[Federal Register Volume 67, Number 34 (Wednesday, February 20, 2002)]
[Proposed Rules]
[Pages 7630-7656]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-3819]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209114-90]
RIN 1545-AH49


Golden Parachute Payments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations relating to golden 
parachute payments to provide guidance to taxpayers who must comply 
with section 280G. Proposed regulations under section 280G were 
previously published in the Federal Register on May 5, 1989 (the 1989 
proposed regulations). These proposed regulations are proposed to apply 
to any payments that are contingent on a change in ownership or control 
occurring on or after January 1, 2004. Taxpayers may rely on these 
proposed regulations until the effective date of the final regulations. 
Alternatively, taxpayers may rely on the 1989 regulations for any 
payment contingent on a change in ownership or control that occurs 
prior to January 1, 2004.

DATES: Written or electronic comments must be received by June 5, 2002. 
Requests to speak and outlines of topics to be discussed at the public 
hearing scheduled for June 26, 2002, must be received by June 5, 2002.

ADDRESSES: Send submissions to CC:ITA:RU (REG-209114-90), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG-209114-90), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, 
Washington, DC or sent electronically, via the IRS Internet site 
www.irs.gov/regs. The public hearing will be held in the IRS 
Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Erinn 
Madden at (202) 622-6030 (not a toll-free number). To be placed on the 
attendance list for the hearing, please contact LaNita M. Vandyke at 
(202) 622-7180.

SUPPLEMENTARY INFORMATION:   

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 280G of the Internal Revenue Code (Code). Sections 280G and 
4999 of the Code were added to the Code by sec. 67 of the Deficit 
Reduction Act, Public Law 98-369 (98 Stat. 585). Section 280G was 
amended by sec. 1804(j) of the Tax Reform Act of 1986, Public Law 99-
514 (100 Stat. 2807), sec. 1018(d) of the Technical and Miscellaneous 
Revenue Act of 1988, Public Law 100-647 (102 Stat. 3581) and sec. 1421 
of the Small Business Job Protection Act of 1996, Public Law 104-188 
(110 Stat. 1755).
    Section 280G denies a deduction to a corporation for any excess 
parachute payment. Section 4999 imposes a 20-percent excise tax on the 
recipient of any excess parachute payment. Related provisions include 
section 275(a)(6), which denies the recipient a deduction for the 
section 4999 excise tax, and section 3121(v)(2)(A), which relates to 
Federal Insurance Contributions Act. Proposed regulations (PS-217-84) 
under section 280G were previously published in the Federal Register at 
54 FR 19390 on May 5, 1989 (the 1989 proposed regulations).

Explanation of Provisions

Overview

    Section 280G denies a deduction to a corporation for any excess 
parachute payment. Section 4999 imposes a 20-percent excise tax on the 
recipient of any excess parachute payment. The disallowance of the 
deduction under section 280G is not contingent on the imposition of the 
excise tax under section 4999, and the imposition of the excise tax 
under section 4999 is not contingent on the disallowance of the 
deduction under section 280G. For example, an individual may be subject 
to the 20-percent excise tax under section 4999 even though the payor 
is a foreign corporation not subject to United States income tax.
    Section 280G(b)(2)(A) defines a parachute payment as any payment 
that meets all of the following four conditions: (a) The payment is in 
the nature of compensation; (b) the payment is to, or for the benefit 
of, a disqualified individual; (c) the payment is contingent on a 
change in the ownership of a corporation, the effective control of a 
corporation, or the ownership of a substantial portion of the assets of 
a corporation (a change in ownership or control); and (d) the payment 
has (together with other payments described in (a), (b), and (c) of 
this paragraph with respect to the same individual) an aggregate 
present value of at least 3 times the individual's base amount. Section 
280G(b)(2)(B) provides that the term parachute payment also includes 
any payment in the nature of compensation to, or for the benefit of, a 
disqualified individual if the payment is pursuant to an agreement that 
violates any generally enforced securities laws or regulations 
(securities violation parachute payment).
    Section 280G(b)(1) defines the term excess parachute payment as an 
amount equal to the excess of any parachute payment over the portion of 
the disqualified individual's base amount that is allocated to such 
payment. For this purpose, the portion of the base amount allocated to 
a parachute payment is the amount that bears the same ratio to the base 
amount as the present value of the parachute payment bears to the 
aggregate present value of all such payments to the same disqualified 
individual.
    Generally, excess parachute payments may be reduced by certain 
amounts of reasonable compensation. Section 280G(b)(4)(B) provides 
that, except in the case of securities violation parachute payments, 
the amount of an excess parachute payment is reduced by any portion of 
the payment that the taxpayer establishes by clear and convincing 
evidence is reasonable compensation for personal services actually 
rendered by the disqualified individual before the date of change in 
ownership or control. Such reasonable compensation is first offset 
against the portion of the base amount allocated to the payment.

[[Page 7631]]

    The 1989 proposed regulations provided guidance regarding the 
application of section 280G to corporations and individuals. Although 
many aspects of the 1989 proposed regulations were well-received, the 
IRS has received numerous comments requesting modification and 
clarification of the 1989 proposed regulations. In response, these 
proposed regulations clarify and revise, as described below, the 1989 
proposed regulations. Many aspects of the 1989 proposed regulations are 
preserved, and these proposed regulations retain the same 
organizational structure as the 1989 proposed regulations. Major 
modifications to the 1989 proposed regulations are described below.

Disqualified Individuals

    A payment constitutes a parachute payment only if the payment is 
made to (or for the benefit of) a disqualified individual. Section 
280G(c) defines the term disqualified individual to include any 
individual who (a) is an employee or independent contractor who 
performs personal services for a corporation, and (b) is an officer, 
shareholder, or highly-compensated individual.
    The determination of whether an individual is a disqualified 
individual under these proposed regulations is substantially the same 
as under the 1989 proposed regulations, with three significant changes. 
First, Q/A-17 of the 1989 regulations provides a de minimis rule for 
purposes of identifying which shareholders of a corporation are 
disqualified individuals. Under the 1989 proposed regulations, an 
individual is a shareholder for purposes of section 280G if the 
individual, at any time during the disqualified individual 
determination period, owns stock of a corporation with a fair market 
value exceeding the lesser of $1 million or 1 percent of the total fair 
market value of the outstanding shares of all classes of the 
corporation's stock. Since the issuance of the 1989 proposed 
regulations, it has become apparent that this rule may include 
individuals who do not possess significant influence over the 
corporation. Therefore, under Q/A-17 of these proposed regulations, the 
$1 million test is eliminated. Under these proposed regulations, an 
individual is a shareholder only if, during the disqualified individual 
determination period, the individual owns stock of a corporation with a 
fair market value that exceeds 1 percent of the total fair market value 
of the outstanding shares of all classes of the corporation's stock. 
The constructive ownership rules of section 318(a) continue to apply 
for purposes of determining the amount of stock owned by the 
individual. Under these rules, for example, to determine the amount of 
stock owned by an individual, the stock underlying vested stock options 
is considered constructively owned by that individual.
    Second, these proposed regulations modify the annualized 
compensation method for determining who is a highly-compensated 
individual under Q/A-19. Under the 1989 proposed regulations, no 
individual whose annualized compensation during the disqualified 
individual determination period is less than $75,000 is treated as a 
highly-compensated individual, even if the individual otherwise 
satisfies the definition of a highly-compensated individual. Q/A-19 is 
modified to provide that an individual must have annualized 
compensation equal to at least the amount described in section 
414(q)(1)(B)(i). This amount for 2002 is $90,000 and is adjusted 
periodically for cost-of-living increases. This modification both 
updates the amount provided in the 1989 proposed regulations and 
provides a mechanism to update this amount periodically without further 
amendment of these regulations.
    Finally, these proposed regulations change the disqualified 
individual determination period under Q/A-20. Under the 1989 proposed 
regulations, the disqualified individual determination period is the 
portion of the year of the corporation ending on the date of the change 
in ownership or control and the immediately preceding twelve months 
(with an option to use the calendar year or the corporation's fiscal 
year). Q/A-20 of these proposed regulations is modified to change this 
period to the twelve months prior to and ending on the date of the 
change in ownership or control of the corporation. Under this rule, the 
disqualified individual determination period is the same length for any 
change in ownership or control and is not affected by the date of the 
change in ownership or control.

Payment in the Nature of Compensation

    A payment may be a parachute payment only if it is a payment in the 
nature of compensation. All payments, in whatever form, are payments in 
the nature of compensation if the payments arise out of the employment 
relationship or are associated with the performance of services. In Q/
A-11, these proposed regulations clarify that payments in the nature of 
compensation include cash, the right to receive cash, or a transfer of 
property.
    Q/A-13 of the 1989 proposed regulations provides that the transfer 
of a nonstatutory option is treated as a payment in the nature of 
compensation (even if the option does not have a readily ascertainable 
fair market value within the meaning of Sec. 1.83-7(b)). The 1989 
proposed regulations reserve the issue of the treatment of statutory 
options (i.e., options to which section 421 applies). These proposed 
regulations revise Q/A-13 to address the treatment of statutory stock 
options to provide that nonstatutory stock options and statutory stock 
options are treated the same. Because both the transfer of a statutory 
option and the transfer of a nonstatutory stock option are payments in 
the nature of compensation, there is no basis for distinguishing 
between these two types of options for purposes of section 280G.
    In addition, these proposed regulations revise Q/A-13 with respect 
to the valuation of both statutory and nonstatutory stock options. 
Under the 1989 proposed regulations, the value of an option with an 
ascertainable fair market value is determined under all the facts and 
circumstances, including the difference between the option's exercise 
price and the value of the property at the time of vesting, the 
probability of an increase or decrease in the value of such property, 
and the length of the option exercise period.
    Since the issuance of the 1989 proposed regulations, commentators 
have indicated that Q/A-13 does not provide sufficient guidance about 
the determination of the value of a stock option. In particular, 
commentators question whether the intrinsic value of the option (the 
difference between the exercise price and the value of the property, or 
spread) determined at the time of the change in ownership or control, 
or a value determined under a valuation model such as Black-Scholes, 
should be used for purposes of section 280G. Using the factors listed 
in the 1989 proposed regulations results in a value different from the 
value obtained from using only the difference between the exercise 
price and the value of the property. Commentators have also noted that 
valuation methods other than spread are often complicated and difficult 
to apply in some circumstances, particularly when the stock underlying 
the option is not publicly traded.
    These proposed regulations continue to provide for the use of the 
factors described in the 1989 proposed regulations. To provide further 
guidance on acceptable and administrable methods for valuing stock 
options, these proposed regulations delegate authority to the 
Commissioner to provide methods for valuation of stock options

[[Page 7632]]

through published guidance. Rev. Proc. 2002-13, 2002-8 I.R.B. (February 
25, 2002) published in conjunction with these proposed regulations, 
provides several valuation methods. One of the methods permitted under 
this revenue procedure is a simplified safe harbor approach modeled 
after the Black-Scholes valuation method. The safe harbor allows a 
corporation to establish a value for stock options based on spread at 
the time of the change in ownership or control, the remaining term of 
the option, and a basic assumption regarding the volatility of the 
underlying stock. Other factors relevant to the Black-Scholes valuation 
model, including a risk-free rate of return and dividend yield, are 
addressed in the table contained in the revenue procedure. The safe 
harbor valuation method provided in the revenue procedure may be used 
without regard to whether the underlying stock is publicly traded.

Contingent on Change

    To be a parachute payment, a payment in the nature of compensation 
to a disqualified individual must be contingent on a change in 
ownership or control. Q/A-22 of the 1989 proposed regulations provides 
guidance on when a payment is contingent on a change in ownership or 
control. Generally, a payment is treated as contingent on a change in 
ownership or control if the payment would not in fact have been made 
had no change in ownership or control occurred. A payment generally is 
treated as one which would not in fact have been made in the absence of 
a change in ownership or control unless it is substantially certain, at 
the time of the change, that the payment would have been made whether 
or not the change in ownership or control occurred.
    These proposed regulations clarify in Q/A-22 that a payment is 
contingent on a change in ownership or control if the payment would not 
have been made absent the change in ownership or control, even if the 
payment is also contingent on a second event, such as termination of 
employment within a period following the change in ownership or 
control. In addition, as under the 1989 proposed regulations, a payment 
generally is treated as contingent on a change in ownership or control 
if (a) the payment is contingent on an event that is closely associated 
with such a change, (b) a change in ownership or control actually 
occurs, and (c) the event is materially related to the change in 
ownership or control. The fact that a payment that is contingent on an 
event closely associated with a change in ownership or control is also 
conditioned on the occurrence of a second event does not affect the 
determination that the payment is contingent on a change in ownership 
or control as the result of the occurrence of the first event.
    Under Q/A-24 of the 1989 proposed regulations, the entire amount of 
a payment is generally treated as contingent on a change in ownership 
or control. These proposed regulations clarify that the general rule of 
Q/A-24(a) (and not the special rules in either Q/A-24(b) or (c), 
discussed below) applies to the payment of amounts due under an 
employment agreement on a termination of employment or change in 
ownership or control that, without regard to the change, would have 
been paid for the performance of services after the termination of 
employment or change in ownership or control, as applicable. Also, the 
general rules of Q/A-24(a) apply to the accelerated payment of an 
amount that is otherwise payable only on the attainment of a 
performance goal or contingent on an event or condition other than the 
continued performance of services for a specified period of time. In 
situations governed by Q/A-24(a), the determination of whether a 
portion of the payment is reasonable compensation for services rendered 
before, on, or after the change in ownership or control is determined 
under Q/As-38 through 44. With respect to amounts due under an 
employment agreement, however, in most situations, a reduction for 
reasonable compensation for services rendered before the change in 
ownership or control is inappropriate, given the general expectation 
that an individual is not under-compensated for services rendered 
before a change in ownership or control. See Conf. Rep. No. 98-861, at 
852 (1984).
    Q/A-24(b) and (c) provide an objective method for determining the 
portion of a payment that is treated as contingent on a change in 
ownership or control for certain types of payments. These rules are not 
appropriate in situations such as the acceleration of salary payments 
under an employment agreement, when the periodic nature of the payments 
for services means that there is no issue in determining the amount of 
the payment that is accelerated, or in situations where a payment is 
conditioned on achievement of a performance goal or other event.
    As under the 1989 proposed regulations, these proposed regulations 
provide that a payment is treated as contingent on a change in 
ownership or control if the change accelerates the time at which the 
payment is made or accelerates the vesting of a payment. Q/A-24(b) and 
(c) provide rules for determining the portion of such payment that is 
treated as contingent on the change in ownership or control. These 
proposed regulations clarify when Q/A-24(b) and (c) apply to a 
contingent payment.
    These proposed regulations clarify that Q/A-24(b) applies if a 
payment is vested, without regard to the change in ownership or 
control, and is treated as contingent on a change in ownership or 
control because the change accelerates the time the payment is made. 
For example, if an individual has a vested right to a payment at normal 
retirement age under a nonqualified deferred compensation plan, but 
instead that payment is made immediately following a change in 
ownership or control, Q/A-24(b) applies to determine the portion, if 
any, of the payment that is treated as contingent on the change in 
ownership or control.
    These regulations clarify that Q/A-24(c) applies to a payment that 
becomes vested as a result of a change in ownership or control to the 
extent that (i) without regard to the change, the payment was 
contingent only on the performance of services for the corporation for 
a specified period of time and (ii) the payment is attributable, at 
least in part, to the performance of services before the date the 
payment is made or becomes certain to be made. For example, if an 
individual will receive a bonus if employed at the end of a 3-year 
period, but the bonus is paid immediately on the date of the change of 
control, Q/A-24(c) applies to determine the portion of the payment that 
is treated as contingent on the change in ownership or control.
    Q/A-24(b) provides that, when a payment is accelerated, the portion 
of the payment that is contingent on the change is the amount by which 
the accelerated payment exceeds the present value of the payment absent 
acceleration. Q/A-24(b) further provides that if the amount of a 
payment without acceleration is not reasonably ascertainable, and the 
acceleration does not significantly increase the value of the payment, 
then the present value of the payment absent the acceleration is equal 
to the amount of the accelerated payment. As a result, the value of the 
accelerated payment is equal to the value of the payment absent 
acceleration and no portion of the payment is treated as contingent on 
a change in control. If the value of a payment absent acceleration is 
not reasonably ascertainable and the acceleration significantly 
increases the value of the payment, the future value of the payment is 
equal to the amount

[[Page 7633]]

of the accelerated payment. When the future value (as opposed to the 
present value) of the payment is deemed to be the amount of the 
accelerated payment, then there is an excess and, therefore, a portion 
of the payment is treated as contingent on the change.
    Q/A-24(c) provides that the portion of the payment treated as 
contingent on the change when both vesting and payment are accelerated 
is the lesser of (1) the payment or (2) the amount determined under Q/
A-24(b) plus an additional amount to reflect the lapse of the 
obligation to perform additional services. Q/A-24(c) provides that for 
purposes of determining the amount under paragraph (b), the 
acceleration of the vesting of a stock option or the lapse of a 
restriction on restricted stock is considered to increase significantly 
the value of the payment.
    Because Q/A-24(b) and (c) operate to provide an objective basis for 
determining the portion of a payment that is earned as of the date of a 
change in ownership or control, and therefore, not contingent on a 
change in ownership or control, these proposed regulations clarify that 
the rules in 
Q/As-38 through 44 (which provide rules related to reasonable 
compensation for services rendered), are inapplicable if the special 
rules in Q/A-24(b) or (c) apply to a payment.

Change in Ownership or Control

    These proposed regulations follow the same approach as the 1989 
proposed regulations for determining when a change in ownership or 
control occurs. However, these proposed regulations clarify that, for 
purposes of determining whether two or more persons acting as a group 
are considered to own more than 50 percent of the total fair market 
value or total voting power of the stock of a corporation on the date 
of a merger, acquisition, or similar transaction involving that 
corporation, a person who owns stock in both corporations involved in 
the transaction is treated as acting as a group with respect to the 
other shareholders in a corporation only to the extent of such person's 
ownership of stock in that corporation prior to the transaction, and 
not with respect to his or her ownership in the other corporation. For 
example, assume individual A owns stock in both corporations X and Y 
when corporation X acquires stock in Y in exchange for X stock. In 
determining whether corporation Y has undergone a change in ownership 
or control, individual A is considered to be acting as a group with 
other shareholders in corporation Y only to the extent of A's holdings 
in corporation Y prior to the transaction, and not with respect to A's 
ownership in X. In determining whether Corporation X has undergone a 
change in ownership or control, individual A is considered to be acting 
as a group with other shareholders in Corporation X only to the extent 
of individual A's holdings in Corporation X prior to the transaction, 
and not with respect to individual A's ownership interest in 
Corporation Y. This rule applies without regard to the type of 
shareholder involved (i.e., whether the shareholder is an individual or 
an institutional shareholder, such as a corporation, mutual fund, or 
trust).
    Comments are requested with respect to whether the change in 
ownership or control rules in these proposed regulations should be 
further revised. Comments are also requested with respect to whether 
additional guidance is necessary regarding the application of the 
change in ownership or control provisions, and these proposed 
regulations in general, in the context of specific business situations 
such as bankruptcy.

