While employee benefits and executive compensation issues rarely drive a transaction, one issue that should be discussed at the beginning of every deal is whether there are any payments that could trigger taxation under Section 280G. Ignoring this Code section or waiting until a few days before closing to address potential Section 280G issues could result in a large tax bill for impacted individuals, as well as a loss of deduction for the corporations involved and angry clients and executives.
Section 280G and its counterpart, Section 4999, were enacted by Congress in 1984 to address Congressional concerns and the then-common belief that corporate executives were receiving financial windfalls in the deluge of mergers and acquisitions occurring in the ‘80s, which in turn was impacting shareholder value and potentially could have a cooling effect on M&A activity. As with many provisions of the United States Tax Code, Section 280G and its counterpart Section 4999 attempt to curtail behavior by (i) imposing an excise tax on certain compensation received in connection with the change of control by the executives under Section 4999; and (ii) causing the corporation to lose its deduction under Section 280G for any compensation that subject to such taxation. While the concept of taxation and loss of deduction sounds simple, the application creates a web of complexity that requires someone familiar with these rules to navigate its application in corporation transactions. This article endeavors to assist practitioners unfamiliar with this area in identifying issues in transactions by providing a brief overview of Section 280G and how it can be avoided or if avoidance is impossible, how to offset it or mitigate its impact.
Overview of Section 280G
Practitioners often refer to the complications caused by Sections 280G and 4999 simply as “280G,” but as noted above, these are two distinct Code sections that work in tandem to penalize both the impacted individual and the corporation. Section 4999 imposes a 20% excise tax on the disqualified individual (referred to as “disqualified individuals” and discussed more in depth below) payee of an “excess parachute payment.” Section 280G disallows a deduction for the payor of such “excess parachute payment.” The 20% excise tax under Section 4999 and the disallowance of deduction under Section 280G only apply if there is an “excess parachute payment,” and there can only be an “excess” if there is first a “parachute payment.”
Determining whether a parachute payment exists depends upon calculation of the disqualified individual’s “base amount.” In general terms, payments and other benefits provided as a result of a change of control will not be subject to these provisions if they do not equal or exceed three times the disqualified individual’s five-year average compensation (“base amount”) using compensation for the five most recent tax years ending before the change of control. See Treas. Reg. §1.280G-1, Q&A-34. If the disqualified individual receives parachute payments in excess of three times the base amount, a 20% excise tax will apply to any amount paid that is in excess of one times the base amount, and the corporation will lose the corresponding deduction for the amount that is subject to the tax. For example, if the disqualified individual’s five-year average compensation was $500,000, and she received a parachute payment of $2,000,000, the 20% excise tax (and corresponding corporate deduction) would apply to $1,500,000 of the excess parachute payment.
Generally, the disqualified individual’s Form W-2 – Box 1, or for independent contractors or outside directors, Form 1099 – Box 1, is used to determine the compensation for purposes of calculating the base amount. However, if the disqualified individual has not performed services for the entire five-year period, his or her total employment period during such five-year period will be included with compensation for any partial year being annualized. Treas. Reg. §1.280G-1, Q&A-35. If the disqualified individual was hired in the year of the change of control (and had no other compensation from the corporation during the five prior taxable years), generally the individual’s base amount will be his or her annualized compensation that was includible in his or her gross income for the period prior to the change of control that was not contingent on the change of control. Treas. Reg. §1.280G-1, Q&A-36. Also, benefits provided to a disqualified individual which have not yet become taxable, such as unexercised stock options or deferred compensation, will have a direct impact on this calculation. If a disqualified individual earns $500,000 a year, and exercised stock options in the year prior to the change of control resulting in additional compensation income of $1,000,000, that disqualified individual’s base amount will be increased by $200,000 (assuming he has worked for the corporation for at least five years).
