The Severance Package That Taxes the Executive and the Company
When change of control payments to an executive exceed a defined multiple of past compensation, the tax code imposes an excise tax on the recipient and denies the deduction to the company. The rule shapes how deals are structured.
The Behaviour Congress Was Aiming At
In the takeover wave of the 1980s, boards routinely granted executives large payments contingent on a change of control. The arrangements were defended as retention devices that let management evaluate a bid without fearing for their own position, and criticised as self dealing that either enriched executives for losing their jobs or discouraged bids that would have benefited shareholders.
The legislative response, enacted in 1984 and found at sections 280G and 4999 of the tax code, did not prohibit these payments. It made them expensive on both sides of the transaction.
The Two Penalties
The rule targets excess parachute payments, and when it applies two consequences follow simultaneously.
The executive owes a twenty percent excise tax on the excess amount, on top of ordinary income tax and payroll taxes. The company loses its deduction for the same excess amount, raising its effective cost.
The symmetry is deliberate. Penalising only the executive would invite the company to gross up the payment; penalising only the company would leave the executive indifferent. Hitting both makes the arrangement costly to everyone involved in agreeing to it.
The Threshold and the Cliff
The mechanics create one of the sharpest cliffs in the tax code, and understanding it requires two distinct figures.
The base amount is the executive average annual compensation over the five taxable years preceding the change of control. The rule is triggered when total change of control payments equal or exceed three times the base amount.
Once triggered, the excise tax and lost deduction apply not to the amount above three times base, but to everything above one times the base amount.
| Base amount | Total parachute payment | Amount subject to penalty |
|---|---|---|
| 200,000 | 599,000 | Nothing, below the threshold |
| 200,000 | 600,000 | 400,000 |
One additional dollar of payment converts nothing into four hundred thousand dollars of excess, carrying an eighty thousand dollar excise tax and a lost corporate deduction on the same amount. This is a genuine cliff rather than a phase in, and it drives essentially all the planning around the rule.
A tax that applies at three times base but is calculated from one times base means the marginal dollar at the threshold can cost more than a hundred thousand times itself. Nobody designs a cliff like that on purpose, and everybody plans around it.
What Counts as a Payment
The scope is broader than cash severance and this is where calculations go wrong. Payments contingent on a change of control include cash severance, the value of accelerated vesting of equity awards, continued benefits, enhanced retirement credits, and tax gross ups themselves.
Accelerated equity vesting is frequently the largest component and the one most often underestimated, because the acceleration is valued under specific regulatory methodology rather than simply at the market value of the shares. A company with generous single trigger vesting can push executives over the threshold without paying any additional cash at all.
The Standard Mitigation Techniques
Because the cliff is so sharp, several approaches are routine in deal planning.
Best after tax cutback provisions are now common in employment agreements. The clause reduces the payment to just below the threshold if doing so leaves the executive better off after tax than receiving the full amount and paying the excise tax. It is elegant precisely because it recognises that the cliff can make less money worth more.
Reasonable compensation allocation allows amounts attributable to services actually performed, including post closing consulting or the value of a non compete agreement, to be excluded from the parachute calculation if supported by valuation evidence.
Accelerating compensation into earlier years raises the base amount, since the base is the five year average. This requires planning well in advance of any transaction and is unavailable once a deal is in view.
The shareholder approval exemption applies to private companies with no readily tradeable stock. If the payments are approved by more than seventy five percent of the voting shareholders after adequate disclosure, and the executive waives the payment absent approval, the rule does not apply. This is heavily used in private equity portfolio company sales and is unavailable to public companies.
Gross Ups Went Out of Fashion
For years companies simply agreed to pay the executive excise tax, and then to pay the tax on that payment, producing a gross up that could substantially exceed the original penalty and was itself non deductible.
Proxy advisers and institutional investors made gross ups a governance objection, and say on pay voting gave that objection teeth. They are now uncommon in new public company agreements, having been largely replaced by the best after tax cutback approach, which shifts the cost of the cliff back to the executive rather than the shareholders.
The Bottom Line
Section 280G is a rule that failed at its stated purpose and succeeded at reshaping practice. It did not stop change of control payments, which grew regardless, and it did create a threshold so punitive that structuring around it became a standard workstream in every merger. The most useful thing to understand about it is the cliff, since it explains why an executive would rationally accept less money, why equity vesting terms matter more than severance formulas, and why private company deals look different from public ones.