Shareholder Approval Requirements

    Section 280G specifically exempts from the definition of the term 
parachute payment several types of payments that would otherwise 
constitute parachute payments. Deductions for payments exempt from the 
definition of parachute payment are not disallowed by section 280G, and 
such exempt payments are not subject to the 20-percent excise tax of 
section 4999. In addition, such exempt payments are not taken into 
account in applying the 3-times-base-amount test of section 
280G(b)(2)(A)(ii).
    The most significant revisions made by these proposed regulations 
with respect to exempt payments are clarifications to the shareholder 
approval requirements which must be met for payments with respect to a 
corporation in which no stock is readily tradeable on an established 
securities market or otherwise immediately before the change in 
ownership or control.
    Section 280G(b)(5)(B) provides that the shareholder approval 
requirements are met if two conditions are satisfied. First, the 
payment is approved by a vote of the persons who owned, immediately 
before the change in ownership or control, more than 75% of the voting 
power of all outstanding stock of the corporation. Second, there is 
adequate disclosure to shareholders of all material facts concerning 
all payments which (but for this rule) would be parachute payments with 
respect to a disqualified individual. Since the issuance of the 1989 
proposed regulations, commentators have indicated that the 1989 
proposed regulations do not fully explain how the shareholder approval 
requirements operate or accurately reflect business practices connected 
with a change in ownership or control.
    The proposed regulations clarify the process of obtaining 
shareholder approval within the structure provided by section 
280G(b)(5)(B). Under this section, a shareholder approval vote is valid 
only if (1) it is a vote of more than 75% of the shareholders entitled 
to vote based on ownership in the corporation immediately before the 
change in ownership or control, and (2) disclosure is made with respect 
to all payments that would otherwise be parachute payments for an 
individual.
    The first step in obtaining shareholder approval is to identify the 
shareholders entitled to vote. Q/A-7 is revised to clarify that stock 
held by a disqualified individual (or by certain entity shareholders) 
is not entitled to vote with respect to a payment to be made to any 
disqualified individual and that this stock is disregarded in 
determining whether the more than 75% approval requirement has been 
met. Once the stock entitled to vote is determined, more than 75% of 
the voting power of such stock must approve the payment. Q/A-7 also 
includes a rule of administrative convenience providing that a vote to 
approve the payment does not fail to be a vote of the shareholders who 
own stock immediately before the change in ownership or control if 
eligibility to vote is based on the shareholders of record at the time 
of any vote taken in connection with a transaction or event giving rise 
to the change in ownership or control within the three-month period 
ending on the date of the change in ownership or control. This rule 
only applies if the disclosure requirements are also met.
    These proposed regulations further clarify that not all parachute 
payments must be subject to a shareholder vote to satisfy the 
shareholder approval requirements with respect to a payment. It is 
permissible for only a portion of the payments that would otherwise be 
made to a disqualified individual to be subject to vote. For example, 
assume that a disqualified individual with a base amount of $150,000 
would receive payments that (but for the exemption for a corporation 
with no readily tradeable stock) would be parachute payments including 
(i) a bonus payment of $200,000, (ii) vesting in stock options with a 
fair market value of $500,000, $200,000 of which is contingent on the 
change in ownership or control, and (iii) severance payments of 
$100,000. In this

[[Page 7634]]

situation, assuming all of the payments are disclosed, the corporation 
may submit to the shareholders for approval (1) all of the payments, 
(2) any one of the three payments, or (3) $50,001 of any one of the 
payments (e.g., options with a value of $50,001). The issue submitted 
to a shareholder vote must be whether the payment will be made to the 
disqualified individual, not whether the corporation will be able to 
deduct the payment. In addition, the vote must be a separate vote of 
the shareholders. Therefore, the merger, acquisition, or other 
transaction cannot be conditioned on the shareholders' approval of the 
payment.
    These proposed regulations also clarify that the shareholder 
approval requirements are met by a single vote on all payments 
submitted to the vote, including payments to more than one disqualified 
individual (assuming the disclosure requirements, described below, are 
also met).
    The shareholder approval requirements also require adequate 
disclosure of all material facts concerning the amount of all parachute 
payments. For this purpose, the proposed regulations clarify that the 
amount of all parachute payments to be made to each disqualified 
individual, and not just the amount of the payments subject to vote, is 
a material fact. These proposed regulations also clarify that 
shareholders should be provided with basic information about the type 
of payments involved (e.g., vesting of stock options or severance 
payments). This disclosure of information must be made to all 
shareholders entitled to vote, not just to shareholders with 75% of the 
voting power entitled to vote.

Reasonable Compensation

    The determination of whether amounts are reasonable compensation is 
relevant for two purposes. First, an excess parachute payment is 
reduced by any portion of the payment that constitutes reasonable 
compensation for services actually rendered before a change in 
ownership or control. Second, amounts that are reasonable compensation 
for services to be rendered after a change in ownership or control are 
exempt from the definition of parachute payment. In both situations, 
reasonable compensation for services must be demonstrated by clear and 
convincing evidence.
    These proposed regulations clarify two issues with respect to 
reasonable compensation for services performed after a change in 
ownership or control. The proposed regulations clarify that clear and 
convincing evidence that a payment is reasonable compensation for 
services rendered after a change in ownership or control exists if the 
individual's annual compensation after the change in ownership or 
control (apart from normal increases) is not significantly greater then 
the individual's annual compensation before the change in ownership or 
control, provided that the individual's duties and responsibilities are 
substantially the same after the change in ownership or control as they 
were before the change in ownership or control. If the individual's 
duties and responsibilities have changed, then the clear and convincing 
evidence must demonstrate that the individual's annual compensation 
after the change in ownership or control is not significantly greater 
than the compensation customarily paid by the employer, or by 
comparable employers, to persons performing comparable services.
    Payments to an individual under an agreement that requires the 
individual to refrain from providing services (such as under a covenant 
not to compete) may also constitute reasonable compensation for 
services to be rendered on or after the date of the change in ownership 
or control. Under Q/A-42 of these proposed regulations, an agreement is 
treated as an agreement to refrain from services (rather than an 
agreement for severance pay) if it is demonstrated with clear and 
convincing evidence that the agreement substantially constrains the 
individual's ability to perform services and there is a reasonable 
likelihood that the agreement will be enforced against the individual. 
If, under the facts and circumstances, the agreement does not satisfy 
these criteria, the payments under the agreement are instead treated as 
severance payments under Q/A-44. If the agreement does satisfy these 
criteria, then the agreement is treated as an agreement for the 
performance of services, and the payment are exempt from the definition 
of parachute payment to the extent the payments are show to be 
reasonable compensation under Q/A-42(a)(2).

Application to Tax-Exempt Organizations

    Commentators have asked whether a payment with respect to a tax-
exempt entity is exempt from the definition of the term parachute 
payment. These proposed regulations clarify that a payment with respect 
to a tax-exempt entity that would otherwise constitute a parachute 
payment is exempt from the definition of the term parachute payment if 
the following two conditions are satisfied.
    First, the payment must be made by a corporation undergoing a 
change in ownership or control that is a tax-exempt organization, as 
defined in these proposed regulations. A tax-exempt organization is 
defined as any organization described in section 501(c) that is subject 
to an express statutory prohibition against inurement of net earnings 
to the benefit of any private shareholder or individual, an 
organization described in subsections 501(c)(1) or 501(c)(21), any 
religious or apostolic organization described in section 501(d), or any 
qualified tuition program described in section 529.
    Second, the organization must meet the definition of tax-exempt 
organization, as defined in these regulations, both immediately before 
and immediately after the change in ownership or control. If this 
second condition is not met, a payment made by a tax-exempt 
organization is not exempt from the definition of parachute payment.
    As noted above, the term tax-exempt organizations includes 
organizations that are described in section 501(c) that already are 
subject to express statutory rules that prohibit the inurement of the 
net earnings of such organizations to the benefit of ``any private 
shareholder or individual.'' Organizations described in the following 
subsections of 501(c) are tax-exempt organizations under application of 
this rule: 501(c)(3) (including any organization described in 
subsections 501(e), (f), or (k)), 501(c)(4), 501(c)(6), 501(c)(9), 
501(c)(11), 501(c)(13) (but only with respect to those organizations 
subject to the express anti-inurement provision), 501(c)(19), and 
501(c)(26). In light of the existing restrictions on these 
organizations, the Service and the Treasury Department believe the 
additional protections of section 280G are unnecessary. In addition, 
the term tax-exempt organization in the proposed regulations includes 
federal instrumentalities organized under Act of Congress (described in 
section 501(c)(1)), black lung trusts (described in section 
501(c)(21)), certain religious and apostolic organizations (described 
in section 501(d)) and qualified tuition programs (described in section 
529). The Service and the Treasury Department recognize that it may be 
appropriate to exempt payments made by other types of tax-exempt 
organizations. Comments are requested on whether any additional 
categories of organizations should be included in the definition of 
tax-exempt organization for purposes of section 280G.

[[Page 7635]]

Definition of Corporation

    Under the 1989 proposed regulations, corporation is defined by 
reference to section 7701(a)(3) of the Code. These proposed regulations 
clarify that the term corporation, for purposes of section 280G and the 
regulations thereunder, includes any entity described in Sec. 301.7701-
2(b) such as, for example, a real estate investment trust under section 
856(a), a corporation that has mutual or cooperative (rather than 
stock) ownership, such as a mutual insurance company, a mutual savings 
bank, or a cooperative bank (as defined in section 7701(a)(32)), and a 
foreign corporation (as defined in section 7701(a)(5)).
    Accordingly, the term corporation also includes any entity 
described in Sec. 301.7701-3(c)(1)(v)(A). That regulation provides, in 
general, that an entity that claims to be, or is determined to be, an 
entity that is exempt from taxation under section 501(a) is treated as 
an association for purposes of the Code. Because the definition of 
corporation includes an association, any entity described in 
Sec. 301.7701-3(c)(1)(v)(A) is a corporation for purposes of sections 
7701 and 280G.

Determination of Excess Parachute Payments

    Once all parachute payments are identified, the determination of 
what portion, if any, of each parachute payment is an excess parachute 
payment is made. This determination is based on the aggregate present 
value of all parachute payments. These proposed regulations modify the 
method described in Q/A-33 of the 1989 proposed regulations for 
determining the present value of a payment contingent on an uncertain 
future event or condition. Under Q/A-33 of these proposed regulations, 
if there is at least a 50-percent probability that the payment will be 
made, the entire present value of a contingent payment should be 
included for purposes of determining if there are excess parachute 
payments. If there is less than a 50-percent probability, then the 
present value of the contingent payment is not included. Once it is 
certain whether or not the payment will be made, the 3-times-base 
amount test in Q/A-30 is reapplied if the initial determination as to 
whether to include the payment was incorrect. If the inclusion or 
exclusion of the payment for purposes of Q/A-30 at the time of the 
change in ownership or control was correct, there is no need to reapply 
the 3-times-base-amount test. In addition, if it is reasonably 
estimated that there is a less than 50-percent probability that the 
payment will be made and the payment is not included in the 3-times-
base-amount test, but the payment is later made, the 3-times-base-
amount test is not reapplied if the test without regard to the 
contingent payment resulted in a determination that the individual 
received (or would receive) excess parachute payments and no base 
amount is allocated to the contingent payment.
    Finally, Q/A-31 provides guidance on determining the present value 
of an obligation to provide health care over a period of years. Under 
these proposed regulations, the determination of the present value of 
this obligation should be calculated in accordance with generally 
accepted accounting principles. For purposes of Q/A-31, it is 
permissible for the obligation to provide health care to be measured by 
projecting the cost of premiums for purchased health care insurance, 
even if no health care insurance is actually purchased. If the 
obligation to provide health care is made in coordination with a health 
care plan that the corporation makes available to a group, then the 
premiums used for this purpose may be group premiums. This method only 
applies for purposes of determining present value. Premiums for health 
care insurance can be used for purposes of determining a corporation's 
loss of deduction or the excise tax obligation for a disqualified 
individual only to the extent such premiums are actually paid for 
health care insurance used to satisfy the corporation's obligation to 
provide health care.

Timing of the Payment of Tax under Section 4999

    In general, the excise tax under section 4999 is due at the time 
that the payment is considered made under Q/A-11 through 13. Q/A-11(b) 
of these proposed regulations clarifies that, except as provided in Q/
A-12 or 13, a payment is considered made in the taxable year that it is 
includible in the disqualified individual's gross income, or for 
benefits excludible from income, in the year the benefit is received. 
Q/A-11(c) of these proposed regulations permits a disqualified 
individual, for purposes of section 4999, to treat certain payments as 
made in the year of the change in ownership or control (or the first 
year for which a payment contingent on a change in ownership or control 
is certain to be made), even though the payment is not yet includible 
in income (or otherwise received). This treatment is not available, 
however, for a payment if the present value is not reasonably 
ascertainable within the meaning of section 3121(v) and Sec. 1.3121(v)-
1(e)(4) or for a payment related to health benefits or coverage. These 
proposed regulations indicate in Q/A-11(c) that the Commissioner may 
provide through published guidance that Q/A-11(c) is or is not 
available with respect to other types of payments.
    According to Q/A-11(c) of these proposed regulations, the payment 
of the excise tax under section 4999 must be made based on the amount 
calculated for purposes of determining excess parachute payments. 
Therefore, to the extent that the determination of whether there is an 
excess parachute payment is based on an incorrect valuation of the 
payment, the excise tax payment under this provision is also incorrect.

Proposed Effective Date

    These regulations are proposed to apply to any payments that are 
contingent on a change in ownership or control occurring on or after 
January 1, 2004. Taxpayers may rely on these proposed regulations until 
the effective date of the final regulations. Alternatively, taxpayers 
may rely on the 1989 proposed regulations for any payment contingent on 
a change in ownership or control that occurs prior to January 1, 2004.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f), this notice of proposed rulemaking 
will be submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written or electronic comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. All comments will be available for public inspection and copying.
    A public hearing has been scheduled for June 26, 2002, beginning at 
10 a.m. in the IRS Auditorium of the Internal Revenue Building, 1111 
Constitution Avenue, NW, Washington, DC. All

[[Page 7636]]

visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by June 
5, 2002. A period of 10 minutes will be allotted to each person for 
making comments. An agenda showing the schedule of speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Erinn Madden, 
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    The proposed amendments to 26 CFR part 1 are as follows:

PART I--INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1986

    1. The authority citation for part 1 is amended by adding the 
following entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.280G-1 also issued under 26 U.S.C. 280G (b) and (e). * 
* *

    2. Section Sec. 1.280G-1 is added to read as follows:


Sec. 1.280G-1  Golden parachute payments.

    The following questions and answers relate to the treatment of 
golden parachute payments under section 280G of the Internal Revenue 
Code of 1986, as added by section 67 of the Tax Reform Act of 1984 
(Pub. L. 98-369; 98 Stat. 585) and amended by section 1804(j) of the 
Tax Reform Act of 1986 (Pub. L. 99-514; 100 Stat. 2807), section 
1018(d) (6)-(8) of the Technical and Miscellaneous Revenue Act of 1988 
(Pub. L. 100-647; 102 Stat. 3581), and section 1421 of the Small 
Business Job Protection Act of 1996 (Pub. L. 104-188, 110 Stat. 1755). 
The following is a table of contents for this section:

Overview:
    Effect of section 280G.................................        Q/A-1
    Meaning of ``parachute payment''.......................        Q/A-2
    Meaning of ``excess parachute payment''................        Q/A-3
    Effective date of section 280G.........................        Q/A-4
Exempt Payments:
    Exempt payments generally..............................        Q/A-5
    Exempt payments with respect to certain corporations...        Q/A-6
    Shareholder approval requirements......................        Q/A-7
    Exempt payments under a qualified plan.................        Q/A-8
    Exempt payments of reasonable compensation.............        Q/A-9
Payor of Parachute Payments................................       Q/A-10
Payments in the Nature of Compensation:
    The nature of compensation.............................       Q/A-11
    Property transfers.....................................       Q/A-12
    Stock options..........................................       Q/A-13
    Reduction of amount of payment by consideration paid...       Q/A-14
Disqualified Individuals:
    Meaning of ``disqualified individual''.................       Q/A-15
    Personal service corporation treated as individual.....       Q/A-16
    Meaning of ``shareholder''.............................       Q/A-17
    Meaning of ``officer''.................................       Q/A-18
    Meaning of ``highly-compensated individual''...........       Q/A-19
    Meaning of ``disqualified individual determination            Q/A-20
     period''..............................................
    Meaning of ``compensation''............................       Q/A-21
Contingent on Change in Ownership or Control:
    General rules for determining payments contingent on          Q/A-22
     change................................................
    Payments under agreement entered into after change.....       Q/A-23
    Amount of payment contingent on change.................       Q/A-24
    Presumption that payment is contingent on change.......   Q/A-25, 26
    Change in ownership or control.........................  Q/A-27, 28,
                                                                      29
Three-Times-Base-Amount Test for Parachute Payments:
    Three-times-base-amount test...........................       Q/A-30
    Determination of present value.........................  Q/A-31, 32,
                                                                      33
    Meaning of ``base amount''.............................       Q/A-34
    Meaning of ``base period''.............................       Q/A-35
    Special rule for determining base amount...............       Q/A-36
Securities Violation Parachute Payments....................       Q/A-37
Computation and Reduction of Excess Parachute Payments:
    Computation of excess parachute payments...............       Q/A-38
    Reduction by reasonable compensation...................       Q/A-39
Determination of Reasonable Compensation:
    General criteria for determining reasonable                   Q/A-40
     compensation..........................................
    Types of payments generally considered reasonable        Q/A-41, 42,
     compensation..........................................           43

[[Page 7637]]

 
    Treatment of severance payments........................       Q/A-44
Miscellaneous rules:
    Definition of corporation..............................       Q/A-45
    Treatment of affiliated group as one corporation.......       Q/A-46
Effective date:
    General effective date of section 280G.................       Q/A-47
    Effective date of regulations..........................       Q/A-48
 

Overview

    Q-1: What is the effect of Internal Revenue Code section 280G?
    A-1: (a) Section 280G disallows a deduction for any excess 
parachute payment paid or accrued. For rules relating to the imposition 
of a nondeductible 20-percent excise tax on the recipient of any excess 
parachute payment, see Internal Revenue Code sections 4999, 275(a)(6), 
and 3121(v)(2)(A).
    (b) The disallowance of a deduction under section 280G is not 
contingent on the imposition of the excise tax under section 4999. The 
imposition of the excise tax under section 4999 is not contingent on 
the disallowance of a deduction under section 280G. Thus, for example, 
because the imposition of the excise tax under section 4999 is not 
contingent on the disallowance of a deduction under section 280G, a 
payee may be subject to the 20-percent excise tax under section 4999 
even though the disallowance of the deduction for the excess parachute 
payment may not directly affect the federal taxable income of the 
payor.
    Q-2: What is a parachute payment for purposes of section 280G?
    A-2: (a) The term parachute payment means any payment (other than 
an exempt payment described in Q/A-5) that--
    (1) Is in the nature of compensation;
    (2) Is made or is to be made to (or for the benefit of) a 
disqualified individual;
    (3) Is contingent on a change--
    (i) In the ownership of a corporation;
    (ii) In the effective control of a corporation; or
    (iii) In the ownership of a substantial portion of the assets of a 
corporation; and
    (4) Has (together with other payments described in paragraphs 
(a)(1), (2), and (3) of this A-2 with respect to the same disqualified 
individual) an aggregate present value of at least 3 times the 
individual's base amount.
    (b) Hereinafter, a change referred to in paragraph (a)(3) of this 
A-2 is referred to as a change in ownership or control. For a 
discussion of the application of paragraph (a)(1), see Q/A-11 through 
Q/A-14; paragraph (a)(2), Q/A-15 through Q/A-21; paragraph (a)(3), Q/A-
22 through Q/A-29; and paragraph (a)(4), Q/A-30 through Q/A-36.
    (c) The term parachute payment also includes any payment in the 
nature of compensation to (or for the benefit of) a disqualified 
individual that is pursuant to an agreement that violates a generally 
enforced securities law or regulation. This type of parachute payment 
is referred to in this section as a securities violation parachute 
payment. See Q/A-37 for the definition and treatment of securities 
violation parachute payments.
    Q-3: What is an excess parachute payment for purposes of section 
280G?
    A-3: The term excess parachute payment means an amount equal to the 
excess of any parachute payment over the portion of the base amount 
allocated to such payment. Subject to certain exceptions and 
limitations, an excess parachute payment is reduced by any portion of 
the payment which the taxpayer establishes by clear and convincing 
evidence is reasonable compensation for personal services actually 
rendered by the disqualified individual before the date of the change 
in ownership or control. For a discussion of the nonreduction of a 
securities violation parachute payment by reasonable compensation, see 
Q/A-37. For a discussion of the computation of excess parachute 
payments and their reduction by reasonable compensation, see Q/A-38 
through Q/A-44.
    Q-4: What is the effective date of section 280G and this section?
    A-4: In general, section 280G applies to payments under agreements 
entered into or renewed after June 14, 1984. Section 280G also applies 
to certain payments under agreements entered into on or before June 14, 
1984, and amended or supplemented in significant relevant respect after 
that date. This section applies to any payment contingent on a change 
in ownership or control which occurs on or after January 1, 2004. For a 
discussion of the application of the effective date, see 
Q/A-47 and Q/A-48.

