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Tax Corner

Fortnightly Magazine - July 1 1996

wind up unfulfilled.

The Internal Revenue Service (IRS) has issued proposed regulations, under the golden parachute rules, that set forth intricate rules for determining the value of an executive's severance benefits. These rules involve subjective judgments and can lead to unanticipated results (em particularly if an acquirer is inclined to interpret the rules to its own advantage.

For example, under the proposed regulations, the IRS treats the immediate vesting of an equity opportunity as a separate right that counts toward the golden parachute threshold. The deemed value of the immediate vesting may turn the severance benefits into "parachute payments," thus giving the acquirer an opportunity to forfeit a portion of an executive's equity opportunity to avoid triggering the golden parachute penalties.

Interpreting Severance Packages

Severance packages for utility executives typically address the golden parachute rules in one of three ways: the cap, the punch-through amount, and the gross-up payment. The amount of after-tax benefits the executive will receive following a change in control can vary dramatically depending on how the agreement is structured. Both the executive and the board of the corporation must clearly understand which approach has been used in the executive's severance agreement.

Golden Parachute Cap. Severance benefits are limited to the maximum amount that avoids triggering the golden parachute penalties. This approach may allow the acquirer to reduce substantially the amount of severance benefits otherwise promised under the severance agreement.

Punch-Through Amount. Severance benefits that trigger the golden parachute penalties will be paid in whole only if the executive would thereby receive a larger after-tax benefit. This type of agreement usually specifies a method for determining the amount at which the executive would "punch-through" the golden parachute cap and receive all severance benefits. While sometimes allowing payment of all severance benefits, this approach does not cushion the executive against the 20-percent excise tax.

Gross-up Payment. The acquirer provides a special "gross-up payment" to make the executive whole for any golden parachute excise taxes. This approach neutralizes the economic impact of the golden parachute rules on the executive. While appropriate under certain circumstances, providing a gross-up payment can cause the acquirer considerable nondeductible expense.

Damage Control

Avoiding the golden parachute rules can be advantageous to the executive and the company, and several actions could reduce potential exposure to the penalties. One approach would accelerate a portion of the executive's taxable income. Done properly, accelerating income will boost the executive's five-year average annual compensation, which determines the golden parachute limit. Another approach would modify the executive's compensation package to include additional equity opportunities in lieu of current salary. Equity opportunities may avoid treatment as "parachute payments," or may receive a lower "parachute payment" value than cash severance benefits. Supplemental pension benefits could also be designed to reduce or avoid "parachute

payment" treatment. The nature of an individual executive's existing compensation package may create additional planning opportunities.

* * *

The merger deals are out there, waiting to be done. Compensation committees and management teams, particularly at publicly traded utilities, should address this issue well in advance of an acquisition offer. Else,