A Detailed 280g Calculation Example

Internal Revenue Code Section 280G addresses the financial consequences of “golden parachute” payments, which are compensatory amounts paid to key individuals when a company undergoes a change in control. These regulations were established to address concerns about excessive payouts to executives during corporate transactions like mergers or acquisitions. When payments trigger these provisions, tax penalties are enacted for both the company and the recipient. Understanding the calculation is a point of focus for companies and executives navigating a change-in-control event.

Gathering the Core Data for Analysis

Before any calculations can be performed, specific data points must be gathered. The analysis hinges on three components: identifying “disqualified individuals,” calculating their “base amount,” and determining the total “parachute payments.” These elements must be accurately established according to the definitions in the Treasury Regulations.

A “disqualified individual” is an employee or independent contractor who performs personal services for the corporation and, at any time during a specific look-back period, falls into one of three categories. The first is an officer of the corporation, with the determination based on facts and circumstances rather than title alone. The number of individuals treated as officers is limited to no more than 50 employees, or if less, the greater of three employees or 10% of the employee population.

The second category includes highly-compensated individuals (HCIs). An HCI is defined under rules that reference other parts of the tax code, such as Section 414. For 2024, this includes an employee with annual compensation above $155,000 who is also within the top 1% of employees by pay, or among the highest-paid 250 employees, whichever group is smaller. The third category is a significant shareholder, defined as someone who owns stock representing 1% or more of the fair market value of all outstanding company stock.

The “base amount” serves as the baseline for testing whether payments are excessive. This figure is the average annual compensation that was includible in the individual’s gross income for the five most recent taxable years ending before the date of the change in control. For example, if an executive’s W-2 compensation for the five years prior to a change in control was $250,000, $260,000, $270,000, $280,000, and $290,000, the base amount would be the average of these figures, which is $270,000.

A “parachute payment” is any payment in the nature of compensation that is contingent on a change in the ownership or effective control of the corporation. These payments can take many forms, including cash severance, transaction bonuses, retention payments, and the value associated with the accelerated vesting of equity awards. The defining characteristic is the direct link between the payment and the change-in-control event.

Applying the Threshold Test

Once the core data has been assembled, the first step is to apply the threshold test. This test determines whether the golden parachute rules are triggered. The question is whether the total parachute payments made to a disqualified individual equal or exceed three times that individual’s base amount. If the total payments fall below this threshold, the rules do not apply, and no penalties are assessed.

To illustrate, consider a hypothetical executive who is a disqualified individual with a calculated base amount of $300,000. In connection with a change in control, this executive is entitled to receive a total of $1,000,000 in payments classified as parachute payments. These payments could be a combination of a cash severance payment and the value of accelerated vesting for outstanding equity awards.

The threshold for this executive is calculated by multiplying the base amount by three. In this scenario, the calculation is 3 multiplied by $300,000, which equals a threshold of $900,000. This figure is the line that determines whether any penalties will apply to the payments.

The next step is to compare the total parachute payments to this calculated threshold. The executive’s $1,000,000 in total parachute payments is greater than the $900,000 threshold. Because the payments exceed this level, they are subject to the consequences of the regulations. This demonstrates the “cliff” nature of the rule; if the total payments had been $899,999, they would have been just under the threshold, and no tax penalties would apply.

Determining the Nondeductible Amount and Excise Tax

After determining that the parachute payments have exceeded the three-times-base-amount threshold, the next step is to calculate the “excess parachute payment.” The penalties are not applied to the entire payment but only to this excess amount. Failing the threshold test does not make the entire payment subject to the penalties, only the portion deemed excessive under the rules.

The excess parachute payment is calculated using a different formula than the threshold test. It is defined as the total amount of the parachute payments minus one times the individual’s base amount. The result of this calculation determines the exact dollar amount on which the penalties are based.

Continuing the running example, the executive received $1,000,000 in total parachute payments and has a base amount of $300,000. To find the excess parachute payment, the base amount is subtracted from the total payments: $1,000,000 minus $300,000 equals $700,000. This $700,000 figure is the excess parachute payment.

The consequences of this $700,000 excess parachute payment are twofold. For the corporation, it loses the ability to claim a tax deduction for this $700,000 portion of the compensation expense. For the executive, they must pay a 20% excise tax on the excess amount, as imposed by Internal Revenue Code Section 4999. This results in a tax of $140,000, which is owed in addition to any applicable income taxes, and the paying company is responsible for withholding it.

Allowable Reductions to Parachute Payments

The total amount of parachute payments can sometimes be reduced through specific, legally defined exceptions. These adjustments can potentially lower the payment amount below the three-times-base-amount threshold, thereby avoiding penalties. Two of the most common reductions involve demonstrating reasonable compensation and obtaining shareholder approval.

One reduction applies to any portion of a payment that can be shown to be “reasonable compensation” for personal services rendered before the change in control. Payments for services to be rendered on or after the date of the change in control are not considered parachute payments and are excluded from the calculation.

For privately-held companies, an exemption exists that can remove payments from the parachute category entirely. This is available if the payments are approved by a separate vote of the company’s shareholders. To qualify, the payments must be approved by more than 75% of the voting power of all outstanding stock after shareholders have received adequate disclosure of all material facts concerning the payments.