Exempt Payments

    Q-5: Are some types of payments exempt from the definition of the 
term parachute payment?
    A-5: (a) Yes, the following five types of payments are exempt from 
the definition of parachute payment--
    (1) Payments with respect to a small business corporation 
(described in Q/A-6 of this section);
    (2) Certain payments with respect to a corporation no stock in 
which is readily tradeable on an established securities market (or 
otherwise) (described in Q/A-6 of this section);
    (3) Payments to or from a qualified plan (described in Q/A-8 of 
this section);
    (4) Certain payments made by a corporation undergoing a change in 
ownership or control that is described in any of the following sections 
of the Internal Revenue Code: section 501(c) (but only if such 
organization is subject to an express statutory prohibition against 
inurement of net earnings to the benefit of any private shareholder or 
individual, or if the organization is described in section 501(c)(1) or 
section 501(c)(21)), section 501(d), or section 529, collectively 
referred to as tax-exempt organizations (described in 
Q/A-6 of this section); and
    (5) Certain payments of reasonable compensation for services to be 
rendered on or after the change in ownership or control (described in 
Q/A-9 of this section).
    (b) Deductions for payments exempt from the definition of parachute 
payment are not disallowed by section 280G, and such exempt payments 
are not subject to the 20-percent excise tax of section 4999. In 
addition, such exempt payments are not taken into account in applying 
the 3-times-base-amount test of Q/A-30 of this section.
    Q-6: Which payments with respect to a corporation referred to in 
paragraph (a)(1), (a)(2), or (a)(4) of Q/A-5 of this section are exempt 
from the definition of parachute payment?
    A-6: (a) The term parachute payment does not include--
    (1) Any payment to a disqualified individual with respect to a 
corporation which (immediately before the change in ownership or 
control) was a small business corporation (as defined in section 
1361(b) but without regard to section 1361(b)(1)(C) thereof),
    (2) Any payment to a disqualified individual with respect to a 
corporation (other than a small business corporation described in 
paragraph (a)(1) of this A-6) if--
    (i) Immediately before the change in ownership or control, no stock 
in such

[[Page 7638]]

corporation was readily tradeable on an established securities market 
or otherwise; and
    (ii) The shareholder approval requirements described in Q/A-7 of 
this section are met with respect to such payment; or
    (3) Any payment to a disqualified individual made by a corporation 
which is a tax-exempt organization (as defined in paragraph (a)(4) of 
Q/A-5 of this section), but only if the corporation meets the 
definition of a tax-exempt organization both immediately before and 
immediately after the change in ownership or control.
    (b) For purposes of paragraph (a)(1) of this A-6, the members of an 
affiliated group are not treated as one corporation.
    (c) The requirements of paragraph (a)(2)(i) of this A-6 are not met 
if a substantial portion of the assets of a corporation undergoing a 
change in ownership or control consists (directly or indirectly) of 
stock in another entity (or any ownership interest in such entity) and 
stock of such entity (or any ownership interest in such entity) is 
readily tradeable on an established securities market or otherwise. For 
this purpose, such stock constitutes a substantial portion of the 
assets of an entity if the total fair market value of the stock is 
equal to or exceeds one third of the total gross fair market value of 
all of the assets of the entity. If a corporation is a member of an 
affiliated group (which group is treated as one corporation under A-46 
of this section), the requirements of paragraph (a)(2)(i) of this A-6 
are not met if any stock in any member of such group is readily 
tradeable on an established securities market or otherwise.
    (d) For purposes of paragraph (a)(2)(i) of this A-6, the term stock 
does not include stock described in section 1504(a)(4) if the payment 
does not adversely affect the redemption and liquidation rights of any 
shareholder owning such stock.
    (e) For purposes of paragraph (a)(2)(i) of this A-6, stock is 
treated as readily tradeable if it is regularly quoted by brokers or 
dealers making a market in such stock.
    (f) For purposes of paragraph (a)(2)(i) of this A-6, the term 
established securities market means an established securities market as 
defined in Sec. 1.897-1(m).
    (g) The following examples illustrate the application of this 
exemption:

    Example 1.  A small business corporation (within the meaning of 
paragraph (a)(1) of this A-6) operates two businesses. The 
corporation sells the assets of one of its businesses, and these 
assets represent a substantial portion of the assets of the 
corporation. Because of the sale, the corporation terminates its 
employment relationship with persons employed in the business the 
assets of which are sold. Several of these employees are highly-
compensated individuals to whom the owners of the corporation make 
severance payments in excess of 3 times each employee's base amount. 
Since the corporation is a small business corporation immediately 
before the change in ownership or control, the payments are not 
parachute payments.
    Example 2.  Assume the same facts as in Example 1, except that 
the corporation is not a small business corporation within the 
meaning of paragraph (a)(1) of this A-6. If no stock in the 
corporation is readily tradeable on an established securities market 
(or otherwise) immediately before the change in ownership or control 
and the shareholder approval requirements described in Q/A-7 of this 
section are met, the payments are not parachute payments.
    Example 3.  Stock of Corporation S is wholly owned by 
Corporation P, stock in which is readily tradeable on an established 
securities market. The Corporation S stock equals or exceeds one 
third of the total gross fair market value of Corporation P, and 
thus, represents a substantial portion of the assets of Corporation 
P. Corporation S makes severance payments to several of its highly-
compensated individuals that are parachute payments under section 
280G and Q/A-2 of this section. Because stock in Corporation P is 
readily tradeable on an established securities market, the payments 
are not exempt from the definition of parachute payments under this 
A-6.
    Example 4.  A is a corporation described in section 501(c)(3), 
and accordingly, its net earnings are prohibited from inuring to the 
benefit of any private shareholder or individual. A transfers 
substantially all of its assets to another corporation resulting in 
a change in ownership or control. Contingent on the change in 
ownership or control, A makes a payment that, but for the potential 
application of the excemption described in A-5(a)(4), would 
constitute a parachute payment. However, one or more aspects of the 
transaction that constitutes the change in ownership or control 
causes A to fail to be described in section 501(c)(3). Accordingly, 
A fails to meet the definition of a tax-exempt organization both 
immediately before and immediately after the change in ownership or 
control, as required by this A-6. As a result, the payment made by A 
that was contingent on the change in ownership or control is not 
exempt from the definition of parachute payment under this A-6.
    Example 5.  B is a corporation described in section 501(c)(15). 
B does not meet the definition of a tax-exempt organization because 
section 501(c)(15) does not expressly prohibit inurement of B's net 
earnings to the benefit of any private shareholder or individual. 
Accordingly, if B has a change in ownership or control and makes a 
payment pays or accrues a payment that would otherwise meet the 
definition of a parachute payment, such payment is not exempt from 
the definition of the term parachute payment for purposes of this A-
6.

    Q-7: How are the shareholder approval requirements referred to in 
paragraph (a)(2)(ii) of Q/A-6 of this section met?
    A-7: (a) General rule. The shareholder approval requirements 
referred to in paragraph (a)(2)(ii) of Q/A-6 of this section are met 
with respect to any payment if--
    (1) Such payment was approved by more than 75 percent of the voting 
power of all outstanding stock of the corporation entitled to vote (as 
described in this A-7) immediately before the change in ownership or 
control; and
    (2) There was adequate disclosure to all persons entitled to vote 
(as described in this A-7) of all material facts concerning all 
material payments which (but for Q/A-6 of this section) would be 
parachute payments with respect to a disqualified individual.
    (b) Voting requirements--(1) General rule. The vote described in 
paragraph (a)(1) of this A-7 must determine the right of the 
disqualified individual to receive the payment, or, in the case of a 
payment made before the vote, the right of the disqualified individual 
to retain the payment. For purposes of this A-7, the vote can be no 
less than the full amount of the payment(s) to be made. The total 
payment(s) submitted for shareholder approval must be separately 
approved by the shareholders. Shareholder approval can be a single vote 
on all payments submitted to vote, including payments to more than one 
disqualified individual. The requirements of this paragraph (b)(1) are 
not satisfied if approval of the change in ownership or control is 
contingent on the approval of any payment that would be a parachute 
payment but for Q/A-6 of this section to a disqualified individual.
    (2) Special rule for vote within 3 months before change. A vote to 
approve the payment does not fail to be a vote of the outstanding stock 
of the corporation entitled to vote immediately before the change in 
ownership or control merely because the determination of the 
shareholders entitled to vote on the payment is based on the 
shareholders of record at the time of any shareholder vote taken in 
connection with a transaction or event giving rise to such change in 
ownership or control and within the three-month period ending on date 
of the change in ownership or control, provided the disclosure 
requirements described in paragraph (c) of this A-7 are met.
    (3) Entity shareholder. Approval of a payment by any shareholder 
that is not an individual (an entity shareholder) generally must be 
made by the person

[[Page 7639]]

authorized by the entity shareholder to approve the payment. However, 
if a substantial portion of the assets of an entity shareholder 
consists (directly or indirectly) of stock in the corporation 
undergoing the change in ownership or control, approval of the payment 
by that entity shareholder must be made by a separate vote of the 
persons who hold, immediately before the change in ownership or 
control, more than 75 percent of the voting power of the entity 
shareholder. The preceding sentence does not apply if the value of the 
stock of the corporation owned, directly or indirectly, by or for the 
entity shareholder does not exceed 1 percent of the total value of the 
outstanding stock of the corporation. Where approval of a payment by an 
entity shareholder must be made by a separate vote of the owners of the 
entity shareholder, the normal voting rights of the entity shareholder 
determine which owners shall vote. For purposes of this A-7, stock 
represents a substantial portion of the assets of an entity shareholder 
if the total fair market value of the stock held by the entity 
shareholder in the corporation undergoing the change in ownership or 
control is equal to or exceeds one third of the total fair market value 
of all of the assets of the entity shareholder.
    (4) Attribution of stock ownership. In determining the persons who 
comprise the ``more than 75 percent'' group referred to in paragraph 
(a)(1) or (b)(3) of this A-7, stock is not counted as outstanding stock 
if the stock is actually owned or constructively owned under section 
318(a) by or for a disqualified individual who receives (or is to 
receive) payments that would be parachute payments if the shareholder 
approval requirements described in paragraph (a) of this A-7 were not 
met. Likewise, stock is not counted as outstanding stock if the owner 
is considered under section 318(a) to own any part of the stock owned 
directly or indirectly by or for a disqualified individual described in 
the preceding sentence. In addition, if a partner authorized by a 
partnership to approve a payment is a disqualified individual with 
respect to the corporation undergoing a change in ownership or control, 
none of the stock held by the partnership is considered outstanding 
stock. However, if all persons who hold voting power in the corporation 
are disqualified individuals or related persons described in either of 
the two preceding sentences, then stock owned by such persons is 
counted as outstanding stock.
    (5) Disqualified individuals. To satisfy the approval requirements 
of paragraph (a) of this A-7, the vote of a disqualified individual who 
receives (or is to receive) a payment that would be a parachute payment 
if the shareholder approval requirements described in paragraph (a) of 
this A-7 were not met is not considered in determining whether the more 
than 75 percent vote has been obtained for purposes of any vote under 
paragraph (a) of this A-7. However, if all persons who hold voting 
power in the corporation are disqualified individuals or related 
persons, then votes by such persons are considered in determining 
whether the more than 75% vote has been obtained.
    (c) Adequate disclosure. To be adequate disclosure for purposes of 
paragraph (a)(2) of this A-7, disclosure must be full and truthful 
disclosure of the material facts and such additional information as is 
necessary to make the disclosure not materially misleading at the time 
the disclosure was made. Disclosure of such information must be made to 
every shareholder of the corporation entitled to vote under this A-7. 
For each disqualified individual, material facts that must be disclosed 
include the total amount of the payments that would be parachute 
payments if the shareholder approval requirements described in 
paragraph (a) of this A-7 were not met and a brief description of each 
payment (e.g., accelerated vesting of options, bonus, or salary). An 
omitted fact is considered a material fact if there is a substantial 
likelihood that a reasonable shareholder would consider it important.
    (d) Corporation without shareholders. If a corporation does not 
have shareholders, the exemption described in Q/A-6(a)(2) of this 
section and the shareholder approval requirements described in this A-7 
do not apply. For purposes of this paragraph (d), a shareholder does 
not include a member in an association, joint stock company, or 
insurance company.
    (e) Examples. The following examples illustrate the application of 
this A-7:

    Example 1. Corporation S has two shareholders--Corporation P, 
which owns 76 percent of the stock of Corporation S, and A, a 
disqualified individual. No stock of Corporation P or S is readily 
tradeable on an established securities market (or otherwise). Stock 
of Corporation S equals or exceeds one third of the assets of 
Corporation P, and thus, represents a substantial portion of the 
assets of Corporation P. All of the stock of Corporation S is sold 
to Corporation M. Contingent on the change in ownership of 
Corporation S, severance payments are made to the officers of 
Corporation S in excess of 3 times each officer's base amount. If 
the payments are approved by a separate vote of the persons who 
hold, immediately before the sale, more than 75 percent of the 
voting power of the outstanding stock of Corporation P and the 
disclosure rules of paragraph (a)(2) of this A-7 are complied with, 
the shareholder approval requirements of this A-7 are met, and the 
payments are exempt from the definition of parachute payment 
pursuant to A-6 of this section.
    Example 2. Corporation M is wholly owned by Partnership P. No 
interest in either M or P is readily tradeable on an established 
securities market (or otherwise). Stock of Corporation M equals or 
exceeds one third of the assets of Partnership P, and thus, 
represents a substantial portion of the assets of Partnership P. 
Corporation M undergoes a change in ownership or control. 
Partnership P has one general partner and 200 limited partners. None 
of the limited partners are entitled to vote on issues involving the 
management of the partnership investments. If the payments that 
would be parachute payments if the shareholder approval requirements 
of this A-7 are not met are approved by the general partner and the 
disclosure rules of paragraph (a)(2) of this A-7 are complied with, 
the shareholder approval requirements of this A-7 are met, and the 
payments are exempt from the definition of parachute payment 
pursuant to A-6 of this section.
    Example 3. Corporation A has several shareholders including X 
and Y, who are disqualified individuals with respect to Corporation 
A. No stock of Corporation A is readily tradeable on an established 
securities market (or otherwise). Corporation A undergoes a change 
in ownership or control. Contingent on the change, severance 
payments are payable to X and Y that are in excess of 3 times each 
individual's base amount. To determine whether the approval 
requirements of paragraph (a)(1) of this A-7 are satisfied regarding 
the payments to X and Y, the stock of X and Y is not considered 
outstanding, and X and Y are not eligible to vote.
    Example 4. Assume the same facts as in Example 3 except that 
after adequate disclosure (within the meaning of paragraph (a)(2) of 
this A-7) to all shareholders entitled to vote, 60 percent of the 
shareholders who are entitled to vote approve the payments to X and 
Y. Because more than 75 percent of the shareholders did not approve 
the payments to X and Y, the shareholder approval requirements of 
paragraph (a)(1) of this A-7 are not satisfied, and the payments are 
not made to X and Y.
    Example 5. Assume the same facts as in Example 3 except that 
disclosure of all the material facts regarding the payments to X and 
Y is made to two of Corporation A's shareholders, who collectively 
own 80 percent of Corporation A's stock entitled to vote and approve 
the payment. Assume further that no disclosure of the material facts 
regarding the payments to X and Y is made to other Corporation A 
shareholders who are entitled to vote within the meaning of this A-
7. Because disclosure regarding the payments to X and Y is not made 
to all of Corporation A's shareholders who were entitled to vote, 
the disclosure requirements of paragraph (a)(2) of this A-7 are not 
met, and the payments are not exempt from the definition of 
parachute payment pursuant to Q/A-6.

[[Page 7640]]

    Example 6. Corporation C has three shareholders--Partnership, 
which owns 20 percent of the stock of Corporation C; A, an 
individual who owns 60 percent of the stock of Corporation C; and B, 
an individual who owns 20 percent of Corporation C. Stock of 
Corporation C does not represent a substantial portion of the assets 
of Partnership. No interest in either Partnership or Corporation C 
is readily tradeable on an established securities market (or 
otherwise). P, a one-third partner in Partnership, is a disqualified 
individual with respect to Corporation C. Corporation C undergoes a 
change in ownership or control. Contingent on the change, a 
severance payment is payable to P in excess of 3 times P's base 
amount. To determine the persons who comprise the ``more than 75 
percent group'' referred to in paragraph (a)(1) of this A-7 who must 
approve the payment to P, one third of the stock held by Partnership 
is not considered outstanding stock. If, however, P is the person 
authorized by Partnership to approve the payment, none of the shares 
of Partnership are considered outstanding stock.
    Example 7. X, an employee of Corporation E, is a disqualified 
individual with respect to Corporation E. No stock in Corporation E 
is readily tradeable on an established securities market (or 
otherwise). X, Y, and Z are all employees and disqualified 
individuals with respect to Corporation E. Each individual has a 
base amount of $100,000. Corporation E undergoes a change in 
ownership or control. Contingent on the change, a severance payment 
of $400,000 is payable to X; $600,000 is payable to Y; and 
$1,000,000 is payable to Z. Corporation E provides a ballot to each 
Corporation E shareholder entitled to vote under paragraph(a)(1) of 
this A-7 listing the payments of $400,000 to X; $600,000 to Y; and 
$1,000,000 to Z. Next to each name and corresponding amount on the 
ballot, Corporation E requests approval (with a ``yes'' and ``no'' 
box) of each total payment to be made to each individual and states 
that if the payment is not approved the payment will not be made. 
Adequate disclosure, within the meaning of this A-7 is made to each 
shareholder entitled to vote under this A-7. More than 75 percent of 
the Corporation E shareholders who are entitled to vote under 
paragraph (a)(1) of this A-7, approve each payment to each 
individual. The shareholder approval requirements of this A-7 are 
met, and the payments are exempt from the definition of parachute 
payment pursuant to A-6 of this section.
    Example 8. Assume the same facts as in Example 7 except that the 
ballot does not request approval of each total payment to each 
individual separately. Instead, the ballot states that $2,000,000 in 
payments will be made to X, Y, and Z and requests approval of all of 
the $2,000,000 payments. Assuming the nature of the payments to X, 
Y, and Z are separately described to the shareholders entitled to 
vote under this A-7, the shareholder approval requirements of 
paragraph (a)(1) of this A-7 are met, and the payments are exempt 
from the definition of parachute payment pursuant to A-6 of this 
section.
    Example 9. B, an employee of Corporation X, is a disqualified 
individual with respect to Corporation X. Stock of Corporation X is 
not readily tradeable on an established securities market (or 
otherwise). Corporation X undergoes a change in ownership or 
control. B's base amount is $205,000. Under B's employment agreement 
with Corporation X, in the event of a change in ownership or 
control, B's stock options will vest and B will receive a severance 
and bonus payment. Contingent on the change, B's stock options 
immediately vest with a fair market value of $500,000, $200,000 of 
which is contingent on the change, and B will receive a $200,000 
bonus payment and a $400,000 severance payment. Corporation X 
distributes a ballot to every shareholder of Corporation X who 
immediately before the change is entitled to vote. The ballot lists 
the following payments to be made to B: the contingent payment of 
$200,000 attributable to options, a $200,000 bonus payment, and a 
$400,000 severance payment. The ballot requests shareholder approval 
of the $200,000 bonus payment to B and states that whether or not 
the $200,000 bonus payment is approved, B will receive $200,000 
attributable to options and a $400,000 severance payment. More than 
75 percent of the shareholders entitled to vote approve the $200,000 
bonus payment to B. The shareholder approval requirements of this A-
7 are met, and the $200,000 payment is exempt from the definition of 
parachute payment pursuant to A-6 of this section.

    Q-8: Which payments under a qualified plan are exempt from the 
definition of parachute payment?
    A-8: The term parachute payment does not include any payment to or 
from--
    (a) A plan described in section 401(a) which includes a trust 
exempt from tax under section 501(a);
    (b) An annuity plan described in section 403(a);
    (c) A simplified employee pension (as defined in section 408(k)); 
or
    (d) A simple retirement account (as defined in section 408(p)).
    Q-9: Which payments of reasonable compensation are exempt from the 
definition of parachute payment?
    A-9: Except in the case of securities violation parachute payments, 
the term parachute payment does not include any payment (or portion 
thereof) which the taxpayer establishes by clear and convincing 
evidence is reasonable compensation for personal services to be 
rendered by the disqualified individual on or after the date of the 
change in ownership or control. See Q/A-37 of this section for the 
definition and treatment of securities violation parachute payments. 
See Q/A-38 through Q/A-44 of this section for rules on determining 
amounts of reasonable compensation.

Payor of Parachute Payments

    Q-10: Who may be the payor of parachute payments?
    A-10: Parachute payments within the meaning of Q/A-2 of this 
section may be paid, directly or indirectly, by--
    (a) The corporation referred to in paragraph (a)(3) of Q/A-2 of 
this section,
    (b) A person acquiring ownership or effective control of that 
corporation or ownership of a substantial portion of that corporation's 
assets, or
    (c) Any person whose relationship to such corporation or other 
person is such as to require attribution of stock ownership between the 
parties under section 318(a).

