What is section 280G? When does it apply?

Section 280G was enacted to protect shareholders’ interests by prohibiting companies from making excessive payments to unqualified individuals when control of a corporation changes hands. Only public and private corporations are covered under Section 280G. It does not apply to partnerships taxed as S-Corps, Partnerships, or LLCs. Golden parachute payments are both limited in amount and subject to a special excise tax under Section 280G. The rule only applies if the payment is worth more than or equal to three times the disqualified individual’s average annual taxable compensation during the five years immediately preceding the change in control.

What is section 280G?

Section 280G of the Internal Revenue Code is designed to prevent excessive remuneration (sometimes known as “golden parachute payments”) to certain officials, highly compensated individuals, and shareholders who own more than 1% of a company (known as “disqualified individuals”). Any compensatory payments or benefits contingent on a change in control are referred to as “parachute payments“.

Understand Golden parachute payments

Golden parachutes are a type of compensation given to important executives when a public firm is sold, and they quit their jobs or have their responsibilities drastically reduced. Golden parachutes are expensive severance provisions written into senior executives’ contracts that recompense them if they are fired. Golden parachutes may include continued insurance and pension benefits in addition to significant bonuses and stock rewards.

How does section 280G affect parachute payments?

The “golden parachute” a reward to top executives of an acquired business who assist in the sale’s success, has become a standard feature of corporate mergers. The tax authorities have taken notice of these contributions, and they may be liable to hefty taxation in certain circumstances. These payments may be termed “golden parachute payments” if a corporation is considering entering into an arrangement with senior executives to give them an incentive to assist in the successful sale of the company. 

How does Section 280G work in M&A transactions?

When it comes to Section 280G, sensitive issues can arise during M&A transactions. If Section 280G is triggered, the individual employee (or independent contractor) receiving compensation subject to Section 280G is personally liable for a nondeductible 20% excise tax on any “excess parachute payments” (in addition to the income and employment taxes that normally apply to such compensation). The employer corporation making such payments is not allowed to claim a tax deduction for the excess. 

Excess parachute payments are reported on the employee’s Form W-2 (or independent contractor’s Form 1099), and the employer corporation must withhold the 20% excise tax in the same way it withholds federal income taxes. If “parachute payments” are made in the acquisition of a target corporation (including privately and publicly held firms), Section 280G applies. The word “parachute payment” is defined in Section 280G along with a variety of other terms of art, and it refers to any compensation payment that is made.

Application of section 280G

While employee benefits and CEO remuneration are rarely the driving force behind a sale, one question that should be addressed at the outset is whether any payments may be subject to Section 280G taxation. Ignoring this Code part or waiting until the last few days before closure to handle potential Section 280G difficulties could result in a hefty tax penalty for impacted individuals, as well as a loss of the deduction for the corporations involved, as well as irritated clients and executives. Section 280G and its counterpart, Section 4999, were adopted by Congress in 1984 in response to congressional concerns and the widespread view at the time that corporate executives were benefiting financially from the flurry of mergers and acquisitions that characterized the 1980s.

When does section 280G apply?

280G applies to payments contingent on a change in control or ownership, which is defined as when one person or more than one person acting as a group acquires 50% or more of the total fair market value (FMV) or voting power of the corporation (Regs. Sec. 1.280G-1, Q&A 27); or assets with a total gross FMV equal to or greater than one-third of the total gross FMV of all of the corporation’s assets in a 12-month period (Regs. Sec. 1.280G-1, Q&A 27); or assets with a total.

• When compensatory payments are made to disqualified individuals – Only “disqualified individuals” are covered by Section 280G. Employees (or independent contractors)Officers of the corporation, shareholders owning more than 1% of the outstanding shares of the corporation’s stock, or highly compensated individuals of the corporation at any time during the 12-month period preceding and ending on the closing date of the acquisition, as well as members of the corporation’s board of directors, are generally disqualified. Section 280G covers a variety of technical standards for identifying disqualified individuals in a corporation.
• When compensatory payment is contingent on a change in the “ownership” or “effective control”– Contingent Compensation Payments refers to any payment (or benefit) in the nature of compensation that is made or made available (under this Agreement or otherwise) to a “disqualified individual” (as defined in Section 280G(c) of the Code) and is conditional (within the meaning of Section 280G (b) (2) (A) I of the Code) on a Change in Ownership or Control of the Company. Any payments or other benefits due to the Executive as a result of a Change in Ownership or Control that could be characterized (as reasonably determined by the Company) as Contingent Compensation Payments will not be made until the Company determines which Contingent Compensation Payments will be treated as Eliminated Payments, as described in this Section 1.3(c).

When doesn’t section 280G apply?

280G does not apply if the total parachute payouts do not reach the 3x safe harbor amount. If total parachute payments exceed the 3x safe harbor limit, all payments beyond the 1x base amount are considered “excess” parachute payments and are subject to a 20% excise tax and deduction loss. In addition, the corporation is required to withhold the recipient’s 20% excise tax (in addition to all other required tax withholdings). 

