280G Considerations for Portfolio Company Exits
Portfolio companies of venture capital and private equity funds usually motivate key executives through compensation tied to performance upon an exit. Such structures align the incentives of the fund with those of the executives but can lead to several tax issues that warrant thoughtful consideration.
Section 280G of the Internal Revenue Code seeks to curb excessive executive compensation triggered by a change in control. The rules apply when a C corporation experiences a change in control if certain “disqualified individuals” (including 1% shareholders, officers or highly compensated individuals) receive an “excess parachute payment.” A parachute payment is a payment triggered by a change in control, which can include benefits such as, for example, deal bonuses, acceleration of vesting of equity awards, retention bonuses and newly received compensation from a buyer (including incentive equity). An “excess” parachute payment occurs if the present value of parachute payments equals or exceeds three times the disqualified individual’s “base amount,” which is generally the individual’s average compensation from the previous five taxable years.
While the excess parachute payment rules only apply to C corporations, many tax advisors believe that a 280G analysis is warranted if a portfolio company is taxed as a partnership but a significant portion of the equity ownership is held through a C corporation blocker. There is an exception from the excess parachute payment rules for a C corporation eligible to make an S election, but the entity ownership and multiple classes of stock present in most private equity and venture capital portfolio companies usually makes such exception unavailable.
The consequence of an excess parachute payment not cured under the shareholder approval exception (discussed below) is denial of the company’s deduction related to the payment and a 20% excise tax levied on the disqualified individual.
Shareholder Approval Exception
The 280G rules provide an exception frequently used by private equity and venture capital portfolio companies such that a privately owned company can avoid 280G consequences by obtaining the approval of disinterested shareholders who own at least 75% of the company’s voting stock. Such approval must be independent of the vote to approve the applicable transaction and must be accompanied with full disclosure about the payments. Prior to such a vote, the disqualified individual(s) must agree to waive any excess parachute payments if approval is not obtained.
Procedurally, the shareholder approval exception usually requires an accounting or law firm to perform due diligence as to the scope of parachute payments, assess whether the payments equal or exceed three times the base amount, and then (if there are excess parachute payments) draft disclosure documents and obtain the disqualified individuals’ waivers and shareholder approval. In managing the foregoing process, many advisers recommend the following steps:
- The process can take several days to several weeks, so it is prudent to initiate it as early as possible.
- Sometimes, the team handling 280G calculations is either newly engaged or part of a separate practice group than the core deal team. It is important for the 280G team to remain apprised of the business deal, especially as to any changes. The 280G team should be informed promptly if there is any change to the consideration received by any employee or director.
- Because the waiver is binding and, if shareholder approval is not obtained, represents real economic loss by each disqualified individual, such persons should understand the waiver and its consequences. It is often prudent for each disqualified individual to retain separate counsel. While shareholder approval is typically obtained, disqualified individuals should not receive advance assurances that approval will be obtained.
- It is important to assess whether any shareholder must “pass through” the vote. The approval is ordinarily voted on directly by the shareholders of the portfolio company; however, if there is a 1% shareholder that is an entity, and stock in the company represents at least one-third of the total gross fair market value of the assets of such entity shareholder, then the entity shareholder must pass through the 280G vote to its owners. For example, if Entity Inc. is 5% owned by LLC and LLC’s only asset is its equity interest in Entity Inc., then LLC must seek approval of the persons who hold more than 75% of the voting power of LLC.
Pass-Through-the-Vote Rule in Private Equity Context
A private equity or venture capital fund may encounter the pass-through-the-vote issue if, for example, the portfolio company has appreciated to constitute more than one-third of its total assets or if the fund is nearing the end of its life cycle and only owns a few remaining portfolio companies. In this regard, the 280G regulations provide that “where approval of a payment by an entity shareholder must be made by a separate vote of the owners of the entity shareholder, the normal voting rights of the entity shareholder determine which owners . . . vote.” That probably means that a fund’s general partner may provide the applicable approval, so long as the fund’s limited partners do not have atypical approval rights over executive compensation matters at the portfolio company level or other analogous, unusual approval rights.
280G is typically a technical compliance matter that does not drive business decisions for private company transactions; however it may produce undesirable tax consequences. It is important to identify and address 280G issues early to facilitate a smooth and timely closing.