In 1996, Congress enacted legislation[1] that for the first time permitted an employee stock ownership plan (ESOP) to be an eligible S corporation shareholder, effective for tax years beginning after December 31, 1997. In 1997 the law was modified further to facilitate ESOPs becoming S corporation shareholders by specifically exempting an ESOP’s share of S corporation flow-through earnings from the tax on unrelated business income[2]. Because ESOPs are tax-exempt trusts, the ESOP’s S corporation earnings are virtually tax free.
If an ESOP owns 100% of the stock of an S corporation, the S corporation’s income is generally not subject to income tax. Furthermore, if the S corporation distributes cash to the ESOP as shareholder, no tax is paid on the distributed cash until the ESOP makes distributions to the plan’s participants, upon retirement, death, disability, or other termination of employment. At that time it is possible for participants to continue the tax deferral if the distribution becomes a rollover to an appropriate tax-exempt vehicle.
If the ESOP owns less than 100% of the S corporation, then the tax savings will be proportionally reduced, and the non-ESOP shareholders will be charged with their share of the S corporation’s earnings.
The Abuse of the S Corporation ESOP
The tax savings opportunities for S corporation ESOPs are substantial, providing fertile ground for creative tax structuring and strategies. As might be anticipated some early S corporation ESOP structures did not meet the spirit or intent of the law, namely to expand broad-based corporate ownership for rank-and-file employees, not just for highly compensated employees and historical owners, while providing employees meaningful retirement funding in the form of equity in their employer[3].
Under the S corporation ESOP law effective in 1998 it was possible for an S corporation to sponsor an ESOP for a small number of employees, sometimes dominated by family members. In some situations stock options or other forms of delayed equity were used to allow an S corporation to be owned by the ESOP and operated on a tax-favored basis for years, only to have the options or delayed equity converted into stock later, shifting ownership away from the ESOP. A small number of executives or outside investors could reap the cumulative benefit of the ESOP’s tax-favored status, with the ESOP participants benefiting only to a nominal degree. Another arrangement split off part of an operating company – along with a sizeable part of the net profits – into a newly formed 100% ESOP-owned S corporation designed to operate free of tax, while funding with untaxed income into large deferred compensation plans for a select group of executives.
Anti-Abuse Legislation
In 2001, Congress enacted legislation[4] to address both actual and anticipated situations that could lead to an inappropriate deferral or avoidance of tax in certain S corporation ESOP structures. Internal Revenue Code Section 409(p) was added to limit the tax benefits of ESOPs maintained by S corporations to those in which the ESOP is designed to provide a meaningful benefit to a broad base of rank-and-file employees. Section 409(p) is essentially an ownership concentration test designed to assure broad-based employee ownership within the ESOP.
In addition to providing specific rules for anti-abuse testing, the law directs the Secretary of the Treasury (“Treasury”) to prescribe regulations as may be necessary to carry out the purposes of Section 409(p)[5]. On July 18, 2003, the Treasury issued temporary and proposed regulations (the “2003 Regulations”) to provide guidance in the application of the provisions of Section 409(p)[6]. On December 17, 2004, a new set of temporary and proposed regulations (the “2004 Regulations” or “Regulations”) were issued to clarify, expand and modify the 2003 Regulations[7]. The 2004 Regulations provided guidance for synthetic equity, and determining whether a transaction constitutes an avoidance or evasion of Section 409(p). The Treasury is also authorized by regulation or other guidance of general applicability to challenge schemes which constitute and avoidance or evasion of Section 409(p)[8]. The new terms created are specific to Section 409(p) and are defined in this chapter.
If an ESOP holding S corporation stock was established on or before March 14, 2001 and its sponsor’s S corporation election was effective on that date, then Section 409(p) is effective for its plan years beginning after December 31, 2004[9]. The 2004 Regulations for such corporations are effective for plan years beginning after December 31, 2004[10], subject to transition rules applicable to the first plan year beginning after that date[11].
For all other S corporation ESOPs, Section 409(p) is effective for plan years ending after March 14, 2001[12]. In any case, ESOPs must contain within the plan document the provisions of Section 409(p), as well as any optional elections available under the Regulations[13].
