Tax Law Blog

This article discusses the application of Sections 280G and 4999 of the Internal Revenue Code and related treasury regulations (“IRC” or “Code”)[1], best practices, and alternative approaches to structuring and approving parachute payments in the context of a deferred compensation plan (“Plan”) for a privately held domestic company (“Company”)[2]. Assume a Plan such as a synthetic equity plan involving phantom stock to be paid in cash upon IRC 409A compliant payment events, substantially simplifying valuation issues noted below.

I. BACKGROUND

Section 280G and §4999 are designed to discourage M&A buyers from tempting executives to give up control and executives from looting target assets in the deal, so they impose punitive rules on both payor and recipient of “golden parachute” payments. Section 280G disallows a deduction for any “excess parachute payment” made by a corporation to a “disqualified individual” in connection with a change in control event. Section 4999 imposes a 20% excise tax on individuals who receive “excess parachute payments” as defined in Section 280G(b).

An “excess parachute payment” is any “parachute payment,” to the extent it exceeds an allocable portion of the recipient's “base amount” (generally the average annual compensation for the five taxable years prior to an acquisition or, if less than five years, the period of employment).

A payment is a “parachute payment” if: (i)  it is paid to or for the benefit of a “disqualified individual” with respect to the corporation (i.e., any employee, independent contractor or director of the corporation who is also an officer, shareholder who owns 1 percent or more by value of the corporation's stock, or “highly-compensated individual”); (ii) it is in the nature of compensation; (iii) it is contingent on a change in the ownership or effective control of a corporation, or on a change in the ownership of a substantial portion of the assets of a corporation (roughly 1/3 of gross assets);  and (iv) the present value of all such payments equals or exceeds 3 times the recipient's base amount. §280G(b)(2)(A), (c). If the threshold is met or exceeded, the aggregate payment(s) is treated as a parachute payment.

II. DISCUSSION

a. Excepted Payments.

Private Company Vote.

Though primarily concerned with public companies, Section 280G and 4999 also apply to private corporations unless an exception applies. The most important exception in this regard is often the shareholder-approval exception under Section 280G(b)(5).

If these exemption requirements are met, parachute payments are treated as exempt from Sections 280G and 4999 entirely: (i) The corporation must be closely held – not readily tradable on an established securities market. IRC § 280G(b)(5)(A). As assumed above, Company meets this requirement. (ii) All material facts regarding the payments must be disclosed to shareholders, including the identity of the individuals receiving payments, the amounts, and the fact that the payments are contingent on a change in control. Treas. Reg. § 1.280G-1, Q/A-7. (iii) The payments must be approved by shareholders owning at least 75% of the voting power of all outstanding stock entitled to vote. Shares owned by disqualified individuals receiving the payments are disregarded for purposes of the 75% test (i.e., excluded from both the numerator and denominator for this vote). (iv) The approval must occur before the change in control and before the payments are made. This typically occurs (and may be required as a condition precedent) in connection with signing or closing of a change of control transaction.[3]

Small Business Corporation.

Payments are excluded if Company (immediately before the change in ownership or control) would qualify as a small business corporation (as defined in section 1361(b) but without regard to section 1361(b)(1)(C) thereof), without regard to whether the corporation had an election to be treated as a corporation under section 1361 in effect on the date of the change in ownership or control. Treas. Reg. § 1.280G-1, Q/A-5 and -6.

In other words, payments would generally be exempt from the golden parachute restrictions if Company were eligible to be treated as an S corporation, regardless of whether it elected to be treated as an S corporation. If Company is a domestic corporation with less than 100 shareholders, since (b)(1)(C) regarding shareholder residence is disregarded, this exception would be met if Company: (i) does not have more than 1 class of voting stock and (ii) does not have any shareholders that are not individuals (besides estates, permitted trusts, and exempt organizations).  

Reasonable Compensation.

Reasonable compensation is exempt from Section 280G and excess parachute payments are reduced for 280G purposes to the extent of reasonable compensation for personal services actually rendered. Payments (or portions thereof) for services rendered before a change in control are included in parachute payments but reduce the amount constituting an excess parachute payment. Payments (or portions thereof) for services rendered after the change in control are excluded as parachute payments. Severance payments are not considered reasonable compensation for services.

Similarly, reasonable compensation in the ordinary course should not be subject to Section 280G. In general, if an option is granted within one year of a change in control event, the grant is presumed to be on account of the event. Reg. §1.280G-1, Q&A-25. But see PLR 9127016, holding that stock options granted within one year of a change in control were only considered contingent to the extent of the potential accelerated value, pursuant to Q&A-24(c), because they were not excessive compared to prior year grants and were fewer than those granted two years before the change in control. In other words, Reg. §1.280G-1, Q&A-24(c) will probably apply to typical stock option grants, even if the Company’s normal period for making option grants falls within one year of the change in control, provided the grant or other transfer is not unusual in the context of the Company's history.

