What Is a Parachute Payment and How Is It Taxed?
Demystify executive parachute payments. Understand their purpose in corporate changes and the specific tax implications for companies and recipients.
A parachute payment is a financial arrangement providing compensation to executives or key employees, typically upon a change in corporate control. These pre-negotiated agreements, included in employment contracts, offer financial security during corporate transitions. They mitigate potential financial risks for executives who might lose their positions or see their roles diminished following major corporate events. Understanding these arrangements involves examining their components, triggers, financial thresholds, and tax implications.
Core Definition and Components
A parachute payment is a compensation package for high-level executives or key employees. These payments are stipulated within employment contracts or severance agreements, ensuring financial protection during corporate changes. Their purpose is to provide security and incentivize executives to remain with the company during uncertain periods, such as an acquisition.
Components commonly include severance pay, often calculated as a multiple of the executive’s annual salary, providing a lump sum or continued income. Bonuses, including those tied to transaction completion or as retention incentives, also form part of these packages.
Other elements often involve equity-based compensation, such as accelerated vesting of stock options or restricted stock units. This acceleration ensures the executive gains full ownership of their equity awards sooner. Additional benefits can extend to continued health insurance, relocation assistance, and reimbursement for legal fees associated with termination.
These payments are directed towards “disqualified individuals,” a term defined by tax regulations. This group includes officers, shareholders owning more than one percent of company stock, and highly compensated individuals (the top one percent of employees or up to 250 highest-paid). These individuals hold significant influence or ownership within the organization.
Triggers for a Parachute Payment
Parachute payments are activated by predefined events, primarily a “change in control” of the corporation. This ensures executives receive contracted compensation when the company’s ownership or strategic direction shifts. The payments compensate executives for potential job loss or a reduction in their authority and influence resulting from such changes.
A change in control can manifest in several ways. Examples include a merger or acquisition where a new entity gains majority ownership or control of the corporation’s stock. It also encompasses a significant shift in voting power or the board of directors’ composition.
A change in control can also be triggered by acquiring a substantial portion of the corporation’s assets, defined as one-third or more of the total gross fair market value. These payments are contingent on the change in control. The arrangements provide executives with financial protection and encourage their continued focus on company performance during transitional periods.
The 3x Average Compensation Threshold
For a payment to be classified as a “parachute payment” under federal tax rules, it must meet a financial threshold. This threshold is met if the aggregate present value of all payments contingent on a change in control equals or exceeds three times the executive’s “base amount.” This criterion determines the special tax treatment applied to these payments under Internal Revenue Code (IRC) Section 280G.
The “base amount” represents the executive’s average annual compensation over a specific period. It is calculated as the average annual taxable compensation, reported in Box 1 of Form W-2 or Form 1099, earned from the corporation during the five most recent taxable years ending before the change in control.
If an executive has not provided services for the entire five-year period, the base amount is determined by annualizing their compensation for the shorter period they were employed. This ensures a consistent baseline for comparison, regardless of the executive’s tenure. If total parachute payments fall below this three-times-base-amount threshold, they are not subject to the tax consequences of IRC Section 280G.
If the payments meet or exceed this threshold, the entire set of contingent payments is considered “parachute payments.” Exceeding this threshold activates the mechanism for calculating the “excess parachute payment,” which is then subject to tax.
Tax Consequences
Payments exceeding the three-times-base-amount threshold trigger two tax consequences under federal law, governed by IRC Section 280G and Section 4999. Both the executive and the company face financial repercussions.
First, the executive is subject to a 20% excise tax on the “excess parachute payment,” in addition to any ordinary income taxes. The “excess parachute payment” is the amount by which total parachute payments exceed one times the executive’s base amount. For example, if the base amount is $500,000 and the parachute payment is $1,500,001, the excise tax applies to $1,000,001 ($1,500,001 minus $500,000).
Second, the corporation making the payments is disallowed a tax deduction for the “excess parachute payment.” This means the company cannot deduct these compensation amounts as a business expense, increasing its taxable income. The disallowance applies to the same “excess parachute payment” amount subject to the executive’s excise tax.
The corporation is responsible for withholding the 20% excise tax if the payment constitutes wages.