The Basic Anti-Abuse Rule
Section 409(p) requires that if an ESOP holds S corporation stock, no portion of the ESOP’s assets attributable to or allocable in lieu of S corporation stock may, during a nonallocation year, accrue or be allocated for the benefit of any disqualified person[14] under the ESOP or other qualified plan. This rule must be complied with each day of the plan year[15]. A plan that does not satisfy this requirement is subject to substantial penalties, as are the individuals having a prohibited allocation and the S corporation sponsoring the ESOP.
A nonallocation year is an ESOP’s plan year during which at any time it holds shares of stock of the S corporation[16] and disqualified persons own 50% or more of:
(1) The outstanding shares of stock in the S corporation, including deemed-owned ESOP shares[17], or
(2) The sum of the outstanding shares of stock of the S corporation, including deemed-owned ESOP shares, plus synthetic equity in the S corporation owned by disqualified persons[18].
In addition to a person’s deemed-owned shares and shares owned outright, the ownership of issued and deemed-owned shares of family members and others may be attributed to him[19].
Treasury is authorized to issue regulations or other guidance providing that a nonallocation year exists if the S corporation’s principal ownership structure constitutes an avoidance or evasion of Section 409(p)[20]. The standard for reviewing the structure looks at all relevant facts and circumstances including the economic benefits in the S corporation enjoyed by the ESOP while a shareholder. Other factors include voting rights, distribution rights and the corporation’s stock and related obligations, including synthetic equity[21].
This essentially means that…
Penalties for Section 409(p) Violation
The consequences of violating the requirements of Section 409(p) are compelling. If there is a nonallocation year, penalties and excise taxes apply. If there is a nonallocation year, each disqualified person is deemed to have received a distribution from the ESOP of any prohibited allocation to his account. In the case of an impermissible accrual, the distribution is treated as occurring on the first day of the plan year of the impermissible accrual. If there is an impermissible allocation, the distribution is deemed to have occurred on the date of the allocation. The disqualified person must include the prohibited allocation in gross income, less any tax basis he might have in the distributed amount. The premature distribution penalty tax applies if he is less than age 59 ½, and because the distribution is deemed, not actual, it is not a distribution eligible for rollover to a tax-exempt vehicle such as a rollover IRA[22]. Any resulting tax liability falls on each disqualified person.
50% Excise Tax on Prohibited Allocations
Next, a 50% excise tax is imposed on the prohibited allocations of employer securities in violation of Section 409(p)[23]. The amount subject to the excise tax is the prohibited allocation to any disqualified person in violation of Section 409(p)[24]. Because historical accruals in a disqualified person’s ESOP account constitute prohibited allocations, the excise tax applies to the entire balance in a disqualified person’s account. The statute also imposes a special rule 50% excise tax for a corporation’s first nonallocation year, based on the total value of all deemed-owned shares of all disqualified persons with respect to the ESOP[25]. This sequence appears to result in multiple excise taxes in a year for the same violation. In public hearings on the 2004 Regulations, Treasury indicated there is no intent to apply the 50% excise tax more than once on an annual basis. But any applicable excise taxes are assessable annually[26].
50% Excise Tax on Synthetic Equity
Annually there is an additional 50% excise tax on any synthetic equity owned by any disqualified person in a nonallocation year[27]. The amount involved for determining the tax is the value of the shares on which the synthetic equity is based[28], not the value of the synthetic equity itself. A stock option right of little or no value, for example, can result in a large excise tax that is based on the value of the shares underlying the option.
The excise tax based on prohibited allocations or on synthetic equity is a liability of the S corporation[29]. The statute of limitations for assessing the 50% excise taxes is three years after the later of the date the prohibited allocation occurred, or the date IRS is notified of the prohibited allocation or synthetic equity ownership[30].
Loss of ESOP Status
If there is a nonallocation year and a prohibited allocation occurs in that year, then the requirements of Section 409(p) would not be met and the ESOP would lose its ESOP status[31]. A loss of ESOP status would mean that any ESOP loan would no longer qualify for the statutory prohibited transaction exemption[32].
A qualified plan is permitted to be an S corporation shareholder[33], but its share of earnings is unrelated business taxable income[34] subject to income tax[35]. An exception is provided for ESOPs. An ESOP’s share of earnings from an S corporation is not treated as unrelated business taxable income and accordingly is not subject to unrelated business income tax[36]. Loss of statutory ESOP status will subject the S corporation ESOP to income tax on its S corporation distribution of earnings.
