CHAPTER 31RY- UPDATE 2008 FULL REVISION AND UPDATE TO CHAPTER 31 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS

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1 CHAPTER 31RY- UPDATE 2008 FULL REVISION AND UPDATE TO CHAPTER 31 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS Richard M. Acheson, Jr. ** Page 31.0 Introduction... 31RY S Corporation ESOPs Federal Income Tax Savings... 31RY The IRC 409(p) Anti-Abuse Provisions... 31RY-3 [1] In General... 31RY-3 [2] Effective Dates... 31RY-4 [3] Basic Rule of IRC 409(p)... 31RY New Terminology... 31RY-5 [1] Deemed-Owned Shares... 31RY-5 [2] Synthetic Equity... 31RY-6 [3] Disqualified Person... 31RY-8 [4] Nonallocation Year... 31RY Penalties For IRC 409(p) Violation... 31RY-10 [1] Income Tax on Disqualified Persons... 31RY-10 [2] 50% Excise Tax on Prohibited Allocations... 31RY-11 [3] 50% Excise Tax on Synthetic Equity... 31RY-11 [4] Loss of ESOP Status... 31RY-12 [5] Loss of Plan Qualification Status... 31RY Family Member Rules... 31RY-12 [1] In General... 31RY-12 [2] Family Member Chart... 31RY The Disqualified Person Tests... 31RY-13 [1] 20% Test... 31RY-14 [2] 10% Test... 31RY Performing the Nonallocation Year Test... 31RY Potential Pitfalls... 31RY-18 [1] Family Attribution Rules... 31RY-19 [2] Synthetic Equity... 31RY-19 [3] New ESOP Loan... 31RY-20 ** The author and editors wish to thank Daniel L. Hogans, Esq., of Morgan, Lewis & Bockius LLP for his review of the 2008 chapter, as well as Susan D. Lenczewski, Esq., of Gray, Plant, Mooty, Mooty & Bennett, P.A., and Kevin G. Long, Esq., of Chang, Ruthenberg & Long, PC, for their substantial assistance in the editing and preparation of the original chapter, and to Michael R. Holzman, Esq., of Morgan, Lewis & Bockius LLP for his assistance in the initial drafts of the original chapter. This chapter is fully revised and replaces the original chapter in the original book ESOP Book All Rights Reserved 31RY-1

2 31.0 ESOPs 31RY-2 [4] Non-Employee as a Disqualified Person... 31RY-20 [5] Stock Forfeitures, Distributions and Repurchases... 31RY-20 [6] Family Relationships... 31RY Maintaining Compliance and Preventing Violation... 31RY-21 [1] Annual Monitoring... 31RY-21 [2] Projective Allocations... 31RY-21 [3] Transfer to Non-ESOP Account... 31RY-21 [4] Failsafe Plan Provisions... 31RY-22 [5] Reshuffling... 31RY-22 [6] Distributions from or Sales of Stock by the ESOP... 31RY-23 [7] Failsafe Provisions in Synthetic Equity Arrangements... 31RY Appendix 24 Supplement... 31RY Conclusion... 31RY Footnotes... 31RY Introduction S corporation ESOPs provide cash flow improvement through permanent income tax savings. That is the principal advantage of an S corporation ESOP over a C corporation ESOP. The extent of the tax savings is determined by the ESOP's ownership percentage of the S corporation the higher the ESOP's ownership percentage the greater the tax savings, with a 100% ESOP-owned S corporation being able to operate essentially 100% free of federal income tax. But to enjoy these enormous tax savings only available to an S corporation ESOP company, the company must strictly comply with a complex set of allocation-related rules. These rules are included in IRC 409(p) 1 and provide crippling penalties for noncompliance. The permanent tax savings are available, but only if strict rules are followed. IRC 409(p) contains several new terms and a greatly expanded definition of family members that apply only for IRC 409(p) testing. Three separate computations may be required to determine whether compliance is met; fortunately, the IRC 409(p) regulations suggest corrective steps to bring about and maintain compliance. IRC 409(p) grants the Secretary of the Treasury ( Treasury ) significant latitude in the regulatory and rule-making arena to minimize circumvention of IRC 409(p). Explaining the rules and their application is the subject of this chapter S Corporation ESOPs Federal Income Tax Savings 2 Until 1998, a combination of two statutory obstacles effectively prevented corporations that had elected S status under the Internal Revenue Code of 1986, as amended ( IRC or Code ), from establishing Employee Stock Ownership Plans ( ESOPs ). First, IRC 1361, which sets forth requirements for an S corporation, did not include qualified retirement plans, including ESOPs, as eligible shareholders. Second, IRC 512 did not include an exemption from the tax on unrelated business taxable income for income and gain on S corporation stock owned by an ESOP. In 1996, Congress removed one of these obstacles by enacting legislation 3 that for the first time permitted an ESOP to be an eligible S corporation shareholder, effective for tax years beginning after December 31, In 1997, Congress enacted legislation 4, also with the same effective date, to specifically exempt income Internal Revenue Code Section will be referenced as IRC throughout this chapter. A Treasury Regulation may be referenced as I.T. Regulation or Temporary Regulation throughout this chapter. This chapter does not address the different treatments of S corporation ESOPs under the various states tax laws. Pub. L , the Small Business Job Protection Act, Section 1316(a)(2). Pub. L , the Taxpayer Relief Act of 1997, Section 1523(a).

