Addressing Sections 280G and 4999 in Executive Employment Agreements

Practical Law Legal Update 8-525-7190 (Approx. 9 pages)

Addressing Sections 280G and 4999 in Executive Employment Agreements

by PLC Employee Benefits & Executive Compensation

The Golden Parachute Rules

Congress enacted Sections 280G and 4999 of the Internal Revenue Code (IRC) (the Golden Parachute Rules) to discourage corporations from making large compensation payments to senior executives and other key service providers in connection with a change in control. These provisions generally impose a 20% excise tax on, and deny the employer a tax deduction for, certain payments and benefits provided to an executive in connection with a change in control of a corporation. Compensation subject to the Golden Parachute Rules may include:

Bonuses.
Accelerated vesting or payment of equity awards.
Severance payments.
Post-termination benefits.

The executives subject to the Golden Parachute Rules are generally either:

Officers.
The highest paid 250 employees within an employer's controlled group (or, for controlled groups with 24,900 or fewer employees, the highest paid 1%) if the employee's annual compensation is more than an indexed threshold ($115,000 for 2013).
Employee-shareholders owning over 1% of the fair market value of the outstanding shares of all classes of the employer's stock.

The Golden Parachute Rules generally provide that if the aggregate value of payments and benefits payable to an executive in connection with a change in control equals or exceeds three times the executive's average annual compensation over the prior five years (the executive's base amount), then the amount exceeding one times the executive's average annual compensation over the prior five years is subject to a 20% excise tax and is not deductible by the employer.

For more information on the Golden Parachute Rules, see Practice Note, Sections 280G and 4999 of the Code: Golden Parachute Payments.

Employment Agreement Provisions Addressing the Golden Parachute Rules

Because of their potential adverse tax consequences, employers should consider the impact of the Golden Parachute Rules when negotiating executive employment agreements. There are several ways for an employment agreement to address the excise tax and loss of deductibility under the Golden Parachute Rules. The agreement can include:

A safe harbor cutback.
A valley provision (also called a better-off cutback).
A full gross-up.
A modified gross-up.
No provision.

Safe Harbor Cutback

Under a safe harbor cutback, if providing the executive all payments and benefits due would trigger the excise tax, then the payments and benefits are reduced to the maximum amount that does not trigger the excise tax. A safe harbor cutback provision is intended to ensure that:

The executive does not incur any excise tax under IRC Section 4999.
The employer does not lose its ability to deduct any payments and benefits under IRC Section 280G.

However, a safe harbor cutback can result in a significant reduction of the payments and benefits otherwise due to the executive.

In drafting a safe harbor cutback provision, an employer must also consider the implications under Section 409A. Section 409A applies to nonqualified deferred compensation, which is broadly defined to include certain bonuses, severance arrangements, equity awards, expense reimbursements and perquisites.

Section 409A's requirements place restrictions on when compensation can be deferred and include specific deadlines by which deferral elections must be made. Section 409A also limits an employer's ability to accelerate the payment date for deferred amounts. Some, but not all, practitioners view the ability of the employer or the executive to elect which payments to reduce or eliminate under a safe harbor cutback provision at the time of the change in control as a late deferral election or accelerated payment under Section 409A. Safe harbor cutback provisions should therefore be carefully drafted to address potential issues under Section 409A. For a model safe harbor cutback provision, see Standard Clauses, Section 280G Employment Agreement Provisions: Safe Harbor Cutback.

Valley Provision

Under a valley provision (also called a better-off cutback), the executive's payments and benefits are reduced to the maximum amount that does not trigger the excise tax unless the executive would be better off (on an after-tax basis) if the executive received all payments and benefits due and paid all excise and income taxes.

If the executive is better off receiving the payments and benefits and paying the applicable taxes, the employer loses its ability to deduct amounts subject to the excise tax. A valley provision can therefore be less beneficial to the employer than a safe harbor cutback. However, under a valley provision, the executive does not risk having payments and benefits reduced to the same extent as the executive would under a safe harbor cutback.

Similar to a safe harbor cutback, a valley provision can involve reduction of payments and benefits. When drafting a valley provision, an employer must therefore consider the same issues related to Section 409A that arise when drafting a safe harbor cutback. For a model valley provision, see Standard Clauses, Section 280G Employment Agreement Provisions: Valley Provision (Better-off Cutback).

Full Gross-up

A full gross-up provision typically reimburses the executive for the excise tax incurred and therefore provides the executive with the same amount of compensation that the executive would have received if the excise tax had not been triggered. Gross-up payments can be very expensive because they must cover:

The 20% excise tax.
All income and excise taxes that the executive incurs on the payment for the 20% excise tax.

