Does 280G Apply to S Corporations? Exemption and 75% Vote Rules

Section 280G does apply to S corporations in principle, but S corporations are automatically exempt from the golden parachute penalties under Section 280G(b)(5)(A)(i): any payment made to a key person at a company that qualified as a “small business corporation” immediately before a change in control is not a parachute payment at all.¹ Because every S corporation meets the Section 1361(b) definition by default, the exemption applies without a shareholder vote and without any disclosure package. The one thing that can undo it is timing: if the S election is revoked before the deal closes, the automatic exemption is gone.

Why S Corps Get an Automatic Pass

Section 280G ordinarily does two things when a change in control triggers a large executive payout. It denies the corporation a deduction for what the statute calls “excess parachute payments,” and Section 4999 hits the recipient with a 20% excise tax on the same amount.¹² The rules bite when payments contingent on the deal reach three times an executive’s five-year average taxable compensation, at which point the excess above that average (not above the three-times figure) is penalized.³

The S corporation exemption sidesteps all of this. Clause (i) of Section 280G(b)(5)(A) says that if the corporation was a small business corporation under Section 1361(b) immediately before the change in control, the payments simply are not parachute payments.¹ Every S corporation satisfies that definition by virtue of being an S corporation. Nothing has to be filed, and no shareholder has to vote. The exemption removes the payments from the parachute category entirely, which is a stronger result than merely excusing them from the penalty.

The rule exists because Section 280G was written to protect dispersed public shareholders from managers enriching themselves in a buyout. In a closely held S corporation the owners and the managers usually overlap, so that concern barely applies.

When the Exemption Disappears

The exemption turns on what the company was “immediately before” the change in control, and that phrase creates a real trap. If the S election is revoked and the company becomes a C corporation before the transaction closes, it no longer qualifies as a small business corporation at the critical moment. The automatic clause (i) exemption is lost.¹

This is more common than it sounds. Buyers sometimes insist on a pre-closing conversion from S to C status for tax or structural reasons. If the conversion is sequenced first and the change in control second, the company falls back on the shareholder approval process available to other private companies. Getting the sequence wrong can cost executives 20% of their excess payments and cost the company its deduction, all on a scheduling decision that was probably negotiable.

The Backup Path if You’ve Converted

When clause (i) is off the table, Section 280G(b)(5)(A)(ii) offers a second exemption for corporations whose stock was not publicly traded immediately before the change in control. It requires two things: an approving shareholder vote and adequate disclosure.¹

The 75% Vote

Shareholders holding more than 75% of the voting power immediately before the change in control must approve the payments. Any disqualified individual whose payments are up for approval is excluded from voting, and their shares are not counted as outstanding for the 75% calculation.¹ The individual must also sign an irrevocable waiver giving up the excess payments if the vote fails. Without that waiver the vote is not “determinative” of the right to receive the money, and the exemption does not apply.

Disclosure Before the Vote

Every voting shareholder must receive full disclosure of the material facts. Treasury regulations require, for each disqualified individual, the event triggering the payments, the total dollar amount that would be treated as parachute payments if the vote failed, and a description of the nature of each payment such as accelerated option vesting or a severance bonus.³ An omitted fact is material if a reasonable shareholder would consider it important. Keep the waivers, disclosure materials, and vote tally documented well enough to survive an IRS audit.

Reasonable Compensation Carve-Out

If neither exemption is available, Section 280G(b)(4) still allows part of the payment to escape the penalty when the corporation can prove it represents reasonable compensation.¹ Payments for services to be performed after the change in control — including consideration for a non-compete — are excluded from the parachute definition entirely if backed by clear and convincing evidence. Payments for services actually performed before the change reduce the excess parachute amount under the same evidentiary standard.

Clear and convincing evidence is a higher bar than the usual preponderance standard. Contemporaneous documentation of duties, comparable compensation data, and a defensible valuation methodology are what carry the argument. This is a fallback, not a primary plan, and it rarely shelters the full amount at issue.

What Failure Costs

Missing every exemption is expensive from two directions. The corporation loses its deduction for the excess parachute payment.¹ For an S corporation or a recently converted one, that lost deduction flows through to shareholders on Schedule K-1, cutting their after-tax proceeds from the deal. The executive owes a non-deductible 20% excise tax on the excess amount under Section 4999.²

When the payment is wages, the corporation must increase its withholding by the amount of the Section 4999 excise tax, and failing to do so leaves the corporation on the hook for the uncollected amount.² Stacked on top of ordinary income tax and the lost deduction, the combined effective rate on the excess payment can approach 60%.

One more trap for deals in progress: any compensation agreement entered into within one year before the change in control is presumed to be contingent on that change unless the corporation can rebut the presumption by clear and convincing evidence.⁴ Bonuses, retention grants, and equity awards signed during the run-up to a transaction draw extra scrutiny, whatever label the parties put on them.

1
Office of the Law Revision Counsel. 26 USC 280G – Golden Parachute Payments
2
Office of the Law Revision Counsel. 26 USC 4999 – Golden Parachute Payments
3
eCFR. 26 CFR 1.280G-1 – Golden Parachute Payments
4
Office of the Law Revision Counsel. 26 USC 280G – Golden Parachute Payments