Payments in the Nature of Compensation

    Q-11: What types of payments are in the nature of compensation?
    A-11: (a) General rule. For purposes of this section, all 
payments--in whatever form--are payments in the nature of compensation 
if they arise out of an employment relationship or are associated with 
the performance of services. For this purpose, the performance of 
services includes holding oneself out as available to perform services 
and refraining from performing services (such as under a covenant not 
to compete or similar arrangement). Payments in the nature of 
compensation include (but are not limited to) wages and salary, 
bonuses, severance pay, fringe benefits, and pension benefits and other 
deferred compensation (including any amount characterized by the 
parties as interest thereon). A payment in the nature of compensation 
also includes cash when paid, the value of the right to receive cash, 
or a transfer of property. However, payments in the nature of 
compensation do not include attorney's fees or court costs paid or 
incurred in connection with the payment of any amount described in 
paragraphs (a)(1), (2), and (3) of Q/A-2 of this section or a 
reasonable rate of interest accrued on any amount during the period the 
parties contest whether a payment will be made.
    (b) When payment is considered to be made. Except as otherwise 
provided in A-11 through Q/A-13 of this section, a payment in the 
nature of compensation is considered made (and is subject to the excise 
tax under section 4999) in the taxable year in which it is includible 
in the disqualified individual's gross income or, in the case of fringe 
benefits and other benefits excludible from income, in the taxable year 
the benefits are received.
    (c) Pre-payment rule. Notwithstanding the general rule described in 
paragraph (b) of this A-11, for purposes of section 4999, a 
disqualified individual is

[[Page 7641]]

permitted to treat a payment as received in the year of the change in 
ownership or control or, if later, the first year in which the payment 
(or payments) is certain to be made without regard to the year in which 
the payment (or payments) is includible in income (or otherwise 
received). The payment of the excise tax for purposes of section 4999 
must be based on the amount calculated for purposes of determining any 
excess parachute payments. However, a disqualified individual may not 
apply this paragraph (c) of this A-11 to a payment to be made in cash 
if the present value of the payment would be considered not reasonably 
ascertainable under section 3121(v) and Sec. 1.3121(v)-1(e)(4) or a 
payment related to health benefits or coverage. The Commissioner is 
permitted to provide that this paragraph (c) is or is not available for 
certain types of payments.
    (d) Transfers of property. Transfers of property are treated as 
payments for purposes of this A-11. See Q/A-12 of this section for 
rules on determining when such payments are considered made and the 
amount of such payments. See Q/A-13 of this section for special rules 
on transfers of statutory and nonstatutory stock options.
    Q-12: If a property transfer to a disqualified individual is a 
payment in the nature of compensation, when is the payment considered 
made (or to be made), and how is the amount of the payment determined?
    A-12: (a) Except as provided in this A-12 and Q/A-13 of this 
section, a transfer of property is considered a payment made (or to be 
made) in the taxable year in which the property transferred is 
includible in the gross income of the disqualified individual under 
section 83 and the regulations thereunder. Thus, in general, such a 
payment is considered made (or to be made) when the property is 
transferred (as defined in Sec. 1.83-3(a)) to the disqualified 
individual and becomes substantially vested (as defined in Sec. 1.83-
3(b) and (j)) in such individual. In such case, the amount of the 
payment is determined under section 83 and the regulations thereunder. 
Thus, in general, the amount of the payment is equal to the excess of 
the fair market value of the transferred property (determined without 
regard to any lapse restriction, as defined in Sec. 1.83-3(i)) at the 
time that the property becomes substantially vested, over the amount 
(if any) paid for the property.
    (b) An election made by a disqualified individual under section 
83(b) with respect to transferred property will not apply for purposes 
of this A-12. Thus, even if such an election is made with respect to a 
property transfer that is a payment in the nature of compensation, the 
payment is generally considered made (or to be made) when the property 
is transferred to and becomes substantially vested in such individual.
    (c) See Q/A-13 of this section for rules on applying this A-12 to 
transfers of stock options.
    (d) The following example illustrates the principles of this A-12:

    Example. On January 1, 2006, Corporation M gives to A, a 
disqualified individual, a bonus of 100 shares of Corporation M 
stock in connection with the performance of services to Corporation 
M. Under the terms of the bonus arrangement A is obligated to return 
the Corporation M stock to Corporation M unless the earnings of 
Corporation M double by January 1, 2009, or there is a change in 
ownership or control of Corporation M before that date. A's rights 
in the stock are treated as substantially nonvested (within the 
meaning of Sec. 1.83-3(b)) during that period because A's rights in 
the stock are subject to a substantial risk of forfeiture (within 
the meaning of Sec. 1.83-3(c)) and are nontransferable (within the 
meaning of Sec. 1.83-3(d)). On January 1, 2008, a change in 
ownership or control of Corporation M occurs. On that day, the fair 
market value of the Corporation M stock is $250 per share. Because 
A's rights in the Corporation M stock become substantially vested 
(within the meaning of Sec. 1.83-3(b)) on that day, the payment is 
considered made on that day, and the amount of the payment for 
purposes of this section is equal to $25,000 (100  x  $250). See Q/
A-38 through 41 for rules relating to the reduction of the excess 
parachute payment by the portion of the payment which is established 
to be reasonable compensation for personal services actually 
rendered before the date of a change in ownership or control.

    Q-13: How are transfers of statutory and nonstatutory stock options 
treated?
    A-13: (a) For purposes of this section, an option (including an 
option to which section 421 applies) is treated as property that is 
transferred not later than the time at which the option becomes 
substantially vested (whether or not the option has a readily 
ascertainable fair market value as defined in Sec. 1.83-7(b)). Thus, 
for purposes of this section, the vesting of such an option is treated 
as a payment in the nature of compensation. The value of an option with 
an ascertainable fair market value at the time the option vests is 
determined under all the facts and circumstances in the particular 
case. Factors relevant to such a determination include, but are not 
limited to: the difference between the option's exercise price and the 
value of the property subject to the option at the time of vesting; the 
probability of the value of such property increasing or decreasing; and 
the length of the period during which the option can be exercised. 
Valuation may be determined by any method prescribed by the 
Commissioner in published guidance for purposes of this A-13. See 
Q/A-33 of this section for the treatment of options the granting or 
vesting of which is contingent on a change in ownership or control and 
that do not have an ascertainable fair market value at the time of 
granting or vesting.
    (b) Any money or other property transferred to the disqualified 
individual on the exercise, or as consideration on the sale or other 
disposition, of an option described in paragraph (a) of this A-13 after 
the time such option vests is not treated as a payment in the nature of 
compensation to the disqualified individual under Q/A-11 of this 
section. Nonetheless, the amount of the otherwise allowable deduction 
under section 162 or 212 with respect to such transfer is reduced by 
the amount of the payment described in paragraph (a) of this A-13 
treated as an excess parachute payment.
    Q-14: Are payments in the nature of compensation reduced by 
consideration paid by the disqualified individual?
    A-14: Yes, to the extent not otherwise taken into account under Q/
A-12 and Q/A-13 of this section, the amount of any payment in the 
nature of compensation is reduced by the amount of any money or the 
fair market value of any property (owned by the disqualified individual 
without restriction) that is (or will be) transferred by the 
disqualified individual in exchange for the payment. For purposes of 
the preceding sentence, the fair market value of property is determined 
as of the date the property is transferred by the disqualified 
individual.

Disqualified Individuals

    Q-15: Who is a disqualified individual?
    A-15: (a) For purposes of this section, an individual is a 
disqualified individual with respect to a corporation if, at any time 
during the disqualified individual determination period (as defined in 
Q/A-20 of this section), the individual is an employee or independent 
contractor of the corporation and is, with respect to the corporation--
    (1) A shareholder (but see Q/A-17 of this section);
    (2) An officer (see Q/A-18 of this section); or
    (3) A highly-compensated individual (see Q/A-19 of this section).
    (b) A director is a disqualified individual with respect to a 
corporation if, at any time during the disqualified

[[Page 7642]]

individual determination period (as defined in Q/A-20 of this section), 
the director is an employee or independent contractor and is, with 
respect to the corporation, either a shareholder (see Q/A-17 of this 
section) or a highly-compensated individual (see Q/A-19 of this 
section).
    Q-16: Is a personal service corporation treated as an individual?
    A-16: (a) Yes. For purposes of this section, a personal service 
corporation (as defined in section 269A(b)(1)), or a noncorporate 
entity that would be a personal service corporation if it were a 
corporation, is treated as an individual.
    (b) The following example illustrates the principles of this A-16:

    Example. Corporation N, a personal service corporation (as 
defined in section 269A(b)(1)), has a single individual as its sole 
shareholder and employee. Corporation N performs personal services 
for Corporation M. The compensation paid to Corporation N by 
Corporation M puts Corporation N within the group of the highly-
compensated individuals of Corporation M as determined under A-19 of 
this section. Thus, Corporation N is treated as a highly-compensated 
individual with respect to Corporation M.

    Q-17: Are all shareholders of a corporation considered shareholders 
for purposes of paragraph (a)(1) of Q/A-15 of this section?
    A-17: (a) No, only an individual who owns stock of a corporation 
with a fair market value that exceeds 1 percent of the fair market 
value of the outstanding shares of all classes of the corporation's 
stock is treated as a disqualified individual with respect to the 
corporation by reason of stock ownership. An individual who owns a 
lesser amount of stock may, however, be a disqualified individual with 
respect to the corporation if such individual is an officer or highly-
compensated individual with respect to the corporation. For purposes of 
determining the amount of stock owned by an individual, the 
constructive ownership rules of section 318(a) apply.
    (b) The following examples illustrates the principles of this A-17:

    Example 1. E, an employee of Corporation A, received options 
under Corporation A's Stock Option Plan. E's stock options vest 
three years after the date of grant. E is not an officer or highly 
compensated individual during the disqualified individual 
determination period and does not own any other Corporation A stock. 
Two years after the options are granted to E, all of Corporation A's 
stock is acquired by Corporation B. Under Corporation A's Stock 
Option Plan, E's options are converted to Corporation B options and 
the vesting schedule remains the same. To determine whether E is a 
disqualified individual based on E's stock ownership, the stock 
underlying the unvested options held by E on the date of the change 
in ownership or control is not considered constructively owned by E 
under section 318(a). Because E does not own, or constructively own, 
Corporation A stock with a fair market value exceeding 1 percent of 
the total fair market value of all of the outstanding shares of all 
classes of Corporation A and E is not an officer or highly-
compensated individual during the disqualified individual 
determination period, E is not a disqualified individual within the 
meaning of A-15 of this section with respect to Corporation A.
    Example 2. Assume the same facts as in Example 1 except that 
Corporation A's Stock Option Plan provides that all unvested options 
will vest immediately on a change in ownership or control. To 
determine whether E is a disqualified individual based on E's stock 
ownership, the stock underlying the options that vest on the change 
in ownership or control is considered constructively owned by E 
under section 318(a). If the stock constructively held by E exceeds 
1 percent of the total fair market value of all of the outstanding 
shares of all classes of Corporation A stock, E is a disqualified 
individual within the meaning of this A-15 of this section with 
respect to Corporation A.
    Example 3. Assume the same facts as in Example 1 except that E 
received nonstatutory stock options that are exercisable for stock 
subject to a substantial risk of forfeiture under section 83. Assume 
further that under Corporation A's Stock Option Plan, the 
nonstatutory options will vest on a change in ownership or control. 
To determine whether E is a disqualified individual based on E's 
stock ownership, the stock underlying the options that vest on the 
change in ownership or control is not considered constructively 
owned by E under section 318(a) because the options are exercisable 
for stock subject to a substantial risk of forfeiture within the 
meaning of section 83. Because E does not own, or constructively 
own, Corporation A stock with a fair market value exceeding 1 
percent of the total fair market value of all of the outstanding 
shares of all classes of Corporation A stock and E is not an officer 
or highly compensated individual during the disqualified individual 
determination period, E is not a disqualified individual within the 
meaning of A-15 of this section with respect to Corporation A.

    Q-18: Who is an officer?
    A-18: (a) For purposes of this section, whether an individual is an 
officer with respect to a corporation is determined on the basis of all 
the facts and circumstances in the particular case (such as the source 
of the individual's authority, the term for which the individual is 
elected or appointed, and the nature and extent of the individual's 
duties). Generally, the term officer means an administrative executive 
who is in regular and continued service. The term officer implies 
continuity of service and excludes those employed for a special and 
single transaction. An individual who merely has the title of officer 
but not the authority of an officer is not considered an officer for 
purposes of this section. Similarly, an individual who does not have 
the title of officer but has the authority of an officer is considered 
an officer for purposes of this section.
    (b) An individual who is an officer with respect to any member of 
an affiliated group that is treated as one corporation pursuant to Q/A-
46 of this section is treated as an officer of such one corporation.
    (c) No more than 50 employees (or, if less, the greater of 3 
employees, or 10 percent of the employees (rounded up to the nearest 
integer)) of the corporation (in the case of an affiliated group 
treated as one corporation, each member of the affiliated group) are 
treated as disqualified individuals with respect to a corporation by 
reason of being an officer of the corporation. For purposes of the 
preceding sentence, the number of employees of the corporation is the 
greatest number of employees the corporation has during the 
disqualified individual determination period (as defined in Q/A-20 of 
this section). If the number of officers of the corporation exceeds the 
number of employees who may be treated as officers under the first 
sentence of this paragraph (c), then the employees who are treated as 
officers for purposes of this section are the highest paid 50 employees 
(or, if less, the greater of 3 employees, or 10 percent of the 
employees (rounded up to the nearest integer)) of the corporation when 
ranked on the basis of compensation (as determined under Q/A-21 of this 
section) paid during the disqualified individual determination period.
    Q-19: Who is a highly-compensated individual?
    A-19: (a) For purposes of this section, a highly-compensated 
individual with respect to a corporation is any individual who is, or 
would be if the individual were an employee, a member of the group 
consisting of the lesser of the highest paid 1 percent of the employees 
of the corporation (rounded up to the nearest integer), or the highest 
paid 250 employees of the corporation, when ranked on the basis of 
compensation (as determined under Q/A-21 of this section) paid during 
the disqualified individual determination period (as defined in Q/A-20 
of this section). For purposes of the preceding sentence, the number of 
employees of the corporation is the greatest number of employees the 
corporation has during the disqualified individual determination period 
(as defined in Q/A-20 of this section). However, no individual whose 
annualized

[[Page 7643]]

compensation during the disqualified individual determination period is 
less than the amount described in section 414(q)(1)(B)(i) for the year 
in which the change in ownership or control occurs will be treated as a 
highly-compensated individual.
    (b) An individual who is not an employee of the corporation is not 
treated as a highly-compensated individual with respect to the 
corporation on account of compensation received for performing services 
(such as brokerage, legal, or investment banking services) in 
connection with a change in ownership or control of the corporation, if 
the services are performed in the ordinary course of the individual's 
trade or business and the individual performs similar services for a 
significant number of clients unrelated to the corporation.
    (c) In determining the total number of employees of a corporation 
for purposes of this A-19, employees are not counted if they normally 
work less than 17\1/2\ hours per week (as defined in section 
414(q)(5)(B) and the regulations thereunder) or if they normally work 
during not more than 6 months during any year (as defined in section 
414(q)(5)(C) and the regulations thereunder). However, an employee who 
is not counted for purposes of the preceding sentence may still be a 
highly-compensated individual.
    Q-20: What is the disqualified individual determination period?
    A-20: The disqualified individual determination period is the 
twelve-month period prior to and ending on the date of the change in 
ownership or control of the corporation.
    Q-21: How is compensation defined for purposes of determining who 
is a disqualified individual?
    A-21: (a) For purposes of determining who is a disqualified 
individual, the term compensation is the compensation which was earned 
by the individual for services performed for the corporation with 
respect to which the change in ownership or control occurs (changed 
corporation), for a predecessor entity, or for a related entity. Such 
compensation is determined without regard to sections 125, 132(f)(4), 
402(e)(3), and 402(h)(1)(B). Thus, for example, compensation includes 
elective or salary reduction contributions to a cafeteria plan, cash or 
deferred arrangement or tax-sheltered annuity and amounts credited 
under a nonqualified deferred compensation plan.
    (b) For purposes of this A-21, a predecessor entity is any entity 
which, as a result of a merger, consolidation, purchase or acquisition 
of property or stock, corporate separation, or other similar business 
transaction transfers some or all of its employees to the changed 
corporation or to a related entity or to a predecessor entity of the 
changed corporation. The term related entity include--
    (1) All members of a controlled group of corporations (as defined 
in section 414(b)) that includes the changed corporation or a 
predecessor entity;
    (2) All trades or business (whether or not incorporated) that are 
under common control (as defined in section 414(c)) if such group 
includes the changed corporation or a predecessor entity;
    (3) All members of an affiliated service group (as defined in 
section 414(m)) that includes the changed corporation or a predecessor 
entity; and
    (4) Any other entities required to be aggregated with the changed 
corporation or a predecessor entity pursuant to section 414(o) and the 
regulations thereunder (except leasing organizations as defined in 
section 414(n)).
    (c) For purposes of Q/A-18 and Q/A-19 of this section, compensation 
that was contingent on the change in ownership or control and that was 
payable in the year of the change is not treated as compensation.

Contingent on Change in Ownership or Control

    Q-22: When is a payment contingent on a change in ownership or 
control?
    A-22: (a) In general, a payment is treated as contingent on a 
change in ownership or control if the payment would not, in fact, have 
been made had no change in ownership or control occurred, even if the 
payment is also conditioned on the occurrence of another event. A 
payment generally is treated as one which would not, in fact, have been 
made in the absence of a change in ownership or control unless it is 
substantially certain, at the time of the change, that the payment 
would have been made whether or not the change occurred. (But see Q/A-
23 of this section regarding payments under agreements entered into 
after a change in ownership or control.) A payment that becomes vested 
as a result of a change in ownership or control is not treated as a 
payment which was substantially certain to have been made whether or 
not the change occurred. For purposes of this A-22, vested means the 
payment is substantially vested within the meaning of Sec. 1.83-3(b) 
and (j) or the right to the payment is not otherwise subject to a 
substantial risk of forfeiture.
    (b)(1) For purposes of paragraph (a), a payment is treated as 
contingent on a change in ownership or control if--
    (i) The payment is contingent on an event that is closely 
associated with a change in ownership or control;
    (ii) A change in ownership or control actually occurs; and
    (iii) The event is materially related to the change in ownership or 
control.
    (2) For purposes of paragraph (b)(1)(i) of this A-22, a payment is 
treated as contingent on an event that is closely associated with a 
change in ownership or control unless it is substantially certain, at 
the time of the event, that the payment would have been made whether or 
not the event occurred. An event is considered closely associated with 
a change in ownership or control if the event is of a type often 
preliminary or subsequent to, or otherwise closely associated with, a 
change in ownership or control. For example, the following events are 
considered closely associated with a change in the ownership or control 
of a corporation: The onset of a tender offer with respect to the 
corporation; a substantial increase in the market price of the 
corporation's stock that occurs within a short period (but only if such 
increase occurs prior to a change in ownership or control); the 
cessation of the listing of the corporation's stock on an established 
securities market; the acquisition of more than 5 percent of the 
corporation's stock by a person (or more than one person acting as a 
group) not in control of the corporation; the voluntary or involuntary 
termination of the disqualified individual's employment; a significant 
reduction in the disqualified individual's job responsibilities; and a 
change in ownership or control as defined in the disqualified 
individual's employment agreement (or elsewhere) that does not meet the 
definition of a change in ownership or control described in Q/A-27, 28, 
or 29 of this section. Whether other events are treated as closely 
associated with a change in ownership or control is based on all the 
facts and circumstances of the particular case.
    (3) For purposes of determining whether an event (as described in 
paragraph (b)(2) of this A-22) is materially related to a change in 
ownership or control, the event is presumed to be materially related to 
a change in ownership or control if such event occurs within the period 
beginning one year before and ending one year after the date of change 
in ownership or control. If such event occurs outside of the period 
beginning one year before and ending one year after the date of change 
in ownership or control, the event is presumed not materially related 
to the change in ownership or control. A payment does

