409(p) Pitfalls You Never Considered But Should

Transcription

1 409(p) Pitfalls You Never Considered But Should Presented by: Pete Shuler, Crowe Horwath Dale Vlasek, McDonald Hopkins The Ohio Employee Ownership Center 32 nd Annual Ohio Employee Ownership Conference April 27, 2018

2 Presenters Pete Shuler Crowe Horwath 155 West Nationwide Blvd., Suite 500 Columbus, Ohio Phone: Dale Vlasek McDonald Hopkins 600 Superior Avenue East, Suite 2100 Cleveland, OH Phone:

3 Code Section 409(p) Purpose To eliminate S Corporation ESOP structures that provide the available tax benefit to a very limited number of individuals 3

4 Section 409(p) Testing In a Nutshell Disqualified Persons (DQP s) cannot have own 50% or more of an S- Corporation, including ESOP shares, non-esop shares, and Synthetic Equity If 50% threshold exceeded, there is a Nonallocation Year, and crippling penalties apply Test applies on each day of the plan year Not protected by IRS correction guidance 4

5 Code Section 409(p) - Consequences of Failure ESOP is DISQUALIFIED due to failure to operate in accordance with its terms Ceases to be an ESOP Probably loses its basic qualification status under Section 401(a) as well. S corporation election terminated due to disqualified plan not being an eligible S corp shareholder Corporation is taxed as a regular C Corporation. Any ESOP loan loses its prohibited transaction exemption Becomes a prohibited transaction and excise tax is due. If the plan is still 401(a) qualified it becomes subject to the tax on Unrelated Business Taxable Income (UBTI). ESOPs are exempt from UBTI, and the plan is no longer an ESOP 5

6 Code Section 409(p) Consequences of Failure (continued) DQPs owe income tax based on the stock in their ESOP account Account is deemed to be distributed to the DQP but no rollover treatment is available Pay taxes without getting the money 10% excise tax on premature distributions if the DQP is under age 59½ Employer owes excise tax 50% excise tax on FMV of stock in DQPs ESOP accounts 50% excise tax on value of the shares on which the Synthetic Equity is based that is held by DQPs First year of failure - 50% excise tax on FMV of all Deemed-Owned Shares held by DQPs 6

7 Code Section 409(p) Definitions Disqualified Person(DQP) an individual is a DQP if: The individual holds 10% or more of either: the Deemed-Owned ESOP shares, or the Deemed-Owned ESOP shares and Synthetic Equity The individual and his Family Members, as a group, hold 20% or more pf either: the Deemed-Owned ESOP shares, or the Deemed-Owned ESOP shares and Synthetic Equity 7

8 Code Section 409(p)- Definitions (continued) Family Members of an individual are: (1) spouse of individual, (2) ancestor or lineal descendant of individual or individual s spouse (3) brother or sister of individual or individual s spouse and any lineal descendant of brother or sister, and (4) spouse of any individual in (2) or (3) take notice of immediate impact of marriage 8

9 S-CORP ESOP IRC SECTION 409(p)(4)(D) FAMILY MEMBER CHART ANY ANCESTOR * ANY ANCESTOR * BROTHER OR SISTER * INDIVIDUAL BEING TESTED * * SPOUSE BROTHER OR SISTER * ANY LINEAL DESCENDANT * ANY LINEAL DESCENDANT * ANY LINEAL DESCENDANT * * ANY LINEAL DESCENDANT * * SPOUSE OF THIS PERSON * GENERALLY A PARTICIPANT OR PERSON HAVING SYNTHETIC EQUITY COPYRIGHT 2015 BSI 9

10 Code Section 409(p)- Definitions (continued) Deemed-Owned ESOP Shares Allocated ESOP shares Pro rata portion of shares in ESOP loan suspense account based on most recent share release allocation If no prior release, pro rata portion is based on a reasonable estimate of the shares that would be released and allocated in the first year of a loan repayment 10

11 Code Section 409(p)- Definitions (continued) Synthetic Equity Stock option Warrant Restricted stock Deferred issuance stock right 11

