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Advertising and Salary Credits Received from Vendors
In Field Service Advice (FSA) Memorandum 9915011, the IRS concluded that the advertising and salary credits received by a retailer from various vendors were properly treated as accessions to wealth includible in income. They could not be treated as nontaxable trade discounts, but were (in essence) allowances for the provision of services.
A retailer using the accrual method of accounting received various reimbursements or offsets (called credits) from certain vendors, with two credits at issue. One was an advertising credit provided to the taxpayer for cooperative advertising; the other was a salary credit for the taxpayer's sales staff. The credits were realized by the taxpayer through offsets to products purchased from vendors offering the credits.
The advertising credits were negotiated between the taxpayer's buyers and the vendors' representatives. The agreements between the taxpayer and the vendors were verbal contracts. The credits were typically based on a percentage of purchases, but could also be a fixed amount for the year. They were commonly referred to as cooperative advertising, an arrangement by which a product is generally advertised with the names of both the vendor and the retailer. The arrangement usually requires advertising as well as other promotions, the cost of which is shared by the vendor and retailer or borne entirely by the vendor. The credits were listed as an advertising reduction on the taxpayer's payment vouchers and were posted to its general ledger; they were recorded for book purposes as an offset to advertising costs.
Salary credits were negotiated by first-tier managers. These credits often involved multiple-year agreements (usually written contracts). They typically offered a credit based on a percentage of the sales of the vendor's product, rather than on purchases by the taxpayer. The contracts were usually entered into when a new store opened or a new line was introduced, and offered a use of credit on payment vouchers. Certain marketing considerations, such as counter space, staffing and pay incentives, were required of the taxpayer to qualify for the credit. Accordingly, the salary credit was provided to encourage more space and sales staff dedicated to promoting the vendor's product. The basic salary credit was determined based on a percentage of sales of the vendor's product. The salary credits were posted to the taxpayer's general ledger accounts as an offset to salary costs.
The taxpayer accounted for the credits as trade discounts under Regs. Sec. 1.471-3(b), arguing that they had the effect of reducing the cost of merchandise purchased. Trade discounts are treated as reductions to purchase price granted by a vendor, and are not included in gross income. They simply represent adjustments to purchase price granted by the vendor to certain purchasers. The Service did not agree with this characterization of the credits.
The IRS held that cooperative advertising was offered by a vendor to encourage local advertising or store displays by the retailer of the vendor's product. In form, such credits appear to be for services provided and not based on volume or quantity. In substance, the advertising credits were a reimbursement of the taxpayer's cost, benefitting both the vendor and the taxpayer. The taxpayer performed a service for which it was compensated by property. Because it provided a service, the taxpayer had to recognize the credits/ discounts as an accession to wealth, requiring inclusion as gross income under Secs. 61 and 451.
The Service held that the salary credits were determined based on a percentage of sales of the vendor's product (although some salary credits were determined using projected sales and then computed as a percentage of certain employees' salaries). They were used to provide bonuses or other financial rewards to the taxpayer's employees for selling the vendor's product and were provided by the vendor to support a level of service in the specified departments that exceeded other departments in the store. The vendors were making specific marketing demands as to product placement and the number and pay (through incentives) of the salespeople who promoted such merchandise. Accordingly, in both form and substance, the taxpayer was performing extra marketing services (in terms of space, staffing and location) and in return received from the vendor a credit offsetting the extra cost of such services (fewer sales staff available in other departments, less counter space available). The salary credit was contingent on the performance of those services and the resulting increase in sales. Because the taxpayer was performing an extraordinary service for the vendor, the credits did not qualify for trade discounts under Regs. Sec. 1.471-3 and had to be accounted for as gross income.
From Brian E. Keller, CPA, Oak Brook, IL
Golden Parachute Payments
The multitude of mergers and acquisitions in recent years (especially in the banking industry) has raised various issues that practitioners need to consider even before the prospect of an acquisition arises. These issues range from the proper structuring of a transaction to provide tax-free treatment to the shareholders and the corporations, to the use of tax attributes carried forward from a target following the acquisition.