Further, if the disqualified individual has changed positions during the five-year period, for instance from outside director to CEO, the base amount may be artificially low. For example, assume an outside director has been receiving director fees of $50,000 per year for the past five years, and then is promoted to the position of CEO with compensation of $1,000,000 in January of 2020 and then a change of control occurs in July of 2020. The base amount for this newly-appointed CEO will be three times the average base compensation he received as a director (3 x $50,000) and would not even consider his compensation as CEO.
It is also important to remember that Sections 280G and 4999 apply to both public and private corporations. The term “corporations” for purposes of these Code sections includes publicly-traded partnerships, Section 854(a) real estate investment trusts, mutual or cooperative corporations, foreign corporations and tax-exempt Section 502(a) corporations. Generally, payments made by partnerships, limited liability companies taxed as partnerships, S corporations, and corporations that could elect to be S corporations (even if they have not done so) are not subject to Sections 280G and 4999. Treas. Reg. §1.280G-1, Q&A-6. However, if an entity is part of an affiliated group that includes a corporation, there may be issues under Sections 280G and 4999 even if the actual payor of the compensation is an entity not otherwise subject to these provisions. Parties in transactions that include affiliated groups should make sure that counsel familiar with these sections advises on the transaction.
Practitioners also should tread carefully if non-U.S. entities are involved in the transaction. There is no specific exemption from Section 280G for non-U.S. corporations. It is possible for the sale of a foreign subsidiary of a U.S. corporation parent to trigger a change of control for Section 280G, or vice versa.
Who Is a “Disqualified Individual”?
There is a common misconception that Section 280G only applies to “executives,” but in reality, Section 280G can potentially impact non-executive level employees, consultants, directors and shareholders. A disqualified individual includes any individual (employee or independent contractor) who is an officer, shareholder, or highly-compensated individual with respect to the corporation. Section 280G(c); Treas. Reg. § 1.280G-1, Q&A-15(a). Additionally, directors are considered disqualified individuals if the director is also a shareholder, officer, or highly-compensated individual with respect to the corporation. Treas. Reg. § 1.280G-1, Q&A-15(b). While an individual may fall within more than one of these categories, all that is required is that the individual fall into one of these three categories within the 12-month period immediately prior to the change of control, and as a result, even former service providers could have concerns under these sections. For example, an individual who terminated employment six-months prior to the change of control, and was a 1% shareholder, would be treated as a disqualified individual for purposes of the change of control. Personal service corporations providing services to the corporation are also treated as “individuals” when determining who is a disqualified individual. Treas. Reg. §1.280G-1, Q&A-16. The fact that a consultant has used his or her own single-member limited liability company to provide services to the corporation does not avoid the tendons of Sections 280G and 4999.
Highly-compensated individuals are persons within the lesser of (i) the highest paid 250 employees; or (ii) the highest paid 1% of employees of the corporation. Treas. Reg. § 1.280G-1, Q&A-19. A shareholder, for these purposes, is only considered a disqualified individual if the shareholder provides services to the corporation (either as an employee or independent contractor, including outside directors) and owns more than 1% of the fair market value of the outstanding shares of all classes of the corporation’s stock. In determining stock ownership, the attribution rules of Section 318(a) apply. Stock underlying a vested option is considered owned by the individual who owns the vested option (and stock underlying an unvested option is not considered owned by the holder of the unvested option). If an unvested option to purchase a corporation’s stock automatically vests upon a change of control, the stock underlying such option is considered owned by the holder of the option for purposes of these rules. Treas. Reg. § 1.280G-1, Q&A-17.