12 Code Section 409(p)- Definitions (continued) Synthetic Equity (continued): Stock Appreciation Right Phantom Stock Similar right to future cash payment based on value of stock or appreciation of value Right to acquire stock or assets of a related entity Nonqualified deferred compensation Vesting provisions are ignored Not paid within 2½ months after year in which it is earned Split dollar life insurance But Synthetic Equity can only be used to make an individual a DQP or to cause a failure - not to avoid either 12

13 Code Section 409(p) - Synthetic Equity Rules Pro-rate Rule Synthetic Equity is counted in the test to the same degree the ESOP owns the company 100 SARs outstanding and ESOP owns 75% of the company 75 SARs are counted in the 409(p) test If Synthetic Equity is in reference to S corporation stock, but payment is to be made in cash or other property (e.g., SAR, phantom stock, etc.): Holder is treated as owning the number of shares having a fair market value equal to the cash/property entitlement on the measurement date. Example: A SAR is granted with regard to 100 shares of S corporation stock - the shares the holder is deemed to own equals the number of shares having a value equal to the appreciation at the time of measurement (without regard to lapse restrictions). Synthetic Equity not based on stock is converted to a number of shares equal to the present value of the Synthetic Equity divided by the fair market value of the S corp stock 13

14 Code Section 409(p) - Synthetic Equity Rules (continued) Triennial Recalculations ESOP may provide that value will be fixed as of a determination date until the day before the third anniversary of the determination date Provision must be included in the ESOP plan document and consistently applied to all persons Additional accruals, allocations, or grants are not considered until each determination date anniversary In determining shares of Synthetic Equity, we recommend: Assume the least favorable interpretation possible (e.g. Synthetic Equity awards based on performance) Consider the least favorable scenarios when projecting forward in terms of demographics, increases in deferred compensation, distribution assumptions, etc. If testing is close, try to simplify the Synthetic Equity structure so inadvertent mistakes are not made Never implement new compensation or other Synthetic Equity programs that may impact the 409(p) testing without getting proper advice and updating the testing 14

15 Code Section 409(p) Potential Pitfalls Marriage/Adoption Divorce Transactions involving non-esop stock Redemption of stock from the ESOP Synthetic Equity awarded without testing first Decrease in stock value and/or increase in nonqualified deferred compensation (Synthetic Equity) value Reshuffling/Recycling Rebalancing 15

16 Code Section 409(p) Marriage/Adoption I Can affect 409(p) test by creating one or more DQPs Example: Test before marriage/adoption ESOP holds 100% of shares DQPs hold 48.92% Participant 1 (one of several DQPs) holds 12.59% of Deemed-Owned ESOP shares and Synthetic Equity Participant 2 holds 9.67% of Deemed-Owned ESOP shares and Synthetic Equity Participant 1 marries Participant 2 Test after marriage/adoption Participant 2 becomes a DQP because 1/2 Family Group owns more than 20% DQPs hold 53.40% (Test Fails!) after the marriage due the addition of Participant 2 to the DQP group 16

17 Code Section 409(p) Marriage/Adoption II Can affect 409(p) test by creating one or more DQPs Example: Test before marriage/adoption ESOP holds 60% of shares DQPs hold 9.23% Participant 8 (only DQP) holds 15.38% of Deemed-Owned ESOP shares and Synthetic Equity Participant 1 holds 6.86% of Deemed-Owned ESOP shares and Synthetic Equity Participant 1 also holds all non-esop shares (40% of total) Participant A marries Participant B Test after marriage/adoption Participant 1 becomes a DQP because 8/1 Family Group owns more than 20% DQPs hold 53.35% (Test Fails!) after the marriage due the addition of Participant 1 to the DQP group Since 1 is a DQP, non-esop shares are included in determining DQP ownership 17

18 Code Section 409(p) Divorce Can affect 409(p) test by reducing number of DQPs Example: Test before divorce ESOP holds 100% of shares DQPs hold 49.76% Participants 1 and 2 are DQPs because A/B Family Groups owns more than 20% Participants 1 and 2 divorce Test after divorce Participant 2 is no longer a DQP 1/2 Family Group no longer exists Participant 2 holds less than 10% DQPs hold 44.80% after the divorce Importance More room for DQPs to receive allocations More cushion 18