[[Page 7644]]

not fail to be contingent on a change in ownership or control merely 
because it is also contingent on the occurrence of a second event 
(without regard to whether the second event is closely associated with 
or materially related to a change in ownership or control). Similarly, 
a payment that is treated as contingent on a change because it is 
contingent on a closely associated event does not fail to be treated as 
contingent on a change in ownership or control merely because it is 
also contingent on the occurrence of a second event (without regard to 
whether the second event is closely associated with or materially 
related to a change in ownership or control).
    (c) A payment that would in fact have been made had no change in 
ownership or control occurred is treated as contingent on a change in 
ownership or control if the change in ownership or control (or the 
occurrence of an event that is closely associated and materially 
related to a change in ownership or control within the meaning of 
paragraph (b)(1) of this A-22), accelerates the time at which the 
payment is made. Thus, for example, if a change in ownership or control 
accelerates the time of payment of deferred compensation that is vested 
without regard to the change in ownership or control, the payment may 
be treated as contingent on the change. See Q/A-24 of this section 
regarding the portion of a payment that is so treated. See also Q/A-8 
of this section regarding the exemption for certain payments under 
qualified plans and Q/A-40 of this section regarding the treatment of a 
payment as reasonable compensation.
    (d) A payment is treated as contingent on a change in ownership or 
control even if the employment or independent contractor relationship 
of the disqualified individual is not terminated (voluntarily or 
involuntarily) as a result of the change.
    (e) The following examples illustrate the principles of this A-22:

    Example 1. A corporation grants a stock appreciation right to a 
disqualified individual, A, more than one year before a change in 
ownership or control. After the stock appreciation right vests and 
becomes exercisable, a change in ownership or control of the 
corporation occurs, and A exercises the right. Assuming neither the 
granting nor the vesting of the stock appreciation right is 
contingent on a change in ownership or control, the payment made on 
exercise is not contingent on the change in ownership or control.
    Example 2. A contract between a corporation and B, a 
disqualified individual, provides that a payment will be made to B 
if the corporation undergoes a change in ownership or control and 
B's employment with the corporation is terminated at any time over 
the succeeding 5 years. Eighteen months later, a change in the 
ownership of the corporation occurs. Two years after the change in 
ownership, B's employment is terminated and the payment is made to 
B. Because it was not substantially certain that the corporation 
would have made the payment to B on B's termination of employment if 
there had not been a change in ownership, the payment is treated as 
contingent on the change in ownership under paragraph (a) of this A-
22. This is true even though B's termination of employment is 
presumed not to be, and in fact may not be, materially related to 
the change in ownership or control.
    Example 3. A contract between a corporation and C, a 
disqualified individual, provides that a payment will be made to C 
if C's employment is terminated at any time over the succeeding 3 
years (without regard to whether or not there is a change in 
ownership or control). Eighteen months after the contract is entered 
into, a change in the ownership of the corporation occurs. Six 
months after the change in ownership, C's employment is terminated 
and the payment is made to C. Termination of employment is 
considered an event closely associated with a change in ownership or 
control. Because the termination occurred within one year after the 
date of the change in ownership, the termination of C's employment 
is presumed to be materially related to the change in ownership 
under paragraph (b)(3) of this A-22. If this presumption is not 
successfully rebutted, the payment will be treated as contingent on 
the change in ownership under paragraph (b) of this A-22.
    Example 4. A contract between a corporation and a disqualified 
individual, D, provides that a payment will be made to D upon the 
onset of a tender offer for shares of the corporation's stock. A 
tender offer is made on December 1, 2008, and the payment is made to 
D. Although the tender offer is unsuccessful, it leads to a 
negotiated merger with another entity on June 1, 2009, which results 
in a change in the ownership of the corporation. It was not 
substantially certain, at the time of the onset of the tender offer, 
that the payment would have been made had no tender offer taken 
place. The onset of a tender offer is considered closely associated 
with a change in ownership or control. Because the tender offer 
occurred within one year before the date of the change in ownership 
of the corporation, the onset of the tender offer is presumed to be 
materially related to the change in ownership. If this presumption 
is not rebutted, the payment will be treated as contingent on the 
change in ownership. If no change in ownership or control had 
occurred, the payment would not be treated as contingent on a change 
in ownership or control; however, the payment still could be a 
parachute payment under Q/A-37 of this section if the contract 
violated a generally enforced securities law or regulation.
    Example 5. A contract between a corporation and a disqualified 
individual, E, provides that a payment will be made to E if the 
corporation's level of product sales or profits reaches a specified 
level. At the time the contract was entered into, the parties had no 
reason to believe that such an increase in the corporation's level 
of product sales or profits would be preliminary or subsequent to, 
or otherwise closely associated with, a change in ownership or 
control of the corporation. Eighteen months later, a change in the 
ownership of the corporation occurs and within one year after the 
date of the change, the corporation's level of product sales or 
profits reaches the specified level. Under these facts and 
circumstances (and in the absence of contradictory evidence), the 
increase in product sales or profits of the corporation is not an 
event closely associated with the change in ownership or control of 
the corporation. Accordingly, even if the increase is materially 
related to the change, the payment will not be treated as contingent 
on a change in ownership or control.

    Q-23: May a payment be treated as contingent on a change in 
ownership or control if the payment is made under an agreement entered 
into after the change?
    A-23: (a) No., payments are not treated as contingent on a change 
in ownership or control if they are made (or to be made) pursuant to an 
agreement entered into after the change (a post-change agreement). For 
this purpose, an agreement that is executed after a change in ownership 
or control pursuant to a legally enforceable agreement that was entered 
into before the change is considered to have been entered into before 
the change. (See Q/A-9 of this section regarding the exemption for 
reasonable compensation for services rendered on or after a change in 
ownership or control.) If an individual has a right to receive a 
parachute payment under an agreement entered into prior to a change in 
ownership or control (pre-change agreement) and gives up that right as 
bargained-for consideration for benefits under a post-change agreement, 
the agreement is treated as a post-change agreement only to the extent 
the value of the payments under the agreement exceed the value of the 
payments under the pre-change agreement. To the extent payments under 
the agreement have the same value as the parachute payments under the 
pre-change agreement, such payments retain their character as parachute 
payments subject to this section.
    (b) The following examples illustrate the principles of this A-23:

    Example 1.  Assume that a disqualified individual is an employee 
of a corporation. A change in ownership or control of the 
corporation occurs, and thereafter the individual enters into an 
employment agreement with the acquiring company. Because the 
agreement is entered into after the change in ownership or control 
occurs, payments to be made under the agreement are not treated as 
contingent on the change.
    Example 2.  Assume the same facts as in Example 1, except that 
the agreement

[[Page 7645]]

between the disqualified individual and the acquiring company is 
executed after the change in ownership or control, pursuant to a 
legally enforceable agreement entered into before the change. 
Payments to be made under the agreement may be treated as contingent 
on the change in ownership or control pursuant to Q/A-22 of this 
section. However, see Q/A-9 of this section regarding the exemption 
from the definition of parachute payment for certain amounts of 
reasonable compensation.
    Example 3.  Assume the same facts as in Example 1 except that 
prior to the change in ownership or control, the individual and 
corporation enter into an agreement under which the individual will 
receive parachute payments in the event of a change in ownership or 
control of the corporation. After the change, the individual agrees 
to give up the right to parachute payments under the pre-change 
agreement in exchange for compensation under a new agreement with 
the acquiring corporation. Because the individual gave up the right 
to parachute payments under the pre-change agreement in exchange for 
other payments under the post-change agreement, payments in an 
amount equal to the parachute payments under the pre-change 
agreement are treated as contingent on the change in ownership or 
control under this A-23. Because the post-change agreement was 
entered into after the change, payments in excess of this amount are 
not treated as parachute payments.

    Q-24: If a payment is treated as contingent on a change in 
ownership or control, is the full amount of the payment so treated?
    A-24: (a)(1) General rule. Yes, if the payment is a transfer of 
property, the amount of the payment is determined under Q/A-12 or Q/A-
13 of this section. For all other payments, the amount of the payment 
is determined under Q/A-11 of this section. However, in certain 
circumstances, described in paragraphs (b) and (c) of this A-24, only a 
portion of the payment is treated as contingent on the change. 
Paragraph (b) of this A-24 applies to a payment that is vested, without 
regard to the change in ownership or control, and is treated as 
contingent on the change in ownership or control because the change 
accelerates the time at which the payment is made. Paragraph (c) of 
this A-24 applies to a payment that becomes vested as a result of the 
change in ownership or control if, without regard to the change in 
ownership or control, the payment was contingent only on the continued 
performance of services for the corporation for a specified period of 
time and if the payment is attributable, at least in part, to services 
performed before the date the payment becomes vested. For purposes of 
this A-24, for the definition of vested see 
Q/A-22(a).
    (2) Reduction by reasonable compensation. The amount of a payment 
under paragraph (a)(1) of this A-24 is reduced by any portion of such 
payment that the taxpayer establishes by clear and convincing evidence 
is reasonable compensation for personal services rendered by the 
disqualified individual on or after the date of the change of control. 
See Q/A-9 and Q/A-38 through 44 of this section for rules concerning 
reasonable compensation. The portion of an amount treated as contingent 
under paragraph (b) or (c) of this A-24 may not be reduced by 
reasonable compensation.
    (b) Vested payments. This paragraph (b) applies if a payment is 
vested, without regard to the change in ownership or control, and is 
treated as contingent on the change in ownership or control because the 
change accelerates the time at which the payment is made. In such case, 
the portion of the payment, if any, that is treated as contingent on 
the change in ownership or control is the amount by which the amount of 
the accelerated payment exceeds the present value of the payment absent 
the acceleration. If the value of such a payment absent the 
acceleration is not reasonably ascertainable, and the acceleration of 
the payment does not significantly increase the present value of the 
payment absent the acceleration, the present value of the payment 
absent the acceleration is treated as equal to the amount of the 
accelerated payment. If the value of the payment absent the 
acceleration is not reasonably ascertainable, but the acceleration 
significantly increases the present value of the payment, the future 
value of such payment is treated as equal to the amount of the 
accelerated payment. For rules on determining present value, see 
paragraph (e) of this A-24, Q/A-32, and Q/A-33 of this section.
    (c)(1) Nonvested payments. This paragraph (c) applies to a payment 
that becomes vested as a result of the change in ownership or control 
to the extent that--
    (i) Without regard to the change in ownership or control, the 
payment was contingent only on the continued performance of services 
for the corporation for a specified period of time; and
    (ii) The payment is attributable, at least in part, to the 
performance of services before the date the payment is made or becomes 
certain to be made.
    (2) The portion of the payment subject to paragraph (c) of this A-
24 that is treated as contingent on the change in ownership or control 
is the lesser of--
    (i) The amount of the accelerated payment; or
    (ii) The amount described in paragraph (b) of this A-24, plus an 
amount, as determined in paragraph (c)(4) of this A-24, to reflect the 
lapse of the obligation to continue to perform services.
    (3) For purposes of this paragraph (c) of this A-24, the 
acceleration of the vesting of a stock option or the lapse of a 
restriction on restricted stock is considered to significantly increase 
the value of a payment.
    (4) The amount reflecting the lapse of the obligation to continue 
to perform services (described in paragraph (c)(2)(ii) of this A-24) is 
1 percent of the amount of the accelerated payment multiplied by the 
number of full months between the date that the individual's right to 
receive the payment is vested and the date that, absent the 
acceleration, the payment would have been vested. This paragraph (c)(4) 
applies to the accelerated vesting of a payment in the nature of 
compensation even if the time at which the payment is made is not 
accelerated.
    (d) Application of this A-24 to certain payments.--(1) Benefits 
under a nonqualified deferred compensation plan. In the case of a 
payment of benefits under a nonqualified deferred compensation plan, 
paragraph (b) of this A-24 applies to the extent benefits under the 
plan are vested without regard to the change in ownership or control. 
Paragraph (c) of this A-24 applies to the extent benefits under the 
plan become vested as a result of the change in ownership or control 
and are attributable, at least in part, to the performance of services 
prior to vesting. Any other payment of benefits under a nonqualified 
deferred compensation plan is a payment in the nature of compensation 
subject to the general rule of paragraph (a) of this A-24 and the rules 
in Q/A-11 of this section.
    (2) Employment agreements. The general rule of paragraph (a) of 
this A-24 applies to the payment of amounts due under an employment 
agreement on a termination of employment or a change in ownership or 
control that otherwise would be attributable to the performance of 
services (or refraining from the performance of services) during any 
period that begins after the date of termination of employment or 
change in ownership or control, as applicable. For purposes of this 
paragraph (d)(2) of this A-24, an employment agreement means an 
agreement between an employee or independent contractor and employer or 
service recipient which describes, among other things, the amount of 
compensation or remuneration payable to the employee or independent

[[Page 7646]]

contractor. See Q/A-42(b) and 44 of this section for the treatment of 
the remaining amounts of salary under an employment agreement.
    (3) Vesting due to an event other than services. Neither paragraph 
(b) nor (c) of this A-24 applies to a payment if (without regard to the 
change in ownership or control) vesting of the payment depends on an 
event other than the performance of services, such as the attainment of 
a performance goal, and the event does not occur prior to the change in 
ownership or control. In such circumstances, the full amount of the 
accelerated payment is treated as contingent on the change in ownership 
or control under paragraph (a) of this A-24. However, see Q/A-39 of 
this section for rules relating to the reduction of the excess 
parachute payment by the portion of the payment which is established to 
be reasonable compensation for personal services actually rendered 
before the date of a change in ownership or control.
    (e) Present value. For purposes of this A-24, the present value of 
a payment is determined as of the date on which the accelerated payment 
is made.
    (f) Examples. The following examples illustrate the principles of 
this A-24:

    Example 1. (i) Corporation maintains a qualified plan and a 
nonqualified supplemental retirement plan (SERP) for its executives. 
Benefits under the SERP are not paid to participants until 
retirement. E, a disqualified individual with respect to 
Corporation, has a vested account balance of $500,000 under the 
SERP. A change in ownership or control of Corporation occurs. The 
SERP provides that in the event of a change in ownership or control, 
all vested accounts will be paid to SERP participants.
    (ii) Because E was vested in $500,000 of benefits under the SERP 
prior to the change in ownership or control and the change merely 
accelerated the time at which the payment was made to E, only a 
portion of the payment, as determined under paragraph (b) of this A-
24, is treated as contingent on the change. Thus, the portion of the 
payment that is treated as contingent on the change is the amount by 
which the amount of the accelerated payment ($500,000) exceeds the 
present value of the payment absent the acceleration.
    (iii) Assume that instead of having a vested account balance of 
$500,000 on the date of the change in ownership or control, E will 
vest in his account balance of $500,000 in 2 years if E continues to 
perform services for the next 2 years. Assume further that the SERP 
provides that all unvested SERP benefits vest immediately on a 
change in ownership or control and are paid to the participants. 
Because the vesting of the SERP payment, without regard to the 
change, depends only on the performance of services for a specified 
period of time and the payment is attributable, in part, to the 
performance of services before the change in ownership or control, 
only a portion of the $500,000 payment, as determined under 
paragraph (c) of this A-24, is treated as contingent on the change. 
The portion of the payment that is treated as contingent on the 
change is the lesser of the amount of the accelerated payment or the 
amount by which the accelerated payment exceeds the present value of 
the payment absent the acceleration, plus an amount to reflect the 
lapse of the obligation to continue to perform services.
    (iv) Assume further that under the SERP E's vested account 
balance of $500,000 will be paid to E on the change in ownership or 
control and an additional $70,000 will be credited to E's account. 
Because the $500,000 was vested without regard to the change in 
ownership or control, paragraph (b) of this A-24 applies to the 
$500,000 payment. Because the $70,000 is not vested, without regard 
to the change, and is not attributable to the performance of 
services prior to the change, the entire $70,000 payment is 
contingent on the change in ownership or control under paragraph (a) 
of this A-24.
    Example 2. As a result of a change in the effective control of a 
corporation, a disqualified individual with respect to the 
corporation, D, receives accelerated payment of D's vested account 
balance in a nonqualified deferred compensation account plan. Actual 
interest and other earnings on the plan assets are credited to each 
account as earned before distribution. Investment of the plan assets 
is not restricted in such a manner as would prevent the earning of a 
market rate of return on the plan assets. The date on which D would 
have received D's vested account balance absent the change in 
ownership or control is uncertain, and the rate of earnings on the 
plan assets is not fixed. Thus, the amount of the payment absent the 
acceleration is not reasonably ascertainable. Under these facts, 
acceleration of the payment does not significantly increase the 
present value of the payment absent the acceleration, and the 
present value of the payment absent the acceleration is treated as 
equal to the amount of the accelerated payment. Accordingly, no 
portion of the payment is treated as contingent on the change.
    Example 3. (i) On January 15, 2006, a corporation and a 
disqualified individual, F, enter into a contract providing for a 
retention bonus of $500,000 to be paid to F on January 15, 2011. The 
payment of the bonus will be forfeited by F if F does not remain 
employed by the corporation for the entire 5-year period. However, 
the contract provides that the full amount of the payment will be 
made immediately on a change in ownership or control of the 
corporation during the 5-year period. On January 15, 2009, a change 
in ownership or control of the corporation occurs and the full 
amount of the payment ($500,000) is made on that date to F. Under 
these facts, the payment of $500,000 was contingent only on F's 
performance of services for a specified period and is attributable, 
in part, to the performance of services before the change in 
ownership or control. Therefore, only a portion of the payment is 
treated as contingent on the change. The portion of the payment that 
is treated as contingent on the change is the amount by which the 
amount of the accelerated payment (i.e., $500,000, the amount paid 
to the individual because of the change in ownership) exceeds the 
present value of the payment that was expected to have been made 
absent the acceleration (i.e., $406,838, the present value on 
January 15, 2009, of a $500,000 payment on January 15, 2011), plus 
$115,000 (1%  x  23 months  x  $500,000) which is the amount 
reflecting the lapse of the obligation to continue to perform 
services. Accordingly, the amount of the payment treated as 
contingent on the change in ownership or control is $208,162, the 
sum of $93,162 ($500,000 - $406,838) - $115,000). This result is not 
changed if F actually remains employed until the end of the 5-year 
period.
    (ii) Assume that the contract provides that the retention bonus 
will vest on a change in ownership or control, but will not be paid 
until January 15, 2011 (the original date in the contract). Because 
the payment of $500,000 was contingent only on F's performance of 
services for a specified period and is attributable, in part, to the 
performance of services before the change in ownership or control, 
only a portion of the $500,000 payment is treated as contingent on 
the change. Because there is no accelerated payment, the portion of 
the payment treated as contingent on the change is an amount 
reflecting the lapse of the obligation to continue to perform 
services which is $115,000 (1%  x  23 months  x  $500,000).
    Example 4.  (i) On January 15, 2006, a corporation gives to a 
disqualified individual, in connection with her performance of 
services to the corporation, a bonus of 1,000 shares of the 
corporation's stock. Under the terms of the bonus arrangement, the 
individual is obligated to return the stock to the corporation if 
she terminates her employment for any reason prior to January 15, 
2011. However, if there is a change in the ownership or effective 
control of the corporation prior to January 15, 2011, she ceases to 
be obligated to return the stock. The individual's rights in the 
stock are treated as substantially nonvested (within the meaning of 
Sec. 1.83-3(b) and (j)) during that period. On January 15, 2008, a 
change in the ownership of the corporation occurs. On that day, the 
fair market value of the stock is $500,000.
    (ii) Under these facts, the payment was contingent only on 
performance of services for a specified period and is attributable, 
in part, to the performance of services before the change in 
ownership or control. Thus, only a portion of the payment is treated 
as contingent on the change in ownership or control. The portion of 
the payment that is treated as contingent on the change is the 
amount by which the present value of the accelerated payment on 
January 15, 2009 ($500,000), exceeds the present value of the 
payment that was expected to have been made on January 15, 2011, 
plus an amount reflecting the lapse of the obligation to continue to 
perform services. At the time of the change, it cannot be reasonably 
ascertained what the value of the stock would been on January 15, 
2011. The acceleration of the lapse of a restriction on stock is 
treated as significantly increasing the

