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ESOP Operational Issues

Section 409(p) Testing (Part 1)

Nancy Dittmer

December 12, 2012

(Nancy Dittmer)This is the first in a series of articles on Section 409(p), the rules that seek to prevent S corporation ESOPs from being used as abusive tax shelters.

There is no doubt that there is a substantial tax advantage to the S corporation ESOP business model because federal taxes and many state taxes can generally be deferred until the ESOP participants receive taxable distributions from the ESOP. In an effort to shut down "abusive" S corporation ESOPs that did not convey broad-based employee ownership, Congress promulgated the anti-abuse rules of Internal Revenue Code Section 409(p). While these rules were aimed at abusive S corporation ESOPs, they apply to all S corporation ESOPs. The consequences of failing the Section 409(p) rules are draconian.

Please note that the details and intricacies involved with Section 409(p) testing are simply too much to be addressed in a column of this nature. What will follow in this and subsequent columns is a general overview of these very complex rules.

Section 409(p) is satisfied if "disqualified persons" do not own 50% or more of the S corporation's "stock." This stock includes allocated and yet-to-be allocated ESOP shares, synthetic equity of the S corporation, and any shares held directly in the S corporation. The ESOP shares and any synthetic equity are considered to be "deemed-owned" shares for purposes of Section 409(p).

The first step in the testing process is to determine whether there are any "disqualified persons." This test is based solely on the ESOP's stockholdings and any synthetic equity, and it does not include direct ownership outside of the ESOP.

In general, a disqualified person is any ESOP participant who owns 10% or more of the ESOP's stock. However, because a participant is deemed to own a portion of any unallocated shares in the ESOP for purposes of this test, a "mock" allocation of the ESOP's unallocated shares must be made.

As a corollary to the 10% test, if any ESOP participant and his or her family members own 20% or more of the ESOP's allocated and unallocated shares, such participant is also a disqualified person. In other words, if three participants each with 7% stock ownership inside the ESOP are family members, then the family group exceeds the 20% threshold, and each participant is a disqualified person.

The definition of "family member" is very broad. A special family attribution rule also can cause an ESOP participant to be a disqualified person if he or she does not satisfy the above 10% or 20% thresholds as an individual/family but is a family member of a participant who satisfies the 20% threshold (and who owns any deemed-owned shares or synthetic equity). This situation may arise when there are multiple family groups and an individual is a member of more than one group.

To add further complexity to the test, an individual who owns "synthetic equity" in the S corporation must count that synthetic equity toward meeting the 10% or 20% threshold if such synthetic equity would result in his or her classification as a disqualified person. Specifically, the synthetic equity can be used to cause the person to be considered a disqualified participant but cannot be counted in the total shares denominator when determining whether another person is a disqualified person.

The definition of synthetic equity is also very broad and includes arrangements such as stock options, stock appreciation rights, phantom stock plans, and other types of rights to unissued stock, as well as certain forms of nonqualified deferred compensation.

The existence of one or more disqualified persons does not mean that the Section 409(p) test is failed. The next step is to determine whether a nonallocation year exists, and that will be discussed in my next column.

Author biography and other columns in this series

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