was not contingent on the change in ownership or control; and
(3) Was not a securities violation parachute payment.
(b) The following examples illustrate the principles of this A-36:
Example 1. On January 1, 2006, A, an individual whose taxable
year is the calendar year, enters into a 4-year employment contract
with Corporation M as an officer of the corporation. A has not
previously performed services for Corporation M (or any predecessor
entity or related entity as defined in Q/A-21 of this section).
Under the employment contract, A is to receive an annual salary of
$120,000 for each of the 4 years that he remains employed by
Corporation M with any remaining unpaid balance to be paid
immediately in the event that A's employment is terminated without
cause. On July 1, 2006, after A has received compensation of
$60,000, a change in the ownership of Corporation M occurs. Because
of the change, A's employment is terminated without cause, and he
receives a payment of $420,000. It is established by clear and
convincing evidence that the $60,000 in compensation is not
contingent on the change in ownership or control, but the
presumption that the $420,000 payment is contingent on the change is
not rebutted. Thus, the payment of $420,000 is treated as contingent
on the change in ownership of Corporation M. In this case, A's base
amount is $120,000 (2 x $60,000). Since the present value of the
payment which is contingent on the change in ownership of
Corporation M ($420,000) is more than 3 times A's base amount of
$120,000 (3 x $120,000 = $360,000), the payment is a parachute
payment.
Example 2. Assume the same facts as in Example 1, except that A
also receives a signing bonus of $50,000 from Corporation M on
January 1, 2006. It is established by clear and convincing evidence
that the bonus is not contingent on the change in ownership. When
the change in ownership occurs on July 1, 2006, A has received
compensation of $110,000 (the $50,000 bonus plus $60,000 in salary).
In this case, A's base amount is $170,000 [$50,000 + (2 x
$60,000)]. Since the $50,000 bonus will not be paid more than once
per year, the amount of the bonus is not increased in annualizing
A's compensation. The present value of the potential parachute
payment ($420,000) is less than 3 times A's base amount of $170,000
(3 x $170,000 = $510,000), and therefore no portion of the payment
is a parachute payment.
Securities Violation Parachute Payments
Q-37: Must a payment be contingent on a change in ownership or
control in order to be a parachute payment?
A-37: (a) No, the term parachute payment also includes any payment
(other than a payment exempted under Q/A-6 or Q/A-8 of this section)
that is in the nature of compensation and is to (or for the benefit of)
a disqualified individual, if such payment is a securities violation
payment. A securities violation payment is a payment made or to be
made--
(1) Pursuant to an agreement that violates any generally enforced
Federal or State securities laws or regulations; and
(2) In connection with a potential or actual change in ownership or
control.
(b) A violation is not taken into account under paragraph (a)(1) of
this A-37 if it is merely technical in character or is not materially
prejudicial to shareholders or potential shareholders. Moreover, a
violation will be presumed not to exist unless the existence of the
violation has been determined or admitted in a civil or criminal action
(or an administrative action by a regulatory body charged with
enforcing the particular securities law or regulation) which has been
resolved by adjudication or consent. Parachute payments described in
this A-37 are referred to in this section as securities violation
payments.
(c) Securities violation parachute payments that are not contingent
on a change in ownership or control within the meaning of Q/A-22 of
this section are not taken into account in applying the 3-times-base-
amount test of Q/A-30 of this section. Such payments are considered
parachute payments regardless of whether such test is met with respect
to the disqualified individual (and are included in allocating base
amount under Q/A-38 of this section). Moreover, the amount of a
securities violation parachute payment treated as an excess parachute
payment shall not be reduced by the portion of
[[Page 7653]]
such payment that is reasonable compensation for personal services
actually rendered before the date of a change in ownership or control
if such payment is not contingent on such change. Likewise, the amount
of a securities violation parachute payment includes the portion of
such payment that is reasonable compensation for personal services to
be rendered on or after the date of a change in ownership or control if
such payment is not contingent on such change.
(d) The rules in paragraph (b) of this A-37 also apply to
securities violation parachute payments that are contingent on a change
in ownership or control if the application of these rules results in
greater total excess parachute payments with respect to the
disqualified individual than would result if the payments were treated
simply as payments contingent on a change in ownership or control (and
hence were taken into account in applying the 3-times-base-amount test
and were reduced by, or did not include, any applicable amount of
reasonable compensation).