3 31RY-3 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.2 and any gain attributable to S corporation voting stock held by an ESOP from the definition of unrelated business taxable income 5. With these two law changes, ESOPs were able to own S corporation voting stock, and earnings attributable to that stock were not taxed while owned by the ESOP. Although an S corporation can issue nonvoting stock and its ESOP can own such stock, the exemption from recognition of income and gain applies only to voting stock. All references in this chapter to stock are to voting stock unless the context clearly indicates otherwise. If an ESOP owns 100% of the stock of an S corporation, the S corporation s income is generally not subject to federal income tax. Furthermore, if the S corporation distributes cash to the ESOP as the shareholder, no tax is paid on the distributed cash until the ESOP makes distributions to the plan s participants, usually upon retirement, death, disability, or other termination of employment. At that time, it is possible for participants to continue to defer the payment of tax if the distribution from the ESOP is rolled over to an individual retirement account or other eligible retirement plan. If the ESOP owns less than 100% of the S corporation, then the tax savings will be proportionally reduced. The non-esop shareholders as well as any nonvoting shares owned by the ESOP will be allocated their share of the S corporation s earnings and be subject to tax, while the ESOP voting shares will enjoy the exemption from tax as described above The IRC 409(p) Anti-Abuse Provisions [1] In General The tax saving opportunities for S corporation ESOPs are substantial, providing fertile ground for creative tax structuring and strategies. 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 with meaningful retirement funding in the form of equity in their employer. 6 Under the laws applicable to S corporation ESOPs first effective in 1998, it was possible to structure arrangements in which a small group of executives, founding shareholders and their family members, 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. In one such arrangement, 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 shared the benefit of the ESOP s tax-favored status, with the ESOP participants benefiting little, if at all. Another arrangement split off part of an operating company along with a sizable part of the net profits into a newly formed 100% ESOP-owned S corporation designed to operate free of tax, while funding large deferred compensation plans for a select group of executives with untaxed income. In 2001, Congress enacted legislation 7 to address both the actual and anticipated situations that could lead to an inappropriate deferral or avoidance of tax in certain S corporation ESOP structures. IRC 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. IRC 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 Treasury to prescribe regulations 8 as may be necessary to carry out the purposes of IRC 409(p). 9 On July 21, 2003, the IRC 512(e)(3). House Conference Report , May 26, 2001, Section VI.B.4(g). Pub. L , the Economic Growth and Tax Relief Reconciliation Act of 2001, Section 656(a). All citations to Regulation Sections are to the final regulations unless otherwise indicated.

4 31.2[2] ESOPs 31RY-4 Treasury issued temporary and proposed regulations ( the 2003 Regulations ) to provide guidance in the application of the provisions of IRC 409(p) 10. The 2003 Regulations provided guidance for (1) identifying disqualified persons, (2) determining if a nonallocation year exists, and (3) defining synthetic equity. On December 17, 2004, a new set of temporary and proposed regulations (the 2004 Regulations ) was issued to clarify, expand and modify the 2003 Regulations. 11 The 2004 Regulations provided guidance for (1) defining and determining the effects of a prohibited allocation, (2) identifying disqualified persons, (3) determining the existence of a nonallocation year, (4) calculating synthetic equity, and (5) determining whether a transaction constitutes an avoidance or evasion of IRC 409(p). On December 20, 2006 final regulations ( Regulations ) were issued effective January 1, 2006, incorporating relatively few, but critical, changes from the 2004 Regulations. 12 Treasury is also authorized by regulation or other guidance of general applicability to find a nonallocation year in any case in which the principal purpose of the ownership structure is to avoid or evade IRC 409(p). 13 The bold italicized terms shown are specific to IRC 409(p) and the Regulations and are defined in this chapter. [2] Effective Dates 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 or before that date, then IRC 409(p) is effective for plan years beginning on or after January 1, The Regulations for such corporations are effective for plan years beginning on or after January 1, For plan years beginning before that date, the 2004 Regulations apply. 