Section 409(p) Testing
This article combines a set of essays written from 2012 to 2016 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 next.
As I noted above, the mere existence of one or more disqualified persons does not by itself trigger a violation of the Section 409(p) rules. Rather, the next step is to determine whether the plan year is a "nonallocation year." So I will now define the term "nonallocation year" in general terms.
To have a nonallocation year, the disqualified persons must effectively "control" the S corporation. Thus, the disqualified persons must own 50% or more of the outstanding stock of the S corporation. For purposes of this calculation, the disqualified person's ownership outside of the ESOP is now added to his or her ESOP ownership and synthetic equity (i.e., deemed-owned shares).
Here is a relatively straightforward example of the two-step test:
Step 1: Determination of Disqualified Persons
- The ESOP owns 100% of the total outstanding shares of 450,000.
- Participant A has an ESOP balance of 35,000 shares and is deemed to own 12,000 of the unallocated suspense shares. So Participant A is deemed to own 10.44% of the ESOP's shares and is a disqualified person.
- Participant B has 25,000 shares in the ESOP and is deemed to own 10,000 of the unallocated shares. Participant B is deemed to own 7.77% of the ESOP's shares and is not a disqualified person.
- Participant C has 40,000 shares in the ESOP and is deemed to own 15,000 of the unallocated shares. Participant C is deemed to own 12.22% of the ESOP's shares and is a disqualified person.
- There are no other participants in the ESOP who are deemed to own more than 7% of the ESOP's shares.
- There no family relationships among the employees.
- There are no synthetic equity programs.
Step 2: Nonallocation Year Calculation
- The two Disqualified Persons (Participants A and C) together are deemed to own 102,000 of the ESOP's shares. The nonallocation percentage is 22.66% and Section 409(p) is satisfied.
If only every Section 409(p) test were so simple. In many situations, the ESOP does not own 100%, and/or there are family relationships among employees and/or owners, attribution of ownership, synthetic equity programs, etc., that can significantly complicate the calculations. We will explore some of these complicating factors in future columns.
But first let us review the draconian consequences of failing Section 409(p), which include the following:
- The disqualified person must pay income tax on the value of the prohibited allocation (whether from the current year or from prior years).
- The employer is subject to a 50% excise tax on the value of shares allocated in a prohibited allocation (whether from the current year or from a prior year) as well as the value of the synthetic equity of the disqualified persons in the nonallocation year.
- The plan would lose its qualified plan status.
- The plan ceases to be an ESOP, so it must pay unrelated business income tax on its pro-rata share of S corporation earnings.
Clearly, violating Section 409(p) is to be avoided at all costs.
Next we will discuss how synthetic equity affects the testing.
First, let's look at an example of how synthetic equity affects the determination of disqualified person status. Synthetic equity can only cause the person to be considered a disqualified participant and cannot be counted in the total shares denominator when determining whether another person is a disqualified person.
- The ESOP owns 100% of the total outstanding shares of 450,000.
- Participant A has an ESOP balance of 14,000 shares and is deemed to own 7,000 of the unallocated suspense shares.
- So Participant A has 4.66% of the ESOP's shares.
- Participant A also has 30,000 warrants to purchase future shares.
- Disqualified person calculation for participant A: (14,000 + 7,000 + 30,000) / (450,000 + 30,000) = 10.625%.
- Note: There are other participants with synthetic equity, but such synthetic equity is not included in the denominator when testing Participant A.
Similarly, when determining if a plan year is a nonallocation year, the synthetic equity of only the disqualified persons would be included in the calculation.
So what constitutes synthetic equity and how is the number of shares to be included in the testing determined?
I assume the term "synthetic equity" is meant to describe something that looks and feels like "equity" but is somehow different or artificial. So logically, tools such as restricted stock, stock options, or warrants that give the holder the right to receive stock in the future are considered to be synthetic equity. Stock appreciation rights, phantom stock, and similar arrangements where the payout to the holder is based on the value of the stock or its appreciation would also be considered synthetic equity. The term synthetic equity is defined to also include certain nonqualified deferred compensation arrangements even if the payments to be made under such arrangements are not tied to the stock's value or appreciation.
The determination of the number of shares of synthetic equity to be included in the Section 409(p) calculations is based on the type of synthetic equity. If the synthetic equity is payable in shares of stock of the S corporation, then one share of stock to be transferred would equal one share of synthetic equity.
