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ESOP Operational Issues

Section 409(p) Testing (Part 2)

Nancy Dittmer

April 11, 2013

(Nancy Dittmer)When I first started this series of columns on Section 409(p) testing, I feared that there existed a degree of "Section 409(p) overload." This topic is discussed at almost every ESOP conference. I discussed it on a recent NCEO Webinar. Yet I continue to encounter situations where Section 409(p) has been overlooked or the testing has been performed incorrectly. So I will forge ahead with this second column on Section 409(p).

My first column on Section 409(p) provided a general overview of the term "disqualified person." As I noted, 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 this column will 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

Step 2: Nonallocation Year Calculation

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:

Clearly, violating Section 409(p) is to be avoided at all costs.

Author biography and other columns in this series

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