15 For all other S corporation ESOPs, IRC 409(p) is effective for plan years ending after March 14, The 2003 Regulations apply for plan years ending after October 20, 2003, and beginning before January 1, The 2004 Regulations apply for plan years beginning after December 1, 2004 but before January 1, 2006, subject to limited exceptions and transition rules. 18 The new rules introduced in the 2003 Regulations dealt with nonqualified deferred compensation 19 and in the 2004 Regulations with impermissible accruals, 20 synthetic equity, 21 and super-voting rights. 22 The final Regulations for such corporations are effective for plan years beginning on or after January 1, In any case, the plan document for an ESOP that holds S corporation stock must contain the provisions of IRC 409(p), as well as any optional elections available under the Regulations IRC 409(p)(7)(A). T.D. 9081, issued July 21, 2003 (68FR42970). T.D. 9164, effective December 17, 2004 (69FR75455). T. D. 9302, effective January 1, 2006, (71FR76134). IRC 409(p)(7)(B). Pub. L , Section 656(d)(2); Regulation Section 1.409(p)-1(i)(1)(ii). Regulation Section 1.409(p)-1(i)(2). Pub. L , Section 656(d)(2); Regulation Section 1.409(p)-1(i)(1)(i) Regulation Section 1.409(p)-IT(i)(2)(ii) Regulation Section 1.409(p)-IT(i)(2)(iii) Regulation Section 1.409(p)-IT(h)(1) Regulation Section 1.409(p)-IT(i)(2)(iii)(A) Regulation Section 1.409(p)-IT(i)(2)(iii)(B) Regulation Section 1.409(p)-IT(i)(2)(iii)(C). Regulation Section 1.409(p)-1(i)(2). See, for example, Regulation Section 1.409(p)-1(f)(4)(iii)(C)(3)(i).

5 31RY-5 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.2[3] [3] Basic Rule of IRC 409(p) IRC 409(p) and the Regulations require that if an ESOP holds S corporation voting stock no portion of the ESOP s assets attributable to or allocable in lieu of S corporation voting stock may, during a nonallocation year, accrue or be allocated for the benefit of any disqualified person 25 under the ESOP or any other qualified plan of the S corporation. This rule must be complied with each day of the plan year. 26 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 New Terminology IRC 409(p) requires the understanding of several new terms: (a) deemed-owned shares, (b) synthetic equity, (c) disqualified person, (d) nonallocation year, (e) related entity, (f) prohibited allocation, (g) impermissible accrual, and (h) impermissible allocation. Terms (a) through (d) are discussed below, (e) is discussed in the following paragraph, and terms (f), (g) and (h) are defined in 31.4 of this chapter. [Please note that defined terms are in bold italics throughout this chapter. These terms are defined in this chapter for the book s Glossary, since the definitions are lengthy and involved.] The 2003 Regulations first added the term related entity, which comes into play when looking at synthetic equity. Under the Regulations, a related entity is one owned in whole or in part by the S corporation and which is a partnership, a trust, a qualified subchapter S subsidiary ( Q-Sub ), or a disregarded entity. 27 The 2003 Regulations limited the impact of the related entity rules by requiring the S corporation s interrelationship with the related entity to be significant, 28 but that requirement was actually weakened in the 2003 Regulations 29 and changed considerably in the Regulations. [1] Deemed-Owned Shares Deemed-owned shares are defined as (1) S corporation stock constituting employer securities allocated to a person s account in the ESOP, 30 plus (2) his share of any unallocated ESOP stock accounts, 31 such as a loan suspense account. [Editors Note: Wherever the term his or he is used the term also means her or she where the context is appropriate.] His share of unallocated stock is treated as if it were allocated in the same proportion as the most recent stock allocation under the ESOP. If an allocation has not yet been made from a loan-related suspense account, a reasonable estimate of the shares that would be released and allocated in the first year of loan repayment should be used. 32 Deemed-owned shares do not include shares of stock owned outside the ESOP or nonvoting shares held inside the ESOP. Because nonvoting shares do not meet the definition of employer securities they are not deemed-owned shares and any income or gain attributable to them is subject to current income taxation. But synthetic equity, a new term and concept with broad impact and potentially severe consequences, is included as deemed-owned shares as well as being treated as outstanding shares for testing purposes, as explained later in this chapter IRC 409(p)(1). IRC 409(p)(3)(A) and Regulation Section 1.409(p)-1(f)(4)(iii)(B). Regulation Section 1.409(p)-1(f)(3) Regulation Section 1.409(p)-IT(f)(2)(iii)(A)(2). 2003Regulation Section 1.409(p)-IT(f)(2)(iii)(C). IRC 409(p)(4)(C)(i)(I) and IRC 409(p)(6)(A), which refers to IRC 409(l) ; Regulation Section 1.409(p)-1-(e)(1). IRC 409(p)(4)(C)(i)(II); Regulation Section 1.409(p)-1-(e)(2). IRC 409(p)(4)(C)(ii); Regulation Section 1.409(p)-1(e)(2). IRC 409(p)(5).

