Section 280G of the Internal Revenue Code (“280G”) (i) denies a corporate deduction for federal income tax purposes and (ii) imposes a 20% excise tax on the “disqualified individual” (e.g., officer) (a “DI”), if the value of the compensation and benefits (the “connected compensation”) received by a DI in connection with a change in control equals or exceeds three times the DI’s “base amount” (such three times of the base amount, the “280G Threshold”). The deduction is denied with respect to, and the 20% excise tax is imposed on, the amount of the connected compensation that exceeds one times the “base amount” (generally the DI’s average compensation over the five years prior to the change in control).
Techniques exist to mitigate the impact of the impact of 280G.
280G mitigation techniques include:
- Straight cutback – compensation that equals or exceeds the 280G Threshold is automatically forfeited. No 280G consequences.
- “Better-off” cutback – the DI retains the greater, on an after-tax basis, of the amount resulting from (i) payment of the full amount (taking into account the 20% excise tax) and (ii) application of a straight cutback.
- Full gross-up – the corporation pays the DI a gross-up payment sufficient to place him or her in the same after-tax position as if the 20% excise tax had not applied.1 Note that such a gross-up costs more than just the 20% excise tax because the gross-up payment is also subject income taxation (and, because it is connected compensation, also the 20% excise tax). Loss of deduction and the 20% excise tax will apply.
- Modified gross-up – the full gross-up, described above, applies only if the connected compensation exceeds the 280G Threshold by a particular amount (e.g., 110%), otherwise a straight cutback is applied.
- Reasonable compensation – payments established by clear and convincing evidence as reasonable compensation for services on or after the change in control (including refraining from performing services under a non-competition agreement) are exempt from 280G.
- Increase compensation in year preceding transaction – a DI or the corporation may take actions to increase the base amount in the year(s) before a potential transaction (e.g., exercise vested options or pay bonuses earlier than usual), which will increase the base amount, thus reducing the chances of exceeding the 280G Threshold (or at least reducing the excess).
- Private corporation shareholder vote – if all material facts concerning the connected compensation are disclosed to all shareholders of a private corporation and 75% of the voting power of the outstanding stock approves the payments in a separate vote, 280G will not apply. DIs must, prior to the vote, irrevocably waive all rights to the connected compensation above the 280G Threshold if the vote fails.