A business contemplating a sale or a purchaser contemplating an acquisition of such a business has many issues to consider in the lead up to and consummation of the sale. One issue is whether there are any special tax concerns with respect to compensatory payments made to employees or other service providers in connection with the sale. In particular, the seller or purchaser in a sale will want to assess whether Sections 280G and 4999 of the Internal Revenue Code of 1986, as amended and the rules and regulations promulgated thereunder (the “Code”) are implicated by the contemplated sale.
What are Code Sections 280G and 4999?
Code Section 280G prevents a corporation from taking a deduction for compensatory payments that it pays to “disqualified individuals” that are contingent upon a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation (referred to here, as a “change in control event”), and that have an aggregate present value that equals or exceeds three times such disqualified individual’s base amount. Such payments are referred to as “excess parachute payments”. A disqualified individual’s base amount is the person’s annualized includible compensation for the preceding five tax years (or such shorter period if the disqualified individual was not employed or providing services to the payor for the full five-year period). In general, the annualized includible compensation is the Box 1 amount in the person’s W-2 for each of the applicable years in such period assuming such person is an employee.
Payments to or from a tax-qualified retirement plan, such as a distribution from a Code Section 401(k) plan, are not counted for this purpose. The following are common examples of payments that may be counted and should be considered when assessing whether there are any parachute payments: severance payments, COBRA reimbursements or outplacement benefits; retention or transaction bonuses; nonqualified deferred compensation plan (such as a “SERP” or “top hat” plan) distributions; gross ups to cover the taxes imposed by Code Section 4999; equity or cash-incentive vesting accelerations and payments; compensatory increases (such as a salary increases) during the 12-month period prior to the change in control event. Importantly for this determination, any payment pursuant to an agreement entered into within 1 year before the change in control event, or an amendment made within such 1-year period of a previous agreement, is presumed to be contingent on such change unless the contrary is established by clear and convincing evidence.
In turn, Code Section 4999 imposes on any person who receives such an excess parachute payment a tax equal to 20% of the amount of such excess parachute payment over one times the person’s base amount.
Which Entities are subject to Code Sections 280G and 4999?
Code Sections 280G and 4999 only applies to corporations or limited liability companies taxed as C corporations. It does not apply to limited liability companies or other entities taxed as partnerships or limited liability companies or corporations taxed as S corporations.
However, if a covered corporation is private (meaning its stock is not traded on an established securities market immediately prior to the change in control event), then the corporation may avail itself of an exception under Code Section 280G that does not count parachute payments when certain “shareholder approval” requirements are met with respect to such parachute payments. These “shareholder approval” requirements are that (1) such payment is approved by a vote of persons who owned, immediately before the change in control event, more than 75% of the voting power of all outstanding stock of the corporation and (2) there was adequate disclosure to the shareholders of all material facts regarding the payments.
This exception – often called the “280G shareholder cleansing vote” – is crucial for many sellers and buyers. Often, a buyer will require that a privately owned seller include a covenant in the purchase agreement that stipulates that the seller will seek to attain such shareholder approval and the disqualified individual’s waiver of the right to receive excess parachute payments if such shareholder approval is not attained.
Who are Disqualified Individuals?
If a seller is subject to Code Section 280G and it is determined that excess parachute payments will be made, it and the purchaser must determine who are the “disqualified individuals” with respect to whom Code Sections 280G and 4999 will apply. Under Code Section 280G, a “disqualified individual” is any individual who is (1) an employee, independent contractor, or other person who performs personal services for corporation, and (2) is an officer, shareholder, or highly-compensated individual. The term “highly-compensated individual” only includes an individual who is (or would be if the individual were an employee) a member of the group consisting of the highest paid 1 percent of the employees of the corporation or, if less, the highest paid 250 employees of the corporation. The Code Section 280G Treasury regulations provide more detailed descriptions of who constitutes an officer, shareholder or highly-compensated individual for purposes of Code Section 280G and should be consulted when making this assessment.
Take Home Point
In summary, given the significant adverse tax consequences applicable to violations of Code Sections 280G and 4999, it is important for practitioners to consider their application in any business sale.