Section 280G and Golden Parachutes: What Founders, Executives and Investors Need to Know

Section 280G of the Internal Revenue Code penalizes “golden parachutes”: payments to certain executives, shareholders and highly paid individuals that are contingent on a change in control. If the total of those payments equals or exceeds three times the individual’s base amount, the recipient owes a 20% excise tax on the excess over one times the base amount, and the company loses its deduction for that excess. Private companies can often avoid the problem with a shareholder approval vote, but only if they plan ahead.

Change-in-control payments can reward and retain key people through a sale, but if no one runs the numbers, Section 280G can create expensive surprises. Here is how the rules work and the mistakes to avoid.

What Counts as a Parachute Payment?

A parachute payment is any payment in the nature of compensation to a disqualified individual that is contingent on a change in ownership or control. It can take many forms:

• Cash severance, transaction bonuses and retention bonuses
• Accelerated vesting of stock options, restricted stock or RSUs
• New equity grants or raises tied to the deal
• Continued benefits and accelerated deferred compensation
• Tax gross-up payments

A payment is generally presumed contingent on the change in control if it is made under an agreement entered into or amended within one year before the change. Termination of employment is not required; a single-trigger bonus paid to an executive who stays can still be a parachute payment. For accelerated vesting, the regulations generally treat only part of the value as contingent on the change, which is one reason calculations matter.

When Does a Change in Control Happen?

Under the Section 280G regulations, a change in ownership or control generally occurs when:

• A person or group acquires stock representing more than 50% of the total fair market value or total voting power of the corporation;
• A person or group acquires, within a 12-month period, stock with 20% or more of the total voting power (this creates a presumption of a change in effective control);
• A majority of the board is replaced within a 12-month period by directors not endorsed by a majority of the prior board; or
• A person or group acquires, within a 12-month period, assets with a total gross fair market value of one-third or more of the corporation’s total gross fair market value.

Who Is a “Disqualified Individual”?

Section 280G applies only to disqualified individuals, determined over the 12 months before the change in control. They include employees and other individual service providers, including independent contractors and directors, who during that period were:

• Officers: determined by actual duties and authority, not title alone, and subject to a cap on how many people can be treated as officers;
• More-than-1% shareholders: owning stock worth more than 1% of the corporation’s total fair market value, with attribution rules applying; or
• Highly compensated individuals: among the highest-paid 1% of employees (or, if fewer, the highest-paid 250), and paid at least the highly compensated employee threshold under Section 414(q), which the IRS adjusts annually.

Former employees can be disqualified individuals if they met one of these tests during the 12-month period.

The Three-Times Threshold

The key number is the “base amount”: generally the individual’s average annual compensation includible in gross income for the five most recent taxable years ending before the change in control (or the shorter period of employment, annualized).

If total parachute payments are less than three times the base amount, there is no excise tax and the company keeps its deduction. If they equal or exceed three times the base amount, the excess parachute payment is everything above one times the base amount.

Example: Suppose an executive’s base amount is $200,000, so the threshold is $600,000. Payments of $599,999 trigger no penalty. Payments of $600,000 create an excess parachute payment of $400,000 (the amount above $200,000). The executive owes a 20% excise tax of $80,000 in addition to regular income tax, and the company cannot deduct the $400,000. That cliff is why a single extra dollar can be so costly.

Exemptions and Planning Tools

• Private company shareholder vote: if no stock of the corporation is readily tradeable on an established securities market, payments are exempt when approved by more than 75% of the voting power of disinterested shareholders after adequate disclosure. The affected individuals must first waive any payments above the safe harbor, so the vote is binding. Public companies cannot use this exemption.
• Small business corporations: corporations that would be eligible to elect S corporation status are generally exempt.
• Reasonable compensation: payments shown by clear and convincing evidence to be reasonable compensation for services after the change in control, including some payments for a genuine covenant not to compete, can be excluded from parachute payments. Payments for services before the change can reduce the excess parachute payment.
• Cutbacks: agreements may reduce payments to just below the threshold, or use a “best net” provision that cuts back only when doing so leaves the executive better off after taxes.

Common Pitfalls

• Missing disqualified individuals. Officers are not limited to the CEO and CFO.
• Assuming termination is required. Payments can be contingent on a change in control even when the executive keeps the job.
• Overlooking compensation. Accelerated equity, retention bonuses and post-deal raises can push someone over the threshold.
• Gross-ups backfiring. A gross-up is itself a parachute payment and is not deductible to the extent it is an excess parachute payment, which makes it expensive.
• Running the shareholder vote late or wrong. Disclosure, waivers and the disinterested-shareholder count must meet the regulations, or the exemption fails.
• Ignoring Section 162(m). For public companies, the $1 million deduction limit on covered employees’ pay interacts with excess parachute payments.

Why Early Planning Matters

Golden parachute issues tend to surface in the middle of deal negotiations, when buyers ask for 280G calculations as part of diligence. Starting early leaves time to model payments, restructure compensation and, for private companies, run a shareholder vote before closing. For a related exit topic, see our post on Section 1202 QSBS.

The Takeaway

Section 280G is a cliff, not a slope: reaching three times the base amount converts everything above one times the base amount into an excess parachute payment. Identify disqualified individuals, calculate base amounts and parachute payments well before signing, and use the private company vote or other planning tools where available. Severance and change-in-control terms in executive agreements should be drafted with 280G in mind; our post on severance terms covers related issues.

Frequently Asked Questions

What is a golden parachute under Section 280G?

It is a payment in the nature of compensation to a disqualified individual that is contingent on a change in ownership or control of a corporation. If the total of those payments equals or exceeds three times the individual’s base amount, the excess over one times the base amount is an excess parachute payment, which triggers a 20% excise tax for the recipient and loses the company’s deduction.

How is the base amount calculated?

The base amount is generally the individual’s average annual compensation includible in gross income over the five most recent taxable years ending before the change in control. For someone employed for a shorter period, the average covers the years actually worked, with partial years annualized.

Can a private company avoid Section 280G?

Often, yes. A company whose stock is not readily tradeable can exempt payments if more than 75% of the disinterested shareholders approve them after adequate disclosure, and the affected individuals waive payments that exceed the safe harbor if the vote fails. Certain companies that would qualify as small business corporations are exempt as well.

Does Section 280G apply to S corporations and LLCs?

Corporations that are eligible to elect S corporation status are generally exempt. Section 280G applies to corporations, so an LLC taxed as a partnership is generally outside it, but an LLC taxed as a corporation, or a subsidiary of a corporation, may be covered. Confirm the entity’s status before relying on an exemption.

How Sutter Law Can Help

We help companies and executives address Section 280G in M&A transactions, including identifying disqualified individuals, working with accountants on calculations, drafting cutback provisions and running private company shareholder votes. Learn more about our mergers and acquisitions practice, or contact us for a free consultation.

This article is general information, not legal advice. Reading it does not create an attorney-client relationship.