6 31.3[2] ESOPs 31RY-6 [2] Synthetic Equity Synthetic Equity includes any stock option, warrant, restricted stock, deferred-issuance stock right, stock appreciation right 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. 34 A right of first refusal to acquire stock held by an ESOP does not constitute a right to acquire stock in the future provided the right is not deemed by Treasury to be a scheme to circumvent IRC 409(p), the right is priced no lower than what would be required under the provisions of IRC 409(h) and the right would not be taken into account in determining whether the corporation has a second class of stock 35. Synthetic equity also includes stock appreciation rights that are 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. 36 In addition to synthetic equity that is directly owned, a person can own synthetic equity constructively. The constructive ownership rules of IRC 318(a) generally apply. A person constructively owns the same proportion of stock and synthetic equity that he owns of a partnership that owns such stock or synthetic equity. Similarly, a person constructively owns the same proportion of stock and synthetic equity as his beneficiary interest in any estate or trust, including any qualified plan trust holding such stock or synthetic equity. 37 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. 38 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. 39 The attribution rules in IRC 318(a) for options to acquire stock are disregarded. 40 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. 41 However, the person holding the right is treated as owning the underlying stock, 42 but only if such treatment results in a nonallocation year. 43 As a result, those shares are not included for determining a person s status as a disqualified person, discussed in [3] below, but they are counted in testing for a nonallocation year, described in [4] 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 in the entity. 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 or in the case of certain fringe benefits excludable from taxation. 44 Both the 2003 and 2004 Regulations significantly expanded synthetic equity to include nonqualified deferred compensation. The definition of deferred compensation is applied broadly, so as to include remuneration subject to IRC 404(a)(5) and IRC 83. Split-dollar life insurance arrangements can result in synthetic equity. Any remuneration for services rendered during an S corporation s taxable year, but paid beyond the fifteenth day of the third month of the year following, constitutes synthetic equity. 45 Treasury has broad authority to add items other than traditional deferred compensation IRC 409(p)(6)(C); Regulation Section 1.409(p)-1(f)(2)(i)(A). Regulation Section 1.409(p)-1(f)(2)(i)(B). IRC 409(p)(6)(C); Regulation Section 1.409(p)-1(f)(2)(ii). IRC 409(p)(3)(B); IRC 318(a)(2)(A) and (B), modified by IRC 409(p)(3)(B)(ii). IRC 409(p)(3)(B); IRC 318(a)(2)(B)(ii). IRC 409(p)(3)(B); IRC 318(a)(2)(C). IRC 409(p)(3)(B)(i)(II). Regulation Section 1.409(p)-1(f)(2)(i),(A). Regulation Section 1.409(p)-1(c)(4)(i). Regulation Section 1.409(p)-1(c)(4)(ii). Regulation Section 1.409(p)-1(f)(2)(iii). Regulation Section 1.409(p)-1(f)(2)(iv)(A).

7 31RY-7 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.3[2] to the synthetic equity list if actual or perceived abuses warrant such action. 46 Depending on the length of the deferral and the nature of the specific provision or arrangement, the definition of deferred compensation and Treasury s authority to add items to the list is broad enough to potentially include covenants not to compete, life insurance arrangements in addition to split-dollar policies, vacation or bonus plans, and even earnouts or escrows associated with a sale of stock if not clearly constituting price adjustments for legitimate contingencies. Although the provisions of IRC 409A are beyond the scope of this chapter, the IRC 409A regulations 47 may provide useful guidance in the analysis of some deferred compensation issues involving IRC 409(p). 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, 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. 48 Similar rules apply for synthetic equity in a related entity. 49 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 any date during the plan year. 50 The ESOP can provide for an annual or more frequent determination date which is either the first day of the ESOP s plan year or any other reasonable date or dates during a plan year, as uniformly and consistently used by the corporation for the purpose of the equivalency determination. 51 If the ESOP so provides, the number of shares a person is treated as owning on a certain determination date can be fixed and not be subject to redetermination until the next following determination date. 52 For the conversion calculations, if the ESOP so provides, the period between determination dates may be extended to be as long as three years, subject to a requirement of fairness and consistency 53. If the extended determination date has been elected it can be accelerated to an earlier date by plan amendment adopted before the new determination date, but only if the acceleration is due to a change in the ESOP s plan year or is due to a merger, consolidation or transfer of plan assets under the rules of IRC 414(1). The new determination date must be consistent with the plan year change or the IRC 414(1) event. 54. A detailed example involving a triennial 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 To avoid multiple inclusions of the same shares for testing purposes, synthetic equity does not include deemed-owned shares. 57 If an S corporation is owned in part by a shareholder who is subject to federal incomes taxes, then the synthetic equity owned or attributed to a person is reduced ratably to account for that non-esop shareholder. 58 This proportional rule can reduce the impact of synthetic equity and is an acknowl IRC 409(p)(7). Treasury Regulations under Section 409A were issued April 17, 2007 (70 FR 19234), and corrections were issued July 31, 2007 (72 FR 41620). Regulation Section 1.409(p)-1(f)(4)(i). Regulation Section 1.409(p)-1f)(4)(ii). Regulation Section 1.409(p)-1(f)(4)(iii)(A). Regulation Section 1.409(p)-1(f)(4)(iii)(B). Regulation Section 1.409(p)-1(f)(4)(iii)(B). Regulation Section 1.409(p)-1(f)(4)(iii)(C). Regulation Section 1.409(p)-1(f)(4)(iii)(C)(3). Regulation Section 1.409(p)-1(h), Example 3. Regulation Section 1.409(p)-1(f)(4)(iii)(A); I.T. Reg. Sec (i). Regulation Section 1.409(p)-1(f)(2)(v). Regulation Section 1.409(p)-1(f)(4)(iv).

