Congress enacted §280G in 1984 over concern that contracts between a corporation and its employees providing golden parachutes directly (or indirectly) attributable to a takeover of a target company would have an adverse effect on takeover activity in general, elevate the concerns of the management of the target company beyond permitted boundaries, including the deflection of shareholder value from the target’s shareholders to key management and control shareholders of the target company. S280G applies to payments under agreements entered into or renewed after June 14, 1984. Section 280G also applies to certain payments under agreements entered into on or before June 14, 1984, and amended or supplemented in significant relevant respect after that date. This section applies to any payment that is contingent on a change in ownership or control and the change in ownership or control occurs on or after January 1, 2004.
As a result, § 280G disallows any deduction for certain payments to a “disqualified individual” (whether or not incident to termination of the individual's employment) if the payment: (i) is contingent on a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of a corporation's assets, provided the present value of the payment exceeds 3 times a defined base amount, or (ii) is paid pursuant to an agreement violating any generally enforced securities laws or regulations. Any payment pursuant to an agreement or amendment thereof entered into within one year before a change of ownership or control is presumed to be contingent on the change unless the contrary is established by clear and convincing evidence. Stated in more technical language, a parachute payment means any payment (other than an exempt payment, as defined in the regulations), that is: (i) in the nature of compensation; (ii) is made or is to be made to (or for the benefit of) a disqualified individual; (iii) is contingent on a change—(a)in the ownership of a corporation; (b)in the effective control of a corporation; or (iii) in the ownership of a substantial portion of the assets of a corporation; and (iv) has an aggregate present value of at least 3 times the individual's base amount.
A “disqualified individual” includes an officer, shareholder, or highly compensated individual (including a personal service corporation or similar entity), as well as any employee, independent contractor, or other person who performs personal services for the corporation and is specified in regulations. A disqualified individual's “base amount” is defined by reference to the individual's average annual taxable compensation for a five-year base period preceding the change of control or ownership. The parachute payments that are compared with three times the base amount to determine the excess parachute payments are net of an allowance for amounts established as reasonable compensation for personal services that were rendered before the change (if not already compensated for) or that are to be rendered after the change. The definition of “base amount” not only determines whether § 280G will apply but also determines the amount of the deduction limitation, since only payments in excess of the portion of the base amount allocable to the payment are nondeductible.
While many compensation agreements will be, by statutory presumption, subject to § 280G because they were made or modified within one year before the change in ownership, others must be shown to be contingent on the change. The arrangement must also be pursuant to a prescribed “change in ownership” transaction. Generally, “change in ownership” means the acquisition of more than 50% of the corporate stock (tested by vote or value) by one person or by a group of persons acting in concert. A change in effective control is presumed to occur when one person or a group acting in concert acquires 20% or more of the total voting power or when a majority of the board is replaced during a twelve-month period against the wishes of a majority of the old board. See Square D Co and Subsidiaries v. Comm’r, 121 TC 168 (2003).
Section 280G applies whether a change in ownership or control is friendly or hostile and whether the corporation is closely held or publicly traded. There are, however, two important exceptions that cause the change of control transaction to be exempt from application of §280G and §4999: (i) a “small business corporation,” defined by § 1361(b) as a corporation that is eligible to elect S corporation status or ii) a corporation whose stock is not readily tradable (on an established securities market or otherwise), provided the parachute payment is approved by the owners of more than 75% of the corporation's voting stock after adequate disclosure of all material facts. The provision is also inapplicable if the acquirer enter into a separate and independent contract with an employee (otherwise a disqualified person) after the change of ownership.
When §280G applies, there is also imposed on the recipient of the payment an excise tax under §4999(a) equal to 20% of an “excess parachute payment” . For this purpose, an “excess parachute payment is defined under the golden parachute rules, which deny a deduction to a corporation for any excess parachute payment that it makes §4999(b) .
The disallowance of the target corporation’s deductions under §280G will have a direct economic impact on the target shareholders. Such shareholders will bear the economic cost by the additional corporate level tax that will be imposed as well as the required withholding on the 20% excise tax. See §4999(c). Unfortunately, a disallowance of the corporation's deductions under § 280G will increase the loss suffered by the target shareholder group. This is because the target group bears the ultimate burden of both the golden parachute payments and the additional corporate tax attributable to § 280G , even if the shareholders sell out, because the well-advised buyer of stock will discount the value of the corporation by this dual burden on the corporation.
Congress again, also provided in §4999, to impose a 20% excise tax on the recipient of the parachute payment. Some insiders will require the corporation to reimburse them if subject to the excise which in turn will increase the excess payment and in turn the excise payment. reimbursements will be additional parachute payments, creating a pyramid effect. On the other hand, corporations may attempt to write caps into parachute agreements to avoid excess payments or may attempt to characterize such excess amounts as loans. But see Yocum v. U.S., 96 AFTR2d 2005-5030 (Ct. Fed. Cl. 2005)(§4999 penalty imposed on retired CEO/president for payments received under restrictive stock agreement in connection with corporation’s asset transfer to new co./joint venture: change in ownership occurred under §280G(b)(2)(A)(i)(II) triggering excise tax upon stock that became vested as result). See CCA 200923031 (June 5, 2009).