How 280g Regulations Affect Parachute Payments

When a company undergoes a merger or acquisition, executives and other key personnel often receive large payments. These “golden parachute” payments are subject to federal tax regulations under Internal Revenue Code (IRC) Section 280G. This provision was enacted to discourage excessive compensation payouts that could arise from a change in corporate control. If these payments are deemed excessive, they trigger tax consequences for both the individual and the corporation. The rules can be triggered even in transactions that appear equitable, so companies contemplating such a transaction must understand these regulations.

Identifying Key Individuals and Payments

Section 280G applies to payments made to a specific group of people known as “disqualified individuals.” This group can include employees, independent contractors, and directors who meet specific criteria during a 12-month look-back period before the change in control. A person’s status as a disqualified individual is determined by whether they are an officer, a significant shareholder, or a highly compensated individual.

An officer’s status is based on authority and duties, not just title. A shareholder who owns more than 1% of the company’s stock and performs services for the company is also a disqualified individual. A highly compensated individual is among the highest-paid 1% of the corporation’s employees, with a cap on the total number of individuals who can be classified this way.

A “parachute payment” is any compensation contingent on a change in control. This broad definition includes more than cash severance, such as:

• Transaction bonuses
• The accelerated vesting of stock options or restricted stock units
• Continuation of benefits like health insurance premiums
• Payments under new employment agreements entered into within a year of the transaction

Any payment from an agreement signed within 12 months before the change is presumed to be contingent on it, a presumption rebuttable only by clear and convincing evidence.

The trigger for these rules is a “change in control.” This event occurs when there is a change in the ownership of a majority of the company’s stock, a change in the effective control of the company, or a change in the ownership of a substantial portion of the company’s assets. A change in effective control is presumed if, within a 12-month period, 20% or more of the company’s voting power is acquired or a majority of the board is replaced by individuals not endorsed by the prior board.

Calculating Potential Tax Consequences

Tax consequences are triggered only if the total value of parachute payments exceeds a specific threshold. The first step is calculating the individual’s “base amount,” which is the average of their annual taxable compensation from the company for the five most recent tax years before the change in control. This amount is derived from the compensation reported on the individual’s Form W-2.

Once the base amount is established, it is multiplied by three to determine the safe harbor threshold. If the total present value of all parachute payments is less than this “three-times base amount,” the Section 280G rules do not apply. This is a cliff test; being even one dollar over the limit triggers the regulations.

If the payments equal or exceed the three-times base amount threshold, the next step is to calculate the “excess parachute payment.” This is the portion of the parachute payments that exceeds one times the individual’s base amount. The three-times test is a trigger, while the penalty is calculated against the lower one-times base amount.

The consequences of an excess parachute payment are twofold. The individual is subject to a 20% non-deductible excise tax on the excess parachute payment, in addition to regular income taxes. The corporation also loses its tax deduction for the excess parachute payment. For example, an executive with a $500,000 base amount who receives $1,500,001 in parachute payments has crossed the three-times threshold. The excess parachute payment is $1,000,001 ($1,500,001 minus the $500,000 base amount), resulting in a $200,000.20 excise tax for the executive and a lost tax deduction of $1,000,001 for the company.

Valuing Compensation and Payments

Assigning a monetary value to all forms of compensation, especially non-cash payments, is a practical challenge in applying Section 280G. The regulations require a present value calculation for all payments, meaning future payments must be discounted to their current worth. This calculation is needed to determine if the three-times base amount threshold has been breached.

The valuation of accelerated equity awards is complex. For awards like stock options and RSUs, the parachute payment value is not the full value of the award, but the value of the acceleration itself. Regulations provide methodologies for this, which involve calculating the value of receiving the payment early and the value of no longer needing to perform future services.

For example, the value of accelerated vesting includes the time value of money and a component related to the likelihood the employee would have remained to vest in the award without the transaction. This calculation can reduce the parachute value of equity but requires careful analysis and often the assistance of valuation experts.

Other non-cash benefits, such as the continuation of health coverage, must also be valued and included in the total parachute payment calculation. The goal is a comprehensive valuation of every contingent benefit. This valuation is foundational to the 280G analysis and mitigation strategies.

Mitigation Through Shareholder Approval

Privately held companies can use a procedural safeguard to avoid Section 280G tax penalties. This method involves obtaining shareholder approval for the payments as outlined by regulations. If this process is followed correctly, the approved payments are exempt from being classified as parachute payments.

The process begins with the disqualified individual executing a binding waiver. They must agree to forfeit any potential excess parachute payments if shareholders do not approve them. This waiver places the compensation at risk and is a prerequisite for a valid shareholder vote.

Following the waiver, the company must disclose all material facts about the payments to all voting shareholders. This disclosure must include the total amount of the payments and a description of how they are contingent on the change in control. The vote must be approved by more than 75% of the voting power of disinterested shareholders, who are those not themselves receiving parachute payments.

This vote must be separate from any vote to approve the transaction, allowing shareholders to approve the deal while rejecting the compensation. The process requires careful planning to meet regulatory requirements.

The Reasonable Compensation Exception

Another strategy is to demonstrate that a portion of the payments is reasonable compensation for services. Payments can be excluded from the parachute calculation if clear and convincing evidence shows they are reasonable compensation for services rendered before or after the change-in-control date. This exception reduces the total amount of potential parachute payments, which can help avoid triggering the three-times base amount threshold.

For services rendered before the change in control, payments qualifying as reasonable compensation under tax principles are accepted. However, arguing that an individual was historically undercompensated is difficult. Stronger arguments relate to payments for services rendered after the transaction.

Payments for future services, such as a commitment to remain with the new company for a transitional period, can be carved out if their value is substantiated. However, assigning value to a non-compete agreement has been curtailed. A Federal Trade Commission (FTC) rule has banned most new non-compete agreements, limiting this tactic for mitigating Section 280G penalties. Any such allocation requires an independent valuation to determine its fair market value.