Can IRC Section 4999 Hurt You?

Can IRC Section 4999 Apply to You

IRC Section 4999 is relevant to you only if you

  • serve as an employee or service provider of a corporation and you are one of the corporation's:
    • Officers.
    • „Highly compensated individuals.
    • Significant shareholders.

And, only if the above is true in your case, then IRC Section 4999 can apply if and only if further

  • you receive a payment (of any description but sometimes called a severance) or payments incidental to a change of control of the corporation, and
  • the payment exceeds three times your average base compensation over the trailing five years.

Who Should Be Concerned

Could your employment agreement or any other bonus, termination or retirement arrangement provide for a severance or other bonus payment that is connected to a change-in-control that could exceed three times your base salary?

If applicable, IRC Section 4999 could hurt you badly

.

The Golden Parachute Rules, Section 280G and Section 4999 of the Internal Revenue Code (IRC)  were enacted by Congress in 1984. IRC Section 280G denies a tax deduction to corporations for parachute payments made to disqualified individuals that exceed a specified amount. In addition, IRC Section 4999 imposes on the recipient a nondeductible 20% federal excise tax (which is in addition to regular income taxes) on these payments.

In general, parachute payments are compensation payments: „

  • Made to (or for the benefit of) so-called disqualified individuals. „
  • Contingent on a change in control. „
  • In excess of a specified amount.

The Golden Parachute Penalties generally do not apply if a disqualified individual’s parachute payments are less than the safe harbor amount of three times the individual’s base amount (the base amount is the average annual taxable compensation for the five years preceding the year of the change in control).

Penalties

If the aggregate payments exceed the Section 280G/Section 4999 safe harbor, then all amounts in excess of one times the individual’s base amount are generally excess parachute payments subject to the Golden Parachute Penalties.

Painful Details

Exceeding the safe-harbor amount results in adding the non-deductible Section 4999 excise taxes onto the income taxes.

Before excise taxes, the income taxes are usually forty or fifty percent.  If the executive safely received one mil less than the safe-harbor limit (equal to three times the base amount), then net of income taxes, the executive could retain about 150% to 180% times the base amount after income taxes. However if the payments to executive exceed the safe-harbor of three times the base amount, a non-deductible excise tax of 20% is imposed on the excess over one times the base amount. 

An executive receiving payments of an amount exactly equal to one mil over three times the base amount would be almost exactly two times the base amount over the base amount, of course.

Two times the base amount times twenty percent excise tax equals 40% of the base amount. Not being able to deduct this cost would mean that an exec needs to earn income of about double this amount in order to pay both the amount of excise tax and the amount of tax on the earned income.

To just pay the income taxes from taxable income on two times the base amount you would need to earn two times 40%, or 80%, times the base amount or two times 50%, or 100%, depending on your individual situation.

Adding up those factors, when the executive's payments are just under the safe harbor limit, the executive retains from about 150% to 180% of the base amount after income taxes, and when the executive barely goes over the safe-harbor limit, the executive retains only 70% to 100% times the base amount after income taxes and the IRC Section 4999 excise tax.

That would be like being paid $3.00 and being able to keep only $0.70 or $1.00.

Meanwhile, the corporation cannot deduct the $3.00 payment, so it needs to earn income of about $5.00 to $6.00 to make that payment of $0.70 or $1.00.