Sec. 280G and the evolving executive compensation landscape

Editors: Alexander J. Brosseau, CPA, and Greg A. Fairbanks, J.D., LL.M.

Since the enactment of Sec. 280G of the Internal Revenue Code as part of the Tax Reform Act of 1984 (Division A, Deficit Reduction Act of 1984, P.L. 98–369) and the issuance of the final Treasury regulations in 2003, the landscape of executive compensation arrangements has changed significantly. In part, arrangements have developed in response to the use of more sophisticated employer structures, changes in capital markets, and demands of management. The effect is that applying Sec. 280G in certain situations is more challenging because it does not address or contemplate considerations that now arise 40 years post–enactment. This item discusses certain issues that may arise in evaluating the current landscape, but other issues may arise as well. Determining the Sec. 280G consequences requires careful analysis of organizational structure as well as payments and benefits provided under executive compensation arrangements.

Background

Sec. 280G was enacted to address the potential for “golden parachutes” paid in connection with a corporate transaction that could discourage potential buyers, encourage executives to favor a corporate transaction that may not be in the shareholders’ interest, and reduce the value of shareholders’ interests. Congress aimed to discourage golden parachutes by limiting the deductibility of excess parachute payments and imposing a 20% excise tax on excess parachute payments.

Sec. 280G applies to “parachute payments,” which are payments in the nature of compensation made to certain “disqualified individuals” if the payments are contingent on either a change in the ownership or effective control of a corporation, or a change in the ownership of a substantial portion of the assets of a corporation (Sec. 280G(b)(2)(A)). Due to the broad definition of “payments in the nature of compensation,” a contingent parachute payment may include not only transaction bonuses but also accelerated vesting of equity incentive awards such as restricted or performance stock units or options (Regs. Sec. 1.280G–1, Q&A 11). Further, this definition does not necessarily require that the payment be treated as compensation or that the payment be made by the corporation undergoing a change in control.

Affiliated groups

Complexities can arise in determining whether certain entities meet the definition of “corporation” under Sec. 280G or in the treatment of affiliated groups of corporations and other organizations. For purposes of Sec. 280G, a corporation is defined based on Sec. 7701(a)(3) and Regs. Sec. 301.7701–2(b). This definition would include, among other entities, a publicly traded partnership treated as a corporation under Sec. 7704(a); an entity described in Regs. Sec. 301.7701–3(c)(1)(v)(A); a real estate investment trust under Sec. 856(a); a corporation that has mutual or cooperative ownership, as defined in Sec. 7701(a)(32); and a foreign corporation, as defined under Sec. 7701(a)(5) (Regs. Sec. 1.280G–1, Q&A 45).

Under Sec. 280G, all members of the same affiliated group under Sec. 1504 (without regard to the exceptions of Sec. 1504(b)) are treated as one corporation (Sec. 280G(d)(5) and Regs. Sec. 1.280G–1, Q&A 46). By disregarding the exemptions of Sec. 1504(b), an affiliated group for purposes of Sec. 280G includes certain corporations that would be excluded from a consolidated tax return, including a tax–exempt corporation under Sec. 501, insurance companies taxed under Sec. 801, foreign corporations, certain regulated investment companies and real estate investment trusts, domestic international sales corporations, and S corporations.

Although the regulations and other IRS guidance do not explicitly state that partnerships and limited liability companies (LLCs) taxed as partnerships are excluded from the application of Sec. 280G, those types of entities are generally not included in the affiliated group of the entities undergoing a change in control. Therefore, partnerships and LLCs taxed as partnerships are not considered subject to Sec. 280G. If a partnership or LLC is involved in a corporate transaction, however, a review of the factual situation may be necessary before concluding that no Sec. 280G issues are present. For example, there may be corporate entities in the organizational structure that experience a change in control with employees receiving contingent compensatory payments. As a result, there may be a need to assess whether there are disqualified individuals who are, or may receive, excess parachute payments under Sec. 280G.

Given the expansion of multinational corporations since 1984, U.S. consolidated tax groups may represent only part of a Sec. 280G affiliated group, with review of the broader multinational affiliated group necessary to evaluate Sec. 280G consequences. For example, the acquisition of a U.S. consolidated tax group that is part of a broader multinational affiliated group would need to be evaluated as a potential change in the ownership of a substantial portion of the assets of the multinational affiliated group and not as a change in the ownership of the U.S. consolidated tax group.

Shareholder-vote exemption

The determination of the Sec. 280G affiliated group can also play an important role in evaluating the availability of the shareholder–vote exemption. Under Sec. 280G, potential parachute payments that are made with respect to a corporation for which no stock is readily tradeable on an established securities market immediately before a change in control can be exempt from Sec. 280G if certain shareholder approval requirements are satisfied (Secs. 280G(b)(5)(A)(ii) and (B) and Regs. Secs. 1.280G–1, Q&A 6(a)(2) and Q&A 7).

If a wholly owned U.S. consolidated tax group is being acquired from a larger multinational affiliated group, then the assessment of whether the shareholder–vote exemption is available is based on whether the stock of the multinational affiliated group or the stock of any member of the multinational affiliated group is readily tradeable on an established securities market and not solely on the tradeability of the stock of the U.S. consolidated tax group.

