The Golden Parachute Problem: How Section 280G Excise Tax Works and When It Bites

When a mining or energy company gets acquired, executives with change-in-control provisions can receive substantial payments. Accelerated equity, severance, bonus guarantees. The numbers can be significant.

Then the tax bill arrives. Not just income tax. An additional 20% federal excise tax on top of income tax. That is Section 280G, and it surprises executives in M&A situations more often than it should.

What is a golden parachute payment and who does Section 280G apply to?

Section 280G of the tax code applies to payments made to "disqualified individuals" in connection with a change in control. Disqualified individuals generally include officers, directors, and certain highly compensated employees. If you are a named executive officer or a member of the board, you are almost certainly a disqualified individual.

A parachute payment is any payment that is contingent on a change in control and that is paid to a disqualified individual. The contingency can be explicit, meaning the payment only happens if there is a deal, or it can be implicit, meaning the payment is accelerated or triggered by the deal even if it would have been paid eventually anyway. Accelerated RSU vesting, CIC severance, bonus guarantees, and accelerated NQDC payments can all count.

How does the IRS calculate whether my payments trigger the excise tax?

The calculation has three steps.

First, compute your base amount. The base amount is your average annual compensation from the company, includable in gross income, over the five calendar years before the year of the change in control. If you have been with the company fewer than five years, you use the period you were employed.

Second, apply the three-times test. If the total present value of your parachute payments equals or exceeds three times your base amount, you have a potential problem. Three times base amount is the threshold, not the taxable amount.

Third, calculate the excess. The portion subject to the excise tax is the amount of parachute payments above one times your base amount. So if your base amount is $500,000, and your total parachute payments have a present value of $2.5 million, the amount above $500,000, or $2 million, is the excess parachute payment subject to the excise tax.

The excise tax is 20% of that excess amount, paid by you on top of ordinary income tax. The company also loses its deduction for the excess amount under Section 280G, and the executive owes the 20% excise tax under the companion provision, Section 4999.

What is the 280G base amount and the three-times test?

The base amount is the foundation of the entire calculation. A few things that affect it.

Compensation that is not includable in income does not count. Employer 401(k) contributions, health insurance premiums, and other excluded items reduce your base amount. Most executives find their base amount is lower than their W-2 wages suggest.

Compensation in years before you joined the company, or in years where you were not a disqualified individual, is excluded. If you became an officer in year three of a five-year lookback, only years three through five count. A shorter lookback period can produce a lower base amount than you might expect, which lowers the threshold.

Payments that are reasonable compensation for services rendered after the change in control, can be excluded from the parachute calculation. Severance pay for future services, post-close consulting arrangements, and earnout-style payments may qualify for exclusion if structured correctly. This is where working with a CPA or tax attorney before the deal closes makes a real difference.

What is a 280G cutback clause and when does it help?

A cutback clause is a provision in an employment agreement or CIC agreement that automatically reduces your parachute payments to just below the three-times threshold if doing so would produce a better after-tax result for you than receiving the full amount and paying the excise tax.

It sounds straightforward. It is actually a calculation that depends on your individual tax situation. The cutback is better when the savings from avoiding the excise tax and associated income tax exceed the amount you had to give up. Whether that is the case depends on the total amount of your payments, your marginal tax rate, and how far you are above or below the threshold.

Some agreements offer a choice: take the cutback automatically or elect to receive the full payment and pay the excise tax yourself. Others apply the cutback without giving you an election. Know what your agreement says before the deal closes.

Should I take the full parachute payment or cut back to avoid the excise tax?

The math is specific to your situation and requires an actual calculation, not a rule of thumb. Three scenarios where the cutback may be the better outcome: you are modestly above the three-times threshold, your marginal rate is high, and the excess parachute amount is relatively small compared to the forgone payment.

Three scenarios where taking the full payment and paying the excise tax may be better: you are far above the threshold, the excise tax is already unavoidable at any realistic cutback level, or the company is offering a gross-up to cover your excise tax liability (less common post-2008, but still seen in some legacy agreements).

The cutback analysis needs to happen before the deal closes. After closing, the elections are made and the payments are fixed. If your employment agreement does not have a cutback provision and you are approaching the threshold, your options narrow once the deal is signed.

What happens to your financial plan if a significant portion of your CIC payment is consumed by the excise tax?

These are general educational points about Section 280G mechanics and not tax advice for your specific situation. Parachute payment calculations are highly fact-specific and require analysis of your compensation history, agreement terms, and deal structure. If you would like to discuss how this applies to your situation before a deal closes, schedule a complimentary call. Link to Calendar

Disclosure: This article is for informational and educational purposes only and does not constitute legal or tax advice. Section 280G calculations are complex and depend on individual facts, compensation history, plan documents, and deal structure. Mountain Legacy Family Wealth Partners does not provide legal or tax advice. Consult your CPA and securities attorney before making decisions related to change-in-control compensation.

Disclaimer: The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP's express prior written consent. Neither IFP Advisors LLC, IFP Securities LLC, dba Independent Financial Partners (IFP), nor their affiliates offer tax or legal advice. Any potential tax advantages or benefits will depend on your circumstances. Consult your tax professional and/or legal expert about your individual tax situation and visit IRS.gov to learn more.