“Golden Parachute” payments impacting your transaction?
Author: Michael De Prima
Here’s a common scenario…
Your company is a target in a transaction and the attorneys tell you that a 280G analysis will need to be performed relating to parachute payments being made as part of the deal, which may also require a shareholder vote. You’re also told time is of the essence so closing does not get held up. You respond, “What the heck is 280G?”. You then scramble to find a tax provider to perform the analysis.
You field a number of data requests and questions from the tax advisors and attorneys without really understanding how or why this information matters. Ultimately, the attorneys draft disclosures and shareholder documents and a “cleansing” vote is held. By this time, you may have spent tens of thousands of dollars on legal and accounting fees for this tax issue you had never heard of until a few weeks ago. Once all is said and done, the information goes into the volumes of other legal and tax documents soon to be forgotten after closing.
What is §280G and why does it matter?
Section 280G of the Internal Revenue Code has been in existence since 1984 and applies when so-called golden parachute payments are made to certain executives at a corporation undergoing a change in control. If it’s triggered, the result is twofold: (i) a deduction disallowance at the organization making the disqualifying payments, and (ii) a 20% excise tax imposed under §4999 on the individuals receiving the payments. However, exposure under §280G exists only if the aggregate value of the parachute payments equals or exceeds 3 times the individual’s base amount.
Sounds intuitive, right? Probably not. This provision of our tax code is notoriously complex and requires a very high degree of precision from a computational standpoint. The discussion below is intended to provide a high-level framework to understand the significance of §280G in an M&A transaction and its basic mechanics.
Who does it apply to?
C corporations only. Section 280G applies to changes in control at C corporations. While partnerships and S corporations are generally exempt, it’s important to note that disqualifying payments being made by an entity other than a C corporation must still be considered if the payments relate to a change in control at a C corporation. For example, a common scenario where §280G is implicated occurs when a C corporation that’s wholly owned by a partnership is undergoing a change in control and parachute payments are being paid by the partnership to individuals at the subsidiary C corporation.
C corporation that could elect S corporation status. S corporations are explicitly exempt from §280G. But an often overlooked provision in the §280G regulations also exempts C corporations that would be eligible to elect S corporation status at the time of the change in control even though no such election was ever made. This might be applicable for example in the professional services setting where the shareholders tend to be individuals (one of the primary requirements for electing S corporation status is that the shareholders must be US resident individuals, with some limited exceptions).
What’s more, the exception states that the nonresident alien prohibition under the S corporation rules is not applicable for this purpose—thus, a C corporation that is not eligible to actually elect S status because it has nonresident shareholders can nonetheless be exempt from §280G.
Due to these nuances, one of the first steps in evaluating the impact of §280G should be reviewing the target corporation’s capitalization table to determine whether the company may be an exempt entity.
Disqualified individuals. The next element relates to the status of the individuals receiving the parachute payments. For §280G to apply, the individuals must be disqualified individuals, which includes employees or independent contractors of the corporation who are also:
- Officers of the corporation
- Highly compensated individuals of the corporation, or
- 1% shareholders of the corporation
Rules beyond the scope of this discussion elaborate on each of these categories. While the highly compensated individual and 1% shareholder tests are fairly mechanical, the officer test is often more subjective and requires a facts-and-circumstances analysis. As such, the parties tend to take a conservative approach here and err on the side of inclusion.
When does it apply?
Change in control. The parachute payments must be made as a result of a change in control or effective ownership at the corporation. Such a change occurs when greater than 50% of the corporation’s stock (measured by value or voting power), or one-third or more of its assets (measured on the basis of total gross fair market value), is acquired by another person.
Parachute payments. The definition of a parachute payment is quite broad and covers any payment in the nature of compensation being made as a result of the change in control. Some of the most common types of parachute payments are cash transaction bonuses, severance payments, and the acceleration of equity-based compensation (discussed below).
In practice, identifying all parachute payments (and their values) can be a moving target. As a deal progresses, the payments may change a number of times. With each iteration, the payments must be tested against §280G, and there are times the payments change because of §280G.
How is it measured?
The 3-times base amount safe harbor. As mentioned above, §280G is only triggered if the aggregate value of all parachute payments equals or exceeds 3 times the disqualified individual’s base amount. If the value of all parachute payments is below this threshold, §280G is inapplicable and you can breathe a small sigh of relief.
Base amount. The base amount is the disqualified individual’s average annualized taxable compensation from the corporation undergoing the change in control (or an affiliated entity) for the 5 taxable years preceding the year in which the change occurs. For this purpose, taxable wages reported on Forms W-2 and contractor payments reported on Forms 1099 must be analyzed.
Valuing parachute payments. Parachute payments are measured by their present value at the time of the change in control. Therefore, present value computations may be necessary for payments that are being accelerated or deferred.
