When preparing for an acquisition or merger, there are numerous issues that require forethought and careful planning from a company before a transaction can be finalized. Of these issues, golden parachutes should be a top priority.

The “Golden Parachute Rules,” which were first established by Congress in 1984 and later finalized in 2003, can result in repercussions for both companies and disqualified individuals. Companies can lose their tax deduction, while disqualified individuals—shareholders who own more than 1 percent of the company’s stock, officers of the corporation, or highly compensated individuals—risk owing excise taxes.

These golden parachute payments are a form of compensation paid out to disqualified individuals following a change in control. Congress supplemented Section 280G as part of the Internal Revenue Code to dissuade companies from issuing golden parachutes for excessive gain either for themselves or management. Many believe that companies see parachute payments as an incentive to solicit an acquisition or merger for the benefit of management, rather than what’s in the best interest of the shareholders.

Parachute payments can include anything from a bonus to restricted stock to severance payments. These payments become problematic when they exceed a certain threshold, which is calculated by comparing the parachute payment with the base amount of the disqualified individual. If payment is less than three times the base amount—or the average annual compensation of the individual over the past five years—it’s considered a safe harbor amount and not subject to penalty. If payment exceeds the base amount, it becomes an excess parachute payment and violates Section 280G.

Section 280G prohibits deductions for excess parachute payments, and Section 4999 begets a 20 percent excise tax from the individual, which the company cannot consider a deductible. Oftentimes, provisions may be built into contracts that limit the number of parachute payments allowed by companies so excess payments won’t frequently occur.

Parachute payments can be reduced when compelling evidence is presented that proves the amount is reasonable compensation for services provided by a disqualified individual after the change in control takes place. This is advantageous because the amount is decreased prior to the payment/base amount calculation transpires. Excess parachute payments can also be reduced when strong evidence proves the amount is reasonable compensation for services provided by a disqualified individual before the change in control happens. A valuation company will get involved at this stage to analyze whether the amount determined can be considered reasonable compensation.

While rare, there are certain corporations that are exempt from Section 280G. These include: S-corps, partnerships, LLCs, and tax-exempt organizations. “Small business corporations” are also exempt from the parachute payment rules. To qualify, these organizations cannot have more than 100 shareholders or more than one class of stock. These requirements typically apply to s-corps, but making an S election isn’t necessary to be distinguished as a small business corporation in regards to the golden parachute rules.