(e) The following examples illustrate the principles of this A-37:
Example 1. A, a disqualified individual with respect to
Corporation M, receives two payments in the nature of compensation
that are contingent on a change in the ownership or control of
Corporation M. The present value of the first payment is equal to
A's base amount and is not a securities violation parachute payment.
The present value of the second payment is equal to 1.5 times A's
base amount and is a securities violation parachute payment. Neither
payment includes any reasonable compensation. If the second payment
is treated simply as a payment contingent on a change in ownership
or control, the amount of A's total excess parachute payments is
zero because the aggregate present value of the payments does not
equal or exceed 3 times A's base amount. If the second payment is
treated as a securities violation parachute payment subject to the
rules of paragraph (b) of this A-37, the amount of A's total excess
parachute payments is 0.5 times A's base amount. Thus, the second
payment is treated as a securities violation parachute payment.
Example 2. Assume the same facts as in Example 1, except that
the present value of the first payment is equal to 2 times A's base
amount. If the second payment is treated simply as a payment
contingent on a change in ownership or control, the total present
value of the payments is 3.5 times A's base amount, and the amount
of A's total excess parachute payments is 2.5 times A's base amount.
If the second payment is treated as a securities violation parachute
payment, the amount of A's total excess parachute payments is 0.5
times A's base amount. Thus, the second payment is treated simply as
a payment contingent on a change in ownership or control.
Example 3. B, a disqualified individual with respect to
Corporation N, receives two payments in the nature of compensation
that are contingent on a change in the control of Corporation N. The
present value of the first payment is equal to 4 times B's base
amount and is a securities violation parachute payment. The present
value of the second payment is equal to 2 times B's base amount and
is not a securities violation parachute payment. B establishes by
clear and convincing evidence that the entire amount of the first
payment is reasonable compensation for personal services to be
rendered after the change in ownership or control. If the first
payment is treated simply as a payment contingent on a change in
ownership or control, it is exempt from the definition of parachute
payment pursuant to Q/A-9 of this section. Thus, the amount of B's
total excess parachute payment is zero because the present value of
the second payment does not equal or exceed three times B's base
amount. However, if the first payment is treated as a securities
violation parachute payment, the amount of B's total excess
parachute payments is 3 times B's base amount. Thus, the first
payment is treated as a securities violation parachute payment.
Example 4. Assume the same facts as in Example 3, except that B
does not receive the second payment and B establishes by clear and
convincing evidence that the first payment is reasonable
compensation for services actually rendered before the change in the
control of Corporation N. If the payment is treated simply as a
payment contingent on a change in ownership or control, the amount
of B's excess parachute payment is zero because the amount treated
as an excess parachute payment is reduced by the amount that B
establishes as reasonable compensation. However, if the payment is
treated as a securities violation parachute payment, the amount of
B's excess parachute payment is 3 times B's base amount. Thus, the
payment is treated as a securities violation parachute payment.
Computation and Reduction of Excess Parachute Payments
Q-38: How is the amount of an excess parachute payment computed?
A-38: (a) The amount of an excess parachute payment is the excess
of the amount of any parachute payment over the portion of the
disqualified individual's base amount that is allocated to such
payment. For this purpose, the portion of the base amount allocated to
any parachute payment is the amount that bears the same ratio to the
base amount as the present value of such parachute payment bears to the
aggregate present value of all parachute payments made or to be made to
(or for the benefit of) the same disqualified individual. Thus, the
portion of the base amount allocated to any parachute payment is
determined by multiplying the base amount by a fraction, the numerator
of which is the present value of such parachute payment and the
denominator of which is the aggregate present value of all such
payments. See Q/A-31, Q/A-32, and Q/A-33 of this section for rules on
determining present value and Q/A-34 of this section for the definition
of base amount.
