The nature of the life sciences and technology industries often results in companies experiencing a lot of M&A activity. Due to this activity, in conjunction with the forms of compensation often paid to employees in connection with a deal—for example, the acceleration of stock compensation—Internal Revenue Code Section 280G is an important consideration in the context of a deal.
What Is Section 280G?
Section 280G regulates excess parachute payments and benefits, which are commonly referred to as golden parachute payments, made to certain executives, employees, or board members in connection with a change in control of a C corp. While partnerships, LLCs, and S corps are generally exempt from Section 280G, certain payments made by such entities may be subject to Section 280G if they’re made in connection with the change in control of a C corp.
Application to Life Sciences and Technology Companies
Growing life sciences and technology companies are often targets of mergers and acquisitions and throughout their life cycles these companies can experience multiple changes in control. Section 280G is an important part of deals that’s often overlooked until the final stages before closing—for example, upon request from a potential buyer—causing additional stress and unnecessary headaches. Being aware of 280G and its potential pitfalls during the early stages of your deal can help prevent any surprises or delays in closing.
What’s Considered a Change in Control?
For purposes of Section 280G, a change in control occurs when there’s an actual or effective change in control of the ownership or management of a corporation. This can include:
- A person or group of persons acquiring ownership of more than 50% of the fair market value or voting power of a corporation
- A change in ownership of a substantial portion of the assets of a corporation
- A person or group of persons acquiring 20% of the voting power of a corporation in a 12-month period
- A change in the majority of the board of directors in a 12-month period
A company should work with its legal counsel and tax advisors to determine whether a change in control has occurred under Section 280G in the context of any deal or restructuring described above.
How Are Change-in-Control Payments Taxed?
If a Section 280G analysis determines there are excess parachute payments paid or accrued as a result of a change in control, two provisions go into effect.
- Section 280G disallows the deduction to the corporation for any excess parachute payment paid or accrued
- The recipient of any excess parachute payments will be subject to a 20% excise tax on the amount of such payments under IRC Section 4999 in addition to any regular income tax or withholding
Who Is a Disqualified Individual Under Section 280G?
Section 280G applies only to disqualified individuals of the corporation under Section 280G. This list includes employees or independent contractors of the corporation who are also a shareholder, officer, or highly compensated individual.
The definitions of these three categories under Section 280G can be complex and based on facts and circumstances. Companies should work with tax advisors and legal counsel to determine and document who is a disqualified individual under Section 280G.
What Are Types of Parachute Payments?
A parachute payment is any payment made or accrued in the nature of compensation to a disqualified individual as a result of a change in control.
Examples of these types of payments can include:
- Retention bonuses
- Earnout bonuses
- Acceleration of vesting for equity-based compensation
- Severance payments
- Amounts paid pursuant to agreements within 12 months of the change in control
- Payments made under the Consolidated Omnibus Budget Reconciliation Act (COBRA)
Companies should carefully analyze employment agreements, stock award agreements, and deal terms to determine which payments might be considered a parachute payment.
Excess Parachute Payments
Once the parachute payments are identified, the company must determine whether any of the payments are considered excess parachute payments. As part of a Section 280G analysis, a calculation for each disqualified individual will be performed to determine which payments, if any, are considered excess parachute payments.
Excess parachute payments are aggregate parachute payments that exceed three times the base amount. The base amount is determined by the average of prior compensation received by the individual from the company in the five-year period before the change in control.
Companies can also rebut the general presumption that a payment is a parachute payment through an analysis of which payments are reasonable compensation for services to be provided after the change in control. This can include value assigned to noncompete agreements which constrain an individual’s ability to perform services after a change in control.
Exceptions to Excess Parachute Payments
Two common exceptions that make payments from corporations exempt from Section 280G are:
If a corporation could qualify as an S corp immediately before the change in control—even without electing to be taxed as an S corp—it can eliminate the need to perform a Section 280G analysis. This is an important exception for a small business—for example, a corporation owned by a small group of individuals—that can eliminate the need to perform a Section 280G analysis.
Corporations that Aren’t Publicly Traded
Another common exception to Section 280G applies when the company obtains shareholder approval of the excess parachute payments. This only applies to corporations that aren’t publicly traded and allows all payments waived by the disqualified individual and approved by shareholder vote to be exempt from treatment as an excess parachute payment. A company will still need to undergo a Section 280G analysis when obtaining shareholder approval as the company must disclose all material facts and payments made to a disqualified individual to properly effectuate the shareholder approval.
As public companies can’t avail themselves of the common exceptions listed above, it’s important that employment agreements are written in such a manner to consider the consequences of Section 280G. This can include claw-back provisions that put both the company and the disqualified individual in the best economic position after considering the impacts of any excess parachute payments.
We’re Here to Help
For guidance on determining disqualified individuals, identifying parachute payments, or calculating excess payments, contact your Moss Adams professional.
You can also visit our M&A Tax Services page for additional resources.