One issue common to many acquisitions is the application of the golden parachute rules of Sec. 280G. Golden parachute payments are severance payments to be made to a corporation's top employees and directors on a change in control. The reasons for these are varied, but the tax implications are comparatively straightforward. Sec. 4999 imposes a 20% nondeductible excise tax on the recipient of an "excess parachute payment." In addition, the corporation making the payments cannot deduct any amount considered an excess parachute payment. These results can be costly, both to the recipient of the payments and the corporation. In some cases, the recipient will receive substantially fewer benefits than if the change in control had not occurred.
One of the more difficult and time-consuming tasks involving golden parachute payments is the determination and computation of excess parachute payments. Although some other issues must first be resolved, these computations are critical. Additionally, this is the area in which the recipient and the corporation have the best opportunity to minimize the effects of the golden parachute rules through careful tax planning.
Sec. 280G contains some basic definitions related to excess parachute payments, but Prop. Regs. Sec. 1.280G-1 includes numerous questions and answers providing far more explanations (and examples).
Parachute Payments
The golden parachute rules apply to "payments in the nature of compensation" to a "disqualified individual," if such payments are contingent (1) on a change in ownership or effective control of a corporation or (2) in the ownership of a substantial portion of a corporation's assets. Payments are in the nature of compensation "if they arise out of an employment relationship or are associated with the performance of services" (Prop. Regs. Sec. 1.280G-1, Q&A-11). These payments generally include wages, bonuses, severance pay, fringe benefits, pension benefits and other deferred compensation.
Certain payments are exempt from the golden parachute rules, even if they would otherwise be considered in the nature of compensation. These include payments from qualified plans (e.g., Sec. 401(a) plans), certain payments of reasonable compensation, payments made by a small business corporation (i.e., a corporation meeting the requirements of Sec. 1361(b), without regard to Sec. 1361(b)(1)(C)) and certain payments made by a corporation, no stock of which is readily tradable on an established securities market (Regs. Sec. 1.280G-1, Q&A-5).
Disqualified Individual
A disqualified individual is any employee or independent contractor of a corporation who, during the 12-month period immediately preceding the date of the change in control of the corporation, was a shareholder, an officer or a highly compensated individual (Prop. Regs. Sec. 1.280G-1, Q&A-15). For purposes of these rules, a shareholder is an individual who owns stock of a corporation with a fair market value (FMV) that exceeds the lesser of $1 million or 1% of the total FMV of the outstanding shares of all classes of the corporation's stock (Prop. Regs. Sec. 1.280G-1, Q&A-17).
The determination of whether an individual is an officer is based on all the facts and circumstances. Generally, an officer is "an administrative executive who is in regular and continued service." The maximum number of individuals who can be considered officers for this purpose is the greater of three employees or 10% of the total number of employees (not to exceed 50) (Prop. Regs. Sec. 1.280G-1, Q&A-18).
A highly compensated individual is an individual who is (or would be, if the individual were an employee) a member of the group consisting of the highest-paid 1% of the employees of a corporation, or (if less) the highest-paid 250 employees of a corporation. However, a highly compensated individual does not include an individual whose annualized compensation, during the 12-month period immediately preceding the date of the change in control of the corporation, is less than $75,000 (Prop. Regs. Sec. 1.280G-1, Q&A-19).
Excess Parachute Payments
The Sec. 280G golden parachute provisions apply when the aggregate present value of the parachute payments equals or exceeds three times the "base amount" of a disqualified individual. The base amount is the average annual compensation includible in a disqualified individual's gross income for the most recent five tax years (or portion thereof) ending before the date of the change in control. Present value is determined by using a discount rate equal to 120% of the applicable Federal rate, compounded semiannually.
