Internal Revenue Code Section 280G was enacted to curb what was seen as abusive executive compensation practices at large, publicly traded businesses in the 1980s.
Many executives had negotiated “golden parachute” clauses so lucrative that the payments owed to outgoing leaders in the event of an acquisition would cripple the business they left behind. Section 280G imposes a 20% excise tax on the recipients of excess parachute payments, over and above any ordinary taxes owed on the compensation. In addition, the amounts paid to the individual that meet the 280G golden parachute requirements are nondeductible to the business.
Section 280G applies to corporations undergoing a change in control. An important exception applies to certain small business corporations: even without a formal S election, a corporation may be treated as an S corporation for this purpose if it otherwise meets the requirements to be one.
While most commonly relevant to corporate transactions, the rules can still be implicated in transactions involving partnerships or LLCs where a corporation is part of the structure (e.g., sale of corporate assets or a corporate subsidiary). As such, many of today’s transactions run the risk of inadvertently violating Section 280G rules if they aren’t tested for compliance during the negotiation process. Even arms-length deals that appear to treat all parties fairly and equitably can run afoul of the rules if payments to certain individuals aren’t structured properly. Here’s what you need to know to properly structure your compensatory arrangements in a manner that doesn’t trigger the 280G excise tax.
What’s a golden parachute payment?
First, let’s define “golden parachute” payment. The short version is that a “parachute payment” generally refers to a payment in the nature of compensation that’s contingent on a change in control. If the aggregate present value of an individual’s parachute payments equals or exceeds three times the individual’s “base amount,” the excise tax and deduction disallowance rules apply to the excess parachute payments. The rules set the base amount as the average includible compensation for the individual over the five most recent taxable years prior to the change in control (see below for more details).
These payments can include severance pay, transaction bonuses, prorated annual bonuses, acceleration of unvested equity, employer-paid COBRA premiums, continued fringe benefits, acceleration of unvested deferred compensation, etc. — the rules are broad in what they consider payments triggered by a change in control. When you start to consider the full range of payments that go to executives during a change in control, it’s easy to see how quickly these parachute payments add up.
Who’s a disqualified individual under Section 280G?
Now, let’s look at which executives and employees are considered “disqualified individuals” under the 280G rules, meaning that payments to them resulting from a change in control may be subject to Section 280G treatment. Generally, “disqualified individuals” are employees or independent contractors who fall into one of the following three categories at the corporation during the 12-month period preceding the closing of the transaction:
- Officers. The statute doesn’t specifically list which officers are covered, but it generally includes traditional C-suite roles (CEO, CFO, COO, etc.) and may extend to other employees based on the scope of their authority and responsibilities. In practice, a 280G analysis often starts with senior executives, including traditional officers, vice presidents, and employees who report directly to the CEO. The regulations apply a facts-and-circumstances test, so officer status depends on the substance rather than the title alone. Generally, at least three individuals (or, if greater, 10% of the corporation’s employees), but no more than 50, are treated as disqualified individuals by reason of officer status.
- 1% shareholders. Individuals who own more than 1% of the outstanding stock and perform services to the corporation are included under the 280G rules as well. For this purpose, unexercised stock rights (e.g., stock options) are taken into account in determining whether an individual is a 1% shareholder.
- Highly compensated individuals. Highly compensated individuals generally include the top 1% of the corporation’s highest-paid employees and independent contractors (with a minimum of one individual), which is determined based on compensation over the 12-month period preceding the change in control.
What’s a “change in control” under Section 280G?
Generally, there are three types of “change in control” that can trigger the application of Section 280G rules to executive payments. A change in control based on stock ownership occurs when any one person or group acquires ownership of stock in the corporation that represents 50% of the corporation’s total fair market value or 50% of its total voting power. A change in control based on asset ownership occurs when any one person or group acquires assets from the corporation equal to or exceeding one-third of the total gross fair market value of the corporation’s assets immediately prior to the transaction. A change in effective control can also occur when a majority of the board of directors is replaced within a 12-month period without the incumbent board’s endorsement.
How 280G calculations work: Base amount and 3x threshold
For employees, the base amount is based on the individual’s average annual includible compensation (generally W-2 Box 1 compensation, subject to certain adjustments) for the five taxable years preceding the change in control. Section 280G is triggered when any disqualified individual receives parachute payments in excess of three times this base amount. Once 280G is triggered, the excise tax and deduction disallowance apply to all payments that exceed the base amount, not just the portion of the payments that exceed the three-times-base-amount threshold. For example, suppose a disqualified individual’s base amount is $500,000, and the three-times-base-amount threshold is $1,500,000. If the disqualified individual receives $1,500,001 in parachute payments, the 20% excise tax would apply to $1,000,001, not merely the $1 in which the total exceeded the three-times-base-amount threshold.
