Section 280G and Parachute Payments: The Distraction In Your M&A Deal

Here’s a common scenario: Your company is a target in a transaction and the attorneys tell you a 280G analysis is needed relating to parachute payments — which may also require a shareholder vote. You’re told time is of the essence. You respond, “What the heck is 280G?”

You field data requests and questions from tax advisors and attorneys without really understanding how or why this information matters. Ultimately, the attorneys draft disclosures and shareholder documents and a “cleansing” vote is held. By this time, you may have spent tens of thousands of dollars on legal and accounting fees for this tax issue you had never heard of.

This provision of the tax code is notoriously complex and requires precise computations. Review this high-level framework to help understand the basic mechanics of Section 280G and its significance in an M&A transaction.

What is Section 280G and why does it matter?

Section 280G of the Internal Revenue Code has been in existence since 1984 and applies when “golden parachute” payments are made to executives at a corporation undergoing a change in control. If triggered, the result is:

1. A deduction disallowance at the organization making the disqualifying payments
2. A 20% excise tax imposed under Section 4999 on the individuals receiving the payments

However, exposure under Section 280G exists only if the aggregate value of the parachute payments equals or exceeds three times the individual’s base amount.

When is Section 280G applicable?

A parachute payment is any payment in the nature of compensation being made as a result of a change in control at a C corporation. Such a change occurs when greater than 50% of the corporation’s stock (measured by value or voting power), or one-third or more of its assets (measured by total gross fair market value), is acquired by another person. Some common types of parachute payments are cash transaction bonuses, severance payments, and the acceleration of equity-based compensation.

In practice, identifying all parachute payments (and their values) can be a moving target. As a deal progresses, the payments may change a number of times. With each iteration, the payments must be tested against Section 280G, and there are times the payments change because of Section 280G.

C corporations may not be the only entities affected

While partnerships and S corporations are generally exempt from Section 280G, disqualifying payments made by an entity other than a C corporation must still be considered if the payments relate to a change in control at a C corporation.

Commonly, Section 280G is implicated when a C corporation that’s wholly owned by a partnership undergoes a change in control and parachute payments are paid by the partnership to individuals at the subsidiary C corporation.

C corporations that could elect S corporation status should take note

An often-overlooked provision in Section 280G regulations exempts C corporations that would be eligible to elect S corporation status at the time of the change in control — even if no such election was made. This may be applicable in a professional services setting where shareholders tend to be individuals (one of the primary requirements for electing S corporation status is that the shareholders must be U.S. resident individuals, with some limited exceptions).

When evaluating the impact of Section 280G, review the target corporation’s capitalization table to determine whether the company may be an exempt entity.

Parachute payment recipients must be disqualified individuals

For Section 280G to apply, the individuals receiving the parachute payments must be disqualified individuals, which includes employees or independent contractors of the corporation who are also one of the following:

1. Officers of the corporation
2. Highly compensated individuals of the corporation
3. 1% shareholders of the corporation

How is Section 280G measured?

Section 280G is only triggered if the aggregate value of all parachute payments equals or exceeds three times the disqualified individual’s base amount. If the value of all parachute payments is below this threshold, Section 280G does not apply.

Base amount looks back five years

The base amount is the disqualified individual’s average annualized taxable compensation from the corporation undergoing the change in control (or an affiliated entity) for the five taxable years preceding the year in which the change occurs. For this purpose, analyze taxable wages reported on Forms W-2 and contractor payments reported on Forms 1099.

Valuing parachute payments

Parachute payments are measured by their present value at the time of the change in control. Therefore, present value computations may be necessary for payments that are being accelerated or deferred.

Accelerated equity vesting

The Section 280G rules provide a favorable discounted value methodology for the acceleration of purely tenure-based vesting (often referred to as “24(c) value” on account of its cite in the regulations). If it applies, this provision has the potential to significantly reduce the value of accelerated equity (and thereby its Section 280G parachute value) below its full intrinsic value.