(b) The following example illustrates the principles of this A-38:
Example. An individual with a base amount of $100,000 is
entitled to receive two parachute payments, one of $200,000 and the
other of $400,000. The $200,000 payment is made at the time of the
change in ownership or control, and the $400,000 payment is to be
made at a future date. The present value of the $400,000 payment is
$300,000 on the date of the change in ownership or control. The
portions of the base amount allocated to these payments are $40,000
(($200,000/$500,000) x $100,000) and $60,000 (($300,000/$500,000)
x $100,000), respectively. Thus, the amount of the first excess
parachute payment is $160,000 ($200,000--$40,000) and that of the
second is $340,000 ($400,000--$60,000).
Q-39: May the amount of an excess parachute payment be reduced by
reasonable compensation for personal services actually rendered before
the change in ownership or control?
A-39: (a) Generally, yes, except that in the case of payments
treated as securities violation parachute payments or when the portion
of a payment that is treated as contingent on the change in ownership
or control is determined under paragraph (b) or (c) of Q/A-24 of this
section, the amount of an excess parachute payment is reduced by any
portion of the payment that the taxpayer establishes by clear and
convincing evidence is reasonable compensation for personal services
actually rendered by the disqualified individual before the date of the
change in ownership or control. Services reasonably compensated for by
payments that are not parachute payments (for example, because the
payments are not contingent on a change in ownership or control and are
not securities violation parachute payments, or because the payments
are exempt from the definition of parachute payment under Q/A-6 through
Q/A-9 of this section) are not taken into account for this purpose. The
portion of any parachute payment that is established as reasonable
compensation is first reduced by the portion of the disqualified
individual's base amount that is allocated to such parachute payment;
any remaining portion of the parachute payment established as
reasonable compensation then reduces the excess parachute payment.
(b) The following examples illustrate the principles of this A-39:
Example 1. Assume that a parachute payment of $600,000 is made
to a
[[Page 7654]]
disqualified individual, and the portion of the individual's base
amount that is allocated to the parachute payment is $100,000. Also
assume that $300,000 of the $600,000 parachute payment is
established as reasonable compensation for personal services
actually rendered by the disqualified individual before the date of
the change in ownership or control. Before the reasonable
compensation is taken into account, the amount of the excess
parachute payment is $500,000 ($600,000--$100,000). In reducing the
excess parachute payment by reasonable compensation, the portion of
the parachute payment that is established as reasonable compensation
($300,000) is first reduced by the portion of the disqualified
individual's base amount that is allocated to the parachute payment
($100,000), and the remainder ($200,000) then reduces the excess
parachute payment. Thus, in this case, the excess parachute payment
of $500,000 is reduced by $200,000 of reasonable compensation.
Example 2. Assume the same facts as in Example 1, except that
the full amount of the $600,000 parachute payment is established as
reasonable compensation. In this case, the excess parachute payment
of $500,000 is reduced to zero by $500,000 of reasonable
compensation. As a result, no portion of any deduction for the
payment is disallowed by section 280G, and no portion of the payment
is subject to the 20-percent excise tax of section 4999.
Determination of Reasonable Compensation
Q-40: How is it determined whether payments are reasonable
compensation?
A-40: (a) In general, whether payments are reasonable compensation
for personal services actually rendered, or to be rendered, by the
disqualified individual is determined on the basis of all the facts and
circumstances of the particular case. Factors relevant to such a
determination include, but are not limited to, the following--
(1) The nature of the services rendered or to be rendered;
(2) The individual's historic compensation for performing such
services; and
(3) The compensation of individuals performing comparable services
in situations where the compensation is not contingent on a change in
ownership or control.
(b) For purposes of section 280G, reasonable compensation for
personal services includes reasonable compensation for holding oneself
out as available to perform services and refraining from performing
services (such as under a covenant not to compete).
Q-41: Is any particular type of evidence generally considered clear
and convincing evidence of reasonable compensation for personal
services?
A-41: Yes, a showing that payments are made under a
nondiscriminatory employee plan or program (as defined in Q/A-26 of
this section) generally is considered to be clear and convincing
evidence that the payments are reasonable compensation. This is true
whether the personal services for which the payments are made are
actually rendered before, or to be rendered on or after, the date of
the change in ownership or control. Q/A-46 of this section (relating to
the treatment of an affiliated group as one corporation) does not apply
for purposes of this A-41. No determination of reasonable compensation
is needed for payments under qualified plans to be exempt from the
definition of parachute payment under Q/A-8 of this section.
