Parachute Payments in Mergers and Acquisitions

For businesses that are merging with or acquiring another business, Sections 280G and 4999 of the Internal Revenue Code (“Code”) can impact the bottom line. These two sections impose adverse tax consequences on corporations that make excess parachute payments and can have repercussions to individuals who receive them.

Parachute payments—commonly referred to as “golden parachutes”—are defined as compensatory payments made to, or for the benefit of, disqualified individuals and are contingent upon a change in control. These payments occur during a merger or acquisition and can be part of a severance package for an executive or officer of the corporation.

Section 280G of the Code prohibits corporations from deducting excess parachute payments. This provision does not apply to partnerships unless the partnership elects to be treated as a corporation. Additionally, under Section 4999 of the Code, individuals receiving excess parachute payments are subject to a 20% excise tax, which is imposed in addition to ordinary income tax. Employers are also required to withhold this excise tax As a payroll deduction.

Who Is Considered a Disqualified Individual?

A disqualified individual is an employee or other service provider who, at any time during the 12-month period preceding a change in control (referred to as the “disqualified individual determination period”), meets any of the following criteria:

• Serves as an officer of the corporation;
• Is a highly compensated individual; or
• Owns at least 1% of the corporation’s outstanding stock.

Individuals holding an officer title are presumed to be officers under the golden parachute rules. However, an individual without such a title may still be deemed an officer if the facts and circumstances demonstrate that the individual exercises the authority of an officer. A maximum of 50 individuals may be treated as officers for purposes of determining disqualified status.

Highly compensated individuals are defined as the highest-paid 1% of employees or service providers within the corporation. For corporations with more than 24,900 employees, this group is capped at the top 250 earners. This classification aligns with Section 414 of the Internal Revenue Code, which sets the compensation threshold—$160,000 for 2025.

An employee-shareholder is considered a disqualified individual if they own more than 1% of the fair market value of the corporation’s outstanding stock. When determining ownership, family attribution rules apply and must be considered.

What Types of Compensation Are Treated as a Parachute Payment?

In general, all forms of compensation and benefits related to the performance of services are treated as parachute payments, regardless of whether they are paid by the corporation undergoing the change in control or by the acquiring entity. However, the following types of payments are excluded from parachute payment treatment:

• Payments to or from tax-qualified retirement plans;
• Payments made by S corporations or organizations that are tax-exempt under Section 501 of the Internal Revenue Code;
• Payments that constitute reasonable compensation for services performed by the disqualified individual on or after the change in control; and
• Payments made by a private corporation that have been approved by shareholders in a vote that satisfies the requirements of the shareholder approval exception.

Whether a payment—or a portion of it—qualifies as reasonable compensation depends on the specific facts and circumstances of each case. In some instances, reasonable compensation may include payments made to a disqualified individual in exchange for a non-compete agreement.

It is important to note that the S corporation exception does not apply if a C corporation is a shareholder. Similarly, the nonprofit exception does not apply if a C corporation controls the tax-exempt entity.

When Are Payments Considered Contingent on a Change in Control?

Adverse tax consequences under Sections 280G and 4999 of the Internal Revenue Code apply only if the payments are contingent upon a qualifying change in control. For these purposes (distinct from the definition under Section 409A), a change in control includes:

• A change in ownership of a corporation (i.e., acquisition of more than 50% of the corporation’s stock);
• A change in the effective control of a corporation (i.e., acquisition of at least 20% of the voting power by a single individual); or
• A change in ownership of a substantial portion of the corporation’s assets (i.e., acquisition of at least one-third of the total gross fair market value of the corporation’s assets).

A payment is considered “contingent” on a change in control if it meets any of the following criteria:

• It would not have been made but for the change in control;
• It is related to the change in control; or
• It is made pursuant to an agreement entered into within one year prior to the change in control.

Importantly, a payment may still be considered contingent on a change in control even if it is also conditioned on another event—such as the termination of employment within a specified period following the change in control. Additionally, payments may be deemed contingent if they are otherwise payable but vesting or timing of payment is accelerated as a result of the change in control.

There is a rebuttable presumption that payments made under agreements entered into within one year before a change in control are contingent on that change. Ultimately, whether a payment is contingent is determined based on the specific facts and circumstances of each case.

When Are Parachute Payments Considered “Excess Parachute Payments”?

Parachute payments become “excess parachute payments” when the aggregate present value of all such payments exceeds three times the disqualified individual’s base amount of compensation. In that case, the excess parachute payment is the portion of the total parachute payments that exceeds one times the base amount.

A disqualified individual’s “base amount” is calculated as the average annual compensation included in the individual’s gross income for services performed for the corporation (and its affiliated group) during the five most recent taxable years preceding the change in control.

What Is the Shareholder Approval Exception?

Certain parachute payments may be exempt from treatment as “excess parachute payments” under Code Section 280G if they meet the requirements of the shareholder approval exception. To qualify, the following conditions must be satisfied:

• The payments must be made by a privately held corporation; and
• The payments must be approved by shareholders in a vote that meets the requirements of Section 280G, including:
• Approval by more than 75% of the voting power of all outstanding stock entitled to vote;
• Exclusion of disqualified individuals from voting;
• A vote that specifically determines whether the disqualified individual will receive the payments; and
• Adequate disclosure of all material facts related to the payments.

The shareholder vote must be separate from the vote approving the change in control. Shareholders may vote on parachute payments for all disqualified individuals collectively or vote on each individual separately. To satisfy the 75% approval threshold, the vote must be conducted among shareholders of record as of any date within the six-month period immediately preceding the change in control. Importantly, shares owned by disqualified individuals whose payments are being voted on are excluded from the voting power calculation.

Disqualified individuals may not vote on:

• Their own parachute payments; or
• Payments to any other disqualified individual.

Additionally, individuals related to disqualified individuals under the attribution rules of Section 318 of the Code are also prohibited from voting.

Example:
Assume a corporation has eight shareholders—A, B, C, D, E, F, G, and H—each owning 12.5% of the company’s shares. If G and H are disqualified individuals receiving parachute payments, their shares are excluded from the vote. If A through E vote in favor and F votes against, the approval rate is 83.33% (62.5% out of the remaining 75%), satisfying the 75% requirement.

The shareholder vote must determine the disqualified individual’s right to receive the payments. This generally means the individual must waive the right to the payments unless shareholder approval is obtained. If the vote fails and the waiver is in place, the individual forfeits the payments.

If the individual does not waive the right, then the shareholder vote will not be determinative of whether payment is made and the excess payments will be treated as excess parachute payments, triggering a 20% excise tax for the individual and denying the corporation a deduction.

The threshold of three times the base amount is referred to as the “280G safe harbor.” If the disqualified individual waives only the amount above the 280G safe harbor and shareholder approval is sought only for the portion of payments exceeding this threshold, the disqualified individual retains the right to receive the safe harbor amount even if the excess is not approved.

Disclosure Requirements:
The corporation must provide full and truthful disclosure to all voting shareholders. This includes:

• All material facts about the parachute payments; and
• Any additional information necessary to ensure the disclosure is not misleading.

The disclosure must cover all payments that would be considered parachute payments in the absence of shareholder approval—not just those excess amounts submitted for a vote. Required details include the event that triggers the payment and a brief description of each payment.

About the Author: Larry W. Rudawsky has over thirty years of experience  working with businesses in the area of employee benefits. He can be reached at lwr@barrettlaw.com or 260.423.8883.