Don’t Let Golden Parachutes Become a Deal’s Lead Balloon

In reaction to the large “golden parachute payments” made and/or benefits given to corporate executives resulting from merger and acquisition transactions, Congress enacted Internal Revenue Code Sections 280G and 4999 in an effort to discourage such payments.

Sections 280G and 4999 attempt to discourage golden parachute payments by denying tax deductions to corporations for all amounts determined to be “excess parachute payments” and by imposing a 20 percent excise tax, in addition to regular income tax, on certain parachute payments received by individuals.

Golden Parachute Payments

Golden parachute payments are contractual arrangements to provide significant monetary compensation and substantial benefits to executives and other highly compensated individuals in the event of termination resulting from a merger, acquisition, or other corporate transaction (in some cases the executives may not lose their jobs). These payments provide a generous “soft landing” to the executives, and can include bonuses, severance, accelerated vesting of corporate options or stock, continuation of healthcare benefits, and continuing use of a corporate jet, just to mention a few. For purposes of Section 280G, excess parachute payments are determined using formulas based on average compensation for prior years compared to the total present value of payments and benefits contingent on the transaction.

Application

Code Section 280G seeks to limit golden parachute payments to officers, shareholders, or highly compensated individuals providing services to a corporation as an employee or independent contractor. A parachute payment must be contingent on a change in ownership of a corporation, a change of effective control of a corporation, or a change in ownership of a substantial portion of the assets of a corporation.

Entity questions relative to Section 280G include:

• What does Section 280G mean by the term “corporation”?
• Are S corporations subject to Section 280G?
• Are partnerships and LLCs taxed as partnerships exempt?

The term “corporation” in Section 280G includes: (i) treating a parent and its subsidiary(ies) as one corporation; (ii) associations; (iii) joint-stock corporations; (iv) insurance companies; (v) publicly traded partnerships, (vi) tax-exempt entities, (vii) foreign entities organized as corporations; and (viii) partnerships and limited liability companies (LLC) that validly checked the box to be classified as a corporation for federal income tax purposes.

Section 280G does not apply to “small” corporations. For purposes of Section 280G, “small” does not refer to the corporation’s revenues or value. Rather, a “small” corporation is any corporation that has validly elected to be an S corporation or is eligible to elect to be an S corporation. Therefore, an S corporation is not subject to Section 280G.

Further, unlike with C corporations, members of an S corporation-affiliated group may not be treated as one corporation. If an S corporation subsidiary that separately meets the qualifications to be an S corporation and a valid Qualified Subchapter S subsidiary election is made for the subsidiary, the subsidiary is not treated as a separate entity from its S corporation parent. However, an S corporation subsidiary that is not wholly owned by the S corporation parent may not qualify for the small corporation exception and may be subject to Section 280G.

Since only corporations are subject to Section 280G, partnerships and LLCs taxed as partnerships should be fine, right? Actually, partnerships could still have Section 280G exposure depending on their structure.

For example, consider a typical private equity structure that includes a C corporation blocker entity that directly or indirectly owns an interest in the LLC or the partnership. In this case, it is possible that Section 280G could apply to excess parachute payments if:

• The blocker corporation’s interest in the LLC or partnership equals or exceeds one-third the total gross fair market value of the blocker corporation’s assets; and
• The employees of the LLC or partnership receiving the parachute payments are considered officers, shareholders, or highly compensated individuals providing services to the blocker corporation.

Given the complexities of Section 280G, it is important to identify and address Section 280G in the early stages of a transaction.

For more information about how Section 280G may affect a transaction, contact us. We are here to help.

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