[[Page 7647]]

value of the payment. Therefore, the value of such stock on January 
15, 2011, is deemed to be $500,000, the amount of the accelerated 
payment. The present value on January 15, 2009, of a $500,000 
payment to be made on January 15, 2011, is $406,838. Thus, the 
portion of the payment treated as contingent on the change is 
$208,162, the sum of $93,162 ($500,000 - $406,838), plus $115,000 
[1%  x  23 months  x  $500,000], the amount reflecting the lapse of 
the obligation to continue to perform services.
    Example 5.  (i) On January 15, 2006, a corporation grants to a 
disqualified individual nonqualified stock options to purchase 
30,000 shares of the corporation's stock. The options do not have a 
readily ascertainable fair market value at the time of grant. The 
options will be forfeited by the individual if he fails to perform 
personal services for the corporation until January 15, 2009. The 
options will, however, vest in the individual at an earlier date if 
there is a change in ownership or control of the corporation. On 
January 16, 2008, a change in the ownership of the corporation 
occurs and the options become vested in the individual. On January 
16, 2008, the options have an ascertainable fair market value of 
$600,000.
    (ii) The payment of the options to purchase 30,000 shares was 
contingent only on performance of services for the corporation until 
January 15, 2009, and is attributable, in part, to the performance 
of services before the change in ownership or control. Therefore, 
only a portion of the payment is treated as contingent on the 
change. The portion of the payment that is treated as contingent on 
the change is the amount by which the accelerated payment on January 
16, 2008 ($600,000) exceeds the present value on January 16, 2008, 
of the payment that was expected to have been made on January 15, 
2009, absent the acceleration, plus an amount reflecting the lapse 
of the obligation to continue to perform services. At the time of 
the change, it cannot be reasonably ascertained what the value of 
the options would have been on January 15, 2009. The acceleration of 
vesting in the options is treated as significantly increasing the 
value of the payment. Therefore, the value of such options on 
January 15, 2009, is deemed to be $600,000, the amount of the 
accelerated payment. The present value on January 16, 2008 of a 
$600,000 payment to be made on January 15, 2009, is $549,964.13. 
Thus, the portion of the payment treated as contingent on the change 
is $116,035.87, the sum of $50,035.87 ($600,000 - $549,964.13), plus 
an amount reflecting the lapse of the obligation to continue to 
perform services which is $66,000 (1%  x  11 months  x  $600,000).
    Example 6.  (i) The facts are the same as in Example 5, except 
that the options become vested periodically (absent a change in 
ownership of control), with one-third of the options vesting on 
January 15, 2007, 2008, and 2009, respectively. Thus, options to 
purchase 20,000 shares vest independently of the January 16, 2008, 
change in ownership and the options to purchase the remaining 10,000 
shares vest as a result of the change.
    (ii) The payment of the options to purchase 10,000 shares was 
contingent only on performance of services for the corporation until 
January 15, 2009, and is attributable, in part, to the performance 
of services before the change in ownership or control. Therefore, 
only a portion of the payment is treated as contingent on the 
change. The portion of the payment that is treated as contingent on 
the change is the amount by which the accelerated payment on January 
16, 2008 ($200,000) exceeds the present value on January 16, 2008, 
of the payment that was expected to have been made on January 15, 
2009, absent the acceleration, plus an amount reflecting the lapse 
of the obligation to perform services. At the time of the change, it 
cannot be reasonably ascertained what the value of the options would 
have been on January 15, 2009. The acceleration of vesting in the 
options is treated as significantly increasing the value of the 
payment. Therefore, the value of such options on January 15, 2009, 
is deemed to be $200,000, the amount of the accelerated payment. The 
present value on January 16, 2008, of a $200,000 payment to be made 
on January 15, 2009, is $183,328.38. Thus, the portion of the 
payment treated as contingent on the change is $38,671.62, the sum 
of $16,671.62 ($200,000 - $183,328.38), plus an amount reflecting 
the lapse of the obligation to continue to perform services which is 
$22,000 (1%  x  11 months  x  $200,000).
    Example 7. Assume the same facts as in Example 5, except that 
the option agreement provides that the options will vest either on 
the corporation's level of profits reaching a specified level, or if 
earlier, on the date on which there is a change in ownership or 
control of the corporation. The corporation's level of profits do 
not reach the specified level prior to January 16, 2008. In such 
case, the full amount of the payment, $600,000, is treated as 
contingent on the change because it was not contingent only on 
performance of services for the corporation for a specified period. 
See Q/A-39 of this section for rules relating to the reduction of 
the excess parachute payment by the portion of the payment which is 
established to be reasonable compensation for personal services 
actually rendered before the date of a change in ownership or 
control.
    Example 8. On January 1, 2002, E, a disqualified individual with 
respect to Corporation X, enters into an employment agreement with 
Corporation X under which E will be paid wages of $200,000 each year 
during the 5-year employment agreement. The employment agreement 
provides that if a change in ownership or control of Corporation X 
occurs, E will be paid the present value of the remaining salary 
under the employment agreement. On January 1, 2003, a change in 
ownership or control of Corporation X occurs, E is terminated, and E 
receives a payment of the present value of $200,000 for each of the 
4 years remaining under the employment agreement. Because the 
payment represents future salary under an employment agreement 
(i.e., amounts otherwise attributable to the performance of services 
for periods that begin after the termination of employment), the 
general rule of paragraph (a) of this A-24 applies to the payment. 
See Q/A-42(c) and 44 of this section for the treatment of the 
remaining payments under an employment agreement.

Presumption That Payment Is Contingent on Change

    Q-25: Is there a presumption that certain payments are contingent 
on a change in ownership or control?
    A-25: Yes, for purposes of this section, any payment is presumed to 
be contingent on such change unless the contrary is established by 
clear and convincing evidence if the payment is made pursuant to--
    (a) An agreement entered into within one year before the date of a 
change in ownership or control; or
    (b) An amendment that modifies a previous agreement in any 
significant respect, if the amendment is made within one year before 
the date of a change in ownership or control. In the case of an 
amendment described in paragraph (b) of this A-25, only the portion of 
any payment that exceeds the amount of such payment that would have 
been made in the absence of the amendment is presumed, by reason of the 
amendment, to be contingent on the change in ownership or control.
    Q-26: How may the presumption described in Q/A-25 of this section 
be rebutted?
    A-26: (a) To rebut the presumption described in Q/A-25 of this 
section, the taxpayer must establish by clear and convincing evidence 
that the payment is not contingent on the change in ownership or 
control. Whether the payment is contingent on such change is determined 
on the basis of all the facts and circumstances of the particular case. 
Factors relevant to such a determination include, but are not limited 
to, the content of the agreement or amendment and the circumstances 
surrounding the execution of the agreement or amendment, such as 
whether it was entered into at a time when a takeover attempt had 
commenced and the degree of likelihood that a change in ownership or 
control would actually occur. However, even if the presumption is 
rebutted with respect to an agreement, some or all of the payments 
under the agreement may still be contingent on the change in ownership 
or control pursuant to Q/A-22 of this section.
    (b) In the case of an agreement described in paragraph (a) of Q/A-
25 of this section, clear and convincing evidence that the agreement is 
one of the three following types will generally rebut the presumption 
that payments under the agreement are contingent on the change in 
ownership or control--
    (1) A nondiscriminatory employee plan or program as defined in 
paragraph (c) of this A-26;
    (2) A contract between a corporation and an individual that 
replaces a prior

[[Page 7648]]

contract entered into by the same parties more than one year before the 
change in ownership or control, if the new contract does not provide 
for increased payments (apart from normal increases attributable to 
increased responsibilities or cost of living adjustments), accelerate 
the payment of amounts due at a future time, or modify (to the 
individual's benefit) the terms or conditions under which payments will 
be made; or
    (3) A contract between a corporation and an individual who did not 
perform services for the corporation prior to the one year period 
before the change in ownership or control occurs, if the contract does 
not provide for payments that are significantly different in amount, 
timing, terms, or conditions from those provided under contracts 
entered into by the corporation (other than contracts that themselves 
were entered into within one year before the change in ownership or 
control and in contemplation of the change) with individuals performing 
comparable services.
    (c) For purposes of this section, the term nondiscriminatory 
employee plan or program means: a group term life insurance plan that 
meets the requirements of section 79(d); a self insured medical 
reimbursement plan that meets the requirements of section 105(h); a 
cafeteria plan (within the meaning of section 125); an educational 
assistance program (within the meaning of section 127); a dependent 
care assistance program (within the meaning of section 129); or a no-
additional-cost service (within the meaning of section 132(b)) or 
qualified employee discount (within the meaning of section 132(c)); and 
an adoption assistance program (within the meaning of section 137). 
Payments under certain other plans are exempt from the definition of 
parachute payment under Q/A-8 of this section.
    (d) The following examples illustrate the application of the 
presumption:

    Example 1. A corporation and a disqualified individual who is an 
employee of the corporation enter into an employment contract. The 
contract replaces a prior contract entered into by the same parties 
more than one year before the change and the new contract does not 
provide for any increased payments other than a cost of living 
adjustment, does not accelerate the payment of amounts due at a 
future time, and does not modify (to the individual's benefit) the 
terms or conditions under which payments will be made. Clear and 
convincing evidence of these facts rebuts the presumption described 
in A-25 of this section. However, payments under the contract still 
may be contingent on the change in ownership or control pursuant to 
Q/A-22 of this section.
    Example 2. Assume the same facts as in Example 1, except that 
the contract is entered into after a tender offer for the 
corporation's stock had commenced and it was likely that a change in 
ownership would occur and the contract provides for a substantial 
bonus payment to the individual upon his signing the contract. The 
individual has performed services for the corporation for many 
years, but previous employment contracts between the corporation and 
the individual did not provide for a similar signing bonus. One 
month after the contract is entered into, a change in the ownership 
of the corporation occurs. All payments under the contract are 
presumed to be contingent on the change in ownership even though the 
bonus payment would have been legally required even if no change had 
occurred. Clear and convincing evidence of these facts rebuts the 
presumption described in A-25 of this section with respect to all of 
the payments under the contract with the exception of the bonus 
payment (which is treated as contingent on the change). However, 
payments other than the bonus under the contract still may be 
contingent on the change in ownership or control pursuant to Q/A-22 
of this section.
    Example 3. A corporation and a disqualified individual, who is 
an employee of the corporation, enter into an employment contract 
within one year of a change in ownership of the corporation. Under 
the contract, in the event of a change in ownership or control and 
subsequent termination of employment, certain payments will be made 
to the individual. A change in ownership occurs, but the individual 
is not terminated until 2 years after the change. If clear and 
convincing evidence does not rebut the presumption described in A-25 
of this section, because the payment is made pursuant to an 
agreement entered into within one year of the date of the change in 
ownership, the payment is presumed contingent on the change under 
A-25 of this section. This is true even though A's termination of 
employment is presumed not to be materially related to the change in 
ownership or control under Q/A-22 of this section.

Change in Ownership or Control

    Q-27: When does a change in the ownership of a corporation occur?
    A-27: (a) For purposes of this section, a change in the ownership 
or control of a corporation occurs on the date that any one person, or 
more than one person acting as a group, acquires ownership of stock of 
the corporation that, together with stock held by such person or group, 
owns more than 50 percent of the total fair market value or total 
voting power of the stock of such corporation. However, if any one 
person, or more than one person acting as a group, is considered to own 
more than 50 percent of the total fair market value or total voting 
power of the stock of a corporation, the acquisition of additional 
stock by the same person or persons is not considered to cause a change 
in the ownership of the corporation (or to cause a change in the 
effective control of the corporation (within the meaning of Q/A-28 of 
this section)). An increase in the percentage of stock owned by any one 
person, or persons acting as a group, as a result of a transaction in 
which the corporation acquires its stock in exchange for property will 
be treated as an acquisition of stock for purposes of this section.
    (b) For purposes of paragraph (a) of this A-27, persons will not be 
considered to be acting as a group merely because they happen to 
purchase or own stock of the same corporation at the same time, or as a 
result of the same public offering. However, persons will be considered 
to be acting as a group if they are owners of an entity that enters 
into a merger, consolidation, purchase or acquisition of stock, or 
similar business transaction with the corporation. If a person, 
including an entity shareholder, owns stock in both entities that enter 
into a merger, consolidation, purchase or acquisition of stock, or 
similar transaction, such shareholder is considered to be acting as a 
group with other shareholders in an entity only to the extent of his 
ownership in that entity prior to the transaction giving rise to the 
change and not with respect to his ownership interest in the other 
entity.
    (c) For purposes of this A-27, section 318(a) applies to determine 
stock ownership.
    (d) The following examples illustrate the principles of this A-27:

    Example 1. Corporation M has owned stock with a fair market 
value equal to 19 percent of the value of the stock of Corporation N 
(an otherwise unrelated corporation) for many years prior to 2006. 
Corporation M acquires additional stock with a fair market value 
equal to 15 percent of the value of the stock of Corporation N on 
January 1, 2006, and an additional 18 percent on February 21, 2007. 
As of February 21, 2007, Corporation M has acquired stock with a 
fair market value greater than 50 percent of the value of the stock 
of Corporation N. Thus, a change in the ownership of Corporation N 
is considered to occur on February 21, 2007 (assuming that 
Corporation M did not have effective control of Corporation N 
immediately prior to the acquisition on that date).
    Example 2. All of the corporation's stock is owned by the 
founders of the corporation. The board of directors of the 
corporation decides to offer shares of the corporation to the 
public. After the public offering, the founders of the corporation 
own a total of 40 percent of the corporation's stock, and members of 
the public own 60 percent. If no one person (or more than one person 
acting as a group) owns more than 50 percent of the corporation's 
stock (by value or voting power) after the public offering, there is 
no change in the ownership of the corporation.

[[Page 7649]]

    Example 3. Corporation P merges into Corporation O (a previously 
unrelated corporation). In the merger, the shareholders of 
Corporation P receive Corporation O stock in exchange for their 
Corporation P stock. Immediately after the merger, the former 
shareholders of Corporation P own stock with a fair market value 
equal to 60 percent of the value of the stock of Corporation O, and 
the former shareholders of Corporation O own stock with a fair 
market value equal to 40 percent of the value of the stock of 
Corporation O. The former shareholders of Corporation P will be 
treated as acting as a group in their acquisition of Corporation O 
stock. Thus, a change in the ownership of Corporation O occurs on 
the date of the merger.
    Example 4. Assume the same facts as in Example 3 except that 
immediately after the change, the former shareholders of Corporation 
P own stock with a fair market value of 51 percent of the value of 
Corporation O stock and the former shareholders of Corporation O own 
stock with a fair market value equal to 49 percent of the value of 
Corporation O stock. Assume further that prior to the merger several 
Corporation P shareholders also owned Corporation O stock 
(overlapping shareholders) with a fair market value of 5 percent of 
the value of Corporation O stock. The overlapping shareholders 
consist of Mutual Company A Growth Fund, which prior to the 
transaction owns 3 percent of the value of Corporation O stock, 
Mutual Company A Income Fund, which prior to the transaction owns 1 
percent of the value of Corporation O stock, and B, an individual 
who prior to the transaction owns 1 percent of the value of 
Corporation O stock. Growth Fund and Income Fund are treated as 
separate shareholders with respect to their ownership interests in 
Corporation O and Corporation P. The overlapping shareholders are 
not treated as acting as a group with the Corporation P shareholders 
with respect to the Corporation O stock each overlapping shareholder 
held before the transaction. Instead, the overlapping shareholders 
are treated as acting as a group separately with respect to 
Corporation O and Corporation P. Because the former shareholders of 
Corporation O are treated as acting as a group with respect to other 
Corporation O shareholders only to the extent of their ownership 
interest in Corporation O and not with respect to their ownership 
interest in Corporation P, a change in the ownership of Corporation 
O occurs on the date of the merger.
    Example 5. A, an individual, owns stock with a fair market value 
equal to 20 percent of the value of the stock of Corporation Q. On 
January 1, 2007, Corporation Q acquires in a redemption for cash all 
of the stock held by shareholders other than A. Thus, A is left as 
the sole shareholder of Corporation O. A change in ownership of 
Corporation O is considered to occur on January 1, 2007 (assuming 
that A did not have effective control of Corporation Q immediately 
prior to the redemption).
    Example 6. Assume the same facts as in Example 5, except that A 
owns stock with a fair market value equal to 51 percent of the value 
of all the stock of Corporation Q immediately prior to the 
redemption. There is no change in the ownership of Corporation Q as 
a result of the redemption.

    Q-28: When does a change in the effective control of a corporation 
occur?
    A-28: (a) For purposes of this section, a change in the effective 
control of a corporation is presumed to occur on the date that either--
    (1) Any one person, or more than one person acting as a group, 
acquires (or has acquired during the 12-month period ending on the date 
of the most recent acquisition by such person or persons) ownership of 
stock of the corporation possessing 20 percent or more of the total 
voting power of the stock of such corporation; or
    (2) A majority of members of the corporation's board of directors 
is replaced during any 12-month period by directors whose appointment 
or election is not endorsed by a majority of the members of the 
corporation's board of directors prior to the date of the appointment 
or election.
    (b) The presumption of paragraph (a) of this A-28 may be rebutted 
by establishing that such acquisition or acquisitions of the 
corporation's stock, or such replacement of the majority of the members 
of the corporation's board of directors, does not transfer the power to 
control (directly or indirectly) the management and policies of the 
corporation from any one person (or more than one person acting as a 
group) to another person (or group). For purposes of this section, in 
the absence of an event described in paragraph (a) (1) or (2) of this 
A-28, a change in the effective control of a corporation is presumed 
not to have occurred.
    (c) If any one person, or more than one person acting as a group, 
is considered to effectively control a corporation (within the meaning 
of this A-28), the acquisition of additional control of the corporation 
by the same person or persons is not considered to cause a change in 
the effective control of the corporation (or to cause a change in the 
ownership of the corporation within the meaning of Q/A-27 of this 
section).
    (d) For purposes of this A-28, persons will not be considered to be 
acting as a group merely because they happen to purchase or own stock 
of the same corporation at the same time, or as a result of the same 
public offering. However, persons will be considered to be acting as a 
group if they are owners of an entity that enters into a merger, 
consolidation, purchase or acquisition of stock, or similar business 
transaction with the corporation. If a person, including an entity 
shareholder, owns stock in both entities that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar 
transaction, such shareholder is considered to be acting as a group 
with other shareholders in an entity only to the extent of his 
ownership in that entity prior to the transaction giving rise to the 
change and not with respect to his ownership interest in the other 
entity.
    (e) Section 318(a) applies to determine stock ownership for 
purposes of this A-28.
    (f) The following examples illustrate the principles of this A-28:

    Example 1. Shareholder A acquired the following percentages of 
the voting stock of Corporation M (an otherwise unrelated 
corporation) on the following dates: 16 percent on January 1, 2005; 
10 percent on January 10, 2006; 8 percent on February 10, 2006; 11 
percent on March 1, 2007; and 8 percent on March 10, 2007. Thus, on 
March 10, 2007, A owns a total of 53 percent of M's voting stock. 
Because A did not acquire 20 percent or more of M's voting stock 
during any 12-month period, there is no presumption of a change in 
effective control pursuant to paragraph (a)(1) of this A-28. In 
addition, under these facts there is a presumption that no change in 
the effective control of Corporation M occurred. If this presumption 
is not rebutted (and thus no change in effective control of 
Corporation M is treated as occurring prior to March 10, 2007), a 
change in the ownership of Corporation M is treated as having 
occurred on March 10, 2007 (pursuant to Q/A-27 of this section) 
because A had acquired more than 50 percent of Corporation M's 
voting stock as of that date.
    Example 2. A minority group of shareholders of a corporation 
opposes the practices and policies of the corporation's current 
board of directors. A proxy contest ensues. The minority group 
presents its own slate of candidates for the board at the next 
annual meeting of the corporation's shareholders, and candidates of 
the minority group are elected to replace a majority of the current 
members of the board. A change in the effective control of the 
corporation is presumed to have occurred on the date the election of 
the new board of directors becomes effective.

