When Do Section 280G Golden Parachute Rules Apply to LLCs?

The phrase “golden parachute” refers to payments made to top executives during corporate mergers and acquisitions, which are governed by a specific set of tax rules in Section 280G of the Internal Revenue Code. These regulations were designed to discourage excessive compensation during a change in ownership. This analysis clarifies how these tax provisions apply to a common business structure, the Limited Liability Company (LLC).

Core Concepts of Section 280G

Section 280G identifies and penalizes certain payments made during a change in a company’s ownership. The rules rely on three definitions. The first is the “parachute payment,” which is any compensation contingent on a change in the ownership or control of a corporation, such as cash bonuses or accelerated vesting of stock options.

The rules target a specific group of “disqualified individuals,” which includes certain officers, highly compensated individuals, and significant shareholders. A significant shareholder is someone who owns more than one percent of the fair market value of the company’s stock.

The final element is the “change in control,” the event that triggers potential parachute payments. A change in control is a significant shift in the ownership of the corporation, such as a sale of a majority of the company’s stock or a sale of a substantial portion of its assets. A sale of assets must involve at least one-third of the total gross fair market value of all company assets to qualify.

Applicability of Section 280G to LLCs

The application of Section 280G to an LLC is determined by its federal tax classification. An LLC’s owners can elect how it will be treated for tax purposes, which dictates its exposure to the golden parachute rules.

General Rule for C-Corporations

Section 280G was specifically written to apply to C-corporations. Therefore, any payments made by a C-corporation that meet the definitions of a parachute payment to a disqualified individual are subject to these rules.

LLCs Taxed as Partnerships

Section 280G does not apply to entities that are taxed as partnerships. Since the default tax classification for a multi-member LLC is as a partnership, most LLCs fall outside the scope of these regulations. The rules are written to apply to “corporations,” and a partnership is not considered a corporation for this purpose.

LLCs Taxed as S-Corporations

An LLC can also elect to be taxed as an S-corporation. S-corporations are exempt from Section 280G under the “small business corporation” exemption. To qualify, a company must meet certain criteria, such as having a limited number of eligible shareholders. An LLC that makes an S-corporation election for tax purposes will also benefit from this exemption.

LLCs Taxed as C-Corporations

If an LLC elects to be taxed as a C-corporation, it becomes subject to Section 280G. In this scenario, the LLC is treated no differently than a traditional C-corporation. Any payments it makes in connection with a change in control must be analyzed under the golden parachute framework.

LLCs as Disregarded Entities

For a single-member LLC, the default tax classification is a “disregarded entity,” so its activities are reported on the owner’s tax return. If the sole owner is a C-corporation, the rules can become applicable. A sale of the LLC’s assets may be treated as a sale of the parent C-corporation’s assets. If the assets constitute a substantial portion of the parent’s total assets, the transaction could trigger Section 280G for payments to disqualified individuals of the parent corporation.

The Shareholder Approval Exemption

Privately-held companies, including LLCs taxed as C-corporations that are subject to Section 280G, can avoid the associated penalties. This method is a shareholder approval exemption, often called the “cleansing vote.” It is available to any corporation whose stock is not readily tradable on an established securities market at the time of the change in control.

To use this exemption, the company must provide all shareholders with all material facts concerning the potential parachute payments. This includes the total amount of the payments, the identity of the individuals receiving them, and the calculations showing how the amounts were determined. The goal is to ensure shareholders can make an informed decision.

Following disclosure, the payments must be approved by more than 75% of the voting power of all outstanding stock. The shares held by the disqualified individuals who are set to receive the payments are excluded from this vote. This places the decision solely in the hands of disinterested shareholders. If this 75% approval is obtained, the payments are exempt from Section 280G.

Tax Consequences of Non-Compliance

When Section 280G applies and an exemption is not secured, there are financial repercussions for both the company and the individual. The penalties are applied to the “excess parachute payment,” which is the amount of the payment that exceeds the individual’s average annual compensation over the previous five years, known as the “base amount.”

For the company, the consequence is a loss of its corporate tax deduction for the excess parachute payment amount. This disallowance directly increases the corporation’s taxable income, making the payments more expensive for the company than standard compensation.

For the individual executive, the recipient of the excess parachute payment is subject to a 20% non-deductible excise tax. This excise tax is levied in addition to the regular federal and state income taxes the individual would already owe. This combination of taxes can result in a substantial reduction in the net amount the executive receives.