19 Code Section 409(p) Transactions involving non-esop stock Can affect 409(p) test by changing non-esop shares held by DQPs Example: Test before stock transaction ESOP holds 60% of shares DQPs hold 13.35% Participant 8 holds 15.38% of Deemed-Owned ESOP shares Participant 1 holds 6.86% of Deemed-Owned ESOP shares Participants 1 & 8 are Family Members and DQPs A third-party who has no ESOP stock or Synthetic Equity sells 40,000 non-esop shares to Participant 1 Test after stock transaction 40,000 non-esop shares are now included in DQP holdings DQPs hold 53.35% (Test Fails!) after the transaction 19

20 Code Section 409(p) Redemption of stock from the ESOP Can affect 409(p) test by increasing the number of DQPs and by increasing the ownership percentage of existing DQPs Example: Test before redemption of stock from the ESOP ESOP holds 100% of 100,000 shares Four DQPs hold 43.22% 800 shares are redeemed from the ESOP to fund the distribution to Participant 18 Test after redemption of stock from the ESOP ESOP holds 100% of 99,200 shares Participant 11 becomes a DQP because ownership percentages increases from 9.94% to 10.02% Five DQPs hold 50.63% (Test Fails!) after the redemption 20

21 Code Section 409(p) Synthetic Equity awarded without testing Can affect 409(p) test by increasing number of DQPs and ownership percentage of existing DQPs Example: Test before Synthetic Equity awarded ESOP holds 100% of shares One DQP holds 15.38% 30,000 share-equivalents are awarded Test after Synthetic Equity Awarded Three DQPs hold 51.51% (Test Fails!) 21

22 Code Section 409(p) Value Changes Can affect 409(p) test by increasing the amount of Synthetic Equity Dollar-based deferred compensation is converted to shareequivalents for the 409(p) test by dividing the present value of the deferred compensation by the FMV of the ESOP shares Lower ESOP FMV = more share equivalents Example: Test before stock FMV dropped ESOP holds 100% of shares Three DQPs hold 48.54% Stock FMV dropped from $10/share to $8.50/shares Test after stock FMV dropped Three DQPs hold 51.16% (Test Fails!) 22

23 Code Section 409(p) Recycling Can affect 409(p) test by increasing the number of DQPs and by increasing the ownership percentage of existing DQPs Example: Test before recycling ESOP holds 100% of 100,000 shares Four DQPs hold 43.22% 800 shares are recycled from Participant 18 s account to all other participants accounts Test after recycling ESOP holds 100% of 100,000 shares Participant 11 becomes a DQP because ownership percentages increases from 9.94% to 10.00% Five DQPs hold 50.54% (Test Fails!) after the redemption 23

24 Code Section 409(p) - Preventive Measures Any preventive measure must be otherwise permissible cannot violate other qualified plan rules Must prevent, not correct if correcting, penalties will apply 24

25 Code Section 409(p) - Preventive Measures (continued) Transfer of stock from potential DQP s account to a non-esop account or a non-esop plan No violation of 401(a)(4) Affirmative action taken no later than the date of transfer Subsequent actions (including benefit statements) must be consistent with the transfer having occurred on that date Clarifies that transfer cannot be done retroactively Tax on UBTI applies IRS/Treasury has allowed in some cases a procedure for correcting 409(p) violations. The corrective steps are effective but costly. 25

26 Code Section 409(p) Planning and Possible Solutions Allow for in-service distributions Reshuffle/rebalance participant accounts (e.g., sell the S corporation stock held in DQPs accounts within the ESOP) Cut back Synthetic Equity (i.e., by cancelling or distributing some or all of it Transfer some stock to non-esop qualified plan or to separate portion of the plan that is not an ESOP Targeted sale of Deemed-Owned Shares in DQP s account to the S Corporation or other accounts 26

27 Code Section 409(p) Planning and Possible Solutions Relax eligibility requirements prior to testing year Change stock ownership structure ESOP purchase (leveraged or non-leveraged) company redeems and retires shares of company stock current direct ownership sold to others Revoke the S election (convert to a C corporation) 27

28 Important Points Avoid failure - penalties are too high Make sure those who are fully aware of all the equity and other compensation arrangements are providing input Daily monitoring test the effect of a change BEFORE implementing Know who is responsible for testing. Do you understand the results? Watch out for potential future failure for example, a majority owner that has close to 10% of the Deemed-Owned shares All marriages can create family groups 28