    Q-29: When does a change in the ownership of a substantial portion 
of a corporation's assets occur?
    A-29: (a) For purposes of this section, a change in the ownership 
of a substantial portion of a corporation's assets occurs on the date 
that any one person, or more than one person acting as a group, 
acquires (or has acquired during the 12-month period ending on the date 
of the most recent acquisition by such person or persons) assets from 
the corporation that have a total gross fair market value equal to or 
more than one third of the total gross fair market value of all of the 
assets of the

[[Page 7650]]

corporation immediately prior to such acquisition or acquisitions.
    (b) A transfer of assets by a corporation is not treated as a 
change in the ownership of such assets if the assets are transferred 
to--
    (1) A shareholder of the corporation (immediately before the asset 
transfer) in exchange for or with respect to its stock;
    (2) An entity, 50 percent or more of the total value or voting 
power of which is owned, directly or indirectly, by the corporation;
    (3) A person, or more than one person acting as a group, that owns, 
directly or indirectly, 50 percent or more of the total value or voting 
power of all the outstanding stock of the corporation; or
    (4) An entity, at least 50 percent of the total value or voting 
power is owned, directly or indirectly, by a person described in 
paragraph (b)(3) of this A-29.
    (c) For purposes of paragraph (b) and except as otherwise provided, 
a person's status is determined immediately after the transfer of the 
assets. For example, a transfer of assets pursuant to a complete 
liquidation of a corporation, a redemption of a shareholder's interest, 
or a transfer to a majority-owned subsidiary of the corporation is not 
treated as a change in the ownership of the assets of the transferor 
corporation.
    (d) For purposes of this A-29, persons will not be considered to be 
acting as a group merely because they happen to purchase or own stock 
of the same corporation at the same time, or as a result of the same 
public offering. However, persons will be considered to be acting as a 
group if they are owners of an entity that enters into a merger, 
consolidation, purchase or acquisition of stock, or similar business 
transaction with the corporation. If a person, including an entity 
shareholder, owns stock in both entities that enter into a merger, 
consolidation, purchase or acquisition of stock, or similar 
transaction, such shareholder is considered to be acting as a group 
with other shareholders in an entity only to the extent of his 
ownership in that entity prior to the transaction giving rise to the 
change and not with respect to his ownership interest in the other 
entity.
    (e) For purposes of this A-29, section 318(a) applies in 
determining stock ownership.
    (f) The following examples illustrate the principles of this A-29:

    Example 1. Corporation M acquires assets having a gross fair 
market value of $500,000 from Corporation N (an unrelated 
corporation) on January 1, 2006. The total gross fair market value 
of Corporation N's assets immediately prior to the acquisition was 
$3 million. Since the value of the assets acquired by Corporation M 
is less than one-third of the fair market value of Corporation N's 
total assets immediately prior to the acquisition, the acquisition 
does not represent a change in the ownership of a substantial 
portion of Corporation N's assets.
    Example 2.  Assume the same facts as in Example 1. Also assume 
that on November 1, 2006, Corporation M acquires from Corporation N 
additional assets having a fair market value of $700,000. Thus, 
Corporation M has acquired from Corporation N assets worth a total 
of $1.2 million during the 12-month period ending on November 1, 
2006. Since $1.2 million is more than one-third of the total gross 
fair market value of all of Corporation N's assets immediately prior 
to the earlier of these acquisitions ($3 million), a change in the 
ownership of a substantial portion of Corporation N's assets is 
considered to have occurred on November 1, 2006.
    Example 3.  All of the assets of Corporation P are transferred 
to Corporation O (an unrelated corporation). In exchange, the 
shareholders of Corporation P receive Corporation O stock. 
Immediately after the transfer, the former shareholders of 
Corporation P own 60 percent of the fair market value of the 
outstanding stock of Corporation O and the former shareholders of 
Corporation O own 40 percent of the fair market value of the 
outstanding stock of Corporation O. Because Corporation O is an 
entity more than 50 percent of the fair market value of the 
outstanding stock of which is owned by the former shareholders of 
Corporation P (based on ownership of Corporation P prior the 
change), the transfer of assets is not treated as a change in 
ownership of a substantial portion of the assets of Corporation P. 
However, a change in the ownership (within the meaning of Q/A-27) of 
Corporation O occurs.

Three-Times-Base-Amount Test for Parachute Payments

    Q-30: Are all payments that are in the nature of compensation, are 
made to a disqualified individual, and are contingent on a change in 
ownership or control, parachute payments?
    A-30: (a) No, to determine whether such payments are parachute 
payments, they must be tested against the individual's base amount (as 
defined in Q/A-34 of this section). To do this, the aggregate present 
value of all payments in the nature of compensation that are made or to 
be made to (or for the benefit of) the same disqualified individual and 
are contingent on the change in ownership or control must be 
determined. If this aggregate present value equals or exceeds the 
amount equal to 3 times the individual's base amount, the payments are 
parachute payments. If this aggregate present value is less than the 
amount equal to 3 times the individual's base amount, no portion of the 
payment is a parachute payment. See Q/A-31, Q/A-32, and Q/A-33 of this 
section for rules on determining present value. Parachute payments that 
are securities violation parachute payments are not included in the 
foregoing computation if they are not contingent on a change in 
ownership or control. See Q/A-37 of this section for the definition and 
treatment of securities violation parachute payments.
    (b) The following examples illustrate the principles of this A-30:

    Example 1. A is a disqualified individual with respect to 
Corporation M. A's base amount is $100,000. Payments in the nature 
of compensation that are contingent on a change in the ownership of 
Corporation M totaling $400,000 are made to A on the date of the 
change. The payments are parachute payments since they have an 
aggregate present value at least equal to 3 times A's base amount of 
$100,000 (3  x  $100,000 = $300,000).
    Example 2. Assume the same facts as in Example 1, except that 
the payments contingent on the change in the ownership of 
Corporation M total $290,000. Since the payments do not have an 
aggregate present value at least equal to 3 times A's base amount, 
no portion of the payments is a parachute payment.

    Q-31: As of what date is the present value of a payment determined?
    A-31: (a) Except as provided in this section, the present value of 
a payment is determined as of the date on which the change in ownership 
or control occurs, or, if a payment is made prior to such date, the 
date on which the payment is made.
    (b)(1) For purposes of determining whether a payment is a parachute 
payment, if a payment in the nature of compensation is the right to 
receive payments in a year (or years) subsequent to the year of the 
change in ownership or control, the value of the payment is the present 
value of such payment (or payments) calculated in accordance with Q/A-
32 of this section and based on reasonable actuarial assumptions.
    (2) If the payment in the nature of compensation is an obligation 
to provide health care, then for purposes of this A-31 and for applying 
the 3-times-base-amount test under Q/A-30 of this section, the present 
value of such obligation should be calculated in accordance with 
generally accepted accounting principles. For purposes of Q/A-30 and 
this A-31, the obligation to provide health care is permitted to be 
measured by projecting the cost of premiums for purchased health care 
insurance, even if no health care insurance is actually purchased. If 
the obligation to provide health care is made in coordination with a 
health care plan that the corporation makes available to a group, then 
the premiums

[[Page 7651]]

used for this purpose may be group premiums.
    Q-32: What discount rate is to be used to determine present value?
    A-32: For purposes of this section, present value generally is 
determined by using a discount rate equal to 120 percent of the 
applicable Federal rate (determined under section 1274(d) and the 
regulations thereunder) compounded semiannually. The applicable Federal 
rate to be used for this purpose is the Federal rate that is in effect 
on the date as of which the present value is determined. See Q/A-24 and 
35 of this section. However, for any payment, the corporation and the 
disqualified individual may elect to use the applicable Federal rate 
that is in effect on the date that the contract which provides for the 
payment is entered into, if such election is made in the contract.
    Q-33: If the present value of a payment to be made in the future is 
contingent on an uncertain future event or condition, how is the 
present value of the payment determined?
    A-33: (a) In certain cases, it may be necessary to apply the 3-
times-base-amount test of Q/A-30 of this section or to allocate a 
portion of the base amount to a payment described in paragraphs (a)(1), 
(2), and (3) of Q/A-2 of this section at a time when the aggregate 
present value of all such payments cannot be determined with certainty 
because the time, amount, or right to receive one or more such payments 
is contingent on the occurrence of an uncertain future event or 
condition. For example, a disqualified individual's right to receive a 
payment may be contingent on the involuntary termination of such 
individual's employment with the corporation. In such a case, it must 
be reasonably estimated whether the payment will be made. If it is 
reasonably estimated that there is a 50-percent or greater probability 
that the payment will be made, the full amount of the payment is 
considered for purposes of the 3-times-base-amount test and the 
allocation of the base amount. Conversely, if it is reasonably 
estimated that there is a less than 50-percent probability that the 
payment will be made, the payment is not considered for either purpose.
    (b) If the estimate made under paragraph (a) of this A-33 is later 
determined to be incorrect, the 3-times-base-amount test described in 
Q/A-30 of this section must be reapplied (and the portion of the base 
amount allocated to previous payments must be reallocated (if 
necessary) to such payments) to reflect the actual time and amount of 
the payment. Whenever the 3-times-base-amount test is applied (or 
whenever the base amount is allocated), the aggregate present value of 
the payments received or to be received by the disqualified individual 
is redetermined as of the date described in A-31 of this section, using 
the discount rate described in A-32 of this section. This 
redetermination may affect the amount of any excess parachute payment 
for a prior taxable year. Alternatively, if, based on the application 
of the 3-times-base-amount test without regard to the payment described 
in paragraph (a) of this A-33, a disqualified individual is determined 
to have an excess parachute payment or payments, then the 3-times-base-
amount test does not have to be reapplied when a payment described in 
paragraph (a) of this A-33 is made (or becomes certain to be made) if 
no base amount is allocated to such payment.
    (c) The following examples illustrate the principles of this A-33:

    Example 1. A, a disqualified individual with respect to 
Corporation M, has a base amount of $100,000. Under A's employment 
agreement with Corporation M, A is entitled to receive a payment in 
the nature of compensation in the amount of $250,000 contingent on a 
change in ownership or control of Corporation M. In addition, the 
agreement provides that if A's employment is terminated within 1 
year after the change in ownership or control, A will receive an 
additional payment in the nature of compensation in the amount of 
$150,000, payable 1 year after the date of the change in ownership 
or control. A change in ownership or control of Corporation M occurs 
and A receives the first payment of $250,000. Corporation M 
reasonably estimates that there is a 50-percent probability that, as 
a result of the change, A's employment will be terminated within 1 
year of the date of the change. For purposes of applying the 3-
times-base-amount test (and if the first payment is determined to be 
a parachute payment, for purposes of allocating a portion of A's 
base amount to that payment), because M reasonably estimates that 
there is a 50-percent or greater probability that, as a result of 
the change, A's employment will be terminated within 1 year of the 
date of the change, Corporation M must assume that the $150,000 
payment will be made to A as a result of the change in ownership or 
control. The present value of the additional payment is determined 
under Q/A-31 and Q/A-32 of this section.
    Example 2.  Assume the same facts as in Example 1 except that 
Corporation M reasonably estimates that there is a less than 50-
percent probability that, as a result of the change, A's employment 
will be terminated within 1 year of the date of the change. For 
purposes of applying the 3-times-base-amount test, because 
Corporation M reasonably estimates that there is a less than 50-
percent probability that, as a result of the change, A's employment 
will be terminated within 1 year of the date of the change, 
Corporation M must assume that the $150,000 payment will not be made 
to A as a result of the change in ownership or control.
    Example 3.  B, a disqualified individual with respect to 
Corporation P, has a base amount of $200,000. Under B's employment 
agreement with Corporation P, if there is a change in ownership or 
control of Corporation P, B will receive a severance payment of 
$600,000 and a bonus payment of $400,000. In addition, the agreement 
provides that if B's employment is terminated within 1 year after 
the change, B will receive an additional payment in the nature of 
compensation of $500,000. A change in ownership or control of 
Corporation P occurs, and B receives the $600,000 and $400,000 
payments. At the time of the change in ownership or control, 
Corporation P reasonably estimates that there is a less than 50-
percent probability that B's employment will be terminated within 1 
year of the change. For purposes of applying the 3-times-base-amount 
test, because Corporation P reasonably estimates that there is a 
less than 50-percent probability that B's employment will be 
terminated within 1 year of the date of the change, Corporation P 
assumes that the $500,000 payment will not be made to B. Eleven 
months after the change in ownership or control, B's employment is 
terminated, and the $500,000 payment is made to B. Because B was 
determined to have excess parachute payments without regard to the 
$500,000 payment, the 3-times-base-amount test is not reapplied and 
the base amount is not reallocated to include the $500,000 payment. 
The entire $500,000 payment is treated as an excess parachute 
payment.

    Q-34: What is the base amount?
    A-34: (a) The base amount of a disqualified individual is the 
average annual compensation for services performed for the corporation 
with respect to which the change in ownership or control occurs (or for 
a predecessor entity or a related entity) which was includible in the 
gross income of such individual for taxable years in the base period 
(including amounts that were excluded under section 911), or which 
would have been includible in such gross income if such person had been 
a United States citizen or resident. See Q/A-35 of this section for the 
definition of base period and for examples of base amount computations.
    (b) If the base period of a disqualified individual includes a 
short taxable year or less than all of a taxable year, compensation for 
such short or incomplete taxable year must be annualized before 
determining the average annual compensation for the base period. In 
annualizing compensation, the frequency with which payments are 
expected to be made over an annual period must be taken into account. 
Thus, any amount of compensation for such a short or

[[Page 7652]]

incomplete taxable year that represents a payment that will not be made 
more often than once per year is not annualized.
    (c) Because the base amount includes only compensation that is 
includible in gross income, the base amount does not include certain 
items that constitute parachute payments. For example, payments in the 
form of excludible fringe benefits are not included in the base amount 
but may be treated as parachute payments.
    (d) The base amount includes the amount of compensation included in 
income under section 83(b) during the base period.
    (e) The following example illustrates the principles of this A-34:

    Example. A disqualified individual, D, receives an annual salary 
of $500,000 per year during the 5-year base period. D defers 
$100,000 of D's salary each year under the corporation's 
nonqualified deferred compensation plan. D's base amount is $400,000 
($400,000  x  (5/5)).

    Q-35: What is the base period?
    A-35: (a) The base period of a disqualified individual is the most 
recent 5 taxable years of the individual ending before the date of the 
change in ownership or control. For this purpose, the date of the 
change in ownership or control is the date the corporation experiences 
one of the events described in Q/A-27, Q/A-28, or Q/A-29 of this 
section. However, if the disqualified individual was not an employee or 
independent contractor of the corporation with respect to which the 
change in ownership or control occurs (or a predecessor entity or a 
related entity as defined in Q/A-21 of this section) for this entire 5-
year period, the individual's base period is the portion of such 5-year 
period during which the individual performed personal services for the 
corporation or predecessor entity or related entity.
    (b) The following examples illustrate the principles of Q/A-34 of 
this section and this Q/A-35:

    Example 1. A disqualified individual, D, was employed by a 
corporation for 2 years and 4 months preceding the taxable year in 
which a change in ownership or control of the corporation occurs. 
D's includible compensation income from the corporation was $30,000 
for the 4-month period, $120,000 for the first full year, and 
$150,000 for the second full year. D's base amount is $120,000, ((3 
x  $30,000) + $120,000 + $150,000)/ 3.
    Example 2. Assume the same facts as in Example 1, except that D 
also received a $60,000 signing bonus when D's employment with the 
corporation commenced at the beginning of the 4-month period. D's 
base amount is $140,000, (($60,000 + (3  x  $30,000)) + $120,000 + 
$150,000) / 3. Since the bonus will not be paid more often than once 
per year, the amount of the bonus is not increased in annualizing 
D's compensation for the 4-month period.

    Q-36: How is the base amount determined in the case of a 
disqualified individual who did not perform services for the 
corporation (or a predecessor entity or a related entity as defined in 
Q/A-21 of this section), prior to the individual's taxable year in 
which the change in ownership or control occurs?
    A-36: (a) In such a case, the individual's base amount is the 
annualized compensation for services performed for the corporation (or 
a predecessor entity or related entity) which--
    (1) Was includible in the individual's gross income for that 
portion, prior to such change, of the individual's taxable year in 
which the change occurred (including amounts that were excluded under 
section 911), or would have been includible in such gross income if 
such person had been a United States citizen or resident;
    (2) Was not contingent on the change in ownership or control; and
    (3) Was not a securities violation parachute payment.
    (b) The following examples illustrate the principles of this A-36:

    Example 1. On January 1, 2006, A, an individual whose taxable 
year is the calendar year, enters into a 4-year employment contract 
with Corporation M as an officer of the corporation. A has not 
previously performed services for Corporation M (or any predecessor 
entity or related entity as defined in Q/A-21 of this section). 
Under the employment contract, A is to receive an annual salary of 
$120,000 for each of the 4 years that he remains employed by 
Corporation M with any remaining unpaid balance to be paid 
immediately in the event that A's employment is terminated without 
cause. On July 1, 2006, after A has received compensation of 
$60,000, a change in the ownership of Corporation M occurs. Because 
of the change, A's employment is terminated without cause, and he 
receives a payment of $420,000. It is established by clear and 
convincing evidence that the $60,000 in compensation is not 
contingent on the change in ownership or control, but the 
presumption that the $420,000 payment is contingent on the change is 
not rebutted. Thus, the payment of $420,000 is treated as contingent 
on the change in ownership of Corporation M. In this case, A's base 
amount is $120,000 (2  x  $60,000). Since the present value of the 
payment which is contingent on the change in ownership of 
Corporation M ($420,000) is more than 3 times A's base amount of 
$120,000 (3  x  $120,000 = $360,000), the payment is a parachute 
payment.
    Example 2. Assume the same facts as in Example 1, except that A 
also receives a signing bonus of $50,000 from Corporation M on 
January 1, 2006. It is established by clear and convincing evidence 
that the bonus is not contingent on the change in ownership. When 
the change in ownership occurs on July 1, 2006, A has received 
compensation of $110,000 (the $50,000 bonus plus $60,000 in salary). 
In this case, A's base amount is $170,000 [$50,000 + (2  x  
$60,000)]. Since the $50,000 bonus will not be paid more than once 
per year, the amount of the bonus is not increased in annualizing 
A's compensation. The present value of the potential parachute 
payment ($420,000) is less than 3 times A's base amount of $170,000 
(3  x  $170,000 = $510,000), and therefore no portion of the payment 
is a parachute payment.

Securities Violation Parachute Payments

    Q-37: Must a payment be contingent on a change in ownership or 
control in order to be a parachute payment?
    A-37: (a) No, the term parachute payment also includes any payment 
(other than a payment exempted under Q/A-6 or Q/A-8 of this section) 
that is in the nature of compensation and is to (or for the benefit of) 
a disqualified individual, if such payment is a securities violation 
payment. A securities violation payment is a payment made or to be 
made--
    (1) Pursuant to an agreement that violates any generally enforced 
Federal or State securities laws or regulations; and
    (2) In connection with a potential or actual change in ownership or 
control.
    (b) A violation is not taken into account under paragraph (a)(1) of 
this A-37 if it is merely technical in character or is not materially 
prejudicial to shareholders or potential shareholders. Moreover, a 
violation will be presumed not to exist unless the existence of the 
violation has been determined or admitted in a civil or criminal action 
(or an administrative action by a regulatory body charged with 
enforcing the particular securities law or regulation) which has been 
resolved by adjudication or consent. Parachute payments described in 
this A-37 are referred to in this section as securities violation 
payments.
    (c) Securities violation parachute payments that are not contingent 
on a change in ownership or control within the meaning of Q/A-22 of 
this section are not taken into account in applying the 3-times-base-
amount test of Q/A-30 of this section. Such payments are considered 
parachute payments regardless of whether such test is met with respect 
to the disqualified individual (and are included in allocating base 
amount under Q/A-38 of this section). Moreover, the amount of a 
securities violation parachute payment treated as an excess parachute 
payment shall not be reduced by the portion of

[[Page 7653]]

such payment that is reasonable compensation for personal services 
actually rendered before the date of a change in ownership or control 
if such payment is not contingent on such change. Likewise, the amount 
of a securities violation parachute payment includes the portion of 
such payment that is reasonable compensation for personal services to 
be rendered on or after the date of a change in ownership or control if 
such payment is not contingent on such change.
    (d) The rules in paragraph (b) of this A-37 also apply to 
securities violation parachute payments that are contingent on a change 
in ownership or control if the application of these rules results in 
greater total excess parachute payments with respect to the 
disqualified individual than would result if the payments were treated 
simply as payments contingent on a change in ownership or control (and 
hence were taken into account in applying the 3-times-base-amount test 
and were reduced by, or did not include, any applicable amount of 
reasonable compensation).
    (e) The following examples illustrate the principles of this A-37:

    Example 1.  A, a disqualified individual with respect to 
Corporation M, receives two payments in the nature of compensation 
that are contingent on a change in the ownership or control of 
Corporation M. The present value of the first payment is equal to 
A's base amount and is not a securities violation parachute payment. 
The present value of the second payment is equal to 1.5 times A's 
base amount and is a securities violation parachute payment. Neither 
payment includes any reasonable compensation. If the second payment 
is treated simply as a payment contingent on a change in ownership 
or control, the amount of A's total excess parachute payments is 
zero because the aggregate present value of the payments does not 
equal or exceed 3 times A's base amount. If the second payment is 
treated as a securities violation parachute payment subject to the 
rules of paragraph (b) of this A-37, the amount of A's total excess 
parachute payments is 0.5 times A's base amount. Thus, the second 
payment is treated as a securities violation parachute payment.
    Example 2.  Assume the same facts as in Example 1, except that 
the present value of the first payment is equal to 2 times A's base 
amount. If the second payment is treated simply as a payment 
contingent on a change in ownership or control, the total present 
value of the payments is 3.5 times A's base amount, and the amount 
of A's total excess parachute payments is 2.5 times A's base amount. 
If the second payment is treated as a securities violation parachute 
payment, the amount of A's total excess parachute payments is 0.5 
times A's base amount. Thus, the second payment is treated simply as 
a payment contingent on a change in ownership or control.
    Example 3. B, a disqualified individual with respect to 
Corporation N, receives two payments in the nature of compensation 
that are contingent on a change in the control of Corporation N. The 
present value of the first payment is equal to 4 times B's base 
amount and is a securities violation parachute payment. The present 
value of the second payment is equal to 2 times B's base amount and 
is not a securities violation parachute payment. B establishes by 
clear and convincing evidence that the entire amount of the first 
payment is reasonable compensation for personal services to be 
rendered after the change in ownership or control. If the first 
payment is treated simply as a payment contingent on a change in 
ownership or control, it is exempt from the definition of parachute 
payment pursuant to Q/A-9 of this section. Thus, the amount of B's 
total excess parachute payment is zero because the present value of 
the second payment does not equal or exceed three times B's base 
amount. However, if the first payment is treated as a securities 
violation parachute payment, the amount of B's total excess 
parachute payments is 3 times B's base amount. Thus, the first 
payment is treated as a securities violation parachute payment.
    Example 4. Assume the same facts as in Example 3, except that B 
does not receive the second payment and B establishes by clear and 
convincing evidence that the first payment is reasonable 
compensation for services actually rendered before the change in the 
control of Corporation N. If the payment is treated simply as a 
payment contingent on a change in ownership or control, the amount 
of B's excess parachute payment is zero because the amount treated 
as an excess parachute payment is reduced by the amount that B 
establishes as reasonable compensation. However, if the payment is 
treated as a securities violation parachute payment, the amount of 
B's excess parachute payment is 3 times B's base amount. Thus, the 
payment is treated as a securities violation parachute payment.

