S Corporation ESOPs: Section 409(p), Nonallocation Years and Disqualified Persons

An S corporation can be owned in part by an ESOP, and the ESOP trust does not pay tax on its share of S income. Congress added a guardrail so that the arrangement benefits a broad group of employees and not just a few owners. That guardrail is section 409(p). If the test is failed in a plan year, the consequences land on the company and the plan, which makes the annual test a compliance item for the CPA firm that serves an S corporation ESOP client. The general accounting for ESOPs is in the ESOP audit guide.

The prohibition

Under section 409(p)(1), an ESOP holding employer securities consisting of S corporation stock must provide that no portion of the assets of the plan attributable to those securities (or allocable in lieu of them) may, during a nonallocation year, accrue or be allocated, directly or indirectly, under any qualified plan of the employer for the benefit of any disqualified person. Under section 409(p)(2), a plan that fails is treated as having distributed to the disqualified person the amount allocated in violation, at the time of the allocation.

What does the excise tax cost?

Section 4979A(a) imposes a tax equal to 50 percent of the amount involved on an allocation that violates section 409(p) and on ownership of synthetic equity by a disqualified person in a nonallocation year. The S corporation whose stock was allocated or owned pays it under section 4979A(c). Under section 4979A(e)(2), the amount involved is:

• the amount allocated to the person's account in violation of section 409(p)(1);
• for synthetic equity, the value of the shares the synthetic equity is based on; and
• for the ESOP's first nonallocation year, the total value of all deemed-owned shares held by all disqualified persons.

Assessment cannot expire before 3 years from the later of the allocation or ownership, or the date the Secretary is notified of it.

Nonallocation year

Under section 409(p)(3), a nonallocation year is any plan year in which, at any time, the plan holds S corporation stock and disqualified persons own at least 50 percent of the number of shares of stock in the S corporation. Ownership is determined with the section 318(a) attribution rules, with modifications: the family definition is expanded, section 318(a)(4) (options) is disregarded, an individual is treated as owning his or her deemed-owned shares notwithstanding the employee trust exception, and synthetic equity is added in under section 409(p)(5). Treas. Reg. 1.409(p)-1(c) runs the test twice, once on outstanding shares and once with synthetic equity included. The test applies at any time during the plan year, so a single day over the threshold makes the year a nonallocation year.

Who is a disqualified person

Under section 409(p)(4), a person is a disqualified person if:

• the aggregate number of deemed-owned shares of the person and the person's family members is at least 20 percent of the deemed-owned shares of stock in the S corporation; or
• for a person not described above, the person's own deemed-owned shares are at least 10 percent of the deemed-owned shares in the corporation.

A family member who has deemed-owned shares of a person in the first group is also a disqualified person. Deemed-owned shares are the stock allocated to the person under the plan plus the person's share of stock held by the plan that is not yet allocated, measured as the amount that would be allocated if the unallocated stock were distributed in the same proportions as the most recent allocation. Family under section 409(p)(4)(D) includes the spouse, ancestors, lineal descendants, siblings and their lineal descendants, and the spouses of those persons. A legally separated spouse is not a spouse.

Synthetic equity

Section 409(p)(6)(C) defines synthetic equity as stock options, warrants, restricted stock, deferred issuance stock rights and similar interests giving a right to acquire or receive S corporation stock, plus stock appreciation rights, phantom stock units and similar rights to future cash based on stock value, except as regulations provide. Treas. Reg. 1.409(p)-1(f) includes nonqualified deferred compensation measured by stock value, with exceptions for eligible retirement plan benefits and grandfathered interests. Synthetic equity can make a person disqualified or a year a nonallocation year, but it cannot remove a disqualification that exists without it.

Worked example: the family test

An S corporation has 1,000 shares outstanding. The ESOP holds 400 of them. The founder owns 400 shares directly and her adult son owns 200 shares directly. Under the plan, 100 shares are allocated to the founder's account, 20 to the son's account, and the founder's share of the unallocated shares is 40. The founder and son are family members.

• Deemed-owned shares of the founder and son together: 100 plus 40 plus 20, or 160.
• Total deemed-owned shares in the corporation: the 400 shares held by the plan.
• Family test: 160 divided by 400, or 40 percent, which is at least 20 percent. The founder and her son are disqualified persons.
• Shares owned by disqualified persons for the 50 percent test: 400 plus 200 directly owned, plus 160 deemed-owned, or 760 of 1,000 shares, which is 76 percent.
• Result: 76 percent is at least 50 percent, so the plan year is a nonallocation year. No S corporation stock may accrue or be allocated to the founder or her son for that year.

The founder's family dominates the ESOP's deemed ownership because the denominator is the plan's shares, not all company shares.

Worked example: synthetic equity and the 10 percent test

The ESOP holds 400 shares. A vice president, unrelated to any owner, has 30 deemed-owned shares and holds an option to buy 20 shares.

• Without the option: 30 divided by 400 is 7.5 percent, below 10 percent, so she is not disqualified.
• With the option, counting the 20 shares deliverable under Treas. Reg. 1.409(p)-1(f)(4): 30 plus 20 is 50 shares, divided by a base of 400 plus 20, or 420, which is 11.9 percent.
• Result: 11.9 percent is at least 10 percent, so she is a disqualified person once the option is counted. Her allocations in a nonallocation year are prohibited, and the option itself is synthetic equity owned by a disqualified person in a nonallocation year if the 50 percent test is also met.

Common errors

• Using total company shares instead of the plan's deemed-owned shares as the denominator for the 20 percent and 10 percent tests.
• Leaving out unallocated suspense account shares from a participant's deemed-owned shares.
• Omitting phantom stock, cash SARs and stock-based deferred compensation from the synthetic equity count.
• Testing only on the last day of the plan year when the test applies at any time during it.
• Treating a legally separated spouse as family, or a spouse of a sibling as outside the family.

Testing checklist

• Share ledger with direct, indirect and synthetic equity holders, including options and phantom plans.
• ESOP allocation report with allocated and unallocated shares by participant.
• Family relationship schedule using the section 409(p) family definition.
• Annual test conclusion signed off by plan counsel or the third-party administrator.
• Review of leverage and repurchase obligations as in the ESOP repurchase obligation guide.
• Shareholder basis tracking for the S corporation owners, see Form 7203 basis limitations.

Sources

• Legal Information Institute, 26 U.S.C. 409, Qualifications for tax credit employee stock ownership plans (subsection (p)): https://www.law.cornell.edu/uscode/text/26/409
• Legal Information Institute, 26 CFR 1.409(p)-1, prohibited allocation of securities in an S corporation: https://www.law.cornell.edu/cfr/text/26/1.409(p)-1
• Legal Information Institute, 26 U.S.C. 4979A, Tax on certain prohibited allocations of employer securities: https://www.law.cornell.edu/uscode/text/26/4979A

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