Paid-for property.

A payment generally is not considered a parachute payment if the disqualified individual transfers cash or property in exchange for the payment, even in the future. Reg. §1.280G-1, Q&A-14. If the original grant or vesting of a stock option was treated as a payment in the nature of compensation, for example, the exercise of the option is not treated as a parachute payment because, in exchange for the stock, the option holder transferred cash (exercise price) and property (option) of equal fair market value.

b. Measuring the Payment.

Payment.

All payments are payments in the nature of compensation if they arise out of an employment relationship or are associated with the performance of services. Section 1.280G-1, Q/A 1(a). A payment in the nature of compensation for purposes of § 280G includes the transfer of cash or property. Any transfer of property (including stock, restricted stock, and stock options) is treated as a payment and must be valued at its fair market value at the time of transfer or vesting. Section 280G(d)(3).

Property.

The terms “transfer” and “property” are interpreted broadly. For example, the grant of stock options to a disqualified individual of a target by an acquirer as a part of a sale is a transfer of property even though it is not funded with target assets.[4]

Property includes options (including an option to which §§ 421, 422, or 423 applies), regardless of whether an option has a readily ascertainable fair market value under § 83. The aggregate transferred amount is used both to determine whether there are parachute payments and to calculate the amount of any excess parachute payments and any excise tax liability associated with the transfer of the option.

Valuation.

For cash in domestic currency, fair market value is simply the face amount transferred. The value of stock and other securities is generally its fair market value at the time it is transferred to the recipient. An option is considered transferred when the option becomes substantially vested within the meaning of Reg. § 1.83-3(b) and (j). Thus, stock options must be valued when a payment in the nature of compensation includes the transfer of a stock option, such as the grant or vesting of a stock option, in connection with a change in ownership or control. When there has been a change in ownership or control for purposes of section 280G is determined under § 1.280G-1, Q/A-27 through Q/A-29.

A taxpayer may value a stock option, whether on publicly traded or privately held stock, using any valuation method that (i) is consistent with generally accepted accounting principles (such as FAS 123 or a successor standard) and (ii) takes into account the factors provided in § 1.280G-1, Q/A 13. Rev. Proc. 2003-68. The initial value of an option is the amount of the payment, subject to adjustment as otherwise applicable (e.g., pursuant to § 1.280G-1, Q/A-24).

Under § 1.280G-1, Q/A-33, for purposes of §§ 280G and 4999, a payor may re-determine the value of an option, during the 18-month period beginning on the date of the change in ownership or control (the re-determination period), in accordance with Rev. Proc. 2003-68. Recalculation is permitted if, during the re-determination period, either of the following occurs: (1) there is a change in the term of the option due to a termination of employment, or (2) there is a change in the volatility of the stock.

Rev. Proc. 2003-68 provides a safe harbor for option valuation for 280G purposes based on the Black-Scholes model, considering volatility, exercise price, spot price, and option term. The safe harbor value equals (number of option shares) x (the spot price) x (the applicable Black-Scholes valuation factor). Assumptions and the determination of each factor must be reasonable and consistent with assumptions made with respect to other options valued in connection with the change in control.

As one would expect, the transfer of securities or options to a disqualified person upon a change of control can quickly complicate the determination of whether and to what extent a parachute payment or excess parachute payment exists. Planning and drafting regarding structure, timing, valuation, and revaluation of any severance or other payment involving securities or options are essential considerations, but their application is beyond the scope of this summary. Though the discussion in the next section assumes cash payments in connection with synthetic equity like Phantom Stock, note that options qualified under §422 and §423 (incentive stock options and employee stock purchase plans) are treated the same as non-statutory stock options under the golden parachute rules. See Reg. §1.280G-1, Q&A-13(a).

c. Approaches to Forfeiture.

