Could the sale of your business trigger “golden parachute” penalties?
Internal Revenue Code Section 280G was intended to penalize excessive payouts to executives in certain M&A transactions. However, it can create traps for the unwary in more common corporate succession plans. Here’s what you need to know.
Sec. 280G imposes a 20% excise tax to the recipient of excess parachute payments, in addition to, any ordinary taxes owed on the compensation. In addition, the amounts paid to the individual are nondeductible.
Because the rules apply to all Subchapter C corporations, many of today’s transactions, including potentially those C corporations held by a partnership, run the risk of inadvertently violating these 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 parties aren’t treated 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.
Many of today’s transactions, including potentially those C corporations held by a partnership, run the risk of inadvertently violating these rules if they aren’t tested for compliance during the negotiation process.
What’s a parachute payment?
The short version is that a parachute payment is any payment in the nature of compensation to, or for the benefit of, a “disqualified individual” if:
- The payment is contingent on a change in ownership or effective control of the corporation, or a change in ownership of a substantial portion of the assets of the corporation.
- The aggregate present value of all such payments to the individual equals or exceeds three times a “base amount” described in the statute.
These payments can include severance pay, transaction bonuses, pro-rated annual bonuses, acceleration of unvested equity, COBRA premiums paid by employer, auto allowance, acceleration of unvested deferred compensation, etc. — the rules are pretty broad in what they will consider as payments triggered by a change in control. When you start to consider the full range of payments that go to executives in the course of a change in ownership, it’s easy to see how quickly these parachute payments add up.
Who’s a disqualified individual?
Generally, “disqualified individuals” are employees or independent contractors who are officers, shareholders, or highly compensated individuals of the corporation during the 12-month period preceding the closing of the transaction.
The statute doesn’t list out which officers are subject to the rules, but it generally includes the traditional C- level officers (CEO, CFO, COO, etc.) and may extend to other employees depending on the source and scope of the employee’s authority. The test is a “facts-and-circumstances” analysis of an executive’s responsibilities, so a CEO can’t carve out an exclusion by using a less formal title.
Shareholders who own more than 1% of the outstanding stock and perform services to the corporation are included under the 280G rules as well. “Highly compensated individuals” at any business will be the top 1% highest paid employees and contractors for 280G purposes.
What’s a “change in control?”
Generally, a change in control based on stock ownership occurs when any one person or group acquires ownership of stock in the corporation that represents either 50% of the total fair market value or 50% of the total voting power of the corporation. A change in control based on asset ownership occurs when any one person or group acquires assets from the corporation equal to or more than the value of one-third of the total gross fair market value of the corporation’s assets immediately prior to the transaction.
How much is “three times the base amount?”
For employees, the base amount is the average of their wages reported in box 1 of the Form W-2 (or Form 1099) over the last five years. Sec. 280G is triggered when any disqualified individual receives parachute payments in excess of three times this base amount. Where 280G is triggered, the excise tax and deduction disallowance apply to the payments in excess of the base amount, not just the payments in excess of 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 be on $1,000,001 ($1,500,001 - $500,000) and not on just the $1.
Can this tax be mitigated?
Companies do have some options when it comes to managing the 280G excise tax on parachute payments. Disqualified individuals at privately held companies can, for lack of a better term, “put it to a vote.” They waive the right to payments in excess of the three times base amount threshold, then the “disinterested shareholders” (those who aren’t disqualified individuals) engage in what is known as a “280G cleansing vote.” If 75% of the disinterested shareholders approve, the excess parachute payment is returned to the individual and it’s no longer subject to the excise tax. However, if the vote comes up short of 75%, the employee isn’t entitled to the waived parachute payments.
Companies do have some options when it comes to managing the 280G excise tax on parachute payments.
Another option available to both public and nonpublic companies is to argue that at least some of the excess parachute payments should be classified as “reasonable compensation.” One of the most common examples of compensation that can be reclassified at a change in ownership is payment for a covenant not to compete. Payments like these will require an independent valuation to establish their value within the total amount paid to the disqualified individual.
Early awareness is key
The best way to keep your business from being subjected to the penalty taxes of IRC Sec. 280G is to plan for it as early as possible. If you’re planning a change in ownership 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.
For more information about how to plan for IRC Sec. 280G excise taxes, please contact Plante Moran.