If the synthetic equity is determined by reference to shares of stock of the S corporation but is payable to the holder in cash, the anticipated cash payment is converted into shares at the current fair market value. For example, if an individual holds a stock appreciation right, the appreciation determined under such right would be divided by the current per share market value of the company stock to calculate the number of shares of synthetic equity.
When the synthetic equity is in the form of nonqualified deferred compensation, the present value of such deferred compensation is converted into shares based on the current value of the shares. So if a participant has a deferred compensation program with a present value of $1 million and the current fair market value of a share of stock is $100, the number of shares of synthetic equity will be 10,000. If the value of a share of stock declines to $50 per share, the number of shares of synthetic equity will increase to 20,000 shares. Accordingly, a steep decline in the per-share stock value could adversely affect the 409(p) testing results. (Note: An ESOP can include a provision allowing for the use of triennial recalculations of the shares of synthetic equity stemming from nonqualified deferred compensation.)
If the ESOP owns less than 100% of the S corporation, then the number of shares of synthetic equity computed using the above methodologies is reduced ratably (i.e., if the ESOP owns 95% of the S corporation, 100 shares of synthetic equity would be reduced to 95 shares).
It is impossible to address all of the complex issues associated with synthetic equity and Section 409(p) in an article of this nature. So please use this general overview only as a starting point in your discussion of this topic with your ESOP advisors.
Frequency and Timing of the Test
I now will focus on the frequency and timing of performing the test.
Section 409(p) must be satisfied on every day of a year. Unlike other testing failures, there is not a prescribed method to make a correction after a nonallocation year occurs. Rather preventive measures should be taken before any event that might trigger a nonallocation year. Therefore, Section 409(p) testing may need to occur at different points throughout any given year.
For example, any change in the ownership of the non-ESOP stock during a year will affect the test as of the date of that change. Assume a participant is a disqualified person and also owns shares outside the ESOP. He or she buys more shares from a retiring shareholder to increase his or her outside ownership. Depending upon the amount of shares involved, this purchase could trigger a nonallocation year as of that day.
Another example that could affect the testing results is a change in family status during the year. If a child of an individual who directly owns the majority of the stock of the S corporation marries an employee who also happens to be a disqualified person, a nonallocation year could occur before the wedding gifts are opened.
Similarly, any issuance of new synthetic equity during a year should be tested in advance. Perhaps a shareholder who has sold some stock to the ESOP is issued a stock warrant. He or she may not have been a disqualified person previously, but the issuance of new synthetic equity could make the shareholder a disqualified person. And depending on the other ownership of the S corporation, that may be enough to trigger a nonallocation year as of that day.
While the Section 409(p) test is a daily test, most ESOPs maintained by private companies typically only update participant balances on an annual basis, as of the last day of the plan year. Nevertheless, there is activity within the ESOP throughout the year that affects participant balances. For example, former participants may receive a distribution of part or all of their share accounts during a plan year. Similarly, active participants may elect to diversify a portion of their share accounts under the ESOP's diversification provisions. The IRS has indicated informally that mid-year activity could immediately affect the 409(p) calculation.
Practitioners are still working to develop best practices for this "daily" testing issue. One alternative is if the shares attributable to former participants are to be recycled within the ESOP, then that number of shares should be added to the mock allocation of shares for purposes of a mid-year 409(p) test. Performing this mock allocation and updated testing before the account balances are actually distributed to the former participants is advisable for an ESOP that is close to a nonallocation year because the results revealed by such a mock allocation of the soon-to-be-recycled shares could show that a violation will occur.
Similarly, if the shares attributable to former participants will be distributed and retired, this could affect the testing results at the time of the distribution. If a participant is deemed to own 95 shares of the ESOP's total 1,000 shares, such participant is not a disqualified person. However, if the ESOP distributes 55 shares to a group of former participants and those shares are retired, that participant's deemed ownership percentage has now increased to 10.05% (95/945). Depending upon the circumstances, this change could be enough to trigger a nonallocation year as of the date those shares are distributed.
Preventative Measures to Avoid a Nonallocation Year
As noted above, 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.
There may be other steps that can be taken based on your specific facts. As always, please consult with your advisors.