In 2001, Congress enacted Internal Revenue Code Section 409(p) to establish anti-abuse rules for S corporation employee stock ownership plans (ESOPs). These rules are meant to ensure that benefits are being provided to a broad group of employees, rather than just a small group of management. All ESOPs that hold S corp stock are required to comply with the §409(p) rules each day of their plan year. These laws are very complex but should be carefully considered and monitored.
Overview
Section 409(p) prohibits disqualified persons from receiving allocations of ESOP assets during a nonallocation year. A nonallocation year occurs when disqualified persons collectively own (or are deemed to own) at least 50% of the ESOP’s shares. A disqualified person is any person who owns (or is deemed to own) at least 10% of the ESOP shares (or 20% when aggregating the number of shares owned by such person and the members of such person’s family). This test can be broken into two steps: identifying disqualified persons and determining their percentage of equity owned by disqualified persons.
Computation
Step 1: Identify Disqualified Persons
The first step in the testing process is to determine if there are any disqualified persons. A disqualified person for §409(p) purposes is a person who (1) owns 10% of all the deemed-owned ESOP shares or (2), together with their family, owns at least 20% of all deemed-owned ESOP shares. This test is based on the ESOP’s shares plus synthetic equity and does not include shares owned directly outside of the ESOP. If there are one or more disqualified persons, that alone does not result in a failure of §409(p). That simply means you must proceed to step two, which is to determine if there is a nonallocation year.
- Deemed-owned shares include:
- Shares allocated to the individual’s ESOP account,
- That person’s share of the S corp stock that remains unallocated (based on the individual’s pro rata share of the last allocation of ESOP stock), and
- Synthetic equity, but only to the extent it results in the individual being considered a disqualified person.
- Synthetic equity is a very broad term for purposes of this test. Synthetic equity may include (but is not limited to) stock options, warrants, restricted stock, phantom stock, stock appreciation rights, nonqualified deferred compensation, and split-dollar life insurance.
- For purposes of determining disqualified persons, family members should include the following:
- The spouse of the individual
- An ancestor or lineal descendant of the individual
- An ancestor or lineal descendant of the individual’s spouse
- A brother or sister of the individual
- A brother or sister of the spouse
- Lineal descendants of siblings
- The spouse of any family member mentioned above
Step 2: Determination of a Nonallocation Year
A nonallocation year occurs when in total one or more disqualified persons own—at any time during the ESOP’s plan year—50% or more of either (1) the outstanding shares (including deemed-owned shares) of the ESOP sponsor’s stock, or (2) the sum of the outstanding shares, the deemed-owned shares, and the synthetic equity owned by disqualified persons. When determining a disqualified person’s ownership, the family attribution rules apply so that the ownership of such person’s family members is counted as belonging to the disqualified person.
Consequences
The consequences of violating the §409(p) requirements are significant and impact the disqualified person, the plan sponsor, and the ESOP as a whole.
- Taxable Income to Disqualified Person – Each disqualified person is deemed to have received a distribution from the ESOP, based on the current fair market value, of any prohibited allocation. If the participant is under age 59 ½, the early distribution 10% penalty tax will apply.
- Loss of ESOP Qualified Plan Status – If the ESOP is leveraged, the loan would be considered a prohibited transaction. With this loss of status, the ESOP would be subject to the unrelated business income tax on any S corp distributions.
- 50% Corporate Excise Taxes – There will be a 50% penalty tax on the fair market value of all deemed-owned shares held by all disqualified persons. If the violation occurs after the first nonallocation year, there also will be a 50% penalty tax on the fair market value of the shares that make up the base of the synthetic equity held by all disqualified persons.
- Termination of S Election – Since the ESOP is no longer a qualified plan, the company’s S election would terminate.
With these consequences, it is important for any S corp ESOP to understand §409(p) testing to ensure compliance. For more information on §409(p), please reach out to a professional at Forvis Mazars.