Golden parachutes are a form of compensation paid to key executives in the event that a public company is sold and the key executives lose their jobs or have their responsibilities sharply curtailed. These are created to protect executives, but they need to be constructed carefully so that the executive doesn’t face high taxation. Typically, a golden parachute is set up at a time when a merger or acquisition deal is not about to occur.
Parachute payment triggers
Two distinct events both need to occur to trigger golden parachute payments:
- A publicly traded company is sold.
- Key executives are terminated without cause, or they resign for “good reason.” These reasons could be related to a job relocation of a significant distance or a “material diminution” (substantial decrease) in the scope of an executive’s responsibilities.
Elements of golden parachute payments
Golden parachute packages can include a variety of benefits. Typically, they continue to pay the executive a cash salary for a certain period, or the equivalent in a lump sum. Payment may also include an estimated cash bonus replacement. Stock award vesting could be accelerated. Typically, benefits will continue to be paid for a specific period, and an executive bonus will be pro-rated for the year of termination.
It is less common for golden parachutes to include outplacement, continued accrual of retirement benefits, or continuation of certain executive perks, such as tax or financial planning or a car allowance.
How to protect against tax penalties
Golden parachute payments are taxed heavily if they are considered excessive. An example would be a parachute package that pays three or more times the executive’s average taxable compensation for the previous five years.
To help employees who might have to pay a supplemental excise tax on these “excessive” payments, some companies have provided employees with a tax reimbursement, or “gross up.” However, these payments can become quite expensive for companies. Another approach is to reduce or cut back golden parachute payments. But be careful not to dramatically reduce benefits. The most common approach now is the “best-after-tax-results” or “best net” approach.
Because of the complexity of golden parachutes and the risk of a substantial tax liability, be sure to meet with compensation consultants and attorneys when setting up and reviewing a golden parachute compensation package. Plan to evaluate the compensation package every two to four years to make sure it’s still serving its intended purpose.