Q-42: Is any particular type of evidence generally considered clear
and convincing evidence of reasonable compensation for personal
services to be rendered on or after the date of a change in ownership
or control?
A-42: (a) Yes, if payments are made or to be made to (or on behalf
of) a disqualified individual for personal services to be rendered on
or after the date of a change in ownership or control, a showing of the
following generally is considered to be clear and convincing evidence
that the payments are reasonable compensation for services to be
rendered on or after the date of the change in ownership or control--
(1) The payments were made or are to be made only for the period
the individual actually performs such personal services; and
(2) If the individual's duties and responsibilities are
substantially the same after the change in ownership or control, the
individual's annual compensation for such services is not significantly
greater than such individual's annual compensation prior to the change
in ownership or control, apart from normal increases attributable to
increased responsibilities or cost of living adjustments. If the scope
of the individual's duties and responsibilities are not substantially
the same, the annual compensation after the change is not significantly
greater than the annual compensation customarily paid by the employer
or by comparable employers to persons performing comparable services.
However, except as provided in paragraph (b) of this A-42, such clear
and convincing evidence will not exist if the individual does not, in
fact, perform the services contemplated in exchange for the
compensation.
(b) Generally, an agreement under which the disqualified individual
must refrain from performing services (such as a covenant not to
compete) is an agreement for the performance of personal services for
purposes of this A-42 to the extent that it is demonstrated by clear
and convincing evidence that the agreement substantially constrains the
individual's ability to perform services and there is a reasonable
likelihood that the agreement will be enforced against the individual.
In the absence of clear and convincing evidence, payments under the
agreement are treated as severance payments under Q/A-44 of this
section.
(c) If the employment of a disqualified individual is involuntarily
terminated before the end of a contract term and the individual is paid
damages for breach of contract, a showing of the following factors
generally is considered clear and convincing evidence that the payment
is reasonable compensation for personal services to be rendered on or
after the date of change in ownership or control--
(1) The contract was not entered into, amended, or renewed in
contemplation of the change in ownership or control;
(2) The compensation the individual would have received under the
contract would have qualified as reasonable compensation under section
162;
(3) The damages do not exceed the present value (determined as of
the date of receipt) of the compensation the individual would have
received under the contract if the individual had continued to perform
services for the employer until the end of the contract term;
(4) The damages are received because an offer to provide personal
services was made by the disqualified individual but was rejected by
the employer; and
(5) The damages are reduced by mitigation. Mitigation will be
treated as occurring when such damages are reduced (or any payment of
such damages is returned) to the extent of the disqualified
individual's earned income (within the meaning of section 911(d)(2)(A))
during the remainder of the period in which the contract would have
been in effect. See Q/A-44 of this section for rules regarding damages
for a failure to make severance payments.
(c) The following examples illustrate the principles of this A-42:
Example 1. A, a disqualified individual, has a three-year
employment contract with Corporation M, a publicly traded
corporation. Under this contract, A is to receive a salary for
$100,000 for the first year of the contract and, for each succeeding
year, an annual salary that is 10 percent higher than the prior
year's salary. During the third year of the contract, Corporation N
acquires all the stock of Corporation M. Prior to the change in
ownership, Corporation N arranges to retain A's services by entering
into an employment contract with A that is essentially the same as
A's contract with Corporation M. Under
[[Page 7655]]
the new contract, Corporation N is to fulfill Corporation M's
obligations for the third year of the old contract, and, for each of
the succeeding years, pay A an annual salary that is 10 percent
higher than A's prior year's salary. Amounts are payable under the
new contract only for the portion of the contract term during which
A remains employed by Corporation N. A showing of the facts
described above (and in the absence of contradictory evidence) is
regarded as clear and convincing evidence that all payments under
the new contract are reasonable compensation for personal services
to be rendered on or after the date of the change in ownership.
Therefore, the payments under this agreement are exempt from the
definition of parachute payment pursuant to Q/A-9 of this section.
Example 2. Assume the same facts as in Example 1 except that A
does not perform the services described in the new contract, but
receives payment under the new contract. Because services were not
rendered after the change, the payments under this contract are not
exempt from the definition of parachute payment pursuant to Q/A-9 of
this section.
