Key Takeaways
- Section 280 G’s purpose: §280G/§4999 are designed to limit excessive “golden parachute” payments to top executives in M&A transactions by denying corporate tax deductions for excess parachute payments and imposing a 20% excise tax on executives who receive such payments.
- Applies to key individuals: The rules apply only to Disqualified Individuals, meaning senior executives, significant shareholders (e.g., >1% owners), and other highly compensated individuals in a company.
- Parachute payments defined: Parachute payments are payments contingent on a change in control and that are made to a Disqualified Individual, but only if the total of such payments has a present value that exceeds 3× the individual’s base amount.
- Base amount and three times threshold: An individual‘s base amount is the average annual taxable pay over the prior five years (or fewer, if they didn’t work for the company over the previous five years). The golden parachute threshold is three times the base amount.
Section 280G of the Internal Revenue Code is a tax provision aimed at curbing excessive payouts (i.e., golden parachute payments) in connection with a merger or acquisition of a U.S. or non-U.S. company. Congress passed §280G in the 1980s to address perceived excesses in golden parachute payments during corporate takeovers. Today, §280G provides a detailed and complex framework around the tax treatment of golden parachute payments and includes thresholds for determining whether there are excessive payments that result in excise taxes. This article provides an overview of §280G, explains its key definitions and how it works, and provides some practical examples to illustrate the rules. This is the first in a series of articles on §280G; subsequent articles will zoom into and explore some of the topics discussed here in greater detail.
Overview of §280G
Section 280G was established to discourage excessive deal-related compensation paid to top executives upon the occurrence of a significant corporate event, such as a merger or change in control. It is often triggered when a company is acquired. Still, it does not apply to partnerships and S corporations (or companies that could elect to be an S corporation even if they have not elected to be one). A critical implication of §280G is that if payouts to key executives are deemed “excessive” under the rules, the buyer is not permitted to deduct those payments because they are not considered reasonable compensation. Additionally, the executive receiving an excess parachute payment faces a punitive excise tax under §4999, which imposes a 20% excise tax on the excess amount defined below. The combined effect of these provisions is to discourage large change-in-control payments by making them costly to the buyer and the senior executives receiving the payments.
Who Is Impacted by §280G?
Not every employee is subject to §280G. The rules apply only to “Disqualified Individuals,” which generally include a corporation’s most senior personnel. Under §280G, a Disqualified Individual is any person who performs services for a company, including both employees and independent contractors, and who is an officer, shareholder, or highly compensated individual of that company. In practice, this typically means the following people:
- Senior executives and officers such as the CEO, CFO, etc.
- Significant shareholders (i.e., greater than 1% stock ownership) that are also employees or independent contractors of the company.
- Highly paid individuals in the company (generally those in the top 1% of employees or the top 250 employees, whichever group is smaller).
What Are Excess Parachute Payments?
To define an excess parachute payment, we first need to define a parachute payment. The term “parachute payment” has a very specific definition in §280G. In simple terms, a parachute payment is any payment in the nature of compensation made to a Disqualified Individual that is contingent on a change in ownership or control of the company, and the total of all such change-in-control payments to that person has a present value of at least three times their base amount. The “base amount” generally includes the average of a Disqualified Individual’s cash compensation over the five years preceding the change in control, including cash bonuses and other benefits. If the aggregate present value of the parachute payments is less than three times (3×) the base amount, then none of the payments are considered parachute payments under §280G. If the three-times threshold is met or exceeded, then all of the change-in-control payments are considered parachute payments.
- "Contingent on a change in ownership or control" means an event like a merger, acquisition or significant sale of company assets triggers the payment. For example, this includes severance that is paid only if a takeover happens, and a bonus to a disqualified individual when the company is acquired. There is a presumption that any contract made or amended within one year before a change in control is contingent on that change, unless the facts and circumstances indicate otherwise. If the payment had been made regardless of an acquisition, then it is generally not considered a parachute payment.
- "In the nature of compensation" means the payment is compensatory – essentially anything of economic value given in exchange for the person's service or employment. This is interpreted broadly and includes not only cash salary and bonuses, but also the value of accelerated stock vesting, option cash-outs, fringe benefits, pension enhancements and other perks given due to the change in control. For instance, if an executive's stock options vest immediately upon an acquisition, the intrinsic value of those options (the difference between fair market value and strike price) counts as a payment in compensation.
There is an excess parachute payment when the amount of total parachute payments to a Disqualified Individual exceeds the three times threshold. Importantly, once there is an excess, even by just $1, the parachute payment’s total amount, less the base amount (as discussed below), becomes subject to §280G.
Calculating the Base Amount and the Three Times Threshold
It is critical to be able to correctly determine the base amount for each Disqualified Individual, since that is what the three times threshold (often called the “safe harbor” limit) is based on. The base amount for an individual is defined as that person’s average annual taxable compensation from the company over the five taxable years preceding the change in control. This includes salary, cash bonuses, and other monetary benefits paid by the company.
Once the base amount is calculated, it is multiplied by a factor of three to determine the three times threshold. If the total present value of all change-in-control payments to the individual is equal to or less than the three times threshold, then §280G does not apply. If the total exceeds the threshold, even by $1, then the total amount of such payments, less the base amount, constitutes the excess parachute payment.
Practical Examples of §280G Calculations
Let’s illustrate the above concepts with a couple of simplified examples.
Example 1: Below the 3× Threshold (No Parachute Payment)
Suppose a CEO’s base amount (five-year average annual pay) is $200,000. The company is being acquired, and the CEO’s employment agreement provides for a $600,000 severance payment if he is terminated due to the change in control. In addition, the CEO’s unvested stock awards (worth $100,000) will vest upon closing. The total value of payments triggered by the deal is $700,000. The 3× threshold in this case is 3 × $200,000 = $600,000.
Is §280G triggered? Yes, because the parachute total ($700,000) exceeds the 3× threshold. The entire $700,000 is considered a “parachute payment,” but the excess parachute payment is only $500,000 ($700,000 parachute payment less $200,000 base amount). This means that $500,000 would not be tax-deductible to the buyer, and the executive/Disqualified Individual would owe the 20% excise tax on $500,000. Consider that if the total change-in-control payments had been $600,000 or less, then none of it would be considered a parachute payment or an excess parachute payment, and no penalties would apply.
Example 2: Below the 3× Threshold (Excess Parachute Payment)
Now, assume another executive/Disqualified Individual has a base amount of $100,000. Three times, that is $300,000. If that executive is slated to receive $200,000 contingent on the sale of the company (from severance, accelerated equity, etc.), then this would be less than the 3x threshold, and §280G/§4999 would not apply.
These examples show the “all-or-nothing” nature of the analysis. Crossing the 3× base amount line – even by a small dollar amount – can have significant tax consequences. This is why companies and executives carefully plan payouts and sometimes intentionally keep them just under the limit to avoid triggering the §280G rules.
We will explore other mitigation strategies in later articles in this series.
Authors: Daniel Mayo, Partner and Lead, National Tax Services | [email protected]; Kevin Kaznica, CFA | [email protected]; and Michael Rasin | [email protected]
