Code Section 280G: Golden Parachute Tax Rules

When a company undergoes a transition like a merger or acquisition, it may provide substantial payments to its executives. These “golden parachutes” are designed to secure executives during periods of uncertainty and reward them for their contributions. However, these compensation packages can lead to significant tax issues for both the company and the individuals if certain thresholds are crossed, altering the financial outcome of the transaction.

Identifying Key Components and Triggers

For these tax rules to apply, three elements must be present simultaneously: a specific type of person receiving the payment, a specific corporate event, and a payment directly linked to that event. If any one of these components is absent, the associated tax penalties do not apply.

A “Disqualified Individual” is the first required component. This term includes corporate officers involved in the company’s management and policy-making. It also includes highly compensated individuals, defined as the highest-paid one percent of employees, up to a maximum of 250 people. Significant shareholders who own more than one percent of the corporation’s stock and provide services to the company also fall into this category.

The second trigger is a “Change in Control,” an event that alters the corporation’s ownership or governance. This can be a change in stock ownership where one person or group acquires a majority stake. It can also be a change in the effective control of the corporation, such as a significant shift in the board of directors’ composition. A sale of a substantial portion of the corporation’s assets, such as one-third or more, also constitutes a change in control.

The final element is the “Parachute Payment,” which is any compensation contingent on the change in control. This includes cash bonuses and the value of accelerated vesting for stock options or other equity awards. For example, if an executive’s unvested stock options become exercisable upon a merger, the value gained is a parachute payment. The payment would not have been made at that time if not for the change in control.

Calculating Potential Tax Consequences

Determining the tax impact involves a multi-step calculation that establishes a baseline of the executive’s normal earnings. This baseline is used to see if payments from the corporate transaction are excessive. After this comparison, potential penalties can be assessed for the individual and the company.

The first step is calculating the individual’s “base amount.” This figure is the average of the person’s annual compensation, as reported on their Form W-2, for the five full calendar years preceding the year of the change in control. This five-year lookback period creates a benchmark of the executive’s historical earnings.

Next, a test is applied by comparing the total value of all parachute payments to the individual’s base amount. The rules are triggered if the total value of these payments equals or exceeds three times the base amount. If the payments are less than this 3x threshold, the special tax rules do not apply.

If the 3x threshold is met, the next step is to calculate the “excess parachute payment.” This is the portion of the payment subject to penalties. The penalty applies to the amount of the parachute payment that exceeds one times the base amount. For example, if an executive’s base amount is $400,000 and they receive a $1,700,000 parachute payment, the excess parachute payment is $1,300,000 ($1,700,000 minus the $400,000 base amount).

An excess parachute payment has two consequences. The disqualified individual faces a 20% excise tax on the excess amount, in addition to regular income taxes. Using the previous example, the executive would owe a $260,000 excise tax. Simultaneously, the corporation loses its tax deduction for that same excess parachute payment, increasing the company’s tax liability.

Available Exemptions and Mitigation

Several exemptions and mitigation strategies can prevent these tax penalties. These options provide ways for companies and executives to structure payments to avoid the excise tax and deduction loss. The availability of these exemptions depends on the company’s corporate structure and the compensation’s nature.

One exemption applies to payments from a small business corporation. To qualify, a corporation must meet criteria similar to those for S corporation status, including having no more than 100 shareholders, only individuals as shareholders, and only one class of stock. A company does not need to be an S corporation to use this exemption if it meets the qualifications.

Another exemption is for payments classified as “reasonable compensation” for services rendered before or after the change in control. To use this exemption, the company must provide clear and convincing evidence that the amount is reasonable for the work performed. This may require a formal compensation study or other documentation to prove the payment is earned compensation.

For privately-held companies, an exemption is available through a formal shareholder approval process. This allows a company to make payments that would otherwise be considered excess parachute payments without triggering penalties, provided specific procedures are followed. This option places the decision in the hands of the shareholders.

The Shareholder Approval Process

When a private company seeks an exemption through shareholder approval, it must follow a regulated procedure to validate the vote. The rules focus on who votes, what information they receive, and the required level of approval.

The first requirement is “adequate disclosure” of all material facts about the payments. Before the vote, the company must provide every shareholder entitled to vote with detailed information about the proposed payments. This includes the total amount each disqualified individual could receive and how the payments are contingent on the change in control.

The payments must be approved by more than 75% of the voting power of all outstanding stock held by disinterested shareholders. The vote must be separate and cannot be tied to the approval of the underlying merger or acquisition transaction.

A component of the voting process is the exclusion of certain shareholders. The disqualified individuals set to receive the parachute payments, and anyone related to them, are not permitted to vote their shares on this matter. This rule prevents conflicts of interest and ensures approval comes from shareholders without a direct financial stake in the vote’s outcome.