IRS Issues S Corporation ESOP Regulations

In Temporary Regulations 1.409(p)-1T, "Prohibited Allocation of Securities in an S Corporation," the IRS has issued comprehensive rules designed to prevent the abuse of ESOPs in S corporations. It accomplishes this by prohibiting allocations and accruals to "disqualified person" (persons owning more than 10% or family members owning more than 20% of ESOP assets, defined to include any synthetic equity they may also own) who collectively own more than 50% of total S corporation assets, including synthetic equity rights. Synthetic equity is defined to include options, restricted stock, phantom stock, stock appreciation rights, and similar plans, as well as many kinds of deferred compensation. The new rules do not add major changes to existing regulations, but do clarify several points. Some commenters had hoped for an easing of the synthetic equity definitions, but the new rules do not give much ground on that issue. Key issues are described below.

Impermissible Accruals and Allocations

In what is mostly a language change, prohibited accruals and allocations are now called impermissible accruals and impermissible allocations, either of which can result in a prohibited allocation. The new wrinkle in the accrual definition is that there is a prohibited allocation "to the extent (and only to the extent)" the employer stock and any assets attributable to the S corporation are held in the ESOP during a nonallocation year for the benefit of a disqualified person. Stock in the account, proceeds from the sale of the stock, and distributions all are included in this definition.

Calculating Individual Ownership

An individual is treated as owning outstanding non-ESOP stock if that individual has a right to acquire such stock unless the actual owner is (1) subject to federal income tax, (2) the right is not one that would constitute a second class of stock, and (3) a principal purpose of the right is not to avoid taxation under the S ESOP rules. The issue here, apparently, is that the right to buy shares would be considered synthetic equity unless the individual is deemed actually to already own the stock. Synthetic equity ownership is added to ESOP ownership in determining who is a disqualified person for the S ESOP abuse test.

Second, for purposes of determining whose ownership makes them a disqualified person, the rules clarify that if any share is treated as owned by more than one person, then the share is counted as a single share, not a share separately owned by multiple people.

Counting Options

The 2003 regulations allowed a potential loophole in that companies could increase their apparent number of outstanding shares by issuing lots of stock options or similar rights to lots of employees, but under terms that made it extremely unlikely that they could ever be exercised. By increasing the number of apparent outstanding shares, the percentage of ownership held by any one individual employee intent on abusing the rules would appear smaller as a result. The new regulations address this problem by looking at such synthetic equity person-by-person so that the synthetic equity of other individuals does not count toward total share calculations for determining if that individual is a disqualified person.

Synthetic Equity

The new regulations are very similar to the 2003 regulations in determining what synthetic equity is. Two new wrinkles are that a nonqualified deferred compensation plan taken into account before January 1, 2005, for FICA purposes, and that was outstanding on the first date the ESOP acquired shares, is now excluded. The definition of synthetic equity, however, is expanded to include the right to acquire stock or assets in any related entity, not just the previously narrowly defined situations. The rules apply now to any rights to acquire assets in such an entity, not just goods, property, or services. The rights are calculated pro-rata to the ownership interests of the S corporation in that entity.

For purposes of determining the total outstanding shares and individual ownership, the regulations count the right to acquire one share, through an instrument such as an option or restricted stock, as ownership of one share. For example, an option on 100 shares is treated as ownership of 100 shares. But the new regulations specify that a stock appreciation right has a value equal to the appreciation at the time of measurement, determined without regard to when the restrictions lapse. Presumably, a company would use some kind of valuation formula to assess this, such as those the new equity compensation rules will provide.

Another new rule provides that shares with voting rights greater than those in the ESOP are counted based on their voting rights. For example, if an employee has the right to acquire a share that has three votes, it counts as three shares.

In determining the number of synthetic shares, determinations can be made on the first day of the plan year or another consistent representative date, but the new rules specify that this day must be representative of ESOP share value over the year. To ease this test, a company can use a moving three-year valuation, with new grants being adjusted at the next determination date.

Finally, in an important change, the rules provide that where an ESOP owns less than 100% of the stock, the synthetic equity calculations are done pro-rata to the ESOP's ownership. If the ESOP owns 30% of the shares, the synthetic equity interest would be multiplied by 0.3, for instance.

Effective Dates

Generally, the rules are effective for plan years beginning after January 1, 2005. Under special transition rules, however, the effective date is before July 1, 2005, for the disposal of existing shares or rights that could cause problems, although an excise tax will apply if this is the first nonallocation year;and the person-by-person and voting rights rules generally become effective July 1, 2005, but there is a special exception for the issuance of additional rights or options intended to get around the rules in the interim. Plans may still rely on the exception for pre-ESOP nonqualified deferred compensation for periods prior to January 1, 2005.

These regulations are very complicated. While few legitimate S ESOPs, except perhaps for some very small companies, will be affected by them other than to make sure proper testing is done, their implementation requires careful consultation with a professional genuinely expert in this field.