Golden Parachutes and Section 280G - An Overview And Practice Tips

            Section 280G of the Internal Revenue Code was enacted by Congress in 1984 to address a perceived concern that executives were being paid lavishly in connection with a change of control of their companies, and that this was inappropriate and should be curbed because shareholders were ultimately bearing the cost of so-called golden parachute payments.  As with many Congressional mandates that, through the tax code, attempt to limit or change behavior, Section 280G of the Code has had minimal actual effect in significantly reducing the size of golden parachutes payments to senior executives in M&A transactions for various reasons.  During the first 20 or so years that the statute was in effect, so-called “280G gross-ups” were prevalent, and these completely sheltered executives from the effects of the 20% excise tax imposed under Section 4999 of the Code (although gross-ups cost corporations and their shareholders because of the loss of deduction imposed by Section 280G the Code, plus the additional payments required to make executives whole under the terms of the gross-ups).  The 280G gross-ups that had been commonplace have now fallen out of favor with corporations because shareholder/proxy advisory firms such as ISS during the last 10 or so years have been extremely vocal regarding their displeasure with gross-ups.  It is now quite uncommon to see a public (or private, for that matter) company with 280G gross-ups in place for their executives in the current landscape (although some grandfathered arrangements still exist).  Because of this, sophisticated counsel, consulting and accounting experts have carefully considered the intracacies of the various exceptions contained in the 280G regulations that permit certain payments of compensation that will not count toward the Section 280G limits.

            Section 280G and its analogue Section 4999 of the Code, deny a corporate deduction for, and impose a 20% excise tax upon a disqualified individual for, respectively, any “excess parachute payment.”  These rules are incredibly complex and defy a precise, accurate description without pages of explanation, but for purposes of this brief article, an excess parachute payment is the excess of any “parachute payments” made to certain executives/individuals that are contingent on a change in control of their corporation over their “base amount,” which is generally the average annual total W-2 compensation earned by the executive over the previous 5 years ending on the year before the year of the consummation of the change in control.  A parachute payment is any payment in the nature of compensation to a so-called “disqualified individual” (discussed below) if the payment is contingent on a change in ownership or effective control of a corporation and if the aggregate present value of the payment exceeds 3 times the executive’s base amount.  Importantly, LLCs that are taxed as partnerships and other disregarded entities for tax purposes (such as subchapter S corps) are exempt from the 280G rules — these rules ONLY apply to corporations.

            So-called disqualified individuals are employees or independent contractors who are also officers, shareholders or highly compensation individuals in respect of the corporation.  For this purpose, whether someone is an “officer” is based on a facts and circumstance test (nature and extent of duties and authority).  There is a presumption (although rebuttable) that an individual who is an officer of a public company is an “officer” for this purpose.  No more than 50 employees may be treated as a disqualified by reason of being an officer.  A “highly compensation individual” is a person who would be among the highest paid 1% of all employees of the corporation, but this number is capped at 250 people.

            A common misperception under Section 280G is that all payments received by disqualified individuals in connection with a change in control transaction are applicable payments for purposes of the excess parachute calculation.  This is not true.  Only payments that are contingent on the change in control  transaction are counted toward this calculation — so that only payments that are not substantially certain to have been made unless the M&A transaction occurred are considered applicable payments.  For example, vested stock options, even if fully cashed-out on the change in control, DO NOT count toward the calculation of a parachute payment.  However, an unvested payment that becomes vested as a result of the M&A transaction is treated as not substantially certain to have been made for this purpose.  Also, certain payments will not be considered parachute payments at all if they can be shown to constitute reasonable compensation for services to be performed AFTER the transaction (see, e.g., Pasini Law LLC article entitled “Restricted Covenants in Executive Compensation - A Silver Lining For Executives?”).  Other payments will reduce the amount by which a parachute payment is considered an to be an excess parachute payment (i.e., it will count toward the 280G calculation but will reduce the excess amount) if it can be shown to constitute reasonable compensation for services performed before the change in control   An event is presumed to be treated as occurring as a result of the M&A transaction if it occurs within the period one year prior to through one year after the closing of the deal.  Once it is determined that the transaction is a “change in control” transaction under Section 280G, the types of payments are parachute-type payments and the individuals are disqualified individuals, then calculations must be performed in order to assess the magnitude, if any, to which such payments exceed 3 times the executive’s base amount.  These 280G calculations are extremely complex and detailed and are almost always performed by consulting firms or accountants specializing only in this field.

            An important practice tip for public company executives regarding your base amount: try to increase your base amount in the years before any change in control transaction is even considered.  This sounds both obvious and simple, but it actually takes thought and planning to systematically attempt to increase your base amount.  Every individual situation is different, and there are many ways to accomplish this (speak with your tax advisor), but one way would be to consider exercising more of your vested options each year when you’re not in a blackout period.  You could consider retaining the stock after exercise to get the hoped-for future appreciation of your company’s equity value (which appreciation after exercise would be taxed at a capital gains rate rather than an ordinary income rate if you had not exercised), and you will be building up your base amount by simply exercising the options that you otherwise would not have exercised until the end of the option period, because ordinary W-2 income is recognized at the time you exercise your options.  This will have the effect of building up your base amount over time and thereby decreasing the amount by which you would be “over the limit” when the time comes for the 280G calculations.  

            Another widely used exception to 280G is the so-called shareholder approval exception.  This can ONLY be used by privately held corporations.  If shareholder approval is properly obtained, this will completely inoculate the corporation from the loss of deductions under Section 280G and the executives from the excise tax.  The shareholder approval rules are also exceedingly complicated, but in a nutshell, Section 280G will not apply to payments made by privately held corporations if the payments meet the shareholder approval requirements, which are, very generally speaking: (1) the payments to executives must be contingent on a separate shareholder vote approving the parachute payments itself (this will generally require waivers from the executives for the amounts that are over the 280G limit if the shareholder approval is not obtained), (2) the 280G shareholder approval must not be linked or otherwise contingent on the approval of the transaction itself, (3) the payment is approved by persons owning at least 75% of the stock of the corporation (by vote) and (4) there is adequate disclosure to all shareholders who are entitled to vote (i.e., not just to the 75%) of all material facts concerning the payments.  Practice tip: Section 280G cut back agreements (not better after-tax agreements but full cut-backs) have been used in cases where large shareholders, who were also disqualified individuals and who otherwise would not have been permitted to vote on the transaction because they would have been over the limit, were permitted to vote because the full cut-back agreement ensured that these individuals would not be receiving parachute payments in connection with the deal.

            Pasini Law LLC is expert in Section 280G matters and is a thought leader in this area.  Please feel free to contact the Firm about your potential 280G issues in connection with M&A transactions.