What are “parachute payments” and 280G?
Takeaway: Parachute payments and Section 280G of the Internal Revenue Code can have significant implications in startup acquisitions, potentially leading to substantial taxes for both the company and executives; however, obtaining the consent of disinterested stockholders and provisions such as the 280G cutback can help mitigate these effects.
Parachute payments and the corresponding Section 280G of the Internal Revenue Code can come into play in acquisitions depending on how the payouts are structured. They can affect the compensation received by employees and have tax implications for the company.
Understanding Parachute Payments
Golden parachutes are significant compensation benefits provided to top executives of a corporation when control of the company changes, usually as a result of a merger or acquisition. These payments often come in the form of cash bonuses, stock options, or other benefits and can be quite substantial.
The concept behind the golden parachute is to provide compensation for executives who may lose their jobs due to the change in control, and also to eliminate any potential conflict of interest that might arise when executives are negotiating the terms of an acquisition.
Introduction to Section 280G
Section 280G of the Internal Revenue Code is the federal tax provision that governs golden parachute payments. Under Section 280G, if the total parachute payments to an individual exceed three times their "base amount" (an average of their taxable compensation over the past five years), then the excess is considered a "parachute payment," and two major tax consequences arise:
The company cannot deduct the portion of the parachute payments that is considered excessive for tax purposes.
The executive receiving the payment must pay a 20% excise tax on the excess amount, in addition to their regular income tax.
Impact on Startup Acquisitions
These provisions are particularly important in the context of startup acquisitions because high-growth startups often provide their executives with substantial equity compensation packages (e.g., founder stock) that could result in significant parachute payments in the event of a sale.
In acquisitions, the calculations under Section 280G are complicated by the fact that a significant portion of an executive's compensation often comes in the form of equity, the value of which may be uncertain and fluctuate significantly. The acquisition may trigger vesting acceleration provisions, which can lead to large unexpected golden parachute payments.
Strategies for Mitigating 280G Risk
There are a couple strategies to mitigate the adverse effects of 280G. The first is to obtain the consent of disinterested stockholders waiving treatment of the compensation in the acquisition as parachute payments. A disinterested stockholder is one who is not receiving a parachute payment. To obtain their consent for the waiver, companies need to approach these stockholders with detailed information about the planned transaction and the potential tax implications of the parachute payments. This approach does not guarantee that the Internal Revenue Service (IRS) will accept the waiver. The IRS has its own conditions to approve these waivers, including that the vote of disinterested stockholders must be meaningful - that is, they should be able to influence the outcome.
Alternatively, to avoid the tax implications of Section 280G, some startups include a "280G cutback" provision in their executive compensation agreements, which states that if an executive's parachute payments would be subject to the excise tax, then the executive gets the greater of the amount resulting from (i) the payments being reduced to a level where the tax would not apply and (ii) the amount they would receive if they paid the tax on the full amount of compensation.
Conclusion
While parachute payments and Section 280G can have significant implications for both the acquired company and its employees, there are strategies and provisions that can be put in place to mitigate these effects. As always, it is crucial for startups considering an acquisition to engage with experienced legal and financial advisors to understand and navigate these complex issues.