8 31.3[3] ESOPs 31RY-8 edgment by Treasury that synthetic equity is potentially abusive only to the extent that the S corporation s income is sheltered through its ESOP. Through this adjustment, a net synthetic equity is derived for use in both the disqualified person and nonallocation year tests. EXAMPLE 1 SYNTHETIC EQUITY RATABLE ADJUSTMENT RULE FACTS: 1000 shares of S corporation stock issued and outstanding 700 shares owned by the ESOP (partially or fully allocated) 300 shares owned by individual A, an individual subject to federal income taxes Individual B has 200 synthetic equity shares in the S corporation QUESTION: How many shares of synthetic equity does B have for IRC 409(p) testing purposes? ANSWER: Because the ESOP owns 70% of the corporation s shares, only 70% of B s synthetic equity shares is counted for IRC 409(p) testing purposes. B s synthetic equity is 140 (70% of 200) shares. There are special rules for shares with greater voting power than ESOP shares. If a person has the right to purchase or receive shares of an S corporation having voting rights greater than the ESOPheld shares having the least voting rights, then that person is treated as having a number of shares equal to the number of ESOP S corporation shares having the lowest voting right that would equal the voting right held by the person. 59 [3] Disqualified Person A disqualified person is any of the following: 1. A person whose deemed-owned shares plus the deemed-owned shares of his family members [see 31.5 of this chapter] are 20% or more of the total deemed-owned shares of the S corporation. 60 The statute specifically uses the word person, not employee, participant, or other limiting term A person whose deemed-owned shares plus his synthetic equity shares plus his family members deemed-owned shares and their synthetic equity shares are 20% or more of the total deemed-owned shares plus total synthetic equity shares of the S corporation owned only by the person and his family members. 62 The treatment of synthetic equity in the denominator was more liberal in the 2003 Regulations, 63 and subject to abuse. 3. A person whose deemed-owned shares are 10% or more of the total deemed-owned shares of the S corporation A person whose deemed-owned shares plus his synthetic equity shares are 10% or more of the total deemed-owned shares plus his synthetic equity shares of the S corporation. 65 Again, Regulation Section 1.409(p)-1(f)(4)(v). IRC 409(p)(4)(A)(i) and Regulation Section 1.409(p)-1(d)(1)(iii). See IRC 7701(a)(1) for a general definition of person. Regulation Section 1.409(p)-1(d)(1)(iv) Regulation Section 1.409(p)-IT(d)(1)(iv). IRC 409(p)(4)(A)(ii) and Regulation Section 1.409(p)-1(d)(1)(i). Regulation Section 1.409(p)-1(d)(1)(ii).