Synthetic Equity as Part of the Anti-Abuse Testing Scheme
Synthetic equity includes any stock option, warrant, restricted stock, deferred issuance stock right, stock appreciation rights payable in stock or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future[37]. Synthetic equity also includes stock appreciation rights payable in cash, phantom stock units or other similar rights to a future cash payment based on the value of the S corporation stock or appreciation in its value[38].
In addition to synthetic equity directly owned, a person can own synthetic equity constructively. He constructively owns his proportionate share of stock and synthetic equity held by any partnership, estate or trust, including any qualified plan trust[39]. He is treated as owning all shares held by a living or grantor trust if he is considered the trust owner under the grantor trust rules[40]. He is also treated as owning his proportionate share of stock or synthetic equity held by another corporation if he owns, directly or indirectly, 50% or more of the value of the stock in that corporation[41]. The attribution rules for options to acquire stocks are disregarded[42].
A person’s right to acquire stock in an S corporation from someone other than the S corporation, its ESOP or a related entity is not treated as synthetic equity, provided that at all times while the rights are effective the underlying stock is issued and outstanding and held by persons subject to federal income taxes[43]. However, the person holding the right is treated as owning the underlying stock[44]. As a result, those shares are not included for determining a person’s status as a disqualified person, discussed in (c) below, but they are counted in testing for a nonallocation year, described in (d) below.
Synthetic equity includes the right to acquire stock or similar interests in an entity but only to the extent of the S corporation’s ownership. It also includes the right to acquire assets of the related entity or of the S corporation itself, other than in the ordinary course of business and certain fringe benefits excludable from taxation[45].
Both the 2003 and 2004 Regulations significantly expanded synthetic equity to include nonqualified deferred compensation. The definition of deferred compensation is applied broadly to include remuneration subject to IRC Section 404(a)(5) and Section 83. Any remuneration for services rendered during an S corporation’s taxable year but paid beyond the 15th day of the 3rd month of the year following constitutes synthetic equity[46]. Treasury has broad authority to add items other than traditional deferred compensation to the synthetic equity list if actual or perceived abuses warrant such action[47]. A covenant not to compete might be subject to special scrutiny to determine if it is a form of deferred compensation for 409(p) purposes. Life insurance arrangements can be interpreted as creating deferred compensation classified as synthetic equity. Earnouts or escrows associated with a sale of stock should be reviewed to determine if they are future payment for future results, or price adjustments for legitimate contingencies, rather than a disguised form of deferred compensation.
All synthetic equity, such as stock options or warrants, is determined by reference to the deliverable underlying shares of the S corporation’s stock, and the holder of the synthetic equity is treated as owning the corresponding number of shares. Example: A stock option for 100 shares would be treated as 100 deemed-owned shares in the hands of a person[48] while a stock appreciation right for 100 shares would translate into a number of shares equal to the present value of the appreciation in the right as of the time of measurement[49]. Similar rules apply for synthetic equity in a related entity[50].
To determine the share equivalent of the synthetic equity that is payable in cash, the present value of the synthetic equity is converted into a number of shares of stock in the S corporation based on the fair market value of the S corporation shares on a determination date[51]. The determination date, generally annual, is either the first day of the ESOP’s plan year or any other reasonable date or dates uniformly and consistently used by the corporation for the purposes of the equivalency determination[52]. The ESOP may provide for determination dates to be extended as much as three years apart, subject to a requirement of fairness and consistency[53]. The number of shares a person is treated as owning on a certain determination date can be fixed but is not subject to redetermination until the next following determination date[54]. A detailed example involving a triannual election is provided in the Regulations[55]. The Regulations do not provide specific guidance for present value calculations or application of any valuation discounts, other than to preclude consideration of a lapse restriction, which by its terms is subject to a substantial risk of forfeiture[56].
