As merger and acquisition activity in the financial services sector has been on the rise in recent years, organizations are increasingly concerned about the tax and cash flow consequences related to so-called “golden parachute payments.” The incorporation of noncompete provisions in severance agreements can help minimize or eliminate those consequences – if the noncompete component is valued properly.
Financial services organizations should take steps to make sure the value allocated to the noncompete component of a parachute payment corresponds to the recipient’s current responsibilities and the likely economic impact of his or her potential competition on the organization.
Parachute payments and the tax code
Parachute payments generally are defined as payments made to “disqualified individuals,” triggered by changes in control. Disqualified individuals include shareholders who own more than 1 percent of the fair market value of the corporation’s stock, officers of the corporation, and highly compensated individuals.
A payment is included in the parachute payment calculation if the payment is triggered by a change in control or made as a result of an event closely associated with the change in control and the event is materially related to the change in control. Severance – voluntary or involuntary – frequently meets this definition.
Internal Revenue Code Section 280G prohibits corporate income tax deductions for excess parachute payments. Such payments result when total parachute payments exceed three times the disqualified individual’s “base amount” (the average annual compensation of the individual over the past five years).
The loss of the corporate deduction is not the only adverse tax consequence of excess parachute payments. In addition to income tax on the entire amount, the disqualified individual also is subject to a 20 percent excise tax on the excess parachute payments. Some employment agreements call for the individual to be compensated for these additional taxes through “gross-up” provisions, which can cause the total cash payout to increase substantially. In such situations, depending upon the magnitude, an acquiring organization might require the employment agreements to be revised or the purchase price to be adjusted.
One way to help shield severance payments in a merger or acquisition from these unfavorable consequences is by entering into a noncompete agreement with the employee. The tax rules specifically exclude compensation for services rendered from the parachute payment calculation. By agreeing to not compete, the individual is considered to provide a service for which they can be reasonably compensated.
When the IRS or the courts review noncompete agreements, the test typically comes down to whether the value assigned is considered reasonable. Prior court cases have used a variety of factors to make this determination, such as whether the noncompete agreement considers the levels of the employee’s compensation in prior years and the compensation paid to similarly situated employees of the organization or comparable employers. Additionally, courts have reviewed the economic damages that potentially could be inflicted upon the organization. In some cases, the blend of both methods has been used to determine the “reasonable compensation” value of the agreement.
Additionally, several courts have addressed the question of whether a covenant not to compete in the context of an acquisition has economic reality. As the U.S. Tax Court noted in the 1997 ruling Thompson v. Commissioner,1 the amount a taxpayer pays or allocates to a noncompete agreement does not always control for tax purposes, particularly if the parties to the agreement do not have adverse tax interests that deter allocations that lack economic reality.
In Thompson, the court focused largely on whether the noncompete agreements at issue had economic reality, “i.e., some independent basis in fact or some arguable relationship with business reality so that reasonable persons might bargain for such an agreement.” It noted numerous factors in evaluating a covenant not to compete, including:
- Whether the employee has the business expertise to compete
- The employee’s intent to compete
- The employee’s economic resources
- The potential damage to the acquirer posed by the employee’s competition
- The employee’s contacts and relationships with customers, suppliers, and other contacts
- The employee’s age and health
While the list is not all-inclusive, it does illustrate relevant factors and serves to reinforce the need to consider all facts and circumstances when establishing noncompete agreements.
Financial services organizations that rely on noncompete agreements to minimize unfavorable tax and cash flow consequences resulting from the acquisition process should prepare for potential challenges. To withstand IRS and judicial scrutiny, they must develop defensible arguments that the values they claim represent reasonable compensation and economic reality.
1 T.C. Memo. 1997-287