Section 280G Regs: Golden Parachute Tax Rules

Section 280G of the Internal Revenue Code contains tax rules designed to address compensation packages contingent on a corporate change in control. Its purpose is to discourage excessive payments, known as “golden parachutes,” to key individuals during events like mergers or acquisitions. The regulations accomplish this by imposing tax penalties on both the company and the individual when payments exceed certain thresholds.

These rules make structuring executive compensation a matter of careful consideration during any corporate transaction. Companies must analyze potential payments to ensure they do not trigger adverse tax consequences. Understanding the framework of Section 280G is a practical necessity for leaders and shareholders involved in the sale of a business.

Key Definitions and Triggers Under Section 280G

The rules are triggered only when a “parachute payment” is made to a “disqualified individual” because of a “change in control.” All three conditions must be met for the regulations to apply. A “disqualified individual” is a person who performs services for the corporation and falls into one of three categories during a 12-month look-back period before the transaction.

An individual only needs to fit into one of these groups to be considered a disqualified individual:

• Certain corporate officers, whose status is determined by authority and duties rather than title.
• Significant shareholders who own more than 1% of the company’s stock value.
• Highly-compensated individuals, defined as the highest-paid 1% of the corporation’s employees, or if less, the top-paid 250 employees.

Change in Control

The next element required to trigger Section 280G is a “change in control,” which can occur in one of three ways.

• A change in the ownership of the corporation’s stock, which occurs when a person or group acquires more than 50% of the total fair market value or voting power of the company’s stock.
• A change in the effective control of the corporation, which is presumed to happen if a majority of board members are replaced within a 12-month period by directors whose appointment was not endorsed by the incumbent board.
• A change in the ownership of a substantial portion of the corporation’s assets, which occurs if a person or group acquires assets from the corporation equal to or exceeding one-third of the total gross fair market value of all company assets within a 12-month period.

Parachute Payment

A “parachute payment” is any compensation that is contingent on a change in control and paid to a disqualified individual. The term is broadly defined to include transaction bonuses, retention bonuses, and any contractual payments triggered by the sale of the company. The key linkage is that the payment would not have been made if the change in control had not occurred.

A component of parachute payments often involves equity compensation. The accelerated vesting of stock options, restricted stock units (RSUs), or other equity awards is considered a payment for Section 280G purposes. Any modifications to employment agreements made within one year before a change in control are also presumed to be contingent on the change, placing the burden on the taxpayer to prove otherwise.

Calculating the Excess Parachute Payment

The process to determine if a payment is an “excess parachute payment” involves a multi-step analysis that compares the value of payments to an individual’s historical compensation.

Step 1: Determine the Base Amount

The first step is to establish the individual’s “base amount,” which serves as the benchmark against which parachute payments are measured. The base amount is the average annual taxable compensation from the corporation for the five most recent taxable years ending before the date of the change in control. This calculation uses the compensation reported on Form W-2 or Form 1099.

For individuals employed for less than five years, the base amount is the average annual compensation for their period of employment. If an individual worked for a partial year, their compensation for that period must be annualized to project what they would have earned over a full year. One-time payments like signing bonuses are not annualized.

Step 2: Identify and Value All Parachute Payments

The next step is to identify and sum the value of all payments and benefits contingent on the change in control. This includes cash payments like severance and transaction bonuses, as well as the value of non-cash benefits. A part of this step is valuing the acceleration of unvested equity awards, for which the regulations provide specific methodologies.

For accelerated stock options, the value involves a calculation that considers the extension of the option term and the time value of money. For accelerated vesting of restricted stock, a portion of the stock’s value is attributed to the lapse of the vesting requirement.

Step 3: Apply the Three-Times Base Amount Test

Section 280G penalties are only triggered if the total value of the parachute payments meets or exceeds three times the individual’s base amount. This test is a cliff; if the total payments are even one dollar below this limit, the rules do not apply. If the total parachute payments are equal to or greater than three times the base amount, the payments become subject to the consequences of Section 280G.

