When a company is sold, senior executives and key personnel often stand to receive significant payments, such as transaction bonuses, accelerated equity vesting, severance, and earnout participation. What many executives discover too late is that the punitive tax regime under Section 280G of the Internal Revenue Code can dramatically reduce the after-tax value of these payments. This article explains how Section 280G works, who it affects, and how thoughtful planning before a transaction closes can preserve value for executives and buyers alike.

The Basic Framework: What Is Section 280G?

Section 280G was enacted in 1984 in response to concerns that executives were receiving excessive “golden parachute” payments in connection with corporate takeovers. The provision operates as a penalty regime with two distinct components. First, under Section 280G, the acquiring company loses its tax deduction for “excess parachute payments” made to certain executives. Second, under the companion provision in Section 4999, the executive who receives those payments owes a 20% excise tax on the excess amount, in addition to ordinary income taxes.

The combined effect can be severe. An executive in the top federal bracket receiving an excess parachute payment faces not only ordinary income tax but also the 20% excise tax, resulting in an effective marginal rate approaching 60% when state taxes are included. The company, meanwhile, loses its deduction entirely for the excess amount, which in a transactional context often means the buyer bears an unexpected cost that may affect deal economics or purchase price allocation.

Who Is Subject to Section 280G?

Section 280G applies only to “disqualified individuals” of a corporation that undergoes a change in control. Disqualified individuals include shareholders who own more than 1% of the corporation’s stock, officers of the corporation (limited to the lesser of 50 individuals or the greater of 3 individuals or 10% of employees), and highly compensated individuals (those among the top 1% of employees by compensation or, if less, the top 250 employees).

For most private company transactions, the executives who are most likely to be disqualified individuals are the CEO, CFO, and other C-suite officers, significant shareholders, and senior personnel with compensation placing them in the top tier of employees. It is worth noting that disqualified individual status is determined based on the 12-month period ending on the date of the change in control, so an executive’s role and compensation during that window matters more than historical titles.

What Counts as a Parachute Payment?

A parachute payment is any payment to a disqualified individual that is contingent on a change in control and that has an aggregate present value equal to or exceeding three times the individual’s “base amount.” The contingency requirement is interpreted broadly. A payment is contingent on a change in control if the change accelerates the payment, increases the amount, accelerates vesting, or otherwise would not have occurred absent the change. Common examples include transaction bonuses payable at closing, acceleration of unvested stock options or restricted stock, severance payments triggered by termination following the transaction, retention bonuses tied to remaining through closing, and earnout or gain share payments contingent on post-closing performance.

The “base amount” is the individual’s average annual taxable compensation from the corporation over the five calendar years preceding the year in which the change in control occurs. If the executive has been employed for fewer than five years, the average is calculated over the actual period of employment, annualized. For executives who provide services through a personal service corporation, the base amount generally includes amounts paid to that entity and is includible in the executive’s personal income, a nuance that requires careful documentation of the executive’s compensation history.

The Three-Times Threshold and Excess Parachute Payment Cliff

Section 280G is triggered only if the aggregate present value of all parachute payments to a disqualified individual equals or exceeds three times that individual’s base amount. If this threshold is met, the consequences apply not to the entire payment, but to the “excess parachute payment,” which is the amount by which the total parachute payments exceed one times the base amount.

Consider an example. An executive has a base amount of $500,000. She is entitled to receive $1.6 million in transaction-related payments (including bonus, accelerated equity, and severance). Because $1.6 million exceeds three times her base amount ($1.5 million), she has excess parachute payments of $1.1 million ($1.6 million minus $500,000). The company loses its deduction for the $1.1 million, and the executive owes a 20% excise tax, $220,000, on top of ordinary income taxes.

The cliff effect of the three-times threshold is notable. If the executive in this example received $1.49 million instead of $1.6 million, she would owe no excise tax and the company would retain its full deduction. This cliff creates both risk and opportunity for planning.

The Private Company Exception: Shareholder Approval

For corporations that are not publicly traded, Section 280G(b)(5) provides an important exception. If certain payments are approved by shareholders in a manner that satisfies the statute’s requirements, those payments are not treated as parachute payments at all, eliminating both the excise tax and the deduction disallowance.

The requirements for a valid shareholder approval, often called a “cleansing vote,” are as follows. First, adequate disclosure must be made to all shareholders entitled to vote; this disclosure must set forth all material facts concerning the payments, including the aggregate value and the potential tax consequences. Second, approval must be obtained from more than 75% of the voting power of all outstanding stock entitled to vote, determined after excluding any stock owned directly or indirectly by the disqualified individual who would receive the payment.

When successful, the cleansing vote offers a complete solution: the payments fall outside Section , the executive pays only ordinary income tax, and the company retains its deduction (subject to other limitations such as reasonable compensation requirements).

Planning Strategies for Executives

Executives approaching a transaction should take Section 280G seriously and engage in proactive planning. Several strategies may be available depending on the circumstances.

The first strategy involves understanding one’s exposure. Executives should gather their W-2s for the prior five years to calculate their base amount. They should also inventory all payments they expect to receive in connection with the transaction, including not only cash bonuses but also the value of accelerated equity, severance entitlements, and any contingent compensation such as earnouts.