9 31RY-9 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.3[4] the treatment of synthetic equity in the denominator is stricter than it was in the 2003 Regulations. 66 The disqualified person test is explained more fully in 31.6 of this chapter, with examples in If any person is a disqualified person by virtue of being a member of a 20% family group, then all family members of that person are treated as disqualified persons, provided that family member has any deemed-owned shares or synthetic equity. 67 If a person is classified as a disqualified person under the family group 20% rule, as well as the 10% individual test, the 20% rule prevails, 68 thereby bringing all of his family members into disqualified person status. Due to the use of the term person in the statute when defining disqualified person, an individual does not have to be an employee or a participant in the ESOP in order to fit within this definition and, consequently, to have synthetic equity. Having synthetic equity can result in a non-participant or a non-employee being a disqualified person. This same rule can cause cousins and stepsiblings to be coupled within a family group by a person who is neither an ESOP participant nor an employee of the S corporation. Note, however, that synthetic equity, whether owned by non-employees, employees or others, will not be counted as deemed-owned shares if the result is to cause a nonallocation year to not occur. 69 Thus, issuing synthetic equity cannot be used to circumvent the IRC 409(p) test. [4] Nonallocation Year A nonallocation year is an ESOP s plan year during which at any time the ESOP holds shares of voting stock of the S corporation 70 and disqualified persons own 50% or more of: 1. The outstanding shares of stock in the S corporation, including deemed-owned ESOP shares, 71 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 72 In addition to a person s deemed-owned shares and shares owned outright, the ownership of issued and deemed-owned shares of other persons may be attributed to him 73. These rules for attribution of ownership are discussed in 31.7 of this chapter. Treasury is authorized to issue regulations or other guidance providing that a nonallocation year exists if the principal purpose of the S corporation s ownership structure constitutes an avoidance or evasion of IRC 409(p). 74 Whether a corporate ownership structure involving synthetic equity constitutes such an avoidance or evasion as its principal purpose is determined by considering all the surrounding facts and circumstances. Factors include features of the corporation s stock and related obligations including synthetic equity, taxability of other shareholders, cash distributions, voting rights, and the ESOP s right to distributions and to benefit from the Corporation s current and future profits Regulation Section 1.409(p)-IT(d)(1)(ii). Regulation Section 1.409(p)-1(d)(2)(i). IRC 409(p)(4)(A)(ii). IRC 409(p)(5), last sentence. IRC 409(p)(3)(A)(i); Regulation Section 1.409(p)-1(c)(1). IRC 409(p)(3)(A)(ii); Regulation Section 1.409(p)-1(c)(1)(i). IRC 409(p)(5); Regulation Section 1.409(p)-1(c)(1)(ii). IRC 409(p)(3)(B); Regulation Section 1.409(p)-1(c)(2) and (c)(4). IRC 409(p)(7)(B). Regulation Section 1.409(p)-1(g)(2).

10 31.4 ESOPs 31RY-10 If an entity related to the S corporation, such as a partnership or trust, specifically segregates profits for the benefit of one or more individuals such that the ESOP does not benefit from those profits, an avoidance or evasion situation exists if those individuals have the right to acquire directly or indirectly 50% or more of those profits, and provided that separate entity itself would have a nonallocation year if it were separately tested under the rules of IRC 409(p). 76 This position was initially published in Revenue Ruling , 77 which described three abusive S corporation structures that resulted in nonallocation years. These structures and any substantially similar structures are also identified as listed transactions subject to further penalties Penalties For IRC 409(p) Violation The income tax and excise tax consequences of violating the requirements of IRC 409(p) are severe for the S corporation sponsor, the disqualified persons involved, and potentially for the ESOP itself. The consequences of violating the provisions of IRC 409(p) are compelling the law imposes potentially crippling nuclear-level penalties if, as of any date during a plan year, a nonallocation year occurs and prohibited allocations occur in that year. However, as explained below, a current year allocation of contributions need not occur within the ESOP in order to cause a nonallocation year and its attendant penalties. 78 Prohibited Allocation A prohibited allocation occurs if there is an impermissible accrual or an impermissible allocation. The prohibited allocation equals the sum of the impermissible accrual plus the impermissible allocation 79. If there is a nonallocation year, the amount of the prohibited allocation will dictate a large part of the penalties resulting from the violation. Impermissible Accrual An impermissible accrual results if, during a nonallocation year, the ESOP account of a disqualified person holds S corporation stock, whether attributable to a contribution in the current year or in prior years. The fair market value of the S corporation stock in the disqualified person s account is the impermissible accrual. The impermissible accrual includes assets attributable to that stock, such as proceeds from the sale of the stock and any distributions of earnings from the S corporation. Any earnings on the proceeds or distributions are also part of the impermissible accrual. 80 Impermissible Allocation An impermissible allocation is any direct or indirect allocation during a nonallocation year, on behalf of a disqualified person, to the ESOP or any other company-sponsored IRC 401(a) qualified plan. However, an impermissible allocation occurs only if the allocation or other additional benefit on behalf of the disqualified person would have otherwise been added to his ESOP account and invested in S corporation stock, but for a plan provision in the ESOP to comply with IRC 409(p). 81 [1] Income Tax on Disqualified Persons 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 that year. In the case of an imper Regulation Section 1.409(p)-1(g)(3). Rev. Rul , I. R. B , February 9, Regulation Section 1.409(p)-1(c)(6) and 1.409(p)-1(b)(2)(ii). Regulation Section 1.409(p)-1(b)(2)(i). Regulation Section 1.409(p)-1(b)(2)(ii). Regulation Section 1.409(p)-1(b)(2)(iii).

