Parachute Payments under Section 280G in Corporate Acquisitions
In corporate acquisitions and dispositions, certain compensation payments by or on behalf of the target corporation that are conditioned on certain change of control events relating to the target corporation may be defined as “excess parachute payments” and as a result subject to income tax deduction disallowance and to an excise tax. Below is an overview of the types of acquisitions and compensation payments to which the excess parachute payment rules are applicable and of certain considerations relevant in attempting to avoid the application of these rules when they are potentially applicable.
An important consideration in the purchase or sale of a business operating in corporate form is the possible application of the golden parachute payment rules of Section 280G of the U.S. Internal Revenue Code.[1] When Section 280G is applicable, an excise tax[2] is payable by a “disqualified individual” in the amount of 20% of any “excess parachute payments” received or to be received by such individual from the corporation. A corporation that makes excess parachute payments is required to withhold this excise tax in addition to other applicable tax withholdings on the compensation amount, and is denied an income tax deduction for the amount of the excess parachute payments. The statute and applicable regulations contain a number of technical requirements that must be taken into account in order to avoid triggering the excise tax and deduction disallowance.
Section 280G applies to acquisitions of entities that are treated as corporations for U.S. federal income tax purposes, and, significantly, does not apply to the acquisition of a business that is treated as a partnership for U.S. federal income tax purposes. An “affiliated group” of corporations[3] is treated as one corporation for these purposes, and any officer of any member of such an affiliated group is treated as an officer of that one corporation.
Section 280G is applicable in the case of the acquisition of a target corporation if “parachute payments” are to be made in connection with the acquisition. Parachute payments generally are defined as compensatory payments that: (1) are made to[4] a “disqualified individual”, (2) are conditioned on a change in the ownership or effective control of a corporation[5] or in the ownership of a substantial portion of a corporation’s assets, and (3) have an aggregate present value that is greater than or equal to three times (3x) the employee’s “base amount” (as defined below).
Acquisitions to which Section 280G is Applicable.
The change-of-control events on which parachute payments must be conditioned include the following: (x) a change in the ownership of the target corporation, (y) a change in effective control of the target corporation, and/or (z) a change in the ownership of a substantial portion of the target corporation’s assets.[6] A “change in ownership” is defined as an acquisition by one person, or a group of persons acting together, of more than 50% of the fair market value or total voting power of the stock of the target corporation. A “change in effective control” means an acquisition during a 12-month period by one person, or a group of persons acting together, of 20% or more of the total voting power of the target corporation’s stock or the replacement of a majority of the target corporation’s board of directors during any 12-month period by directors whose appointment or election is not endorsed by a majority of the previous members of the board. A “change in ownership of a substantial portion” of a corporation’s assets is defined as an acquisition during a 12-month period by one person, or a group of persons acting together, of assets of the target corporation that have a total gross fair market value greater than or equal to one-third (1/3) of the total gross fair market value of all of the target corporation’s assets immediately before the acquisition.
In some cases, whether payments to an individual are conditioned on one or more of the relevant change-of-control events is clear (for example, if a corporate executive is eligible for a special bonus upon the successful completion of an acquisition). However, Section 280G also creates a presumption that: (i) any agreement entered into or (ii) any amendment made to an existing agreement in either case during the period beginning one (1) year before the date of acquisition was contingent on the acquisition unless the contrary is established by “clear and convincing evidence.” Therefore, compensation arrangements that are entered into in anticipation of an expected acquisition (even if they do not explicitly reference the change of control), as well as other agreements entered into during the relevant pre-acquisition period, must be analyzed under the rules of Section 280G to determine whether they are subject to excise tax and deduction disallowance.
Disqualified Individual.
A disqualified individual generally is defined as an employee, an independent contractor or an individual who, at any time during the 12-month period ending on the date of the acquisition, was an officer of the corporation, a shareholder owning more than 1% of the corporation’s stock, or a highly compensated employee of the corporation. A director of the corporation who falls into one of these three categories also is treated as a disqualified individual.
Calculations.
The “base amount” with respect to a disqualified individual is defined, in general terms, as the individual’s average annual compensation from the target corporation for the most recent five taxable years preceding the taxable year of the acquisition (or, if the individual worked for the target corporation for fewer than five years, for the number of years that the individual worked for the target corporation).
In the event that Section 280G is triggered, the “excess parachute payments” for a disqualified individual are equal to the amount of the individual’s “parachute payments,” minus such individual’s base amount. The numerical trigger for the application of Section 280G (determined by reference to “parachute payments”) and the amounts subject to excise tax and deduction disallowance (“excess parachute payments”) are calculated in different ways. In order to trigger the application of Section 280G, the disqualified individual’s compensation that is contingent on the acquisition must be (in present value terms) more than three times (3x) that individual’s base amount. On the other hand, excess parachute payments that are subject to excise tax and deduction disallowance are determined by reference to the base amount, not three times (3x) the base amount. This distinction is important to keep in mind, because the amount disallowed as a deduction and subject to excise tax may be considerably larger than the amount by which the payment in question passed the threshold to be treated as a “parachute payment.”
The amount treated as a parachute payment under these rules does not include any portion of such payment that the taxpayer establishes by clear and convincing evidence is reasonable compensation for personal services to be rendered on or after the date of the change, and the amount treated as an excess parachute payment is reduced by the portion of such payment that the taxpayer establishes by clear and convincing evidence is reasonable compensation for personal services actually rendered before the date of the change. Reasonable compensation for services actually rendered before the date of change is first offset against the base amount.