Reasonable compensation exception

An important exception to the definition of a parachute payment is any amount established by clear and convincing evidence as reasonable compensation for services to be performed on or after the date of the change in control. This might apply when target employees are going over to the acquiring entity with an increase in compensation.

Regulations also provide that reasonable compensation includes refraining from the performance of services. Therefore, value ascribed to a noncompete agreement might result in a reduction of parachute payments. When seeking to reduce or eliminate parachute payments under the reasonable compensation exception, work with your tax advisor to perform a compensation study.

The 12-month presumption

Any payment made pursuant to an agreement entered into within one year preceding the change in control is presumed to be contingent on the change, unless the contrary is established by clear and convincing evidence. This presumption can have broad consequences and pull in amounts provided for under agreements entered into months before a transaction was ever contemplated.

Excess parachute payments

If the present value of all parachute payments equals or exceeds the disqualified individual’s three-times base amount, the result is referred to as an “excess parachute payment.” The excess is measured by the value of the payments over one-time the base amount rather than the three-times base amount that determines whether Section 280G is triggered. It’s this excess that is subject to the deduction disallowance and 20% excise tax.

Examples

Example 1. X Corp is being acquired in a deal where Buyer is purchasing 100% of X Corp’s stock. X Corp pays CEO a cash bonus of $1.5 million and accelerates stock options worth $200,000 as part of the transaction; thus, CEO’s total parachute payments equal $1.7 million. Assume CEO’s base amount is $600,000.

In order to have Section 280G exposure, the total parachute value must equal or exceed three times the base amount of $600,000, or $1.8 million. Because total parachute payments are less than the three-times base amount, CEO’s parachute payments are not impacted by Section 280G. Therefore, there is no deduction disallowance for the parachute payments and no excise tax imposed on CEO.

Example 2. Assume instead that CEO’s base amount is $400,000. The three-times base amount safe harbor is now $1.2 million. Since this is less than the parachute payment value of $1.7 million, Section 280G is now triggered.

The resulting excess parachute payment is $1.3 million ($1.7 million of parachute payments less CEO’s base amount of $400,000). The $1.3 million is disallowed as a deduction at X Corp and CEO is subject to an excise tax of 20% of the $1.3 million, or $260,000.

How can you address Section 280G exposure?

Private companies

The regulations offer a powerful mechanism for privately held corporations to eliminate Section 280G. Such corporations can vote away the impact of Section 280G using what’s referred to as a cleansing vote.

Under this procedure, the parachute payments can escape Section 280G if the payments are approved by more than 75% of the voting power of the corporation’s outstanding stock. For this purpose, shareholders who are disqualified individuals receiving parachute payments (and certain related persons) cannot take part in the vote and their stock is not counted in the 75% test.

Although the cleansing vote can eliminate Section 280G’s consequences, it’s not without risk. The regulations provide that the cleansing vote must determine the right of the disqualified individual to receive the payments. In other words, if greater than 75% of the shareholders do not vote in favor, then the payments may be forfeited completely. Consequently, it’s important to assess whether the payments are being put to a “friendly vote” when using the private company voting exemption.

Public Companies

Since public companies cannot use the cleansing vote procedure, they must deal with Section 280G in a different manner. Of course, the corporation and disqualified individuals can simply choose to accept the deduction disallowance and excise tax.

More common, however, is the use of a “better off” agreement, which allows disqualified individuals to choose one of the following options that puts them in the best economic position:

1. Paying the 20% excise tax
2. Reducing their parachute payments by an amount that will put them below the three-times base threshold (commonly referred to as a claw-back provision)

SEC reporting rules require publicly traded corporations to have a significant amount of detail and disclosure in relation to the payments, which makes a well-documented Section 280G study all the more critical in the public company setting.

How we can help

Section 280G is a complex set of rules and is usually compounded by the rush of the typical M&A transaction. A comprehensive and precise analysis is critical when dealing with this issue, as is close collaboration among the target, its tax advisors, and its attorneys.

CLA’s team of professional advisors can guide you through the entire transaction process and help you understand how Section 280G may impact your M&A deal.