A founder I worked with sold his company on a Friday and called me the following Wednesday with a question he had not been able to make sense of. His tax preparer had walked him through the closing statements and flagged a number he did not recognize — an “excess parachute payment” of about $1.4 million that was, the preparer said, subject to a 20% federal excise tax on top of ordinary income tax. The same $1.4 million was, separately, non-deductible by the buyer. The founder wanted to know how the tax had appeared. He had never seen the phrase “parachute payment” in any of the documents he had signed. He had also never been asked to vote on anything.
That conversation is one I have had, in some version, a half dozen times over the last few years. Section 280G of the Internal Revenue Code — the “golden parachute” provision — is one of the cleanest examples in M&A tax practice of a rule that produces real money outcomes and is, in private-company deals, almost entirely fixable through a single procedural step that has to happen before closing. The fix is the shareholder cleansing vote under Section 280G(b)(5). The vote works. The reason it does not get done is that no one on the deal team thinks it is their job to remember to ask for it.
This post walks through what Section 280G does, why founders get hit by it, what the cleansing vote actually accomplishes, and the three things to negotiate at the LOI to make sure the cleansing vote happens.
What Section 280G actually does
Section 280G is a Reagan-era anti-greenmail provision that imposes two penalties on excess parachute payments to “disqualified individuals” in connection with a change in control. The recipient pays a 20% federal excise tax on the excess portion, on top of regular ordinary-income tax. The company loses the deduction on the excess portion. Both penalties run together, so the federal government collects ordinary income tax from the founder, a 20% excise tax from the founder, and the company’s lost deduction increases the company’s corporate tax liability by 21% of the same dollars. The combined effective tax rate on excess parachute dollars can exceed 75% when state taxes layer on.
The Treasury regulation that operationalizes the statute lives at 26 CFR § 1.280G-1. The math is mechanical and not negotiable; the statute does the work without regard to whether the parties intended the result.
The mechanism that triggers the penalties is a two-part test. The recipient must be a “disqualified individual” — typically an officer, a more-than-1% shareholder, or one of the company’s most-highly-compensated employees. The recipient must receive parachute payments — broadly defined as compensation contingent on a change in control — that exceed three times the recipient’s “base amount,” which is roughly the recipient’s average annualized W-2 compensation over the prior five years.
Once the three-times-base-amount threshold is exceeded, every dollar of the parachute payment in excess of one times the base amount becomes an “excess parachute payment” subject to the penalties. The math is harsh. A founder with a $300,000 average annual W-2 over the prior five years has a base amount of $300,000. Three times the base amount is $900,000. If the founder receives change-in-control payments — accelerated equity, retention bonus, transaction bonus, severance, anything contingent on the deal — totaling $1 million, the three-times threshold is exceeded and $700,000 of the $1 million becomes excess parachute payment subject to the penalties.
The triggering math is the trap. A small increase in change-in-control payments — say, from $899,999 (just below three times base) to $900,001 (just above) — converts $600,001 of payments from non-parachute to excess parachute, with $120,000 of new excise tax and $126,000 of new corporate-deduction loss. The “cliff” effect is real and the dollar-counting matters down to the last bonus payment.
The kinds of payments that count as parachute payments
The statute and regulations are broad on what counts. Accelerated vesting of equity awards is the most common trigger, particularly for founders who hold a meaningful unvested equity position at the time of the change in control. The full value of the accelerated vesting counts as a parachute payment, except to the extent the company can demonstrate that the acceleration was earned through pre-change-in-control services (a “Q-3 valuation” under the regulations, which most companies do not undertake in private-deal practice).
Cash transaction bonuses paid contingent on closing are parachute payments. Retention bonuses paid contingent on the founder remaining employed post-closing are typically parachute payments, with the portion attributable to post-closing services sometimes carved out under Q-3 valuation principles. Severance payments triggered by the change in control are parachute payments. Even reasonable compensation for personal-services contracts can be partially recharacterized as parachute payments if the contract was entered into in connection with the change in control.
What does not count is ordinary compensation paid in the ordinary course of business that is not contingent on the change in control. Salary continues to be salary. Annual bonuses paid in the ordinary cycle are ordinary compensation. The line between “ordinary” and “contingent on the change in control” is the analytical heart of the 280G calculation, and a careful 280G analysis run by tax counsel before closing is what separates a $1.4 million excess parachute payment from a $0 excess parachute payment in the cases where the math is close.
The cleansing vote is the fix and most founders have never heard of it
Section 280G(b)(5) provides that the parachute-payment penalties do not apply to payments approved by shareholders of a private company in a manner that satisfies specific statutory requirements. The exception eliminates the 20% excise tax on the recipient and restores the buyer’s deduction on the payment. Both penalties go away. The cleansing vote is, in effect, a free fix to a real problem, and it is available only to private-company deals. Public-company targets have no analogous escape valve.
