Golden Parachutes in M&A Transactions – A Basic Overview

M&A Practice Brief  

By: Gray Hutchison and Amy E. Risseeuw

In an M&A transaction involving the sale of a corporation, particular attention should be given to payments to be made to executives of the corporation which are triggered by the change in control. Section 280G of the Internal Revenue Code provides for a punitive tax on certain compensation paid to a “disqualified individual” in connection with a change in control (“golden parachutes” or “parachute payments”) if the payments are deemed excessive under the provisions of Section 280G. The tax imposed is 20% of the portion of the parachute payments that is determined to be excessive. In addition to the tax on the individual receiving an excess parachute payment, the corporation making the payment may not take a deduction for such excess parachute payment.

Which types of companies does 280G apply to?

280G applies to all C-corporations, which are corporations taxed under subchapter C of the Internal Revenue Code. S-Corporations (taxed under subchapter S of the Internal Revenue Code) and non- corporate entities (such as limited liability companies and partnerships) are exempt from 280G.

Who is a “disqualified individual” subject to the 280G rules?

A “disqualified individual” is any individual who was an employee, independent contractor or director of the corporation during the 12-month period ending on the date of the change of control transaction and who was:

• a 1% shareholder,
• an officer (for any corporation, this group is the greater of 3 individuals or 10% of the total employees of the corporation (up to 50 maximum), or
• a highly compensated employee making at least $120,000 a year (for 2017), adjusted for inflation, and in the top 1% of all employees of the corporation in terms of compensation.

What are “parachute payments”?

Parachute payments include only compensation that is payable or that becomes vested in connection with a change in control. It does not include payments made for vested stock options or payments for stock that is already owned by a disqualified individual (except for restricted stock to the extent that restrictions lapse in connection with the change of control). It includes the value of any benefits specifically resulting from the change in control, such as:

• severance pay,
• acceleration of vesting of unvested stock options or accelerated lapsing of restrictions on restricted stock,
• bonus payments resulting from the change in control,
• any other change in control-related compensation, and
• the value of any new compensation, such as stock option grants, restricted stock grants, bonuses or increases in compensation, that is granted within 12 months of the change of control transaction.

What are “excess parachute payments”?

Parachute payments payable to a disqualified individual that equal or exceed three (3) times such individual’s “base amount” trigger a 20% excise tax on the amount by which such parachute payments exceed the base amount. The base amount for an individual is his or her average W-2 compensation for the five preceding calendar years. If the individual has been employed for less than 5 years, then the base amount is determined by reference to the average compensation over the shorter number of years. In addition, compensation for a partial year of employment is annualized.

How is the penalty calculated?

The individual tax and the corporation’s inability to take a deduction apply to the amount of parachute payments in excess of the base amount. For example, if the total payments are $2,500,000 and the base amount is $700,000, then 280G is triggered because the total payments exceed $2,100,000 (3 times the base amount), and then the penalty is applied to the amount that the parachute payments exceed the base amount, or $1,800,000. Thus, $1,800,000 of the individual’s payments would be subject to regular taxation plus the 20% excise tax, and the Company would not be able to deduct $1,800,000 of the total payments.

What can private companies do to avoid this penalty?

A privately held company can still make excess parachute payments without triggering the 280G penalties if:

• full disclosure of the payments and the extent to which they are excess parachute payments is provided to “disinterested stockholders” (those who are not disqualified individuals or related to disqualified individuals),
• 75% of the disinterested stockholders approve the payments, and
• the disqualified individual entitled to the payments agrees (prior to the stockholder vote) to waive his or her right to receive the excess portion of the payments if the vote is unfavorable.

What can public companies do?

A publicly traded company might provide in its employment (or change in control) agreements with disqualified individuals that:

• any payments due will be reduced to the extent required to eliminate the excess and therefor avoid the application of 280G; or
• any payments due will be reduced only in the event that the net after-tax benefit to the individual is greater than the net after-tax benefit to the individual if the payments are made in full and the excise tax is paid; or
• full payment will be made to the individual plus a “gross up” bonus to cover the excise tax imposed on the payment.

The first two public company approaches are common. The third approach is less so because of the additional expense to the corporation and recent increased scrutiny by stockholders of executive compensation.

Another option is for the corporation to have a compensation consultant prepare a study to determine if all or a portion of the payments can be considered reasonable compensation for past or future services (which would reduce or eliminate the amount of the excess parachute payments and the resulting 280G penalty).

In summary, in any transaction involving a change of control of a corporation, it is important to consider whether 280G is applicable and whether any actions need to be taken. A corporation’s legal counsel and accounting advisors will be instrumental in this analysis.

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H. Gray Hutchison and Amy E. Risseeuw are attorneys in the Employee Benefits & Executive Compensation practice group and the M&A practice group, respectively, of Wyrick Robbins, which represents clients across a broad range of industries in connection with their significant corporate transactions. The M&A group publishes Practice Briefs periodically as a service to clients and friends. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.