For example, if the amount subject to the excise tax is $1,000,000 and the 20% excise tax therefore equals $200,000, the gross-up payment is not limited to $200,000. The employer must also reimburse the executive for the income and excise taxes that will be imposed on the additional $200,000 payment to the executive.

The employer cannot deduct amounts subject to the excise tax or the gross-up payment.

Because gross-ups can be expensive, shareholder advisory groups, including Institutional Shareholder Services (ISS), consider Section 280G gross-ups a problematic pay practice. For more information on ISS's 2013 proxy voting guidelines, see Legal Update, Institutional Shareholder Services Releases 2013 US Proxy Voting Summary Guidelines. Public company employers considering providing a full gross-up in an executive employment agreement should therefore carefully assess how it may be perceived by shareholders.

Employers providing a tax gross-up must confirm that the payment schedule included in the employment agreement complies with Section 409A. For more information on Section 409A's payment schedule requirements, see Practice Note, Section 409A: Deferred Compensation Tax Rules: Overview. For a model full gross-up provision, see Standard Clauses, Section 280G Employment Agreement Provisions: Full Gross-up.

Modified Gross-up

A modified gross-up provision typically provides that the executive is eligible to receive a full gross-up for the 20% excise tax, unless reducing payments and benefits by a specified percentage or amount would completely avoid imposition of the excise tax. If reduction would avoid imposition of the excise tax, then payments and benefits are typically cut back to the maximum amount that can be provided without triggering the excise tax, and the executive does not receive a gross-up.

Because gross-ups can be expensive, some employers prefer to include a modified gross-up rather than a full gross-up in executive employment agreements. Under a modified gross-up, the employer avoids paying an expensive tax gross-up for only a marginal benefit to the executive. Instead, if the executive's payments and benefits exceed the threshold under IRC Section 280G by only a small amount, then the payments and benefits are reduced and the employer does not pay a gross-up.

As with full gross-ups, certain shareholder advisory groups, including ISS, consider modified gross-ups a problematic pay practice.

Because payments and benefits could be reduced under a modified gross-up provision, employers must carefully draft the provision to avoid the potential issues under Section 409A that arise when drafting safe harbor cutback or valley provisions. Employers must also confirm that the payment schedule for any gross-up complies with Section 409A. For a model modified gross-up provision, see Standard Clauses, Section 280G Employment Agreement Provisions: Modified Gross-up.

No Provision

If the employment agreement is silent and does not address the Golden Parachute Rules, then:

The executive receives all payments and benefits subject to the excise tax.
The executive is liable for the excise tax.
The employer loses its ability to deduct amounts subject to the excise tax.

Recent Executive Employment Agreements

The following is a sampling of recent executive employment agreements contained in PLC What's Market with summaries of their respective provisions addressing IRC Sections 280G and 4999. To view additional summaries, visit PLC What's Market.

Employment Agreement	Filing Date	Section 280G Provisions
ETRADE Financial Corporation Chief Executive Officer*	February 26, 2013	Valley provision. Section 6(b)
Bunge Limited Chief Executive Officer	February 7, 2013	Safe harbor cutback. Section 7.5
The Middleby Corporation President and Chief Executive Officer and Chairman of the Board	January 25, 2013	Valley provision. Section 5(g)
Steven Madden, Ltd. Chief Executive Officer and Chairman of the Board	January 3, 2013	Valley provision. Section 9.6(a)
Glacier Bancorp, Inc. President and Chief Executive Officer	December 24, 2012	Safe harbor cutback. Section 10(e)
Costco Wholesale Corporation Chief Executive Officer and President	December 21, 2012	None specified.
CBOE Holdings, Inc. President and Chief Executive Officer	December 12, 2012	Valley provision. Section 8(b)
Williams-Sonoma, Inc. President and Chief Executive Officer	December 7, 2012	None specified.
Limited Brands, Inc. Chief Executive Officer of Victoria's Secret	November 30, 2012	None specified.
Tyson Foods, Inc. President and Chief Executive Officer	November 19, 2012	Valley provision. Section 8(b)
Humana Inc. President and Chief Executive Officer	November 5, 2012	Valley provision. Section 7.2
Coca-Cola Enterprises, Inc. Chairman of the Board of Directors and Chief Executive Officer	October 26, 2012	Valley provision. Section 15
Visa Inc. Chief Executive Officer	October 24, 2012	None specified.
Best Buy Co., Inc. President and Chief Executive Officer	August 21, 2012	Valley provision. Section 10(a)
The Hershey Company President and Chief Executive Officer	August 8, 2012	None specified.
Yahoo! Inc. President and Chief Executive Officer	July 19, 2012	None specified.
Elan Corporation, plc Chief Executive Officer	May 1, 2012	Full gross-up. Section 6(a)

Addressing Sections 280G and 4999 in Executive Employment Agreements | Practical Law