Beware Golden Parachute Rules in Bank M&A

February 19, 2020 | Article

In many bank merger and acquisition transactions, “pay to stay” bonuses and other types of compensatory payments contingent on a change in ownership or control of the target bank are put in place. Sometimes these payments may equal or exceed three times the executive’s base compensation (their average compensation for the five years preceding the year of acquisition). This could potentially expose these compensatory payments to the “golden parachute” rules of Section 280G.

Why Care About Golden Parachute Payments?
Consequences associated with making parachute payments subject to section 280G include:

  • The corporation cannot deduct the compensation paid in excess of the base compensation amount for each applicable executive.
  • The executive receiving the excess payment is personally subject to a nondeductible 20% excise tax on the excess amount, plus ordinary income tax (and applicable employment taxes) on the entire amount of compensation received.

Example:
Assume executive A, in connection with an acquisition, receives a bonus of $1,200,000, and A’s base compensation amount is $200,000. The golden parachute rules are triggered because the total amount of A’s compensation contingent on the acquisition ($1,200,000) equals or exceeds three times A’s base amount ($600,000). A’s excess parachute payment is $1,000,000 ($1,200,000 minus the base compensation of $200,000). The bank’s lost tax deduction is $1,000,000 (resulting in a cost of $250,000 assuming a combined federal and state tax rate of 25%), and A’s 20% excise tax is $200,000. Thus, in this example, the total “penalty” imposed is $450,000.

Disqualified Individuals within Golden Parachute Payments
The golden parachute rules apply only to excess parachute payments made to certain “disqualified individuals.” Disqualified individuals include any employee or independent contractor performing personal services for the corporation who is an officer, shareholder, or highly compensated individual (HCI) during the “disqualified individual determination period.” The disqualified individual determination period is the 12 months prior to and ending on the acquisition change in ownership or control date.

Determining whether an individual is an officer is generally straight-forward, although special rules can apply depending on the particular facts and circumstances.

The determination of whether an individual is considered a shareholder is more complicated and requires a calculation of value to be made. During the disqualified individual determination period, if at any time therein, an individual (who is an employee or independent contractor) owns stock worth more than 1% of the fair market value of the outstanding shares of all classes of stock, that individual will be considered a shareholder.

An HCI is a member of a group consisting of the highest paid 1% of the target bank's employees not to exceed 250. An individual must have annualized compensation of at least $130,000 to be treated as an HCI. This amount applies for 2020 and is adjusted annually for inflation.

Changes of Ownership or Control
Parachute payments must be contingent on the change in ownership (generally a more than 50% stock ownership change) or effective control of the target bank or a change in ownership of a substantial portion (generally one-third or more) of the target bank’s assets in order to trigger the golden parachute rules.

Common types of parachute payments that may be contingent on an acquisition, and that would not have been paid had no acquisition occurred, include deferred compensation, change-in-control bonuses, “pay to stay” bonuses, severance payments, accelerated vesting of stock options and stock awards, and post-change consulting agreements.

If these type of payments—in the aggregate—equal or exceed three times the prior five years’ average compensation to an officer, shareholder or HCI, the negative tax consequences of Section 280G will apply unless steps are taken to avoid these rules.

Avoiding Section 280G
There are several exceptions that can apply to avoid the Section 280G golden parachute treatment of excess compensation payments.

Shareholder approval exception: The first and possibly most viable exception for privately held banks involves obtaining shareholder approval of the payments. Golden parachute payments do not include any payment from a nonpublicly traded corporation that has been approved by shareholders owning more than 75% of the voting stock of the target corporation immediately before the acquisition. There must be adequate disclosure to all the target’s shareholders of all material facts concerning the payments prior to taking the approval vote.

Small business corporation exception: The golden parachute rules do not apply to any payment to a disqualified individual if the target corporation is a small business corporation immediately before the acquisition. The term small business corporation generally refers to an S corporation, except that the S corporation prohibition against having nonresident alien shareholders does not apply. It is important to note that the S corporation election need not be actually made for this relief to apply.

To qualify as a small business corporation, the target corporation:

  • Can have no more than 100 shareholders (shareholders that are related to one another can be aggregated, and spouses are counted as one shareholder).
  • Cannot have shareholders that are corporations, partnerships, certain trusts, estates or tax-exempt organizations.
  • Cannot have more than one class of stock.
  • Cannot be an insurance company.
  • Cannot be a bank that uses the Section 585 bad debt reserve method for computing the bad debt deduction.

Thus, if a target bank meets the requirements to be a small business corporation as outlined above, the payments made by the bank would not be subject to the golden parachute rules.

Reasonable compensation exception: Parachute payments do not include any payment that constitutes reasonable compensation for personal services provided on or after the date of an acquisition. This approach requires an extensive analysis of the facts and documentation supporting the payments. It is most often relied upon by public companies since generally only privately held corporations can take advantage of the shareholder approval exception.

The Importance of Golden Parachute Rules in Merger &Acquisition Dealings
When negotiating bank merger or acquisition deals involving target banks or bank holding companies making compensatory payments as a result of the acquisition, it is important to evaluate the potential impact of the golden parachute rules. The tax consequences of these rules could have a substantial effect on the target bank or corporation as well as its executives. Early on in the due diligence process, acquirers and targets should identify any compensatory payments that could be subject to the golden parachute rules and consider application of the exceptions. Careful planning of post-change payments could reap significant benefits if considered in advance of an acquisition.

The financial institutions industry is full of merger and acquisition activity. A new twist on M&A activity is positioning credit unions as buyers.

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