Suppose you are the founder of a hot startup. You and your other co-founders have worked hard. You’ve been at it for years. And now, you have finally gotten what you have been working for. A healthy buyout offer. The kind of offer you want to take. You’ll be living differently in a few months, happy with what you accomplished, but first you have to navigate through the chaos of the deal.
Along the way, you are going to have to figure out a whole host of issues. How will your board react to the indemnification provisions in the buyout agreement? Will the buyer stick and refuse to budge on an unreasonable provision of some kind that will jeopardize an approval you need? Will the buyer want to subject your deal consideration to some kind of sticky and gross retention requirement? That is, are you going to have to warm a chair and fog a mirror in the office for the next 12-18 months in order to get/keep your money?
You will haggle. You will negotiate hard. Emotions from some of the parties involved will boil over.
Then, just when you nearing the end of the frightfulness, your lawyers will tell you that they think you may have a problem.
“You had an unusually low salary for the past several years,” one of them will say. You will think to yourself–”D’uh, bozo. But look at me now! Ha!”
“This is problematic,” the lawyer will intone, “because it makes your ‘base amount’ unusually small.” A small voice in the back of your mind will start to crackle. “What the heck is this guy talking about?” you will think to yourself.
“Taxes!” the lawyer will scream, and you will almost jump out of your chair. “You are going to have to pay penalty taxes!”
Suddenly the world will start swimming. You will feel dizzy, faint. “Oh my God,” you will think. “I have made it this far. Please God, please don’t say I am going to have to pay penalty taxes.” But you will recover and collect yourself.
“What are you talking about?” you will say casually, coolly. You didn’t get this far by losing your head in negotiations.
“Well,” the lawyer will say. “You see, there is this federal tax code provision called Section 280G. And it provides that if you receive deal consideration or other payments in the nature of compensation in connection with the deal that equal or exceed 3X your ‘base amount,’ you owe penalty taxes on the amount in excess of 1X your base amount–unless you disclose the amount of these payments to all voting shareholders and agree to forfeit some of the payments if more than 75% of the disinterested shareholders don’t agree to approve them in a separate vote.”
“What the hell?”
“Yes,” the lawyer says. “That’s right. It is a horrible tax. Brutal. Congress must have passed it in a fit of apoplectic rage at the wealthy.”
“But hey, wait a minute,” you will say. “I’ve owned my stock since day one. I am not getting anything but stock consideration in this deal. No cash bonuses. Nothing. Plus, I’ve worked for years for a pittance.”
“It is true. It is true,” the lawyer will say. “But because your founder stock was subject to service-based vesting (remember that stuff your investor wanted to put on you?), and some of it is still unvested and is accelerating on this deal, the value of that accelerated vesting counts as compensation in calculating the 280G payment amounts.” And he will go on, “Your pitiful salary over the last several years actually makes your situation now worse, because 3X your base amount is so small…” As he drones on, your mind will wander. You will be thinking of sandy white beaches, the heat of the sun on your body. And you won’t want to think of these dastardly matters any more.
[Story to be continued in my next novel.]
Section 4999 of the Internal Revenue Code imposes a 20% excise tax on any person who receives an “excess parachute payment.”
An “excess parachute payment” is the excess of any “parachute payment” over the portion of the “base amount” allocated to it.
The “base amount” is generally an individual’s average taxable compensation from the corporation over the last 5 years, excluding the year in which the transaction occurs.
A “parachute payment” is any payment in the nature of compensation made to or for the benefit of a “disqualified individual” that is contingent on a change in the ownership or effective control of a corporation, or the ownership of a substantial portion of the assets of a corporation, if the aggregate present value of such payments equals or exceeds three times the disqualified individual’s base amount.
Payments are “in the nature of compensation” if they arise out of an employment relationship or are associated with the performance of services.
For example, in the above scenario, if a founder had been fully vested in the shares for several years before the transaction, the transaction consideration he received for those shares would not be a payment in the nature of compensation.
If, however, the founder’s shares, or some portion of them, were subject to the service-based vesting that was accelerating on the M&A deal, the acceleration of that vesting could give rise to 280G problems.
A “disqualified individual” is generally a service provider who is an officer, shareholder, or highly compensated individual (within the meaning of the Section 280G rules)
What Can Founders Do?
Unfortunately, sometimes founders get caught up in Section 280G complications. This can happen if a founder’s shares have not fully vested and are vesting on a deal. It could also happen if a founder is receiving a significant bonus payment in connection with the deal–for example, a retention bonus. It can also happen if the founder received a stock or option award within a year of the deal. Unfortunately, for founders, sometimes there is no escape from having to pay the excise tax unless the payments are disclosed and made subject to forfeiture if more than 75% of the disinterested shareholders don’t approve them in a separate vote.
If you are selling your corporation, engage with tax counsel early on in the deal on Section 280G questions. Don’t put off data sharing with counsel until the deal has progressed, because even though you might think you don’t have a problem–you might, and you should figure this out as early as you can in your process. Also, your transaction agreement probably contains a representation that no excess parachute payments will be made in connection with the deal. A breach of that representation can result in an indemnification claim by the buyer.
The Public Policy Lessons
Section 280G is a bad law for startups, because founders usually work for years for little or no pay. There are exceptions from 280G for S corporations (and C corporations that could make S elections) and for companies classified as partnerships for tax purposes. The Congress, however, ought to pass an additional exemption for startups with less than a certain amount of assets (say, a billion). Section 280G is also bad because it unduly complicates transactions. We need simpler, less complex, less onerous laws.
*Section 4999 imposes the 20% excise tax on persons receiving the excess parachute payments. Section 280G denies a tax deduction for any excess parachute payments made. Colloquially, people use 280G to refer to both of these tax consequences.