Example 3. Assume the same facts as in Example 1 except that
under the new contract A agrees to perform consulting services to
Corporation N, when and if, Corporation N requires A's services.
Assume further that when Corporation N does not require A's
services, the contract provides that A must not perform services for
any other competing company. Corporation N previously enforced
similar contracts against former employees of Corporation N. Because
A is substantially constrained under this contract and Corporation N
is reasonably likely to enforce the contract against A, the
agreement is an agreement for the performance of services under
paragraph (b) of this A-42. Assuming the requirements of paragraph
(a) of this A-42 are met and there is clear and convincing evidence
that all payments under the new contract are reasonable compensation
for personal services to be rendered on or after the date of the
change in ownership, the payments under this contract are exempt
from the definition of parachute payment pursuant to Q/A-9 of this
section.
Example 4. Assume the same facts as in Example 1, except that
the employment contract with Corporation N does not provide that
amounts are payable under the contract only for the portion of the
term for which A remains employed by Corporation N. Shortly after
the change in ownership, and despite A's request to remain employed
by Corporation N, A's employment with Corporation N is involuntarily
terminated. Shortly thereafter, A obtains employment with
Corporation O. A commences a civil action against Corporation N,
alleging breach of the employment contract. In settlement of the
litigation, A receives an amount equal to the present value of the
compensation A would have received under the contract with
Corporation N, reduced by the amount of compensation A otherwise
receives from Corporation O during the period that the contract
would have been in effect. A showing of the facts described above
(and in the absence of contradictory evidence) is regarded as clear
and convincing evidence that the amount A receives as damages is
reasonable compensation for personal services to be rendered on or
after the date of the change in ownership. Therefore, the amount
received by A is exempt from the definition of parachute payment
pursuant to Q/A-9 of this section.
Q-43: Is any particular type of payment generally considered
reasonable compensation for personal services actually rendered before
the date of a change in ownership or control?
A-43: (a) Yes, payments of compensation earned before the date of a
change in ownership or control generally are considered reasonable
compensation for personal services actually rendered before the date of
a change in ownership or control if they qualify as reasonable
compensation under section 162.
Q-44: May severance payments be treated as reasonable compensation?
A-44: (a) No, severance payments are not treated as reasonable
compensation for personal services actually rendered before, or to be
rendered on or after, the date of a change in ownership or control.
Moreover, any damages paid for a failure to make severance payments are
not treated as reasonable compensation for personal services actually
rendered before, or to be rendered on or after, the date of such
change. For purposes of this section, the term severance payment means
any payment that is made to (or for the benefit of) a disqualified
individual on account of the termination of such individual's
employment prior to the end of a contract term, but does not include
any payment that otherwise would be made to (or for the benefit of)
such individual on the termination of such individual's employment,
whenever occurring.
(b) The following example illustrates the principles of this A-44:
Example. A, a disqualified individual, has a three-year
employment contract with Corporation X. Under the contract, A will
receive a salary of $200,000 for the first year of the contract, and
for each succeeding year, an annual salary that is $100,000 higher
than the previous year. In the event of A's termination of
employment following a change in ownership or control, the contract
provides that A will receive the remaining salary due under the
employment contract. At the beginning of the second year of the
contract, Corporation Y acquires all of the stock of Corporation X,
A's employment is terminated, and A receives $700,000 ($300,000 for
the second year of the contract plus $400,000 for the third year of
the contract) representing the remaining salary due under the
employment contract. Because the $700,000 payment is treated as a
severance payment, it is not reasonable compensation for personal
services on or after the date of the change in ownership or control.
Thus, the full amount of the $700,000 is a parachute payment.
Miscellaneous Rules
Q-45: How is the term corporation defined?
A-45: For purposes of this section, the term corporation has the
meaning prescribed by section 7701(a)(3) and Sec. 301.7701-2(b). For
example, a corporation, for purposes of this section, includes a
publicly traded partnership treated as a corporation under section 7704
(a); an entity described in Sec. 301.7701-3(c)(1)(v)(A) of this
chapter; a real estate investment trust under section 856(a); a
corporation that has mutual or cooperative (rather than stock)
ownership, such as a mutual insurance company, a mutual savings bank,
or a cooperative bank (as defined in section 7701(a)(32)), and a
foreign corporation as defined under section 7701(a)(5).
