Does 280G Apply to S Corporations?

When a company is sold or merges, executives and other key personnel can receive substantial payments. These “golden parachute” payments are governed by tax rules in Section 280G of the Internal Revenue Code. The regulations can impose tax burdens, making an understanding of their scope a concern for any company contemplating a change in control, as the financial consequences can be significant.

The General Application of Section 280G

Section 280G targets specific payments made during a corporate change in control. The regulation focuses on a “parachute payment,” which is any compensation paid to a “disqualified individual” that is contingent on a change in ownership or control of a corporation. The forms of compensation are broad and can include transaction bonuses, severance pay, the acceleration of unvested stock options, and continuation of benefits.

The rules apply to “disqualified individuals,” a category that includes employees or independent contractors who are also officers, significant shareholders, or highly compensated individuals. An officer’s status is determined by their authority, not just their title. A shareholder is disqualified if they own more than 1% of the corporation’s stock, while a highly compensated individual is among the highest-paid 1% of employees, capped at the top 250.

To determine if a payment is excessive, it is measured against the individual’s “base amount.” The base amount is the person’s average annual taxable compensation from the company over the five most recent tax years preceding the change in control. If the total of all parachute payments to a disqualified individual equals or exceeds three times this base amount, the rules are triggered.

The tax consequences of exceeding this threshold are significant. The portion of the payment deemed an “excess parachute payment” is subject to a 20% excise tax levied on the individual, in addition to regular income taxes. The corporation, in turn, loses its tax deduction for this same excess amount. The “excess” portion is not just the amount over the three-times limit, but the total parachute payment minus one times the individual’s base amount.

The S Corporation Exemption from Section 280G

A significant exemption shields S corporations from Section 280G, as the rules do not apply to payments made by a “small business corporation.” The definition of a small business corporation aligns with the requirements for S corporation status. To qualify for this exemption, a corporation cannot have more than 100 shareholders, its shareholders must be individuals who are U.S. citizens or residents, and it must have only one class of stock.

A C corporation may also qualify for the exemption if it was eligible to elect S corporation status at the time of the change in control, even if it never made the election. For example, a closely-held C corporation that meets the S corporation eligibility tests could be exempt.

A nuance exists for S corporations that previously operated as C corporations. The exemption applies if the corporation has been an S corporation for its entire existence. If it converted from a C corporation, the protection is secure as long as the S election has been in place for a sufficient period before the transaction.

Securing the Shareholder Approval Exemption

Private companies can also use a shareholder approval exemption to avoid Section 280G penalties. This option is available to corporations whose stock is not readily tradable on an established securities market. It allows companies, including S corporations that may want to take a cautious approach, to cleanse payments that would otherwise be considered excess parachute payments.

Before the vote, the company must disclose all material facts about the potential payments to all voting shareholders, including the total amount and the recipient’s identity. A prerequisite is that the payment is contingent on shareholder approval, meaning the disqualified individual must waive their right to the payment if the vote fails.

To secure the exemption, the payments must be approved by a vote of more than 75% of the voting power of all outstanding stock. The shares held by the disqualified individuals receiving the payments are excluded from this vote. This ensures the approval comes from disinterested shareholders.

If the 75% threshold is met, the payments are exempt from the definition of parachute payments, and neither the 20% excise tax nor the deduction disallowance will apply. If the vote fails, the disqualified individual’s prior waiver becomes effective, and the portion of the payment that would have been an excess parachute payment cannot be made.