ESOP Operational Issues
Section 409(p) Testing (Part 3)
September 12, 2013This installment in my series of columns on Section 409(p) testing (see Part 1 and Part 2) is a general overview of 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.
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.
- 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.
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 a column of this nature. So please use this general overview only as a starting point in your discussion of this topic with your ESOP advisors.
Author biography and other columns in this series