ESOP Operational Issues
Section 409(p) Testing (Part 5)
September 9, 2016At long last, here is the final installment in my series on Section 409(p). As noted in Part 2, violating Section 409(p) should definitely be avoided. So what steps are available to prevent a Section 409(p) failure?
The steps to avoid violation of these rules may vary depending upon the cause of the potential violation. Also, any preventive measure must be otherwise permissible. I.e., it cannot violate other qualified plan rules. Some possible alternatives include:
- Reducing the level of synthetic equity by cancelling or distributing part or all of the synthetic equity. (Please consult with your advisor on any Section 409(n) implications before proceeding.)
- Rebalancing participants' accounts. The use of a plan-wide rebalancing calculation results in each participant having the same proportion of company stock and other investments. Often for an ESOP that changes from pure share accounting to rebalancing, the result is a reduction in the number of shares in the accounts of long-term employees, which may be beneficial for 409(p) testing. Any targeted rebalancing that does not encompass all participants would be subject to nondiscrimination testing and likely would not satisfy the nondiscrimination requirements.
- Allow for in-service withdrawals that could reduce the share balance of a disqualified person or potential disqualified person. Such a feature must be offered on a nondiscriminatory basis. As a result, the impact on the ESOP's repurchase obligation must be evaluated.
- Transfer shares from a participant's ESOP account to a non-ESOP account. This alternative is included in the Section 409(p) regulations, and the IRS has provided sample plan document language. Such a transfer is not a payout to the affected participant but rather is a transfer to a non-ESOP account where such shares will be subject to unrelated business income tax (UBIT) on their pro-rata share of the S corporation earnings. Note, the transfer must be done in advance of an event that would cause a violation of Section 409(p). It cannot be done be retroactively. The ESOP will file a Form 990-T, the UBIT will be paid by the ESOP, and the funds for the payment must come from the account of the affected participant. If the participant does not have sufficient other investments within the ESOP to fund the tax payment, the shares can be sold (subject to the prohibited transaction exemption requirements.) The number of shares to be transferred will be calculated to avoid a nonallocation year and could be relatively small. Even if the number of shares transferred grows annually, the UBIT liability will likely be preferable to the consequences of a 409(p) violation.
- Change the provisions of the ESOP to relax eligibility and delay the reallocation of forfeitures to increase the number of participants with share balances and dilute the percentage owned by potential disqualified persons.
- Revoke the S election.