ESOP Operational Issues
Section 409(p) Testing (Part 2)
April 11, 2013When 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
- 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
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.
- 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.
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.
- 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.
Author biography and other columns in this series