So long as cumulative parachute payments exceed the 3x safe harbor threshold, the 280G penalty is effectively a cliff over the 1x base amount. Both the beneficiary and the corporation may face considerable tax implications as a result of this punitive provision.

Which transactions trigger section 280G?

Only C corporations that are not eligible to make a Selection are subject to Section 280G. Section 280G can be triggered by an employer’s asset sale, stock sale, or taxable merger. Compensation payments induced by M&A transactions that result in a change in control are subject to the excise tax.

• Effective control – This means a change in control of the Company or a substantial percentage of its assets is defined as a change in ownership or effective control of the Company, as determined in accordance with Section 280G(b)(2) of the Code and the rules made thereunder.
• Ownership – Section 280G of the Internal Revenue Code is designed to prevent excessive remuneration (sometimes known as “golden parachute payments”) to certain officials, highly compensated individuals, and shareholders who own more than 1% of a company (known as “disqualified individuals”).
• A substantial portion of assets – The present value of a payment is calculated as of the CIC date, or, if the payment is made before that date, as of the payment date. A discount rate of 120 percent of the appropriate Federal rate compounded semiannually is used to calculate the present value.

Types of payments that trigger section 280G

Section 280G can be triggered by an employer’s asset sale, stock sale, or taxable merger. Compensation payments induced by M&A transactions that result in a change in control are subject to the excise tax. Transaction bonuses, severance pay, the Section 280G value of accelerated stock options, restricted stock awards, and other equity compensation, as well as some signing bonuses, retention bonuses, and buyer equity awards, are all examples of parachute payments. 

If the present value of an employee’s parachute payments equals or surpasses three times the “base amount” of his remuneration, he has an excess parachute payment amount. The employee’s average yearly remuneration for the five taxable years preceding the M&A transaction year is the “base amount” of compensation. Because the excise tax is applied to every dollar over a one-year average compensation level, even $1.00 over the Section 280G threshold will result in a significant tax burden.

Exceptional payments and transactions of section 280G

Compensation payments provided by a corporation to its employees, officials, and directors are tax-deductible for the corporation. When remuneration is given due to a change in control, however, 280G disallows a tax deduction for certain compensation payments.

• Relatively short payments for 280G – The golden parachute provisions, Sections 280G and 4999 of the Internal Revenue Code should always be evaluated in the context of a transaction. Excess parachute payments are subject to a 20% excise tax under Section 4999, and excess parachute payments are not eligible for a tax-deductible under Section 280G. If a “disqualified individual” gets payments in connection with a change in control that is equivalent to or exceeds three times the individual’s base amount, the golden parachute penalties apply (five-year average annual compensation.
• Subsidiaries – If there is a substantial possibility that a reasonable shareholder would consider an omitted fact important, it is considered relevant. Many practitioners, for example, feel that material facts disclosure covers all compensation that the executive may earn in connection with the change in control, not only the parachute payments. These practitioners believe that without knowing the complete amount that a disqualified individual will get in connection with the transaction, shareholders cannot make an informed choice about whether to accept payment.
• Employee benefits – Employees of the Company and its subsidiaries (the “Company Employees”) will be provided by the Surviving Corporation and its subsidiaries. I for the twelve months immediately following the Closing Date, (x) the same level of base salary as on the Closing Date, (y) employee benefit and incentive plans, programs, contracts, and arrangements that are no less favorable, in aggregate, than similar employee benefit plans, programs, contracts, and arrangements (excluding stock-based compensation, the Deferred Compensation Plan Payments, and all change of control bonuses and/or severance payment).
• S corporation – 280G allows a private corporation’s shareholders to convene a shareholder vote to determine a disqualified individual’s entitlement to receive or retain parachute payments, avoiding the disallowance of deductions and the imposition of an excise tax on the excess parachute payments.
• Approval of shareholder – Holders of a majority of the shares of Stock represented voting in person or by proxy at an annual or extraordinary meeting of company shareholders where a quorum is present are said to have been approved.

Where and how does section 280G leave its impact?

If holders of more than 75 percent of the voting power of all outstanding stock of a privately owned target firm approve the payments and benefits submitted for shareholder approval immediately prior to the possible acquisition and before the vote, Section 280G applies.

• Cut-backs, Gross-Ups, and Best Net Clauses – With the national unemployment rate in the United States remaining above 9%, many people are attempting to pinpoint the causes of the current predicament. Excessive executive salary is frequently blamed. Tax gross-ups, in particular, have been a major source of conflict among shareholders, legislators, and shareholder consulting firms. Companies are divided between protecting their top executives and pleasing those opposed to tax increases. Tax gross-ups are payments made by a firm to meet an individual’s tax burden associated with a kind of compensation.
• Private Companies with Shareholder Vote – The right to vote in a poll will be expressed as a percentage of the company’s paid-up equity share capital. As a result, a shareholder who owns 51 percent of the company’s paid-up shares can exercise majority control over it.
• Reasonable Compensation – The IRS usually examines distributions made by an S corporation to a shareholder-employee to make sure the company isn’t evading paying employment taxes by misrepresenting compensation payments as dividend distributions.

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