[1] P. L. 104-188, the Small Business Job Protection Act, Section 1316(a)(2)
[2] P. L. 105-34, the Taxpayer Relief Act of 1997, Section 1523(a); Code Section 512(e)(3)
[3] House Conference Report 107-84, May 26, 2001, Section VI.B.4(g)
[4] P. L. 107-16, the Economic Growth and Tax Relief Act of 2001, Section 656(a)
[5] Code Section 409(p)(7)(A)
[6] T. D. 9081, issued July 21, 2003 (68FR42970)
[7] T. D. 9164, effective December 17, 2004
[8] Code Section 409(p)(7)(B)
[9] P. L. 107-16, Section 656(d)(2); Temporary Regulation Section 1.409(p)-IT(i)(i)(ii)
[10] Temporary Regulation Section 1.409(p)-IT(i)(2)(i) and Temporary Regulation Section 1.409(p)-IT(i)(2)(ii)(E)
[11] Temporary Regulation Section 1.409(p)-IT(i)(2)(iii)
[12] P. L. 107-16, Section 656(d)(2); Temporary Regulation Section 1.409(p)-IT(i)(i)(i)
[13] See for Example Temp. Reg. Sec. 1.409(p)-IT(f)(4)(iii)(B)(2)
[14] Code Section 409(p)(l)
[15] Code Section 409(p)(3)(A)
[16] Code Section 409(p)(4)(A)(ii) and Temporary Regulation Section 1.409(p)-IT(d)(1)(i)
[17] Temporary Regulation Section 1.409(p)-IT(d)(1)(ii)
[18] Temporary Regulation Section 1.409(p)-IT(d)(1)(ii)[2003 Regulations]
[19] Code Section 409(p)(4)(B); Temporary Regulation Section 1.409(p)-IT(d)(2)(i)
[20] Code Section 409(p)(3)(A)(i); Temporary Regulation Section 1.409(p)-IT(c)(1)
[21] Code Section 409(p)(3)(A)(ii); Temporary Regulation Section 1.409(p)-IT(c)(1)(i)
[22] Code Section 409(p)(2)(A); Temporary Regulation Section 1.409(p)-IT(b)(2)(iv)(A)
[23] Code Section 4979A(a)(3)
[24] Code Section 4979A(e)(2)(A)
[25] Code Section 4979A(e)(2)(C); Code Section 4979A(a)(3)
[26] Treasury Hearings on Proposed Regulations (Reg. 129709-03), WDC, April 20, 2005
[27] Code Section 4979A(a)(4)
[28] Code Section 4979A(e)(2)(B)
[29] Code Section 4979A(c)(2)
[30] Code Section 4979A(e)(2)(D)
[31] Code Section 4975(e)(7); Temporary Regulation Section 1.409(p)-IT(b)(2)(iv)(B)
[32] Code Section 4975(d)(3); Temporary Regulation Section 1.409(p)-IT(b)(2)(iv)(B)
[33] Code Section 1361(c)(6)
[34] Code Section 512(e)(1)(A)
[35] Code Section 512
[36] Code Section 512(e)(3)
[37] Code Section 409(p)(6)(c); Temporary Regulation Section 1.409-IT(f)(2)(i)
[38] Code Section 409(p)(6)(c); Temporary Regulation Section 1.409-IT(f)(2)(ii)
[39] Code Section 409(p)(3)(B); Code Section 318(a)(2)(A) and (B), modified by Code Section 409(p)(3)(B)(i)
[40] Code Section 409(p)(3)(B); Code Section 318(a)(2)(B)(ii)
[41] Code Section 409(p)(3)(B); Code Section 318(a)(2)(C)
[42] Code Section 409(p)(3)(B)(i)(II)
[43] Temporary Regulation Section 1.409(p)-IT(f)(2)(i), last sentence
[44] Temporary Regulation Section 1.409(p)-IT(c)(4)
[45] Temporary Regulation Section 1.409(p)-IT(f)(2)(iii)
[46] Temporary Regulation Section 1.409(p)-IT(f)(2)(iv)(A)
[47] Code Section 409(p)(7)
[48] Temporary Regulation Section 1.409(p)-IT(f)(4)(i)
[49] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)
[50] Temporary Regulation Section 1.409(p)-IT(f)(4)(ii)
[51] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)(A)
[52] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)(B)(l)
[53] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)(B)(2)
[54] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)(B)(1)
[55] Temporary Regulation Section 1.409(p)-IT(h), example 3
[56] Temporary Regulation Section 1.409(p)-IT(f)(4)(iii)(A); I.T. Reg. Sec. 1.83-3(i)
Updated March 25, 2024