Further, the shareholder–vote exemption may not be available for a corporation due to the tradeability of an entity that owns an interest in the corporation, even if that entity is not part of the affiliated group of the corporation. If a corporation is owned partially by an entity that is readily tradeable on an established securities market and the entity’s investment in the corporation makes up a substantial portion of the assets of the entity, then the shareholder–vote exemption is not available with respect to the corporation undergoing a change in control for the purposes of Sec. 280G. This is the case even if the other owners are not readily tradeable and the corporation being acquired itself is not readily tradeable. The investment in the corporation makes up a substantial portion of the assets of the entity if the fair market value (FMV) of the investment in the corporation is more than one–third of the total gross FMV (the value of the assets of the entity without regard to any liabilities associated with the assets) of all of the assets (the value of the assets of the entity without regard to any liabilities associated with the assets) of the entity (Regs. Sec. 1.280G–1, Q&A 6(c)). Thus, careful review of the ownership structure is necessary to conclude whether the shareholder–vote exception is available in this type of situation.

Whether stock is readily tradeable on an established securities market is often straightforward, whereas other situations may require a more nuanced review of the facts. Stock is considered to be readily tradeable if it is regularly quoted by brokers or dealers making a market in the stock (Regs. Sec. 1.280G–1, Q&A 6(e)), and an established securities market is one that is defined in Regs. Sec. 1.897–1(m) (Regs. Sec. 1.280G–1, Q&A 6(f)). If a corporation’s stock is traded on the “pink sheets” or an “expert market,” the shares are likely considered traded on an established securities market; however, there may be questions regarding whether the volume and frequency of trading results in stock that is readily tradeable. A detailed review of transactions in the stock over a multiyear period and of the persons who may transact in the stock (e.g., buy, sell, or quote), as well as how they may transact in the stock, may be necessary to conclude whether the stock is readily tradeable on an established securities market for purposes of Sec. 280G.

Certain parachute payments

The evolving landscape of business structures has resulted in organizations with both corporate and partnership entities. These more sophisticated organizational structures can lead to more complex executive compensation arrangements. Certain industries may make use of a combination of cash and corporate stock from a corporation and a profits interest from a partnership to compensate executives.

Generally, profits interests are a type of partnership interest granted to an individual in connection with their services to a partnership and are designed not to generate compensation income to the holder at the time of grant, vesting, or disposition (see, e.g., Rev. Procs. 93–27 and 2001–43). Executives who are also “disqualified individuals” for purposes of Sec. 280G may receive accelerated vesting and payment with respect to a profits interest they hold in a partnership in connection with a transaction that constitutes a change in ownership or control of a corporation for purposes of Sec. 280G. While the profits interest payment would not be expected to generate compensation income and would be coming from a partnership entity that would not be part of the corporation under the Sec. 280G affiliated–group rules, the payment could still potentially be treated as a parachute payment for purposes of Sec. 280G. The inclusion of this payment is due to the broad definition of a parachute payment, which requires that the payment be “in the nature of compensation to (or for the benefit of) a disqualified individual” (Sec. 280G(b)(2)(A)). This definition does not necessarily require that the payment be treated as compensation or that the payment be made by the corporation.

Executives may also be compensated with restricted stock or partnership capital interests, which are generally taxed under Sec. 83. Under the rules of Sec. 83, property that is transferred in exchange for the performance of services is taxed based on the excess of the FMV of the property at the earlier of when the rights in the property are transferable or when the property is no longer subject to a substantial risk of forfeiture, over the amount (if any) paid for the property (Sec. 83(a)). Individuals who receive restricted stock are permitted to make an election (commonly referred to as a Sec. 83(b) election) to include the excess of the FMV of the property at the time of transfer over the amount (if any) paid for the property in income in the year that the property is transferred (Sec. 83(b)). Under Sec. 280G, Sec. 83(b) elections are disregarded for purposes of determining the value of parachute payments (Regs. Sec. 1.280G–1, Q&A 12). As a result, the lapse of a substantial risk of forfeiture in connection with a change in control is considered to be a parachute payment, even if the lapse is not a compensatory event due to a previously made Sec. 83(b) election.

Other situations involving equity awards may result in unexpected treatment as a parachute payment based on the underlying terms found in articles of incorporation or shareholder agreements. As an example, certain founders’ shares or equity awards from a non–U.S. entity may appear vested; however, there may be punitive repurchase provisions included in articles of incorporation or other documentation requiring employees to sell shares back to the company for the lesser of cost or FMV if they voluntarily leave the company. These provisions may rise to the level of a substantial risk of forfeiture under Sec. 83, and while the individuals may have made a Sec. 83(b) election when the shares were acquired, the lapse of that substantial risk of forfeiture in connection with a transaction could result in a parachute payment.

Further considerations

The evolving landscape of executive compensation arrangements continues to present new and emerging topics that practitioners should be aware of, in addition to those discussed above, when evaluating Sec. 280G. Other additional issues include, but are not limited to, structuring or investment activity that may trigger Sec. 280G, determining the base amount of disqualified individuals in complex business structures, computing the value of parachute payments for performance–based awards, the methodology used to determine the value of noncompetition covenants to reduce the amount of parachute payments as post–change reasonable compensation, and the intersectionality of Sec. 280G and the expanding scope of Sec. 162(m).

As the executive compensation landscape is constantly evolving, practitioners should stay up to date on new developments to advise their clients on relevant Sec. 280G impacts of their compensation arrangements.

Editors

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with Deloitte Tax LLP or Grant Thornton LLP as noted in the byline.

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