An additional complication arises in the case of equity compensation subject to a vesting schedule, because the value of the equity compensation has to be determined for purposes of applying the Section 280G rules. In certain cases that involve a time-based vesting schedule, a helpful valuation rule is available that may allow a valuation that is significantly lower than the difference between the stock’s value and its exercise price. However, certain equity awards, including equity awards the vesting of which occurs on a performance-based schedule, are not eligible for this generally taxpayer-favorable valuation method.
Exceptions to Parachute Payment Status.
The term “parachute payment” does not include any payment to a disqualified individual with respect to a corporation that, immediately before the change, was either an S corporation or a corporation that met all of the requirements for “small business corporation” status under the S corporation rules,[7] even if such corporation did not make an election to be treated as an S corporation. Payments to or from certain qualified retirement plans or accounts also are not included in the term “parachute payments.”
The term “parachute payment” does not include any payment to a disqualified individual with respect to a corporation that, immediately before the change: (i) had no readily tradable stock, and (ii) obtains shareholder approval for the payments in question in compliance with the rules of Section 280G.
In order to obtain shareholder approval that complies with Section 280G, (i) a payment must be approved by a vote of the persons that owned, immediately before the change, more than 75% of the voting power of all of the acquired corporation’s outstanding stock, and (ii) there must have been adequate disclosure to shareholders of all material facts concerning all payments that would be parachute payments to a disqualified individual in the absence of the shareholder approval exception. The votes of all shareholders (and not just the proportion that would be required to obtain approval) must be solicited, and in connection with soliciting votes all shareholders must be provided information disclosing the relevant facts relating to all potential parachute payments.
A number of special requirements must be complied with in order to utilize shareholder approval as a way to avoid the application of Section 280G. For example, the shareholder approval of the putative parachute payments must be separate from the approval of the acquisition itself. That is, shareholders must be given the choice to vote against the compensation arrangements even if they choose to vote in favor of the actual acquisition. However, in contrast, a single vote can be made with respect to compensatory payments of multiple disqualified individuals. Also, shareholders of the acquired corporation may not agree in advance to approve payments subject to Section 280G shareholder approval.
Prior to the start of the shareholder approval process outlined above, disqualified individuals must execute a parachute payment waiver agreement with respect to putative parachute payments to which such individuals may be contractually entitled. The reason for this is that, in order for a shareholder vote to exempt what would otherwise be parachute payments from the Section 280G deduction disallowance and excise tax, the shareholder vote itself must determine whether a disqualified individual has the right to such payments, rather than merely approving a pre-existing right. Such a waiver agreement usually contains an agreement by the disqualified individual to waive his or her rights to compensatory payments that are greater than or equal to 300% of such person’s base amount unless such payments are approved by vote of more than 75% of shareholders.
Public corporations are not permitted to “cleanse” the Section 280G “taint” using shareholder approval processes like private corporations can. Instead, a public company may need to do a fact-intensive analysis regarding whether the putative parachute payments are “reasonable compensation” for personal services actually rendered on or after the date of the acquisition. A covenant not to compete can be considered as an agreement for the performance of personal services in certain circumstances. An analysis of any covenant not to compete is needed in order to see whether it qualifies, and a valuation is needed to determine what its value is and whether it is considered “reasonable compensation.”
Practical Implications during the Acquisition Process.
Both target corporations and their potential acquirers should include the possible existence of potential parachute payments in their respective due diligence processes, including: (x) identifying potential disqualified individuals and relevant payment rights and obligations, and (y) collecting relevant documentation. In an acquisition agreement, representations and warranties are often requested from the target corporation to the effect that the acquisition will not trigger any parachute payments under Section 280G and that no related additional payments (such as a gross-up to a disqualified individual) will be triggered by the acquisition. In a case where a target corporation is eligible for a shareholder vote process to “cleanse” potential parachute payments, the target corporation may be requested to: (x) agree to undertake the necessary shareholder vote in accordance with the rules of Section 280G and its regulations, and (y) deliver, as a condition to closing, evidence either that the required shareholder approval was obtained or that such approval was not obtained and the relevant payments have been waived or cancelled and will not be made. [1] All “Section” references herein are to the U.S. Internal Revenue Code of 1986, as amended to date.
[2] The excise tax is imposed by Section 4999 on “excess parachute payments”, as defined in Section 280G.
[3] An “affiliated group” is defined by reference to Section 1504, which in general terms requires a chain of ownership of at least 80%, by vote and value, of each corporation in the group other than the group’s parent by one or more other corporations in the group.
[4] Payments made to another person for the benefit of the disqualified individual are also included in this definition.
[5] A corporation includes any entity treated as a corporation for federal income tax purposes, including not only corporations organized as such under state law, but also, for example, an LLC that elects to be treated as a corporation for federal income tax purposes.
[6] For simplicity, any of the relevant change-of-control events on which parachute payments must be conditioned is referred to herein simply as an “acquisition.”
[7] In general terms, to qualify as a small business corporation, a corporation must (i) have no more than 100 shareholders, (ii) have no shareholders that are not individuals (with limited exceptions for certain trusts, estates, and tax-exempt organizations), (iii) have no U.S. nonresident aliens as shareholders and (iv) have only a single class of stock. Each of these requirements is subject to further interpretive rules.
If you have any questions about this alert, or any other matters, do not hesitate to reach out to:
Seth Lebowitz (Partner - Tax group) at 212.573.8152 or via slebowitz@sadis.com
