Trent Dykes and Kerra Melvin

Selling your company can be an exciting and overwhelming process. In addition to the complexity of negotiating the terms of your merger or asset sale, you will inevitably be bombarded with tons of deal-related jargon. Enter one such term, Internal Revenue Code (IRC) Section 280G (280G) or the “golden parachute payment” rules, a federal tax provision that comes into play when there is a change in control of a corporation. 280G impacts both the corporate entity and its executives, shareholders, and other “highly compensated individuals” associated with the corporation and imposes harsh tax consequences if not properly addressed. This post will provide a high-level summary of 280G, discuss when 280G applies, ways to avoid 280G liability, and how to calculate individual tax liability (under IRC § 4999) if 280G does apply.

What is 280G?

Generally, compensation payments made by a corporation to employees, officers, and directors are deductible by the corporation for tax purposes. However, 280G disallows a tax deduction for certain compensation payments made to “disqualified individuals,” such as officers, shareholders, and “highly compensated individuals,” when the compensation is paid pursuant to a change in control. The disallowance does not apply to every compensation payment made pursuant to a change in control. Instead, the deduction is only disallowed if the compensation paid is deemed an “excess parachute payment” under 280G. In addition to disallowance of the corporate compensation tax deduction, under IRC § 4999, a person who receives a “parachute payment” will be required to pay a 20% excise tax on the amount of the payment that is an “excess parachute payment.” This 20% tax must be paid in addition to the standard income and payroll taxes paid on the compensation. The crux of the 280G analysis is determining when compensation is considered a “parachute payment” for purposes of 280G.

When does 280G apply?

280G generally applies to compensation-related payments if:

(1)   the payments are made to a “disqualified individual”;

(2)   the payments are contingent on a change in control; and

(3)   the amount of the payment equals or exceeds three times the disqualified individual’s average annual compensation from the corporation (or its related entities) for the five years preceding the year of the change in control. The period consisting of the most recent five taxable years ending before the date the change occurs is called the “base period.” The individual’s average annual taxable compensation during the base period is termed the “base amount.”

Who is a “disqualified individual”?

280G only applies if payments are made to a “disqualified individual.”  Disqualified individuals include individuals who perform services for the corporation and qualify as:

(1)   an officer;[1]

(2)   a shareholder;[2] or

(3)   a “highly compensated individual.”

To be considered a “highly compensated individual,” the person must:

(1)   have an annual salary of at least $115,000;[3] and

(2)   be a person who is a member of a group consisting of the highest paid 1% of the employees of the corporation or, if less, the highest paid 250 employees of the corporation.

How do you determine whether a payment is contingent on a change in control?

280G does not apply unless payments made to disqualified individuals are contingent on a change in control. A payment will be contingent on a change in control if the payment would not, in fact, have been made had no change in control occurred. A payment that would in fact have been made had no change in control occurred is also treated as contingent on a change in control if the change in control accelerates the time at which the payment is made. Thus, for example, if a change in control accelerates the time of payment of deferred compensation that is vested without regard to the change in control, the payment may be treated as contingent on the change.

Payments made pursuant to an agreement or an amended agreement entered into within one year before the change in control are presumed to be contingent on the change in control unless the taxpayer establishes otherwise by clear and convincing evidence. This one-year look-back period was put in place to deter the use of raises, bonuses, plan amendments, and other planning devices shortly before a change in control. Payments made in connection with an event that is considered closely associated with a change in control, such as a termination of employment as a result of the change in control, will also be deemed payments contingent on a change in control.

The amount of a payment subject to tax can be reduced if the disqualified individual can prove that all or part of the payments in excess of base amount constitutes reasonable compensation for services rendered prior to the change in control. The taxpayer has the burden of proving this by clear and convincing evidence. Note that severance payments are never considered to be reasonable compensation for services actually rendered before or to be rendered after the change in control.

What types of payments may constitute parachute payments?

Payments in the nature of compensation that may constitute a change in control payment (i.e., “parachute payments”) may include, among other things:

  • bonuses (stay bonuses, retention bonuses, performance-based bonuses, etc.);
  • severance pay;
  • continuation of welfare or fringe benefits;
  • success fees or transaction bonuses;
  • accelerated vesting or distribution of pension benefits and other deferred compensation;
  • outplacement benefits;
  • stock options;
  • restricted stock, phantom stock or stock appreciation award;
  • payments that violate any generally enforced securities laws or regulations;
  • other forms of compensation;
  • benefits and severance provided under employment agreements entered into coincident with, or as a condition to, the change in control closing – or payments result from a subsequent termination of employment;
  • equity or option grants made within 12 months prior to the change in control closing;
  • increases in compensation as a result of the change in control; or
  • amendments made to employment agreements within 12 months prior to closing. [4]

What are the exceptions to 280G liability?

