ESOP Operational Issues
Section 409(p) Testing (Part 4)
May 8, 2014As I continue my series of articles on Code Section 409(p) (see Part 1, Part 2, and Part 3), I want to 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.
My next installment will discuss the preventative measures that may be taken to avoid a nonallocation year.