For example, if an executive’s base amount is $500,000, the threshold would be $1,500,000. If their total parachute payments are $1,600,000, the payments have triggered the Section 280G penalties because they exceed the threshold.

Step 4: Calculate the “Excess” Portion

Once the three-times threshold is breached, the penalty is not applied to the amount over the threshold. Instead, the “excess parachute payment” is the portion of the total parachute payment that exceeds one times the base amount. This means that once the three-times test is failed, the entire base amount becomes the deductible portion, and everything above that single base amount is considered “excess.”

Using the previous example, the executive’s total parachute payment is $1,600,000 and their base amount is $500,000. The excess parachute payment is calculated by subtracting one times the base amount from the total payment. The excess portion is $1,100,000 ($1,600,000 – $500,000), and this is the amount subject to tax consequences.

Tax Consequences of Excess Payments

When a payment is determined to be an “excess parachute payment,” the Internal Revenue Code imposes tax consequences on both the individual receiving the payment and the company making it. The financial impact can be substantial, altering the net benefit of the payment for the recipient and increasing the cost for the corporation.

Impact on the Individual

A disqualified individual who receives an excess parachute payment is subject to a 20% excise tax under Internal Revenue Code Section 4999. This tax is levied on the entire amount of the excess payment and is in addition to all other applicable taxes, including federal and state income taxes. The paying company is responsible for withholding this excise tax from the payment.

Some employment agreements contain “gross-up” provisions, where the company agrees to pay the executive an additional amount to cover the cost of the 20% excise tax. This gross-up payment is also considered a parachute payment, subject to the same excise tax and non-deductibility rules, which can increase the overall cost to the company.

Impact on the Company

The tax consequences for the paying corporation are also notable. Under Section 280G, the company is denied a corporate tax deduction for the entire amount of the excess parachute payment. This loss of deductibility means the company must pay corporate income tax on the amount, increasing the after-tax cost of the compensation.

This deduction disallowance applies to the same “excess” amount that is subject to the individual’s excise tax. The combination of the individual excise tax and the corporate deduction disallowance creates a double penalty, as the same dollar of compensation is taxed at both the individual and corporate levels.

Exemptions and Mitigation Strategies

The regulations provide several exemptions and strategies that can be used to avoid or lessen the impact of Section 280G. These approaches range from reclassifying payments to seeking specific approvals from shareholders.

Reasonable Compensation Exemption

One way to reduce the total value of parachute payments is to demonstrate that a portion of the payment constitutes “reasonable compensation” for services rendered. The regulations allow payments to be excluded from the parachute calculation if they can be proven by “clear and convincing evidence” to be reasonable compensation for services performed either before or after the change in control.

For services rendered before the change, this might involve showing that an individual was undercompensated in prior years. For services to be rendered after the change, a payment could be tied to a new employment agreement or a non-compete covenant. Supporting this claim often requires documentation, such as compensation studies and analysis of market data.

Small Business Corporation Exemption

Section 280G provides an exemption for payments made by a “small business corporation.” A small business corporation is one that would be eligible to make an election to be treated as an S corporation under Internal Revenue Code Section 1361. This exemption is available even if the company has not formally elected S corporation status, as long as it meets the eligibility criteria.

The rules also provide an exception for corporations whose stock is not readily tradable on an established securities market. This provision effectively exempts many privately held companies that meet the underlying shareholder requirements from the scope of Section 280G.

Shareholder Approval Exemption

The most widely used strategy for privately held companies to avoid Section 280G penalties is the shareholder approval exemption. This process allows a company to “cleanse” payments that would otherwise be considered excess parachute payments. To be valid, this process must follow a strict set of procedural requirements.

• There must be adequate disclosure of all material facts concerning the payments to all shareholders who are entitled to vote.
• The payments must be approved by more than 75% of the voting power of all outstanding stock held by “disinterested shareholders,” who are not themselves disqualified individuals receiving payments.
• Before the vote, each disqualified individual must execute a legally binding waiver agreeing to forfeit their right to the potential excess parachute payment if the 75% shareholder approval is not obtained.