1. Automatic Forfeiture. The Plan may include a provision that precludes an excess parachute payment by automatically cancelling any parachute payment under Section 280G.[5] An automatic forfeiture provision is generally disfavored, both by executives and board members, as being too rigid and tying the board’s hands with respect to compensation that was both intended and helpful in facilitating an advantageous deal. It may be appropriate where simplicity and risk-aversion are the chief concerns. The footnoted language below could be somewhat improved by incorporating a to-the-extent concept so that forfeiture is not all or nothing, and clarifying that forfeiture applies to an excess parachute payment as opposed to any parachute payment, whether or not fully deductible.
2. Shareholder-Approval Covenant. Instead of automatic forfeiture above, the Plan could require Company to seek shareholder approval pursuant to Section 280G(b)(5) in connection with a change in control. But note that if disqualified individuals comprise more than 25% of Company’s shareholder within the determination period, the exception could not be met. The payments would need to be reduced or restructured through cutback or other ameliorating provision. By design, it is difficult to manipulate the 75% voting threshold because an individual is disregarded if they are a disqualified individual at any time within the twelve-month period before the date of the change of control. See Treas. Reg. § 1.280G-1, Q/A-20 (disqualified individual determination period). Regardless of the chosen approach, it is typically good practice for the Plan to provide for a “cleansing” vote, which may be optional or mandatory. Where the vote exemption is the only ameliorating provision, cutback may be automatic except to the extent that payments were approved by a sufficient percentage of shareholders to meet the private company voting exception.
3. Automatic Cutback to Safe Harbor (Pro-Company). The Plan could provide that payments are automatically reduced to the maximum amount that does not trigger excess parachute payments (i.e., just below three times base amount). This is viewed as a pro-Company approach because it protects the company from 280G noncompliance regardless of the effect to the executive, and is generally simpler to administer than any structure that takes the executive’s result into account. Automatic cutback minimizes Board discretion, deliberation, and conflict questions, avoids or mitigates the risk of not meeting the 75% hurdle, and avoids needing to separately figure each executive’s tax consequences, while also protecting executives from excise tax. Amid the typical fog and fatigue that often attends a change of control, the value of a streamlined process should not be underestimated.
4. Cutback when Helpful (Middle Approach). The Company’s Plan could include a cutback providing the better of (or permitting an executive’s election between) (i) any severance and other payments with no reduction, or (ii) the severance and other payments reduced below the §280G threshold -- whichever provides the greater benefit to the executive on an after-tax basis. As a slight variation, the straight cutback above could include a common proviso that payments will only be cutback to the extent that the cutback results in a better after-tax outcome for the executive. While this sort of best-result or elective approach provides more flexibility for individual executives, it can complicate or delay deliberations, approval, and closing, or may invite scrutiny from a displeased minority.
5. Gross Up (Pro-Executive). Some companies have chosen to include a gross-up payment to the executive for any excise taxes the executive may incur because of §4999. This can obviously become extremely expensive for the company, depending on the amount of the parachute and other payments triggering §280G. The payments are non-deductible to the Company, plus the 20% excise tax is grossed up, plus any cumulative taxes that would apply to the tax gross-up. A practitioner should be wary of this approach and the mess that may ensue.

III. CONCLUSION

What’s right for the Company will always depend on its unique situation and the goals of its board and shareholders. The best option often involves some flavor or combination of alternatives 2, 3, and 4 above. It rarely hurts to include a shareholder approval option, and in many cases it may be prudent to include a mandatory approval procedure as a matter of course, since to the extent it is available any parachute payments will be exempt. Even where a 75% shareholder vote is unavailable, the Company must still observe applicable state law approval requirements. In addition to approval mechanics, it usually makes sense to include some form of cutback. While blanket forfeiture may be too blunt a tool, it will generally be in the Company’s and shareholders’ interest to vest discretion in the board instead of the executive, except where an executive’s election does not unduly disadvantage the Company or its shareholders.

Navigating the legal landscape of the IRC is rarely straightforward and choosing the wrong mitigation approach can increase tax exposure and transaction friction. An experienced tax attorney can help you model alternatives, assess shareholder‑approval strategies, and structure payments that withstand scrutiny. If your organization is evaluating a change‑in‑control event or updating its deferred compensation structures, contact your tax attorney for tailored guidance and proactive planning.

[1] Unless otherwise indicated, all references to sections, chapters, and similar designations refer to the Code.

[2] Note that Section 280G applies both to corporations, including foreign corporations (as defined in §7701(a)(5)), whether publicly traded or privately held. Likewise, disqualified person is applicable to domestic US residents, as well as nonresident aliens and US resident aliens. Because US subjects its residents to income tax on a worldwide basis, a foreign corporation may inadvertently trip on Section 280B by paying an excess parachute payment to a US resident alien, even where no US company is involved in the transaction. In addition to the loss of a US FIT deduction (which may be of limited concern to the foreign corporation), such a payment may trigger unanticipated withholding obligations.

[3] IRC § 280G(b)(5)(B); Treas. Reg. § 1.280G-1, Q/A-7.

[4] DEFRA Blue Book at 203. See also H.R. Rep. No. 98-861 (Conf. Rep. 1984).

[5] Such a provision might provide as follows: Notwithstanding any other provision of this Plan, any award agreement, or any other agreement, contract, or understanding entered into by a Participant with the Company (except an agreement, contract, or understanding that expressly addresses Section 280G or Section 4999 of the Code), and notwithstanding any other arrangement for the direct or indirect provision of compensation to the Participant (whether or not such compensation is deferred, is in cash, or is in the form of a benefit to or for the Participant), if a Participant is a “disqualified individual,” as that term is defined in Section 280G(c) of the Code, any Plan Securities held by the Participant and any right to receive any benefit under this Plan will not become exercisable or vested to the extent that such right to exercise, vesting, payment, or benefit would cause any benefit under this Plan to be considered a “parachute payment” within the meaning of Section 280G(b)(2) of the Code (or any amendment thereto) (“Parachute Payment”).