The key item is that the golden parachute rules apply when a disqualified individual receives payments in excess of three times his base amount. However, the 20% excise tax (and the amount not deductible by the corporation) is based on the excess parachute payments, which are equal to the parachute payments in excess of one times the base amount. An employment contract that limits severance payments to 2.99 times an employee's base salary often fails to avoid the parachute payment rules. In most cases, the employee also receives benefits from deferred compensation plans, stock option plans, etc., that cause the total parachute payments to exceed three times the base amount, subjecting not only these additional benefits to the parachute rules, but also a large portion of the severance payments.
The proposed regulations provide some additional rules when computing the aggregate present value of the parachute payments. Prop. Regs. Sec. 1.280G-1, Q&A-24(b), provides that, if a payment would have been made whether or not a change in control occurred, but receipt of the payment is accelerated due to a change in control, the payment is considered a parachute payment only to the extent the accelerated payment exceeds the present value of the payment absent the acceleration.
Prop. Regs. Sec. 1.280G-1, Q&A-24(c), applies to a payment accelerated by a change in control that was "substantially certain...to have been made without regard to the change if the disqualified individual had continued to perform services for the corporation for a specified period of time." Simply put, a vesting period applies to the payment. In this situation, the parachute payment equals the lesser of (1) the amount of the accelerated payment or (2) the amount by which the accelerated payment exceeds the present value of the payment that was expected to be made absent the acceleration, plus an amount reflecting the lapse of the obligation to continue to perform services (but not less than 1% of the amount of the accelerated payment multiplied by the number of full months that the vesting is accelerated).
Example: R is an officer of T Corporation. R has an employment agreement with T. The agreement states that, in the event of a change in control of T, R is entitled to a lump-sum payment from T equal to 2.99 times R's annual base salary (including bonuses and pre-tax contributions to any qualified T plans). In addition, T will continue to provide health, life and disability coverage for R and his family for the five-year period following the change in control. R also has nonqualified T stock options and participates in T's nonqualified deferred compensation plan. On Jan. 1, 1999, 100% of the stock of T was acquired by an unrelated third party; T was merged into the acquiring corporation.
R's salary (including deferred compensation and Sec. 401(k) contributions) for the past five years was as follows: 1994—$100,000; 1995—$125,000; 1996—$150,000; 1997—$175,000; 1998—$200,000. In addition, R exercised stock options in 1996, resulting in $250,000 of ordinary income, which was included on R's 1996 Form W-2. Consequently, R's base amount is $200,000.
In accordance with his employment agreement, R is to receive 2.99 times his base salary, plus health, life and disability coverage for the next five years. R's base salary is $200,000; therefore, he will receive a $598,000 severance payment. The premiums for insurance coverage are $100 per month. The present value of the insurance premiums for five years (assuming a 5% discount factor) is approximately $5,300.
The sales agreement between T and the acquiring corporation provided for the payment of benefits under T's nonqualified stock option and deferred compensation plans. The deferred compensation plan was terminated and the accrued benefits thereunder were paid. All outstanding T options (vested or otherwise) were caused to be exercised or cancelled or both, in exchange for a cash payment to the option holders, equal to the stock's current FMV, less the exercise price of the options. R had accrued $100,000 of benefits under the deferred compensation plan, which would have been paid on Jan. 1, 2001. R also had options to acquire 10,000 shares of T stock at $10 a share; half would have vested on Jan. 1, 2000 and half on Jan. 1, 2001. As of Jan. 1, 1999, the stock was valued at $50 per share; R received $400,000 for his options (($50 FMV – $10 exercise price) x 10,000 shares).
Absent the acquisition of T, R would have received the $100,000 of accrued benefits under the deferred compensation plan on Jan. 1, 2001. The present value of this payment, assuming a 5% discount factor (compounded semiannually), is approximately $90,000. Therefore, $10,000 ($100,000 – $90,000) of the deferred compensation is considered a parachute payment.