Accelerated equity vesting. The accelerated vesting of equity has some special rules that can make this facet of §280G one of the more complicated and scrutinized. This is a common issue when dealing with stock options and similar instruments that are being cashed out in a transaction. The §280G rules provide a favorable discounted value methodology for the acceleration of purely tenure-based vesting (often referred to as “24(c) value” on account of its cite in the regulations). If it applies, this provision has the potential to significantly reduce the value of accelerated equity (and thereby its §280G parachute value) below its full intrinsic value.
Reasonable compensation exception. An important exception to the definition of a parachute payment is any amount established by clear and convincing evidence as reasonable compensation for services to be performed on or after the date of the change in control. This might apply for example when target employees are going over to the acquiring entity with an increase in compensation. But, the clear-and-convincing standard is a high threshold, and generally a compensation study should be performed if a taxpayer is seeking to reduce or eliminate parachute payments under the reasonable compensation exception.
Another important aspect of the reasonable compensation exception relates to covenants not to compete. The regulations provide that reasonable compensation includes refraining from the performance of services. Therefore, value ascribed to a noncompete agreement might result in a reduction of parachute payments as well.
The 12-month presumption. Any payment made pursuant to an agreement entered into within one year preceding the change in control is presumed to be contingent on the change, unless the contrary is established by clear and convincing evidence. This presumption can have broad consequences and pull in amounts provided for under agreements entered into months before a transaction was ever contemplated. Again, clear-and-convincing is a high standard, so companies must exercise caution when analyzing payments made or agreements entered into during the 12-month presumption period.
Excess parachute payments. If the present value of all parachute payments equals or exceeds the disqualified individual’s 3-times base amount, the result is referred to as an excess parachute payment. But the excess is measured by the value of the payments over 1-time the base amount rather than the 3-times base amount that determines whether §280G is triggered. It’s this excess that is subject to the deduction disallowance and 20% excise tax.
Examples
Example 1. X Corp is being acquired in a deal where Buyer is purchasing 100% of X Corp’s stock. X Corp pays CEO a cash bonus of $1,500,000 million and accelerates stock options worth $200,000 as part of the transaction; thus, CEO’s total parachute payments equal $1,700,000. Assume CEO’s base amount is $600,000.
In order to have §280G exposure, the total parachute value must equal or exceed 3 times the base amount of $600,000, or $1,800,000. Because total parachute payments are less than the 3-times base amount, CEO’s parachute payments are not impacted by §280G. Therefore, there is no deduction disallowance for the parachute payments and no excise tax imposed on CEO.
Example 2. Assume instead that CEO’s base amount is $400,000. The 3-times base amount safe harbor is now $1,200,000. Since this is less than the parachute payment value of $1,700,000, §280G is now triggered.
The resulting excess parachute payment is $1,300,000 ($1,700,000 of parachute payments less CEO’s base amount of $400,000). The $1,300,000 is disallowed as a deduction at X Corp and CEO is subject to an excise tax of 20% of the $1,300,000, or $260,000.
How can §280G exposure be addressed?
Private companies. The regulations offer a powerful mechanism to eliminate the sting of §280G in the case of privately held corporations. Such corporations can vote away the impact of §280G using what’s referred to as a cleansing vote.
Under this procedure, the parachute payments at issue can escape the net of §280G if the payments are approved by more than 75% of the voting power of the corporation’s outstanding stock. For this purpose, shareholders who are disqualified individuals receiving parachute payments (and certain related persons) cannot take part in the vote and their stock is not counted in the 75% test.
The voting process further requires that all shareholders entitled to vote be given adequate disclosure of all material facts concerning the payments prior to the vote. Additionally, special rules provide for the greater-than-75% threshold being met in the case of entity shareholders.
Although the cleansing vote can eliminate §280G’s consequences, it’s not without risk. The regulations provide that the cleansing vote must determine the right of the disqualified individual to receive the payments. In other words, if greater than 75% of the shareholders do not vote in favor, then the payments may be forfeited completely. Consequently, it’s important to assess whether the payments are being put to a “friendly vote” when using the private company voting exemption.
Public companies. Since public companies cannot use the cleansing vote procedure, they must deal with §280G in a different manner. Of course, the corporation and disqualified individuals can simply choose to accept the deduction disallowance and excise tax. More common, however, is the use of a “better off” agreement which allows disqualified individuals to choose the option that puts them in the best economic position between (i) paying the 20% excise tax, or (ii) reducing their parachute payments by an amount that will put them below the 3-times base threshold (commonly referred to as a claw-back provision).
Due to SEC reporting rules, publicly traded corporations are required to have a significant amount of detail and disclosure in relation to the payments, which makes a thorough and well-documented §280G study all the more critical in the public company setting.
Takeaway
Section 280G is a complex set of rules and is usually compounded by the rush of the typical M&A transaction. A comprehensive and precise analysis is critical when dealing with this issue, as is close collaboration among the target, its tax advisors, and its attorneys. A flawed or incomplete analysis can have significant impacts on the target and those receiving parachute payments. Companies that find themselves in need of a §280G analysis should act quickly yet prudently when engaging assistance in this area.
Please contact your CLA professional to learn how §280G may impact your M&A deal and how we can assist.
Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
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