Payments not large enough to come within 280G. If the current payments and the present value of future payments do not equal or exceed three times the disqualified individual’s base amount, then the earnings will not constitute “parachute payments” subject to 280G.

Example: If current and future payments total $2 million and the disqualified individual’s base amount is $750,000, then the $2 million in payments is only 2.67 times the disqualified individual’s base amount and therefore not subject to 280G.

Subsidiaries. A sale of a wholly-owned subsidiary will not result in a change in control of the parent corporation unless the change involves a substantial portion of the parent corporation’s assets or a change in the effective control of the parent corporation.

Employee benefit plan exception. Payments made pursuant to the terms of the following types of plans are not subject to the rules governing golden parachute payments:

(1)   qualified retirement plans;

(2)   IRC § 403(a) annuities;

(3)   simplified employee pensions; and

(4)   simple retirement accounts.

S corporation exception. 280G does not apply if the company is an S corporation.

Shareholder approval exception. Disqualified individuals can avoid 280G liability if 75% of the disinterested shareholders approve the payments.  This exception is the most commonly utilized exception by startups and venture-backed companies. To avoid rules governing excess parachute payments using shareholder approval, the following must be met:

(1)   the stock of the corporation must not be readily tradeable on an established securities market or otherwise;

(2)   more than 75% of the disinterested shareholders must approve the golden parachute payments;[5] and

(3)   all persons entitled to a vote must receive adequate disclosure of all material facts concerning all material payments constituting parachute payments to disqualified individuals.

The disinterested shareholder voting requirement means that none of the shareholders who will be receiving parachute payments will be included in the vote on the payments. This requirement also excludes any shares that are beneficially owned by the shareholder (i.e., shares held by spouses, descendants, and controlled entities).

How are the additional tax and the disallowed deduction calculated if 280G and § 4999 apply?

An “excess parachute payment” subject to the 20% excise tax under IRC § 4999 equals the aggregate amount of the parachute payments in excess of the disqualified individual’s base amount. The corporation must withhold the 20% excise tax.

Example: Executive A has a base amount of $640,000 and payments pursuant to change with a total present value of $2,184,000. Taking $2,184,000 divided by $640,000, we reach a ratio of 3.4125. Since the payments pursuant to change are greater than or equal to three times the base amount, the payments are deemed “parachute payments.”

To calculate the “excess parachute payment” subject to the 20% excise tax, we take the total parachute payments of $2,184,000 less the base amount of $640,000, which is $1,544,000. The excess parachute payment of $1,544,000 is multiplied by the 20% excise tax rate to reach an additional tax liability under IRC § 4999 of $308,800. The tax will be due when the amounts are paid. Alternatively, the taxpayer can elect to prepay the § 4999 excise tax on future payments.

The corporation’s deduction mirrors the disqualified individual’s additional tax and is taken in the year the parachute payment is made. In our example, the deduction is disallowed for the $1,544,000 excess parachute payment, so ABC, Inc., will be  allowed a deduction for $640,000 of the $2,184,000 payment (assuming the full parachute payment is a current payment), or 29.3% of the total payment.

Please note that this post was not drafted as a complete analysis of 280G or the legal issues associated with a change in control. The tax regulations governing 280G and IRC § 4999 are highly complex and subject to change.  Companies or individuals faced with a potential 280G issue should consult with their attorneys and/or tax advisors immediately.

[1] If a corporation has 30 or fewer employees, the maximum number of “officers” for 280G purposes is three; if the company has between 31 and 500 employees, no more than 10% of the employees will qualify as officers; if the corporation has more than 500 employees, the maximum number of officers is 50. However, even if an individual is not considered an “officer” based on these rules, they may still be a “shareholder” or “highly compensated individual” under 280G. 26 C.F.R. § 1.280G-1, A-18(c).

[2] Only an individual who owns stock of a corporation with a fair market value that exceeds 1% of the fair market value of the outstanding shares of all classes of the corporation’s stock is treated as a disqualified individual. An individual who owns a lesser amount of stock may, however, be a disqualified individual with respect to the corporation if such individual is an officer or highly-compensated individual with respect to the corporation. 26 C.F.R. § 1.280G-1, A-17(a).

[3] Amount for 2012. See IRC § 414(q) to determine the applicable threshold for the year in which the change in control occurs.

[4] To determine the total value of the payments, you must include the sum of all current payments (payments made at the time of change) plus the present value of all future payments (payments scheduled to be made after the change). The present value of future payments is determined using a discount rate equal to 120% of the applicable federal rate, compounded semiannually.

[5] The vote must determine the right of the disqualified individual to receive the payment, or, in the case of a payment made before the vote, the right of the disqualified individual to retain the payment. Therefore, the disqualified individual must irrevocably waive his right to the excess payments or benefits and subject them to shareholder approval.