A second strategy involves working with the buyer on shareholder approval. In private company transactions, the cleansing vote is often the most straightforward solution if the shareholder base is sufficiently concentrated. Executives should ensure that the buyer’s transaction team is aware of the issue early and that the disclosure materials and voting process satisfy the statutory requirements. Incomplete disclosure or procedural missteps can invalidate the approval entirely.

A third strategy involves restructuring compensation to stay below the threshold. If a cleansing vote is not feasible, for example, if the shareholder base is too dispersed or if key shareholders are unwilling to approve, executives may be able to restructure their compensation to remain below the three-times threshold. This might involve reducing or forgoing certain transaction bonuses, allocating value to payments that are not contingent on the change in control (such as amounts already vested), or deferring payments to reduce their present value.

A fourth strategy involves allocating payments to reasonable compensation. A portion of parachute payments may be excluded from the calculation if they constitute reasonable compensation for services rendered before or after the change in control. For example, if an executive agrees to provide consulting services to the buyer post-closing, a payment allocable to those services may not be treated as a parachute payment. Similarly, non-compete agreements may support an allocation to reasonable compensation for the covenant, though this requires careful valuation and documentation.

A fifth strategy involves negotiating tax gross-up provisions. In some transactions, executives may negotiate for the buyer or seller to provide a "gross-up" payment that covers any excise tax liability under Section 4999. Under a gross-up arrangement, if an executive is ultimately subject to the 20% excise tax, whether due to an unsuccessful cleansing vote, an IRS audit recharacterizing payments, or contingent amounts exceeding initial estimates, the indemnifying party agrees to make the executive whole by paying an additional amount sufficient to cover the excise tax and the taxes on the gross-up payment itself. While gross-ups can be expensive for the party providing them, they offer executives protection against the risk that careful planning may nonetheless fail to avoid Section 280G consequences, and they are particularly valuable in situations where the outcome of a cleansing vote is uncertain or where contingent payments create unpredictable exposure.

Considerations for Selling Shareholders

Founders and significant shareholders who are also executives face a unique confluence of interests. They are often the parties who must approve a cleansing vote for other executives, while simultaneously being disqualified individuals themselves by virtue of their ownership stake.

For these individuals, several considerations are paramount. First, their own payments must be analyzed and, if appropriate, submitted for shareholder approval (excluding their own shares from the vote). Second, they should coordinate with the buyer regarding the timing and process for any cleansing vote, as the vote must occur before the closing of the transaction. Third, they should ensure that the transaction documents appropriately allocate responsibility for Section 280G compliance, including who bears the cost if a cleansing vote fails and excise taxes become due.

In some transactions, buyers will insist that sellers or executives bear the economic risk of Section 280G by reducing the purchase price or requiring indemnification if excess parachute payments arise. Executives and sellers should be attentive to these provisions during negotiation and understand their potential exposure.

Contingent Payments and Earnouts

Gain share agreements, earnouts, and other contingent payments present particular complexity under Section 280G. The regulations require that contingent payments be valued by taking into account the probability that the contingency will be satisfied. However, if the actual payments ultimately exceed the estimated amount, Section 280G requires a redetermination, potentially resulting in excess parachute payments years after the transaction closed.

For purposes of a cleansing vote, the safest approach is to disclose and seek approval for the maximum potential contingent payments. This ensures that the shareholder approval covers whatever is ultimately paid, avoiding the risk that a successful earnout triggers unexpected excise taxes. Executives participating in earnout arrangements should confirm that the cleansing vote contemplates the full upside of their contingent compensation.

Common Pitfalls to Avoid

Several mistakes occur regularly in Section 280G planning. One common pitfall is late identification of the issue. Section 280G should be analyzed early in the transaction process, not in the days before closing. Shareholder approval requires adequate lead time for disclosure, voting, and documentation.

Another pitfall involves incomplete base amount analysis. Executives who have changed roles, received irregular compensation, or provided services through entities such as personal service corporations may have base amounts that are difficult to calculate. Careful review of historical compensation is essential.

A third pitfall is failure to coordinate with the buyer. In most transactions, the buyer has a significant interest in Section 280G compliance because the buyer will lose deductions for excess parachute payments. Executives should work collaboratively with the buyer’s advisors rather than treating 280G as solely a seller-side issue.

A fourth pitfall involves flawed cleansing vote procedures. The shareholder approval must satisfy precise statutory requirements. Common errors include insufficient disclosure, failure to properly exclude shares held by disqualified individuals, and obtaining approval after the change in control has occurred.

Conclusion

Section 280G is a technical and often overlooked area of tax law that can have significant financial consequences for executives in corporate transactions. The 20% excise tax, combined with ordinary income taxes, can consume more than half of an executive’s transaction-related compensation. For buyers, the loss of deductibility for excess parachute payments can affect deal economics and valuation.

The good news is that Section 280G is a problem that can often be solved with proper planning. For private company transactions, a well-executed shareholder approval vote can eliminate 280G exposure entirely, preserving both the executive’s after-tax compensation and the company’s deduction. For situations where a cleansing vote is not available, restructuring and reasonable compensation allocations offer alternative paths to mitigation.

Executives and selling shareholders who are approaching a transaction should engage experienced tax and legal advisors early in the process, assemble the information necessary to calculate their exposure, and work proactively with the buyer and other stakeholders to implement an appropriate solution. The cost of ignoring Section 280G until closing is often measured in hundreds of thousands of dollars, an outcome that is entirely avoidable with thoughtful advance planning.