Absent the acquisition of T, R would have received $200,000 on Jan. 1, 2000, as a result of exercising half of his stock options. R would have received an additional $200,000 on Jan. 1, 2001, as a result of exercising the remaining options. The present value of the options vesting Jan. 1, 2000, assuming a 5% discount factor (compounded semiannually), is approximately $190,000. The amount reflecting the lapse of the obligation to continue to perform services for the options is $24,000 ($200,000 accelerated payment x 1% x 12 months). The amount of the options considered a parachute payment is, therefore, $34,000 ($200,000 – $190,000 + $24,000).
The present value of the options vesting Jan. 1, 2001, assuming a 5% discount factor (compounded semiannually), is approximately $181,000. The amount reflecting the lapse of the obligation to continue to perform services for these options is $48,000 ($200,000 accelerated payment x 1% x 24 months). The amount of these options considered a parachute payment is, therefore, $67,000 ($200,000 – $181,000 + $48,000).
The aggregate present value of the parachute payments made to R is $714,300, comprised of the following amounts:
Severance payment
Insurance benefits
Deferred compensation
Stock options
Total
$ 598,000
5,300
10,000
101,000
$714,300
As previously determined, R's base amount is $200,000; three times this base amount is $600,000. The aggregate present value of the parachute payments exceeds $600,000; therefore, Sec. 280G applies to the payments.
The excess parachute payment is $514,300 ($714,300 present value of parachute payments – $200,000 base amount). This is the amount subject to the 20% excise tax and not deductible by T. The excise tax that R will owe on the payments received from T is approximately $103,000 ($514,300 x 20%). Therefore, R will receive $103,000 less than if T had not been acquired and a change in control had not occurred.
Planning Suggestions
To resolve this loss in benefits to R, T can gross up the payments to R for the excise tax he will owe on the excess parachute payments. Usually, a second gross-up will be made to cover the income taxes due on the excise tax gross-up (which is additional income to R). This, however, can be costly to T—upwards of 25% of the total payments otherwise made to R, not to mention the large deduction T loses for the excess parachute payments.
T could do several things to minimize (or even eliminate) the excess parachute payments. It can increase R's base amount by substantially increasing his compensation in the year prior to the year in which the change of control occurs. This can be achieved by accelerating the vesting period of nonqualified stock options, so as to allow R to exercise the options prior to the change in control.
Accelerating the vesting period of nonqualified stock options would also serve to reduce the amount of the option payments considered to be parachute payments. For example, if all of R's stock options were vested as of Jan. 1, 1999 (the date of the change in control), none of the option payments would be considered parachute payments. The aggregate present value of the parachute payments would, therefore, equal $613,300 ($714,300 - $101,000), which would not exceed three times R's base amount. R would not owe any excise tax on the payments he receives from T, and T could deduct the full amount of the payments made to R.
The excess parachute payments could also be reduced by deferring the date on which the severance payments (or other benefit payments) become payable to R. By deferring the payments, the present value of the parachute payments is reduced, which may reduce the present value of the payments below three times R's base amount.
T may also want to establish that a portion of the payments made to R is reasonable compensation for services rendered on or after the date of the change in control. Payments for reasonable compensation are not considered to be parachute payments. Therefore, they are not included in the computation of excess parachute payments, are not subject to the 20% excise tax and are fully deductible by T. Prop. Regs. Sec. 1.280G-1, Q&A-42, provides examples of reasonable compensation for services rendered on or after the date of a change in control.
Amounts established to be reasonable compensation for services rendered prior to a change in control are not excluded from the parachute payment provisions. Instead, they reduce the portion of the individual's base amount allocated to such parachute payment; any remaining portion of the parachute payment established as reasonable compensation reduces the excess parachute payment (Prop. Regs. Sec. 1.280G-1, Q&A-39, Example 1).
Conclusion
The golden parachute payment rules are complex, and the computations can be time-consuming--up to 50 or more individuals could fall under the Sec. 280G provisions when a change in control occurs. However, with careful planning, the payor corporation and relevant individuals should be able to rearrange the various employment agreements and benefits plans to minimize the effect and cost of parachute payments.
From Kevin F. Powers, CPA, Oak Brook, IL
