Free Fallin’…With a Golden Parachute
For those who have been involved in the sale of a company, Section 280G of the Internal Revenue Code may sound familiar. Section 280G governs what the IRS considers to be “golden parachute payments” and is generally applicable when a corporation is undergoing a change in control (including both stock sales and asset sales). At a high level, Section 280G imposes on disqualified individuals a 20% excise tax on excess parachute payments paid and a corresponding loss of deduction on such payments by the corporation.
What is a parachute payment, and who is a disqualified individual? Parachute payments arise from payments that are in the nature of compensation paid or payable to a disqualified individual that are contingent on a change in control of a corporation. These payments are known as contingent payments. Common types of contingent payments include transaction bonuses, retention bonuses, severance benefits, new equity awards, and the acceleration of vesting on previously granted equity. A disqualified individual generally includes any employee, director, or contractor that during the 12-month period prior to the change in control was either an officer, a greater than 1% shareholder, or a highly compensated individual.
If a disqualified individual’s aggregate contingent payments exceed three times the disqualified individual’s “base amount” (generally their average compensation over the preceding 5 years) then they will be parachute payments, and any parachute payments in excess of one times the disqualified individual’s base amount are subject to the Section 280G excise tax and loss of the deduction as excess parachute payments.
This is a bit of an oversimplification, but for a publicly-traded company, the analysis ends there and the affected parties are stuck with the adverse Section 280G consequences. For privately-held companies, a company can solicit a shareholder cleansing vote to approve the payments and eliminate the excise tax and loss of deduction. In order to move forward with a cleansing vote, the disqualified individuals need to agree to waive receipt of (or return) any parachute payments in excess of three times their base amount if the requisite greater than 75% shareholder approval is not obtained (excluding any shares owned by the disqualified individuals subject to the vote).
As part of the cleansing vote, voting shareholders are required to be provided with a disclosure notice that sets forth each disqualified individual’s base amount and a description of the parachute payments that are being voted on. The disclosure of this information can cause heartburn for some disqualified individuals, particularly where there are a large number of employee-shareholders that would otherwise not be privy to the disqualified individuals’ compensation information. Unfortunately, options for avoiding disclosure are few and far between.
For companies and executives that are considering entering into a sale of the company or taking on a significant investor, it’s never too early to begin considering the potential impacts of Section 280G. In doing so, be aware that there is a presumption under the Section 280G rules that certain payments (including equity grants) made in the 12-month period prior to a change in control are considered parachute payments under Section 280G. If a future transaction seems to be in the cards, companies may want to consider planning around the 12-month rule and taking other measures to reduce potential parachute payments in the hopes of avoiding a cleansing vote.