The determination of whether an individual is an officer is based on the facts and circumstances in each particular case (such as the source of the individual’s authority, the term for which the individual is elected or appointed, and the nature and extent of the individual’s duties). Treas. Reg. §1.280G-1 Q&A-18(a). Generally, the term “officer” means an administrative executive who is in regular and continued service. Any individual who has the title of officer is presumed to be an officer unless the facts and circumstances demonstrate that the individual does not have the authority of an officer. However, an individual who does not have the title of officer may nevertheless be considered an officer if the facts and circumstances demonstrate that the individual has the authority of an officer. The term “officer” includes individuals who are officers with respect to other members of the acquired corporation’s controlled group. Treas. Reg. §1.280G-1 Q&A-18(b). Treasury Regulations limit the number of employees of the corporation and its controlled group that can be treated as disqualified individuals solely by reason of being an “officer” to the lesser of (i) 50 employees; or (ii) the greater of 3 employees or 10% of employees of the controlled group, rounded up to the nearest integer. Treas. Reg. §1.280G-1 Q&A-18(c).
What Is a “Parachute Payment”?
Under Section 280G(b)(2), a parachute payment is any payment in the nature of compensation to (or for the benefit of) a “disqualified individual” if (i) the payment is contingent on a change of the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation; and (ii) the aggregate present value of the payments in the nature of compensation which are contingent on such change equals or exceeds three times the individual’s base amount. Section 280(G)(2)(b).
Virtually all payments of cash or valuable property to an employee or independent contractor will be considered to be in the nature of compensation, including bonuses, severance pay, fringe benefits, pension benefits, and other deferred compensation. Treas. Reg. § 1.280G-1, Q&A-11. More difficult questions arise in the categorization of items such as stock options, restricted stock, and other benefits subject to vesting or forfeiture, particularly the determination of when a payment has been made and whether a payment is contingent upon a change of control. Property transferred in connection with services is generally subject to taxation under Section 83, and becomes taxable when it is transferred if it is substantially vested and has an ascertainable value. However, if the property is subject to forfeiture at the time of transfer or does not have a readily ascertainable value, taxation will occur at a later date. If property previously transferred to a disqualified individual becomes vested as a result of the change of control, it will be included in the parachute payment computation unless exempt as reasonable compensation for services rendered before the date of the change of control. Treas. Reg. § 1.280G‑1, Q&A-12. This result applies even if the disqualified individual made a Section 83(b) election to tax the property as compensation income at the time it was actually transferred to him. Treas. Reg. §1.280G-1, Q&A-34(d).
A special rule applies with respect to non-qualified stock options. Under Q&A-13 of the regulations, an option is treated as a payment in the nature of compensation at the time the option vests (regarding of whether the option has a readily ascertainable fair market value as defined in Treas. Reg. § 1.83-7(b)). Treas. Reg. §1.280G-1, Q&A-13. If an option is fully vested and also has an ascertainable value prior to the change of control, it will not be considered in the calculation of the parachute payment; similarly, if the option would become substantially vested without regard to the change of control and its value is ascertainable, it would not be included in the calculation. For parachute payment purposes, an option which vests upon a change of control is valued on the basis of all facts and circumstances, including the option spread at that time, the probability that the spread will increase or decrease, and the length of the option exercise period. Valuation of such options may be challenging, especially when a disqualified individual’s employment agreement or severance agreement contains a golden parachute cap which is intended to limit the amount of “compensation” he receives as a result of a change of control. (See the discussion below regarding cut-backs).
Practitioners should continue to ask the parties to the transaction whether there are any new payments being made to any service provider throughout the transaction until to the closing. A client may advise at the beginning of a transaction that it has none of the payments that would be treated as parachute payments, but as the transaction progresses, decide to pay large change of control bonuses to employees. Even a small bonus could create a Section 280G issue when added to already existing parachute payments.
What Transactions Trigger Section 280G?
The term “change of control” can have many meanings, both under the law, and in written agreements between the parties. In any corporate transaction, it is important to review all change of control definitions in the various agreements to determine whether the proposed transaction would actually constitute a change of control for purposes of the agreements. In addition, it is important to determine whether the transaction would constitute a “change of control” for purposes of Section 280G (because in some cases, what is a change of control under a written agreement may not be a change of control under Section 280G and vice versa).