Q-46: How is an affiliated group treated?
A-46: For purposes of this section, and except as otherwise
provided in this section, all members of the same affiliated group (as
defined in section 1504, determined without regard to section 1504(b))
are treated as one corporation. Rules affected by this treatment of an
affiliated group include (but are not limited to) rules relating to
exempt payments of certain corporations (Q/A-6, Q/A-7 of this section
(except as provided therein)), payor of parachute payments (Q/A-10 of
this section), disqualified individuals (Q/A-15 through Q/A-21 of this
section (except as provided therein)), rebuttal of the presumption that
payments are contingent on a change (Q/A-26 of this section (except as
provide therein)), change in ownership or control (Q/A-27, 28, and 29
of this section), and reasonable compensation (Q/A-42, 43, and 44 of
this section).
Effective Date
Q-47: What is the general effective date of section 280G?
A-47: (a) Generally, section 280G applies to payments under
agreements entered into or renewed after June 14, 1984. Any agreement
that is entered into before June 15, 1984, and is renewed after June
14, 1984, is treated as a new contract entered into on the day the
renewal takes effect.
(b) For purposes of paragraph (a) of this A-47, a contract that is
terminable or cancellable unconditionally at will by either party to
the contract without the consent of the other, or by both parties to
the contract, is treated as a new
[[Page 7656]]
contract entered into on the date any such termination or cancellation,
if made, would be effective. However, a contract is not treated as so
terminable or cancellable if it can be terminated or cancelled only by
terminating the employment relationship or independent contractor
relationship of the disqualified individual.
(c) Section 280G applies to payments under a contract entered into
on or before June 14, 1984, if the contract is amended or supplemented
after June 14, 1984, in significant relevant respect. For this purpose,
a supplement to a contract is defined as a new contract entered into
after June 14, 1984, that affects the trigger, amount, or time of
receipt of a payment under an existing contract.
(d)(1) Except as otherwise provided in paragraph (e) of this A-47,
a contract is considered to be amended or supplemented in significant
relevant respect if provisions for payments contingent on a change in
ownership or control (parachute provisions), or provisions in the
nature of parachute provisions, are added to the contract, or are
amended or supplemented to provide significant additional benefits to
the disqualified individual. Thus, for example, a contract generally is
treated as amended or supplemented in significant relevant respect if
it is amended or supplemented--
(i) To add or modify, to the disqualified individual's benefit, a
change in ownership or control trigger;
(ii) To increase amounts payable that are contingent on a change in
ownership or control (or, where payment is to be made under a formula,
to modify the formula to the disqualified individual's advantage); or
(iii) To accelerate, in the event of a change in ownership or
control, the payment of amounts otherwise payable at a later date.
(2) For purposes of paragraph (a) of this A-47, a payment is not
treated as being accelerated in the event of a change in ownership or
control if the acceleration does not increase the present value of the
payment.
(e) A contract entered into on or before June 14, 1984, is not
treated as amended or supplemented in significant relevant respect
merely by reason of normal adjustments in the terms of employment
relationship or independent contractor relationship of the disqualified
individual. Whether an adjustment in the terms of such a relationship
is considered normal for this purpose depends on all of the facts and
circumstances of the particular case. Relevant factors include, but are
not limited to, the following--
(1) The length of time between the adjustment and the change in
ownership or control;
(2) The extent to which the corporation, at the time of the
adjustment, viewed itself as a likely takeover candidate;
(3) A comparison of the adjustment with historical practices of the
corporation;
(4) The extent of overlap between the group receiving the benefits
of the adjustment and those members of that group who are the
beneficiaries of pre-June 15, 1984, parachute contracts; and
(5) The size of the adjustment, both in absolute terms and in
comparison with the benefits provided to other members of the group
receiving the benefits of the adjustment.
Q-48: What is the effective date of this section?
A-48: This section applies to any payment that is contingent on a
change in ownership or control that occurs on or after January 1, 2004.
Taxpayers can rely on these rules for the treatment of any parachute
payment made after February 20, 2002.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-3819 Filed 2-19-02; 8:45 am]
BILLING CODE 4830-01-P