What is a Section 280G analysis?
A Section 280G analysis is performed in connection with a potential change in control to:
- Identify disqualified individuals.
- Inventory all payments that may be contingent on the transaction.
- Calculate each individual’s base amount.
- Determine whether total payments exceed the three-times threshold.
- Quantify any excess parachute payments subject to excise tax and loss of deduction.
These analyses are typically performed during diligence and updated as deal terms evolve.
Are there any common pitfalls when it comes to parachute payments
When reviewing potential parachute payments, it’s best to take a conservative view.
For example, severance payments that aren’t planned at the time of the ownership change frequently give rise to 280G treatment. Many executives and other disqualified individuals initially plan to stay with the business after the change in control, so there may be no expectation at the time that an individual will terminate and be paid severance. However, the rules create a rebuttable presumption that severance paid within one year before or after the transaction is contingent on the change in control. Because there’s a risk that a disqualified individual may leave within the one-year window, it’s common practice to assume that a termination will occur, that severance will be paid, and to plan for the impact of 280G where applicable.
We’re also seeing more equity arrangements that include repurchase rights triggered by a termination of employment, particularly where the repurchase price is below fair market value. These provisions can cause rights that might otherwise appear vested to be treated as contingent compensation for Section 280G purposes, which can significantly affect the 280G analysis.
Finally, any agreements entered into or changes in salary or bonus in the year leading up to a change in control may also constitute parachute payments. This is also true where disqualified individuals negotiate an agreement with the buyer for post-change services. The analysis focuses on whether the arrangements are legally binding or reasonably anticipated, and whether the compensation reflects reasonable remuneration for post-change services. In practice, analyses often take a conservative view of draft or developing arrangements where the parties reasonably anticipate they will be implemented.
Ways to address or mitigate 280G exposure
Companies do have options for managing the 280G excise tax on golden parachute payments.
For private companies, the most commonly used mitigation technique is the shareholder approval process. Disqualified individuals at private companies can “put it to a vote.” They waive the right to payments in excess of the three-times-base-amount threshold, then the shareholders engage in what’s known as a “280G cleansing vote.” If the required shareholder approval is obtained, the waived payments may be restored and excluded from parachute payment treatment. However, if the vote comes up short of 75% of the voting power of the outstanding stock entitled to vote, the employee isn’t entitled to the waived parachute payments. An important nuance is that any shareholder who is a disqualified individual who receives, or will receive, parachute payments as a result of the change in control isn’t eligible to vote. This can pose an issue where significant shareholders are also receiving parachute payments. The shareholder approval exception is only available to privately held corporations and requires full disclosure of the payments to all shareholders entitled to vote.
Another option available to both public and nonpublic companies is to establish that some portion of the payments represents “reasonable compensation,” including, where appropriate, compensation for services to be rendered after the change in control or amounts properly allocable to a covenant not to compete.
Companies may also use contractual design features such as “cutback” provisions (reducing payments to avoid Section 280G) or “gross-up” provisions (reimbursing excise tax), though gross-ups have become less common.
Minimizing parachute payment penalties: Early awareness is key
The best way to keep your business from being subjected to the penalty taxes of IRC Section 280G is to plan for it as early as possible. If you’re planning a change in control as part of an exit strategy, be aware of these concerns at the outset and plan your compensation over the next few years accordingly. If you find yourself in the middle of an M&A transaction that you hadn’t planned for, raise these concerns as early as possible in the negotiations. The sooner you start to plan for parachute payment penalties, the easier it is to structure transactions that avoid or minimize them.
Key takeaways
- Golden parachute payments are compensation triggered by a change in control and may fall under Section 280G if certain thresholds are met.
- If Section 280G applies, excess payments are subject to a 20% excise tax and are nondeductible to the company.
- Because the rules are broad, many transactions can inadvertently create 280G exposure if payments aren’t reviewed during planning.
- The rules apply to disqualified individuals, including certain executives, shareholders, and highly compensated employees.
- Early evaluation and structuring of compensation can help reduce or avoid exposure to 280G penalties.
- For companies contemplating a transaction, early modeling and proactive structuring can materially reduce both tax exposure and deal friction.
280G analysis: Contact our authors
Are you anticipating or planning a transaction that could trigger Section 280G treatment? For guidance on managing the impact of IRC Section 280G excise taxes on your business, get connected with a member of our team — we’re here to help.