“Change of control” is not specifically defined in the statute, other than to provide that transactions that are a change in the “ownership or effective control of the corporation” or “in the ownership of a substantial portion of the assets of the corporation” would constitute a change of control. See Section 280G(b)(2)(A)(i). The Treasury Regulations, specifically, Q&A-27, do provide some guidance regarding what constitutes a change of control. Generally, a change of control occurs under Section 280G on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, has more than 50% of the total fair market value or total voting power of the stock of such corporation, referred to as a change in the ownership of a corporation. However, a change of control also is presumed to occur if there is a change in the effective control of the corporation, which means that there has been either (i) an acquisition of 20% or more of the total voting power of the corporation by any person or group; or (ii) the replacement of a majority of the board members of the corporation (other than the directors whose appointment is approved by a majority of the current board). This presumption may be rebutted if the parties can establish that the acquisition of stock or replacement of a majority of the board did not result in a transfer of power to control (directly or indirectly) the management and policies of the corporation from any one person (or more than one person acting as a group) to another person (or group). See Treas. Reg. §1.280G-1, Q&A-28. Further, a change in the effective control does not occur if the changes do not occur within a 12-month period (for instance, a person could not purchase 10% of the stock in three separate years and trigger a change of control).
Finally, a change of control occurs when there is a change in the ownership of a substantial portion of the corporation’s assets. A “substantial portion” means assets having a total gross fair market value equal to or more than one-third of the total gross fair market value of all of the assets of the corporation immediately prior to the acquisition. Treas. Reg. §1.280G-1, Q&A-29. A transfer of assets will not be treated as a change of control for Section 280G purposes if the assets are transferred to (i) a current shareholder of the corporation in exchange for or with respect to its stock; (ii) an entity if 50% or more of the voting power is owned (directly or indirectly) by the impacted corporation; (iii) a person that owns 50% or more of the total voting power of all the outstanding stock of the impacted corporation; or (iv) any entity for which 50% or more of the total value or voting power is owned by any of the entities described in (i), (ii) or (iii).
When analyzing whether a change of control has occurred in a controlled group of corporations, it generally must be a change of control of the parent entity. The sale of a subsidiary of the parent would not trigger a change of control unless the subsidiary’s assets equal more than one-third of the parent’s assets. It is important to identify which entity is undergoing the change of control so that the proper analysis can be completed for Section 280G purposes.
What Is an “Excess Parachute Payment”?
Loss of deductibility and application of the excise tax only apply to the “excess parachute payment.” Once it has been determined that there is a parachute payment (that the payments contingent on change of control exceed three times the base amount), the excess of such contingent payments over one times the base amount will be considered the “excess parachute payment” to which the excise tax and loss of deduction apply. In other words, going one dollar over the three times base amount threshold results in the entire amount of the contingent payments, reduced only by one times the base amount, being subject to these tax provisions.
What Payments Are Contingent on a Change of Control?
As noted previously, the payments must not only be in the nature of compensation, but also must be contingent on the change of control. Most executive employment agreements and compensation plans (i.e., severance agreements, bonus plans, nonqualified deferred compensation plans, stock option plans) contain change of control provisions that will most likely be triggered by a merger, asset sale or stock sale, resulting in bonus payments, higher severance payments and acceleration of equity in connection with the transaction. These types of payments, that clearly are triggered on the change of control, are easy to identify, but rarely are the only payments that are treated as contingent on a change of control.
Whether a payment is contingent on a change of control is generally determined under a “but for” test. To exclude the payment, it must be substantially certain, at the time of the change, that the payment would have been made whether or not the change occurred. Acceleration of vesting or acceleration of the time for payment will cause the payment to be treated as contingent upon the change, at least to some extent. Treas. Reg. §1.280G-1, Q&A-29. The portion of the payment treated as contingent is the amount by which the payment exceeds the present value of the payment absent the acceleration. Treas. Reg. §1.280G-1, Q&A-24. However, if the payment of deferred compensation was not vested (for example, it would have been forfeited had the disqualified individual terminated employment prior to age 65), the entire amount of the payment will be included in the computation if the change results in substantial vesting.
