How to Run Back of the Envelope Parachute Payment (280G) Calculations

A parachute payment, in plain English, is a payment made to an executive when a company is sold, to help him or her land softly.

A parachute payment, in tax speak, is more complicated.

But here’s the gist: In the 1980’s Congress reacted to the public’s perennial outcry that executives get paid too much. So, in a token gesture intended to protect shareholders, Congress passed Sections 280G and 4999. Under these rules, if an executive is receiving cash or property above a certain threshold at an exit event, such executive will be subject to an additional 20% tax and the payor loses the compensation deduction. Effectively the government sent this message, “Don’t worry shareholders, if we think an executive is looting the company at an exit event, we’ll protect you by taking our share of the loot.”

I’m joking… sort of. But truly, this is how the law works.

I outline below how to estimate whether you have a 280G problem. This comes with the expected caveat that these rules are complicated, so ultimately, you’ll want an actual tax code Section 280G analysis performed. Also, know that if the target is a private corporation, even if there is a problem, the tax penalties can be avoided if greater than 75% of the disinterested shareholders approve the payments.

Ok. Now to the good stuff.

How to run back of the envelope parachute payment (280G) calculations in 3 Easy Steps…

1. Do the rules apply to you?

Section 280G only applies if the target in the transaction is a C corp that has any of the following: (i) multiple classes of stock, (ii) entity shareholders, and/or (iii) more than 100 shareholders.

If the target is such a C corp, then the rules apply to you if you provided services to the target at any time during the 12 months prior to the closing, and were also one or more of: an officer, a greater than 1% shareholder (counting vested options), or in the top paid 1%, each as defined in more detail under the rules.

2. What is your safe harbor amount?

If the parachute payment rules do apply to you, the next step is to determine your safe harbor amount. Your safe harbor amount is the amount of compensation that you are allowed to receive that is considered contingent on the change in control, without the 20% tax penalty applying.

To determine your safe harbor amount, average the W-2 income (use Box 1) you received from the target between 2018-2022. If you were a contractor for any portion of that time include the Form 1099-MISC amount.

For example:

Now take the average and multiply it by 3. In our example that is $600,000.

Now subtract $1. The result is your “safe harbor” amount. In our example that is $599,999.

If the safe harbor is exceeded, the 20% penalty applies to any amount above 1x the average. So, for example, if the above individual received $600,000 of compensation contingent on the change in control, the penalty tax would be $80K ($600,000 – $200,000 = $400,000 x 20% = $80K). This is in addition to regular income and employment tax.

3. What amounts count against your safe harbor amount?

As noted above, any amount considered contingent on the change in control counts against the safe harbor. Unfortunately, the tax rule is overbroad and these amounts generally include:

• The full value of equity granted to you within the 12 months prior to closing;
• The acceleration value of equity granted to you prior to the 12 months prior to closing that is accelerating at closing;
• Any bonuses paid to you in the 12 months prior to closing;
• Any transaction bonuses;
• Any potential severance;
• Certain amounts from your offer letter with buyer, including any increase in base salary, promised bonuses, equity awards, and potential severance.

Add all of those things up and see if they exceed your safe harbor from Step 2. If they do, you have a potential problem.

Gratefully, purchase price you’ll be receiving in exchange for vested equity that you’ve owned for more than one year, does not count against your safe harbor.

To sum up: If the target is a C corp and you are an officer, greater than 1% shareholder, or in the top 1% paid and provided services within 12 months of closing, the parachute payment rules can apply to you. Average your last 5 years of salary, multiply that by 3 and subtract $1 to determine your safe harbor. If there’s even a chance that your safe harbor may be exceeded, you should have an actual tax code Section 280G analysis performed. Often buyer will require that an analysis be done in any event.

Mike Baker frequently performs tax code Section 280G calculations and assists with the stockholder vote process. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.