11 31RY-11 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.4[2] missible 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 his gross income, less any tax basis he might have in the distributed amount. The premature distribution penalty tax applies if he is still employed and younger than age 59½ or, if he is separated from service with the employer, if he terminated employment before attaining age Because the distribution is deemed, and not actual, it is not a distribution eligible for rollover to a tax-exempt vehicle such as another eligible retirement plan or an IRA. 83 Any resulting tax liability falls on each disqualified person. [2] 50% Excise Tax on Prohibited Allocations An excise tax is imposed on the S corporation equal to 50% of the prohibited allocations of employer securities in violation of IRC 409(p). 84 The amount subject to the excise tax is the prohibited allocation to any disqualified person in violation of IRC 409(p)(1). 85 Because historical accruals in a disqualified person s ESOP account constitute prohibited allocations, 86 the excise tax applies to the entire balance in a disqualified person s account. The statute also imposes the 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. 87 This appears to result in multiple excise taxes in a year for the same violation. In the public hearings on the 2004 Regulations, Treasury indicated that 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. 88 [3] 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. 89 The amount involved for determining the tax is the value of the shares on which the synthetic equity is based, 90 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. 91 The statute of limitations for assessing the 50% excise tax 92 is three years after the later of the date the prohibited allocation occurred, or the date the IRS is notified of the prohibited allocation or synthetic equity ownership. 93 Because the excise tax is assessed in any nonallocation year, the excise tax may be imposed on the same synthetic equity in multiple years if there are multiple nonallocation years IRC 72(t)(2)(A). IRC 409(p)(2)(A); Regulation Section 1.409(p)-1(b)(2)(iv)(A). IRC 4979A(a)(3). IRC 4979A(e)(2)(A). Regulation Section 1.409(p)-1(b)(2)(ii). IRC 4979A(e)(2)(C); IRC 4979A(a)(3). Treasury Hearings on Proposed Regulations (Reg ), WDC, April 20, IRC 4979A(a)(4). IRC 4979A(e)(2)(B). IRC 4979A(c)(2). As discussed in this chapter, there are two 50% excise taxes; one for violating the prohibited allocation rules and one for violating the synthetic equity rules. IRC 4979A(e)(2)(D).

12 31.4[4] ESOPs 31RY-12 [4] Loss of ESOP Status If a nonallocation year and a prohibited allocation were to occur in the same year, then the requirements of IRC 409(p) would not be met and the ESOP would lose its ESOP status under IRC 4975(e)(7). 94 A loss of ESOP status would mean that any existing loan to the ESOP would no longer qualify for the statutory prohibited transaction exemption, 95 making the existing loan a prohibited transaction and resulting in excise taxes. Loss of statutory ESOP status will also subject the trust to income tax on its share of taxable income attributable to its share of earnings of the S corporation. While a qualified retirement plan is permitted to be an S corporation shareholder, 96 the exemption from unrelated business taxable income subject to income tax is available only for ESOPs as to earnings or gains attributable to voting shares. 97 An ESOP s share of such earnings or gains from an S corporation is not treated as unrelated business taxable income and accordingly is not subject to unrelated business income tax. 98 [5] Loss of Plan Qualification Status IRC 409(p) requires the plan document for an S corporation ESOP to prohibit allocations to disqualified persons in a nonallocation year. 99 Thus, if a violation of IRC 409(p) occurs, such violation will also violate the terms of the plan document, and will result in a loss of tax qualification. 100 Loss of tax qualification would mean that the ESOP is no longer a qualified S corporation shareholder and the corporation s S election would automatically terminate 101 by virtue of having a nonqualifying shareholder. Interestingly, a footnote in the Conference Committee Report concerning IRC 409(p), indicates that plan disqualification is not the legislative intent just because an excise tax is imposed Family Member Rules [1] In General In determining the family members in a family group the following individuals are treated as members of an individual s family: 1. The individual s spouse; All ancestors and lineal descendants of the individual or his spouse; A sibling of the individual or the individual s spouse and any lineal descendants of the sibling; 105 and 4. The spouse of any person included in the family group because of (2) or (3) IRC 4975(e)(7); Regulation Section 1.409(p)-1(b)(2)(iv)(B). IRC 4975(d)(3); Regulation Section 1.409(p)-1(b)(2)(iv)(B). IRC 1361(c)(6). IRC 512(e)(3). IRC 512(e). IRC 409(p)(1). Regulation Section 1.409(p)-1(b)(2)(iv)(B). IRC 1361(c)(6). House Conference Report , May 26, 2001, section VI.B.4(g), f. n IRC 409(p)(4)(D)(i); Regulation Section 1.409(p)-1(d)(2)(ii)(A). IRC 409(p)(4)(D)(ii); Regulation Section 1.409(p)-1(d)(2)(ii)(B). IRC 409(p)(4)(D)(iii); Regulation Section 1.409(p)-1(d)(2)(ii)(C). IRC 409(p)(4)(D)(iv); Regulation Section 1.409(p)-1(d)(2)(ii)(D).

