An M&A transaction can trigger Internal Revenue Code (IRC) Section 280G regulations. Learn more about Section 280G golden parachutes—and the relevant tax considerations—below.
What Is a Section 280G Golden Parachute?
The term golden parachute refers to financial compensation or contracts with key executives and are connected to a transaction or takeover attempt.
While Section 280G is titled Golden Parachute Payments, this isn’t a defined or technical term in the IRC or Treasury regulations. The terms defined in Section 280G are:
- Excess parachute payments
- Parachute payments
Why Is Section 280G Important?
Section 280G was initially implemented to prevent abuses in management compensation practices and protect shareholders from management depriving shareholders of transaction gains.
When a company is looking to undergo a transaction that could constitute a change in control, Section 280G is an important consideration. If the company has parachute payments that rise to the level of excess parachute payments, the company won’t get a tax deduction for those excess payments. Additionally, the individual receiving the payments will be subject to a 20% excise tax on the payments received, in addition to other applicable federal and state income taxes.
What Are the Differences Between Parachute Payments and Excess Parachute Payments?
A parachute payment, as defined in Section 280G, is a compensatory payment made to certain disqualified individuals if both of the following are true:
- The payment is contingent on a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation.
- The payment equals or exceeds three times the base amount. Generally, the base amount is the average W-2 or 1099 compensation from the past five years.
What Constitutes a Disqualified Individual for Section 280G Golden Parachutes?
The term disqualified individual under Section 280G generally includes an employee, independent contractor, or other person providing services for a corporation that falls into one or more of the following groups.
- An officer of the corporation; determined based on the facts and circumstances such as the source of the individual’s authority and duties. Note that a person with the term officer in their title is presumed to be one.
- A shareholder who, including constructive ownership, owns stock in the corporation worth more than 1% of the fair market value of all outstanding shares.
- A highly-compensated individual; those who are among the highest paid 1% of the corporation
What Are Some Examples of Golden Parachute Payments?
Some common examples of golden parachute payments include the following.
- Equity compensation, such as stock options or restricted stock, where vesting accelerates upon a change in control
- Transaction bonuses
- Retention bonuses
- Severance payments or related benefits
- Management incentive plan payments
- Increases in compensation pursuant to an agreement within 12 months of the change in control
What Are the Section 280G Regulations?
Treasury regulations are tax regulations issued by the IRS. Treasury Regulation Section 1.280G-1 is the only regulation under Section 280G currently. This regulation is formatted as 48 questions with answers and examples of how to apply Section 280G.
What Are Section 280G Exceptions?
In general, there are five types of payments exempt from parachute payment taxes in the 280G regulations.
- Payments from an S corporation or a company that could qualify as an S corporation immediately before the change in control
- A non-public corporation that obtains shareholder approval
- Payments to or from a qualified plan
- Certain payments made by certain tax-exempt organizations
- Certain payments of reasonable compensation for services to be rendered on or after a change in control
Can the Section 280G Golden Parachute Excise Tax Be Mitigated?
The 20% excise tax will apply to the parachute payments. The most common way private companies mitigate it is following the process in the Section 280G regulations to obtain shareholder approval of these payments. This generally includes all of the following:
- The individuals waiving their right to the payments, meaning subjecting payments they’re otherwise entitled to receive is to be up for vote by the shareholders
- The details of the payments being disclosed to all shareholders
- At least 75% of shareholders, excluding those with excess parachute payments, approving the payments
There are also times when obtaining the 75% approval from shareholders may not be possible or practical. For example, when there are several individual shareholders and management doesn’t feel confident enough individuals will approve the payments.
In this case, the individual may benefit from giving up a portion of the payments or having a clawback provision in payment agreements, so they won’t have excess parachute payments.
For example, if a disqualified individual had a base amount of $100, three times the base amount would be $300. If that individual was entitled to $320 of payments, $220 would be subject to the 20% excise tax, which would be $44.
Alternatively, if the individual could give up their rights to $21 of that payment such that the payments received were $299, the excise tax wouldn’t apply, and the individual would end up with more net cash.
How Does Section 280G Affect M&A Transactions?
Section 280G is a common issue affecting corporations in M&A transactions. The seller, and buyer in cases where retention of key employees is important, will want to ensure the compensatory plans in place for key employees benefit those employees in a way that isn’t subject to an overly heavy tax burden.
Those payments lose value to employees when they’re subject to around 70% tax, assuming the 20% excise tax on top of the 37% federal tax and, for this example, assuming a state tax rate of 13%.
The corporation will have an interest in making sure it’s allowed a tax deduction for any of the payments made.
What Transactions Can Trigger Section 280G?
Parachute payments include those paid to a disqualified individual if such payment is contingent on any of the following conditions.
A Change in Ownership of the Corporation
When a person or group of persons acquires stock that exceeds 50% of fair market value or total voting power of the stock.
A Change in Effective Control of the Corporation
This can happen when either:
- Any one person or more than one person acting as a group, acquires in a 12-month period 20% or more of the total voting power of the stock of the corporation
- A majority of members of the corporation’s board of directors is replaced during any 12-month period when not endorsed by a majority of the members of the corporation’s prior board of directors
A Change in Ownership of a Substantial Portion of the Corporation’s Assets
When there’s a change in ownership of the corporation’s assets that equals or exceeds a third of the fair market value of all corporation assets during a 12-month period.
How Can Shareholders Vote on Section 280G Effects?
For private companies, there‘s an option to undergo a shareholder approval process for payments and exempt those payments from Section 280G. This requires each of the following:
- Individuals receiving the payments waive their rights to such payments
- Details of the payments are adequately disclosed to all shareholders
- Payments are approved by more than 75% of the voting power of all outstanding stock, excluding those shareholders receiving parachute payments
Can Section 280G Cause Due Diligence Issues?
A buyer usually cares about Section 280G during due diligence for the following reasons:
- If the corporation will take a tax deduction for payments made, the buyer will want to ensure it’s an allowed deduction and not creating a historical tax exposure they may be liable for.
- If the 20% excise tax applies to employees, the corporation is required to withhold the excise tax. The buyer will want to ensure it won’t be liable if there was a failure to withhold these amounts.
We’re Here to Help
For guidance exploring Section 280G golden parachute guidelines and requirements, reach out to your Moss Adams professional.
You can find additional resources at our M&A Tax Services webpage.