Computation and Reduction of Excess Parachute Payments

    Q-38: How is the amount of an excess parachute payment computed?
    A-38: (a) The amount of an excess parachute payment is the excess 
of the amount of any parachute payment over the portion of the 
disqualified individual's base amount that is allocated to such 
payment. For this purpose, the portion of the base amount allocated to 
any parachute payment is the amount that bears the same ratio to the 
base amount as the present value of such parachute payment bears to the 
aggregate present value of all parachute payments made or to be made to 
(or for the benefit of) the same disqualified individual. Thus, the 
portion of the base amount allocated to any parachute payment is 
determined by multiplying the base amount by a fraction, the numerator 
of which is the present value of such parachute payment and the 
denominator of which is the aggregate present value of all such 
payments. See Q/A-31, Q/A-32, and Q/A-33 of this section for rules on 
determining present value and Q/A-34 of this section for the definition 
of base amount.
    (b) The following example illustrates the principles of this A-38:

    Example. An individual with a base amount of $100,000 is 
entitled to receive two parachute payments, one of $200,000 and the 
other of $400,000. The $200,000 payment is made at the time of the 
change in ownership or control, and the $400,000 payment is to be 
made at a future date. The present value of the $400,000 payment is 
$300,000 on the date of the change in ownership or control. The 
portions of the base amount allocated to these payments are $40,000 
(($200,000/$500,000)  x  $100,000) and $60,000 (($300,000/$500,000) 
x  $100,000), respectively. Thus, the amount of the first excess 
parachute payment is $160,000 ($200,000--$40,000) and that of the 
second is $340,000 ($400,000--$60,000).

    Q-39: May the amount of an excess parachute payment be reduced by 
reasonable compensation for personal services actually rendered before 
the change in ownership or control?
    A-39: (a) Generally, yes, except that in the case of payments 
treated as securities violation parachute payments or when the portion 
of a payment that is treated as contingent on the change in ownership 
or control is determined under paragraph (b) or (c) of Q/A-24 of this 
section, the amount of an excess parachute payment is reduced by any 
portion of the payment that the taxpayer establishes by clear and 
convincing evidence is reasonable compensation for personal services 
actually rendered by the disqualified individual before the date of the 
change in ownership or control. Services reasonably compensated for by 
payments that are not parachute payments (for example, because the 
payments are not contingent on a change in ownership or control and are 
not securities violation parachute payments, or because the payments 
are exempt from the definition of parachute payment under Q/A-6 through 
Q/A-9 of this section) are not taken into account for this purpose. The 
portion of any parachute payment that is established as reasonable 
compensation is first reduced by the portion of the disqualified 
individual's base amount that is allocated to such parachute payment; 
any remaining portion of the parachute payment established as 
reasonable compensation then reduces the excess parachute payment.
    (b) The following examples illustrate the principles of this A-39:

    Example 1. Assume that a parachute payment of $600,000 is made 
to a

[[Page 7654]]

disqualified individual, and the portion of the individual's base 
amount that is allocated to the parachute payment is $100,000. Also 
assume that $300,000 of the $600,000 parachute payment is 
established as reasonable compensation for personal services 
actually rendered by the disqualified individual before the date of 
the change in ownership or control. Before the reasonable 
compensation is taken into account, the amount of the excess 
parachute payment is $500,000 ($600,000--$100,000). In reducing the 
excess parachute payment by reasonable compensation, the portion of 
the parachute payment that is established as reasonable compensation 
($300,000) is first reduced by the portion of the disqualified 
individual's base amount that is allocated to the parachute payment 
($100,000), and the remainder ($200,000) then reduces the excess 
parachute payment. Thus, in this case, the excess parachute payment 
of $500,000 is reduced by $200,000 of reasonable compensation.
    Example 2. Assume the same facts as in Example 1, except that 
the full amount of the $600,000 parachute payment is established as 
reasonable compensation. In this case, the excess parachute payment 
of $500,000 is reduced to zero by $500,000 of reasonable 
compensation. As a result, no portion of any deduction for the 
payment is disallowed by section 280G, and no portion of the payment 
is subject to the 20-percent excise tax of section 4999.

Determination of Reasonable Compensation

    Q-40: How is it determined whether payments are reasonable 
compensation?
    A-40: (a) In general, whether payments are reasonable compensation 
for personal services actually rendered, or to be rendered, by the 
disqualified individual is determined on the basis of all the facts and 
circumstances of the particular case. Factors relevant to such a 
determination include, but are not limited to, the following--
    (1) The nature of the services rendered or to be rendered;
    (2) The individual's historic compensation for performing such 
services; and
    (3) The compensation of individuals performing comparable services 
in situations where the compensation is not contingent on a change in 
ownership or control.
    (b) For purposes of section 280G, reasonable compensation for 
personal services includes reasonable compensation for holding oneself 
out as available to perform services and refraining from performing 
services (such as under a covenant not to compete).
    Q-41: Is any particular type of evidence generally considered clear 
and convincing evidence of reasonable compensation for personal 
services?
    A-41: Yes, a showing that payments are made under a 
nondiscriminatory employee plan or program (as defined in Q/A-26 of 
this section) generally is considered to be clear and convincing 
evidence that the payments are reasonable compensation. This is true 
whether the personal services for which the payments are made are 
actually rendered before, or to be rendered on or after, the date of 
the change in ownership or control. Q/A-46 of this section (relating to 
the treatment of an affiliated group as one corporation) does not apply 
for purposes of this A-41. No determination of reasonable compensation 
is needed for payments under qualified plans to be exempt from the 
definition of parachute payment under Q/A-8 of this section.
    Q-42: Is any particular type of evidence generally considered clear 
and convincing evidence of reasonable compensation for personal 
services to be rendered on or after the date of a change in ownership 
or control?
    A-42: (a) Yes, if payments are made or to be made to (or on behalf 
of) a disqualified individual for personal services to be rendered on 
or after the date of a change in ownership or control, a showing of the 
following generally is considered to be clear and convincing evidence 
that the payments are reasonable compensation for services to be 
rendered on or after the date of the change in ownership or control--
    (1) The payments were made or are to be made only for the period 
the individual actually performs such personal services; and
    (2) If the individual's duties and responsibilities are 
substantially the same after the change in ownership or control, the 
individual's annual compensation for such services is not significantly 
greater than such individual's annual compensation prior to the change 
in ownership or control, apart from normal increases attributable to 
increased responsibilities or cost of living adjustments. If the scope 
of the individual's duties and responsibilities are not substantially 
the same, the annual compensation after the change is not significantly 
greater than the annual compensation customarily paid by the employer 
or by comparable employers to persons performing comparable services. 
However, except as provided in paragraph (b) of this A-42, such clear 
and convincing evidence will not exist if the individual does not, in 
fact, perform the services contemplated in exchange for the 
compensation.
    (b) Generally, an agreement under which the disqualified individual 
must refrain from performing services (such as a covenant not to 
compete) is an agreement for the performance of personal services for 
purposes of this A-42 to the extent that it is demonstrated by clear 
and convincing evidence that the agreement substantially constrains the 
individual's ability to perform services and there is a reasonable 
likelihood that the agreement will be enforced against the individual. 
In the absence of clear and convincing evidence, payments under the 
agreement are treated as severance payments under Q/A-44 of this 
section.
    (c) If the employment of a disqualified individual is involuntarily 
terminated before the end of a contract term and the individual is paid 
damages for breach of contract, a showing of the following factors 
generally is considered clear and convincing evidence that the payment 
is reasonable compensation for personal services to be rendered on or 
after the date of change in ownership or control--
    (1) The contract was not entered into, amended, or renewed in 
contemplation of the change in ownership or control;
    (2) The compensation the individual would have received under the 
contract would have qualified as reasonable compensation under section 
162;
    (3) The damages do not exceed the present value (determined as of 
the date of receipt) of the compensation the individual would have 
received under the contract if the individual had continued to perform 
services for the employer until the end of the contract term;
    (4) The damages are received because an offer to provide personal 
services was made by the disqualified individual but was rejected by 
the employer; and
    (5) The damages are reduced by mitigation. Mitigation will be 
treated as occurring when such damages are reduced (or any payment of 
such damages is returned) to the extent of the disqualified 
individual's earned income (within the meaning of section 911(d)(2)(A)) 
during the remainder of the period in which the contract would have 
been in effect. See Q/A-44 of this section for rules regarding damages 
for a failure to make severance payments.
    (c) The following examples illustrate the principles of this A-42:

    Example 1. A, a disqualified individual, has a three-year 
employment contract with Corporation M, a publicly traded 
corporation. Under this contract, A is to receive a salary for 
$100,000 for the first year of the contract and, for each succeeding 
year, an annual salary that is 10 percent higher than the prior 
year's salary. During the third year of the contract, Corporation N 
acquires all the stock of Corporation M. Prior to the change in 
ownership, Corporation N arranges to retain A's services by entering 
into an employment contract with A that is essentially the same as 
A's contract with Corporation M. Under

[[Page 7655]]

the new contract, Corporation N is to fulfill Corporation M's 
obligations for the third year of the old contract, and, for each of 
the succeeding years, pay A an annual salary that is 10 percent 
higher than A's prior year's salary. Amounts are payable under the 
new contract only for the portion of the contract term during which 
A remains employed by Corporation N. A showing of the facts 
described above (and in the absence of contradictory evidence) is 
regarded as clear and convincing evidence that all payments under 
the new contract are reasonable compensation for personal services 
to be rendered on or after the date of the change in ownership. 
Therefore, the payments under this agreement are exempt from the 
definition of parachute payment pursuant to Q/A-9 of this section.
    Example 2. Assume the same facts as in Example 1 except that A 
does not perform the services described in the new contract, but 
receives payment under the new contract. Because services were not 
rendered after the change, the payments under this contract are not 
exempt from the definition of parachute payment pursuant to Q/A-9 of 
this section.
    Example 3. Assume the same facts as in Example 1 except that 
under the new contract A agrees to perform consulting services to 
Corporation N, when and if, Corporation N requires A's services. 
Assume further that when Corporation N does not require A's 
services, the contract provides that A must not perform services for 
any other competing company. Corporation N previously enforced 
similar contracts against former employees of Corporation N. Because 
A is substantially constrained under this contract and Corporation N 
is reasonably likely to enforce the contract against A, the 
agreement is an agreement for the performance of services under 
paragraph (b) of this A-42. Assuming the requirements of paragraph 
(a) of this A-42 are met and there is clear and convincing evidence 
that all payments under the new contract are reasonable compensation 
for personal services to be rendered on or after the date of the 
change in ownership, the payments under this contract are exempt 
from the definition of parachute payment pursuant to Q/A-9 of this 
section.
    Example 4. Assume the same facts as in Example 1, except that 
the employment contract with Corporation N does not provide that 
amounts are payable under the contract only for the portion of the 
term for which A remains employed by Corporation N. Shortly after 
the change in ownership, and despite A's request to remain employed 
by Corporation N, A's employment with Corporation N is involuntarily 
terminated. Shortly thereafter, A obtains employment with 
Corporation O. A commences a civil action against Corporation N, 
alleging breach of the employment contract. In settlement of the 
litigation, A receives an amount equal to the present value of the 
compensation A would have received under the contract with 
Corporation N, reduced by the amount of compensation A otherwise 
receives from Corporation O during the period that the contract 
would have been in effect. A showing of the facts described above 
(and in the absence of contradictory evidence) is regarded as clear 
and convincing evidence that the amount A receives as damages is 
reasonable compensation for personal services to be rendered on or 
after the date of the change in ownership. Therefore, the amount 
received by A is exempt from the definition of parachute payment 
pursuant to Q/A-9 of this section.

    Q-43: Is any particular type of payment generally considered 
reasonable compensation for personal services actually rendered before 
the date of a change in ownership or control?
    A-43: (a) Yes, payments of compensation earned before the date of a 
change in ownership or control generally are considered reasonable 
compensation for personal services actually rendered before the date of 
a change in ownership or control if they qualify as reasonable 
compensation under section 162.
    Q-44: May severance payments be treated as reasonable compensation?
    A-44: (a) No, severance payments are not treated as reasonable 
compensation for personal services actually rendered before, or to be 
rendered on or after, the date of a change in ownership or control. 
Moreover, any damages paid for a failure to make severance payments are 
not treated as reasonable compensation for personal services actually 
rendered before, or to be rendered on or after, the date of such 
change. For purposes of this section, the term severance payment means 
any payment that is made to (or for the benefit of) a disqualified 
individual on account of the termination of such individual's 
employment prior to the end of a contract term, but does not include 
any payment that otherwise would be made to (or for the benefit of) 
such individual on the termination of such individual's employment, 
whenever occurring.
    (b) The following example illustrates the principles of this A-44:

    Example. A, a disqualified individual, has a three-year 
employment contract with Corporation X. Under the contract, A will 
receive a salary of $200,000 for the first year of the contract, and 
for each succeeding year, an annual salary that is $100,000 higher 
than the previous year. In the event of A's termination of 
employment following a change in ownership or control, the contract 
provides that A will receive the remaining salary due under the 
employment contract. At the beginning of the second year of the 
contract, Corporation Y acquires all of the stock of Corporation X, 
A's employment is terminated, and A receives $700,000 ($300,000 for 
the second year of the contract plus $400,000 for the third year of 
the contract) representing the remaining salary due under the 
employment contract. Because the $700,000 payment is treated as a 
severance payment, it is not reasonable compensation for personal 
services on or after the date of the change in ownership or control. 
Thus, the full amount of the $700,000 is a parachute payment.

Miscellaneous Rules

    Q-45: How is the term corporation defined?
    A-45: For purposes of this section, the term corporation has the 
meaning prescribed by section 7701(a)(3) and Sec. 301.7701-2(b). For 
example, a corporation, for purposes of this section, includes a 
publicly traded partnership treated as a corporation under section 7704 
(a); an entity described in Sec. 301.7701-3(c)(1)(v)(A) of this 
chapter; a real estate investment trust under section 856(a); a 
corporation that has mutual or cooperative (rather than stock) 
ownership, such as a mutual insurance company, a mutual savings bank, 
or a cooperative bank (as defined in section 7701(a)(32)), and a 
foreign corporation as defined under section 7701(a)(5).
    Q-46: How is an affiliated group treated?
    A-46: For purposes of this section, and except as otherwise 
provided in this section, all members of the same affiliated group (as 
defined in section 1504, determined without regard to section 1504(b)) 
are treated as one corporation. Rules affected by this treatment of an 
affiliated group include (but are not limited to) rules relating to 
exempt payments of certain corporations (Q/A-6, Q/A-7 of this section 
(except as provided therein)), payor of parachute payments (Q/A-10 of 
this section), disqualified individuals (Q/A-15 through Q/A-21 of this 
section (except as provided therein)), rebuttal of the presumption that 
payments are contingent on a change (Q/A-26 of this section (except as 
provide therein)), change in ownership or control (Q/A-27, 28, and 29 
of this section), and reasonable compensation (Q/A-42, 43, and 44 of 
this section).

Effective Date

    Q-47: What is the general effective date of section 280G?
    A-47: (a) Generally, section 280G applies to payments under 
agreements entered into or renewed after June 14, 1984. Any agreement 
that is entered into before June 15, 1984, and is renewed after June 
14, 1984, is treated as a new contract entered into on the day the 
renewal takes effect.
    (b) For purposes of paragraph (a) of this A-47, a contract that is 
terminable or cancellable unconditionally at will by either party to 
the contract without the consent of the other, or by both parties to 
the contract, is treated as a new

[[Page 7656]]

contract entered into on the date any such termination or cancellation, 
if made, would be effective. However, a contract is not treated as so 
terminable or cancellable if it can be terminated or cancelled only by 
terminating the employment relationship or independent contractor 
relationship of the disqualified individual.
    (c) Section 280G applies to payments under a contract entered into 
on or before June 14, 1984, if the contract is amended or supplemented 
after June 14, 1984, in significant relevant respect. For this purpose, 
a supplement to a contract is defined as a new contract entered into 
after June 14, 1984, that affects the trigger, amount, or time of 
receipt of a payment under an existing contract.
    (d)(1) Except as otherwise provided in paragraph (e) of this A-47, 
a contract is considered to be amended or supplemented in significant 
relevant respect if provisions for payments contingent on a change in 
ownership or control (parachute provisions), or provisions in the 
nature of parachute provisions, are added to the contract, or are 
amended or supplemented to provide significant additional benefits to 
the disqualified individual. Thus, for example, a contract generally is 
treated as amended or supplemented in significant relevant respect if 
it is amended or supplemented--
    (i) To add or modify, to the disqualified individual's benefit, a 
change in ownership or control trigger;
    (ii) To increase amounts payable that are contingent on a change in 
ownership or control (or, where payment is to be made under a formula, 
to modify the formula to the disqualified individual's advantage); or
    (iii) To accelerate, in the event of a change in ownership or 
control, the payment of amounts otherwise payable at a later date.
    (2) For purposes of paragraph (a) of this A-47, a payment is not 
treated as being accelerated in the event of a change in ownership or 
control if the acceleration does not increase the present value of the 
payment.
    (e) A contract entered into on or before June 14, 1984, is not 
treated as amended or supplemented in significant relevant respect 
merely by reason of normal adjustments in the terms of employment 
relationship or independent contractor relationship of the disqualified 
individual. Whether an adjustment in the terms of such a relationship 
is considered normal for this purpose depends on all of the facts and 
circumstances of the particular case. Relevant factors include, but are 
not limited to, the following--
    (1) The length of time between the adjustment and the change in 
ownership or control;
    (2) The extent to which the corporation, at the time of the 
adjustment, viewed itself as a likely takeover candidate;
    (3) A comparison of the adjustment with historical practices of the 
corporation;
    (4) The extent of overlap between the group receiving the benefits 
of the adjustment and those members of that group who are the 
beneficiaries of pre-June 15, 1984, parachute contracts; and
    (5) The size of the adjustment, both in absolute terms and in 
comparison with the benefits provided to other members of the group 
receiving the benefits of the adjustment.
    Q-48: What is the effective date of this section?
    A-48: This section applies to any payment that is contingent on a 
change in ownership or control that occurs on or after January 1, 2004. 
Taxpayers can rely on these rules for the treatment of any parachute 
payment made after February 20, 2002.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-3819 Filed 2-19-02; 8:45 am]
BILLING CODE 4830-01-P