The requirements for a valid cleansing vote are procedurally specific. The vote must occur before the change in control closes. Adequate disclosure must be made to all shareholders entitled to vote, including the aggregate value of the payments and a summary of the tax consequences. The vote must be approved by more than 75% of the voting power of the outstanding stock entitled to vote, calculated after excluding any stock owned directly or indirectly by the disqualified individuals who will receive the payments. The disqualified individuals must irrevocably waive their right to the excess parachute payments before the vote, so that if the vote fails, the excess payments do not get made.
The 75% supermajority is the most-discussed mechanic and rarely the binding constraint in practice. Most private companies have a concentrated shareholder base — founders, PE sponsor, key employees — and the vote excludes the disqualified individuals’ own shares. The remaining shares are typically sponsor-controlled or institutional and routinely vote in favor when the disclosure is adequate and the alternative is leaving cash on the table.
The procedural details are the trap. The vote must not be coerced through the merger vote — a separate vote, with separate disclosure and a separate vote sheet, is required. The vote cannot be locked in through a drag-along or a voting agreement, because the statute requires the vote to be a genuine cleansing vote and the regulations have interpreted that requirement to mean a non-coerced one. The irrevocable waiver from the disqualified individual is a real waiver — if the vote fails, the individual loses the excess payments entirely.
The disclosure piece is where most cleansing votes go wrong. The statute requires “adequate disclosure” of all material facts about the payments, including the aggregate value, the basis for the payments, and the potential tax consequences. The standard disclosure is a multi-page document prepared by tax counsel and circulated to the voting shareholders along with the vote materials. A disclosure that omits a material payment or understates the aggregate value is a defective vote, and a defective vote produces no cleansing.
Why the cleansing vote does not happen automatically
The cleansing vote is procedurally simple but logistically demanding. It requires tax counsel to run the 280G calculation before closing, requires the company to prepare the disclosure document, requires the disqualified individuals to sign waivers, and requires the shareholder vote to be solicited and tabulated on a separate vote sheet. In a deal moving at typical M&A speed — six to ten weeks from LOI to close — the cleansing vote is one more workstream that the deal team has to organize, and it is, by default, no one’s specific responsibility.
The buyer’s counsel does not generally treat the cleansing vote as their issue. The buyer’s loss on the disallowed deduction is real but is a smaller dollar number than the seller’s loss on the 20% excise tax, and the buyer’s counsel is focused on transaction-level economics, not on individual-recipient tax. The seller’s company counsel may flag the issue but does not always push for the vote because the vote is procedurally complex and the company is in the middle of a closing process. The founder’s personal tax counsel — if the founder has personal tax counsel separate from the company’s deal counsel — is usually engaged late and lacks the standing to organize a shareholder vote.
The result is that, in a meaningful fraction of middle-market private-company deals, the cleansing vote does not happen and the excise tax lands on the founder at closing. The same asymmetry that runs through other founder-side issues shows up here — the workstream that protects the founder’s pocketbook is not anyone’s specific job, and the workstream that protects the deal’s transactional economics gets attended to as a matter of course.
The three things to negotiate at the LOI
The cleansing vote is most efficiently organized when it is committed to at the LOI stage. By the time the deal is six weeks from closing, the workstream is harder to mobilize and the calendar is harder to fit.
The first is a representation by the company in the LOI that the company will cooperate to organize and obtain a 280G cleansing vote prior to closing. The language is short and the buyer typically does not object. The commitment locks in the workstream as a deal item rather than as an afterthought.
The second is the engagement of dedicated 280G tax counsel. The 280G analysis is technical and the disclosure document is its own deliverable. The LOI should specify that the company will engage 280G tax counsel — sometimes a separate firm, sometimes a dedicated practice at the company’s main deal firm — to run the calculation and prepare the disclosure. The buyer’s counsel typically reviews but does not own the workstream.
The third is the timing commitment. The cleansing vote must occur before the change in control, with adequate time for disclosure circulation and shareholder response. The LOI should specify that the closing date is conditioned on the cleansing vote having been completed at least one business day before closing, with appropriate flexibility for vote-related delays. The deal-terms asymmetry on closing-condition mechanics often shows up around 280G timing, with the buyer’s instinct being to hold the closing condition on the vote and the seller’s instinct being to specify the timing tightly enough to prevent the buyer from extracting last-minute concessions.
A founder who has these three items in the LOI is going to land at closing with the cleansing vote complete and the excise tax avoided. A founder who has not raised these items is going to land at closing with a $1.4 million parachute haircut and a phone call to their tax preparer four days later.
For founders working through a sale where any meaningful piece of the consideration is contingent on the change in control — accelerated equity, transaction bonus, retention bonus, severance — the 280G conversation is one of the highest-dollar-value LOI items in the entire deal. The cost of organizing the cleansing vote is small. The cost of skipping it is large and lands on the founder.
If you are reading an LOI with a meaningful change-in-control payment component and want to think through whether you are exposed to a parachute haircut, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
— John