If a payment is merely accelerated by a change of control, it will not be treated as contingent upon the change of control if the acceleration does not increase the present value of the payment. These calculations are complicated if the payment that is accelerated would have been paid without regard to the change so long as the individual continued to perform services for a specified period of time. In that event, the value of the acceleration will take into account not only the value provided to the disqualified individual by earlier payment, but also the value added by elimination of the risk of forfeiture for failure to continue to perform services. If the disqualified individual and the employer are unable to establish a reasonably ascertainable value for both of these elements, then the entire amount of the accelerated payment will be included in the computation. This typically occurs with respect to performance-based bonuses or awards that are accelerated and vested upon the change of control regardless of whether the performance criteria have been achieved, in which case the entire amount of the payment would be treated as the parachute payment.
The present value of a payment which is to be made in the future is determined as of the date on which the change of control occurs, or on the date of payment if the payment is made before the change of control. First, the payment is discounted at a rate equal to 120% of the applicable federal rate. Treas. Reg. §1.280G-1, Q&A-32. Secondly, if the payment is contingent on an uncertain future event or condition, then the likelihood of whether the payment will be made must be reasonably estimated. If it is reasonably estimated that there is a 50% or greater probability that the payment will be made, then the full amount of the payment is considered for purposes of the 3-times the base amount test and the allocation of the base amount. Treas. Reg. §1.280G-1, Q&A-33. If it is reasonably estimated that there is a less than 50% probability that the payment will be made, the payment is not considered for either of these purposes. If the likelihood estimate is later determined to be incorrect, the 3-times the base amount test must be reapplied (and the portion of the base amount allocated to previous payments must be reallocated (if necessary) to such payments) to reflect the actual timing and amount of the payment.
For example, if a disqualified individual will be entitled to payment of $1,000,000 in the event his employment is terminated within one year after a change of control, and the corporation reasonably estimates that there is a 50% probability the disqualified individual’s employment will be terminated within one year, then the entire payment would be considered. If the timing of the payment can also be reasonably estimated, an additional discount may be applied. The determination of the likelihood of an event occurring can be made as late as the date the corporation files its income tax return for the year in which the change of control occurs. For example, if a change of control occurs on June 1 and the corporation files its income tax return in April of the following year, the corporation can look back and determine whether or not the event has occurred or has become likely to occur.
Avoiding, Offsetting and Mitigating the Impact of Section 280G
Once the parties have identified that there are payments that may trigger taxation under Sections 280G and 4999, the next step is to outline those potential payments and determine whether there is any way to avoid, offset or mitigate the potential impact of these sections. It is important to note that while legal counsel can certainly run some initial calculations, most often an accounting firm is charged with running the final calculations that will be relied upon for analyzing the Section 280G issues, withholding taxes, and filing returns.
There are three primary approaches to avoiding, mitigating or offsetting Section 280G liability: (i) if it is a non-public corporation, relying upon the shareholder vote exception; (ii) reducing the amounts payable to the disqualified individual to one dollar less than the amount that would trigger the excise tax (called a “cut-back”); or (iii) “grossing-up” the payments so that the disqualified individual receives the same amount after application of the excise tax under Section 4999 as he or she would have received had Section 4999 not applied.
Law firms often work closely with the accounting firms and clients to determine the best approach to avoid, mitigate, or offset Section 280G liability. The law firms also will draft the documents outlined below (whether it be the documents for the shareholder vote, cut-back, or gross-up language for agreements with the disqualified individuals). Both counsel for the buyer and the seller will review these documents, so practitioners should focus on getting documents drafted with enough time for both sides to review and provide comments. This process is generally collegial when both law firms handle a high volume of deals but becomes more challenging when one side’s counsel is unfamiliar with Section 280G or does not have executive compensation counsel assisting with the transaction.