Page 253 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 239

lesser of (a) the employee’s annual compensation or (b) the Section 401(a)(17) compensation
limit and (3) voluntary window programs. Programs subject to 409A rules limit changes in
time and form of payment, including a six-month delay before any key executive can receive
payment upon leaving the company.
Change of Control Contracts. These employment agreements specify pay and benefits
that the executive will receive it the executive loses his or her position following a defined
change of control (COC) of the company. The control change could be defined as (1) a specific
percentage of the voting shares that have been acquired by a person or organization (typically
not less than 20 percent), (2) a merger, (3) a sale of a stated portion of the company’s assets,
(4) a specified change in the composition of the board of directors (composition of directors
may be described as an unapproved change both in stated portion of the board and prescribed
time period), and/or (5) liquidation or dissolution of the company. Depending on the
language, the contract may be activated at time of shareholder approval or later when the
transaction is completed. Typically, these are called golden parachutes.
There are two types of contracts that will trigger payment: single and double. A single-
trigger contract typically permits the covered executive to leave voluntarily within 30 days
following a change in control and receive all the benefits stated in the contract. A modified
single-trigger contract provides severance benefits for a voluntary termination (typically within
30 days after a one-year anniversary of the defined change of control). Sometimes called
a walk-away, it is in essence a delayed single-trigger contract. Its purpose is to retain key
executives for a stated period to ensure a smooth transition of leadership. A double-trigger
contract requires both a change in control and termination, either involuntary (being asked to
leave) or constructive (providing good cause for the executive to leave within a specified
period following the change of control). Typically, this period is two to three years. Double-
trigger contracts are more prevalent. A hybrid is a modified trigger that permits voluntary
termination with full benefits typically for a brief period after one year in addition to being
a double trigger for the first two to three years.
Change of control packages typically provide the maximum allowable under Section
280G of the IRC (“Golden Parachute Payments”) to be tax deductible, in other words, less
than three times the base amount. The latter is defined as average annual W-2 compensation
for the five preceding years. Amounts of three times or more this base average will trigger an
excise tax described in Section 4999 of the IRC of 20 percent of the amount received in excess
of the base average amount. Additionally, the company will lose its tax deduction on amounts
in excess of the base period amount. Some contracts insert language indicating that in no
event will payments exceed the amount allowable under law to receive a tax deduction. If the
parachute payment is in excess of that provided in Section 280G, then any amount in excess
of one time (not three times) the person’s base amount is considered an excess parachute
payment and is not tax deductible to the company. Reasonable compensation is tax deductible
under Section 162. But for purposes of IRC Sections 280G and 4999, the IRS ruled in 2002
that stock option values must be based on the option’s fair value based on a Black-Scholes or
similar pricing formula.
Since the five-year average is the base for calculating the allowable golden parachute pay-
ment, it favors individuals who had significant W-2 earnings during this period. Namely, it
would be advantageous to have large stock option exercises, big incentive payouts, and no
deferrals of pay. It would also favor a person who had relatively flat earnings during this period
as opposed to a person who had a rapidly increasing total pay package during the five years