Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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How does the anti-abuse test work?

The anti-abuse test, described in section 409(p), is a two-part test.

First, determine who "disqualified persons" are. Under the law, a "disqualified person" is an individual who owns 10% or more of the shares in the ESOP, counting both allocated shares and a pro-rata portion of the unallocated shares. A person is also a disqualified person if he or she together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children, or the spouses of any of these other family members) owns 20% or more. Synthetic equity, broadly defined to include stock options, stock appreciation rights, and other equity equivalents, is also counted as ownership (in effect, ESOP ownership) for this determination. Shares directly owned are not considered in determining who is a disqualified person.

Second, determine if disqualified persons own or are deemed to own at least 50% of all shares in the company. In making this determination, ownership is defined to include:

a. shares held directly (in contrast with step 1 above)

b. shares allocated to the individual's ESOP account

c. the individual's pro-rata share of the unallocated shares owned through the ESOP

d. shares owned through synthetic equity, including the equivalent equity value of any deferred compensation paid out after more than 2.5 months after the compensation award is granted.

Item d is shares that are "deemed-owned" by the disqualified person. The text must be performed in two rounds, first with items a, b, and c, and the second time with all four items.

If disqualified individuals own (or are deemed to own) at least 50% of the stock of the company in either round of the test, then the company has a "nonallocation year" and is subject to severe penalties. In the first nonallocation year, there is a 50% tax on the fair market value of shares allocated to all disqualified individuals even if no additional allocations are made to those individuals that year (in other words, the tax applies simply if disqualified individuals own (or are deemed to own) more than 50% of the company in the first year).

In addition, disqualified persons may not receive allocations from the ESOP during nonallocation years without a substantial tax penalty. If such an allocation does occur, it is taxed as a distribution to the recipient and a 50% corporate excise tax would apply to the fair market value of the stock allocated. If synthetic equity is owned, a 50% excise tax would also apply to its value as well.

Finally, both an allocation to a disqualified person and the accumulation of ownership or deemed ownership of 50% or more of the stock constitutes a prohibited allocation and the plan would no longer be an ESOP.

Effective Date

For plans in existence prior to March 14, 2001, the rules became effective for plan years beginning after December 31, 2004. For plans established after March 14, 2001, or for pre-existing C corporation ESOPs that switched to S status after this date, the effective date is for plan years ending after March 14, 2001.

Authorization to Disallow Existing Abuses in Plans

In addition, the conference report directed the IRS to develop regulations to define existing plans as subject to this legislation, regardless of when they were established, if their purpose is "in substance, an avoidance or evasion of the prohibited allocation rule.

For details on S corporation ESOPs, see S Corporation ESOPs.

Link to this FAQ Topic: S Corporation ESOPs