Section 4999: Excise Tax on Golden Parachute Payments
Navigate the financial and procedural rules of Section 4999, which governs the excise tax on executive payments made during corporate takeovers.
Internal Revenue Code Section 4999 contains rules designed to address substantial compensation packages awarded to executives during corporate takeovers. These rules impose a specific excise tax on “golden parachute” payments to discourage excessive arrangements arising from a change in corporate control. This framework creates tax consequences for both the company making the payment and the individual receiving it, establishing a clear line for what constitutes such a payment.
Identifying a Parachute Payment
A payment is classified as a parachute payment subject to excise tax only if it meets three specific criteria. The first condition is that the payment must be made to a “disqualified individual.” This category includes company officers, certain significant shareholders, and a specific group of the highest-paid employees or independent contractors. A highly compensated individual is one who is among the highest-paid one percent of employees or the highest-paid 250 employees, whichever group is smaller.
The second requirement is that the payment must be contingent on a “change in control” of the corporation. This is triggered by events like an acquisition of more than 50% of the corporation’s stock by value or voting power, a change in the majority of the board of directors, or an acquisition of 20% or more of the corporation’s voting power. A change in control also occurs with an acquisition of a substantial portion of the corporation’s assets, defined as one-third or more of the total gross fair market value.
The final test is the three-times base amount test. The rules are triggered only if the total present value of all payments contingent on the change in control equals or exceeds three times the individual’s “base amount.” The present value is calculated using a discount rate of 120 percent of the Applicable Federal Rate (AFR). If the total value does not reach this threshold, the payments are not considered parachute payments, and the excise tax does not apply.
Calculating the Excise Tax
The first step in calculating the excise tax is to determine the individual’s “base amount.” This figure is the average of the individual’s annual compensation includible in their gross income for the five taxable years immediately preceding the year of the change in control. This includes salary, bonuses, and the value of taxable benefits.
Once the base amount is established, the “excess parachute payment” is calculated. The 20% excise tax is not applied to the amount that exceeds the three-times trigger; instead, it is levied on the portion of the payment that exceeds one times the individual’s base amount. If total payments are $300,000 and the base amount is $100,000, the entire $300,000 is a parachute payment, but only the $200,000 “excess” portion is subject to the tax.
To illustrate, an executive with a base amount of $400,000 receives $1,500,000 in payments contingent on a change in control. Since $1,500,000 is greater than three times the base amount ($1,200,000), the parachute rules apply. The excess parachute payment is $1,100,000 ($1,500,000 minus the $400,000 base amount). The executive’s excise tax is 20% of this excess, or $220,000, and the corporation is denied a tax deduction for the $1,100,000 excess payment.
Exceptions and Mitigation Strategies
The tax code provides several exceptions that prevent a payment from being subject to the 20% excise tax. One exception applies to corporations that, immediately before the change in control, were eligible to be a small business corporation, or S corporation. Payments from these entities are exempt from the golden parachute rules.
Another exception is available for non-publicly traded corporations, which can avoid the tax by securing shareholder approval. This process requires the company to provide adequate disclosure of all material facts concerning the payments to all shareholders. The payments must then be approved by a vote of more than 75% of the voting power of all outstanding stock, excluding stock owned by the individuals receiving the payments.
Payments established by clear and convincing evidence as reasonable compensation for services rendered on or after the change in control are not treated as parachute payments. This portion is excluded from the calculation to determine if the three-times base amount threshold is met. Similarly, any payment made to or from a qualified retirement plan, such as a 401(k) or a simplified employee pension (SEP) plan, is not considered a parachute payment.
Reporting and Paying the Tax
The employer is responsible for withholding the 20% excise tax from the payment, in addition to regular income tax withholding, and must report these amounts. The employer reports the total parachute payment as wages in Box 1 of the employee’s Form W-2. The 20% excise tax withheld is specifically reported in Box 12 of Form W-2, designated with the code “K”.
The employee is ultimately responsible for reporting and paying the tax as part of their annual income tax filing. The individual reports the 20% excise tax on their Form 1040, U.S. Individual Income Tax Return. The amount shown in Box 12 with code K on the W-2 is transferred to the “Other Taxes” section of the Form 1040.