Editor: Mark Heroux, J.D.
Sec. 280G, relating to "golden parachute payments," and its Sec. 4999 excise tax counterpart are two of the more draconian provisions in the Internal Revenue Code. Sec. 280G disallows a deduction to a corporation for an excess parachute payment made to an individual, and Sec. 4999 imposes a 20% nondeductible excise tax penalty on a disqualified individual who receives an excess parachute payment from a C corporation. A disqualified individual is any individual (or any personal service corporation or similar entity) who is both an employee or an independent contractor and a shareholder, officer, or highly compensation individual. As such, taxpayers must take care to ensure no payments are made that could implicate Sec. 280G.
As stated above, Sec. 280G applies to C corporations — either public or private. Sec. 280G includes language that exempts S corporations from its provisions. The application of Sec. 280G to partnerships and limited liability companies (LLCs) classified as partnerships (collectively referred to as "partnerships") is, however, less straightforward. The following discussion provides a high-level review of certain scenarios where a change in control of a partnership could potentially lead to Sec. 280G exposure.
Partnerships are implicitly excluded from the application of Sec. 280G
On its face, Sec. 280G does not directly apply to partnerships, as it expressly applies to C corporations only. For purposes of Sec. 280G, the regulations define a corporation to include:
- A publicly traded partnership treated as a corporation under Sec. 7704(a);
- An entity described in Regs. Sec. 301.7701-3(c)(1)(v)(A);
- A real estate investment trust under Sec. 856(a);
- A corporation that has mutual or cooperative (rather than stock) ownership, such as a mutual insurance company, a mutual savings bank, or a cooperative bank (as defined in Sec. 7701(a)(32)); and
- A foreign corporation as defined under Sec. 7701(a)(5) (Regs. Sec. 1.280G-1, Q&A 45).
Additionally, all members of the same affiliated group (as defined in Sec. 1504) are generally treated as one corporation (Regs. Sec. 1.280G-1, Q&A 46). None of the definitions above, however, include the term partnership (non-publicly traded) or LLC. Stepping outside of the language of Sec. 280G and its regulations, the IRS has provided no guidance on whether Sec. 280G applies to partnerships. In January 2017, the IRS released an updated Golden Parachute Payments Audit Techniques Guide, which again made no reference to partnerships — directing its agents to apply the Sec. 280G provisions to corporations.
Therefore, it can be inferred from the lack of any express language that Sec. 280G does not extend to partnerships for federal income tax purposes — reflecting the position that most tax practitioners have historically taken. So why should taxpayers still care about Sec. 280G when selling a partnership? Depending on the facts and circumstances of both the ownership and operational structures of the partnership, a partner or employee receiving payments contingent on change in control could still implicate Sec. 280G.
Focus on the ownership structure
The perception that Sec. 280G applies only to C corporations — and never extends to partnerships — can lead to taxpayers' finding they have run afoul of the Sec. 280G and Sec. 4999 rules, with no available remedy. Depending on how a taxpayer's ownership is structured, the sale of a partnership interest can have a Sec. 280G impact on partners or members that are C corporations — a fact that can be easily overlooked.
The reason for this is Sec. 280G applies to payments that are contingent on a change in control of ownership, which is defined to mean when one person or more than one person acting as a group acquires:
- 50% or more of the total fair market value (FMV) or voting power of the corporation (Regs. Sec. 1.280G-1, Q&A 27); or
- Assets with a total gross FMV equal to or greater than one-third of the total gross FMV of all of the assets of the corporation in a 12-month period (Regs. Sec. 1.280G-1, Q&A 29).
A change in control occurs not only through a change in a corporation's ownership, but also through the sale of a substantial share of the corporation's assets. This is important because a C corporation partner may experience a Sec. 280G change in control if its divested interest in the partnership assets constitutes at least one-third of its total assets by gross FMV.
Example 1: Partnership P has four equal partners: C corporation A, C corporation B, and individuals E and F. The value of Corporation A's ownership interest in Partnership P represents 40% of the gross FMV of the assets of Corporation A and is thus a substantial portion of the assets of Corporation A. Corporation B's share of the Partnership P assets, however, does not represent a substantial portion of the assets of Corporation B. On June 30, 20X1, 100% of the assets of Partnership P are sold to a third party. If Corporation A has any individuals who can be deemed to receive compensation contingent on the change in control as a result of the disposition of the substantial portion of Corporation A's assets, Corporation A will have Sec. 280G exposure.
Focus on the operational structure
It is not uncommon for a C corporation's stock to be owned, in whole or in part, by a partnership, with the substantial share of the operations occurring, and assets being held, at the C corporation level — and with the executives technically being employed at the partnership level. However, if an individual — in the capacity as either an owner or an employee of a partnership owning stock of the C corporation — receives compensation contingent on a change in control, that individual may be deemed to be a disqualified individual of the C corporation, thereby implicating Sec. 280G.
Example 2: Corporation A is owned by LLC X and individuals Y and Z. LLC X is owned by two members, Q and R, who both perform substantial services for Corporation A. In the decision to sell Corporation A, LLC X employs T, who performs substantial services for Corporation A by assisting the owners with finding a buyer for Corporation A. Contingent upon the successful sale of Corporation A, T is to receive a payment for his assistance. On June 30, 20X2, Corporation A is sold. Individuals Q, R (through LLC X), and T receive payments contingent on the change in control of Corporation A. Although Q and R do not directly own Corporation A, the IRS may "look through" LLC X to determine the ultimate recipient of the change-in-control payments. Additionally, although T is employed by LLC X, due to his substantial services in assisting in the sale of Corporation A, his payment may also be deemed compensation contingent on change in control and may be subject to the provisions of Sec. 280G.
Questions upon due diligence
Due diligence is an essential step in the acquisition process, where the potential buyer essentially looks under the hood to make sure all the parts are properly running and there are no foreseeable future issues. One question that frequently comes up during due diligence is the issue of Sec. 280G. Unlike with public corporations, Sec. 280G permits the shareholders of a private corporation to hold a shareholder vote to determine the right of a disqualified individual to receive or retain parachute payments and, in doing so, avoid the disallowance of deductions and the imposition of an excise tax on the excess parachute payments. Due to this exception, potential buyers of private corporations will generally require the seller to engage in a shareholder vote before the transaction closes.
In situations where an LLC is acquired, with no corporation present in the structure, the question of Sec. 280G is often overlooked, as it does not directly apply to LLCs. However, there are buyers that are risk-averse and, in taking a belt-and-suspenders approach, will request that the LLC conduct an ownership vote in accordance with the provisions of Sec. 280G and its regulations. Their reasoning for this is that when Congress enacted Secs. 280G and 4999 in 1984, LLCs were still uncommon in most states. It was not until the 1990s that LLCs rose in prevalence, quickly outpacing other legal entities as the preferred entity type. Due to this prevalence and a perceived risk that the IRS may extend the provisions of Sec. 280G to LLCs, some buyers consider the cost of a Sec. 280G analysis and vote to be a worthwhile expense.
As of this writing, the authors do not take the position that a vote is generally necessary for a partnership or LLC classified as a partnership, but they recommend that the taxpayer consider all the facts and circumstances surrounding the transaction for purposes of determining potential Sec. 280G exposure and consult with a tax adviser.
Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.