13 31RY-13 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS 31.5[2] If any person is a disqualified person by virtue of being a member of a 20% family group, then all his family members who have deemed-owned shares are treated as disqualified persons. 107 [2] Family Member Chart The Family Member Chart provides a general graphic representation of the family member rules. If the person being tested and his spouse are legally separated through divorce or under a decree of separate maintenance, that spouse is not treated as the person s spouse. 108 See the discussion of Family Attribution Rules in 31.8[1] of this chapter for a situation where a person with no equity deemed, synthetic or actual can be part of a family group. FAMILY MEMBER CHART S CORPORATION ESOP IRC SECTION 409(p)(4)(D) 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. * SEE 31.8 FOR POSSIBLE EXCEPTIONS. COPYRIGHT 2008 BSI 31.6 The Disqualified Person Tests There are two disqualified person tests: the 20% Test and the 10% Test. A person can be classified as a disqualified person on his own or as part of a group that includes his family members. 109 If he would be treated as a disqualified person alone under the 10% test but is also a member of a 20% family group, then his classification as a disqualified person is based on the 20% family group relationship. 110 This order of classification assures that each and all of his family members, no IRC 409(p)(4)(B); Regulation Section 1.409(p)-1(d)(2)(i). IRC 409(p)(4), last sentence; Regulation Section 1.409(p)-1(d)(2)(iii). IRC 409(p)(4). IRC 409(p)(4)(A)(ii).

14 31.6[1] ESOPs 31RY-14 matter how insignificant their deemed-owned shares might be, is/are classified as a disqualified person(s). The result has impact both in determining who is a disqualified person as well as who is treated as owning stock for the nonallocation year test described in 31.7 of this chapter. The shares to be used in determining disqualified person status for both the 20% family group and the 10% individual tests are the same. They include all voting shares held in the ESOP, whether or not allocated, plus synthetic equity. 111 [1] 20% Test A person is a disqualified person under the family member rules if the sum of his deemed-owned shares plus the deemed-owned shares of his family members is 20% or more of the ESOP s total deemed-owned shares of the S corporation. 112 Synthetic equity is ignored for the first part of this test. He is also classified as a disqualified person if the sum of his deemed-owned shares plus his synthetic equity shares plus his family members deemed-owned shares and his family members synthetic equity shares is 20% or more of the ESOP s total deemed-owned shares plus their combined synthetic equity shares of the S corporation. 113 ESOP-owned shares are always counted in determining a family group s deemed-owned shares, even if the shares are not yet allocated but are in a suspense account. 114 A suspense account can arise, for example, from an ESOP loan that has not yet been paid in full 115 or from annual additions that in prior years exceeded the annual addition maximum under IRC Any suspense shares are treated as being allocated and as deemed-owned shares as to each family member in the same proportion as they were allocated by the most recent stock allocation under the ESOP. 117 A person s synthetic equity is included as deemed-owned shares, unless without it that person is already treated as a disqualified person or a year is already treated as a nonallocation year. 118 The inclusion of synthetic equity in the calculations cannot be used to create a safe haven from a disqualified person or nonallocation year classification. [2] 10% Test If a person is not a member of a 20% family group, he will still be classified as a disqualified person if he alone is deemed to own 10% or more of the deemed-owned shares of the S corporation. 119 If his deemed-owned shares plus his synthetic equity shares are 10% or more of the ESOP s total deemed-owned shares plus his synthetic equity shares in the S corporation, then he is classified as a disqualified person 120. As in the 20% family member test a person is deemed to own his share of any suspense shares in the ESOP using the same allocation rules used for the 20% family member test. 121 Again, his synthetic equity is included as deemed-owned shares unless without it he is already treated as a disqualified person or a year is already treated as a nonallocation year IRC 409(p)(4) and (5). IRC 409(p)(4)(A)(i); Regulation Section 1.409(p)-1d)(1)(iii). IRC 409(p)(4)(A)(i); Regulation Section 1.409(p)-1(d)(1)(iv). IRC 409(p)(4)(C)(ii); Regulation Section 1.409(p)-1 (e)(2). I.T. Regulation Section (c). I.T. Regulation Section (b)(6)(i). IRC 409(p)(4)(C)(ii); Regulation Section 1.409(p)-1 (e)(2). IRC 409(p)(5). IRC 409(p)(4)(A)(ii); Regulation Section 1.409(p)-1(d)(1)(i). IRC 409(p)(4)(A)(ii); Regulation Section 1.409(p)-1(d)(1)(ii). IRC 409(p)(4)(C)(ii); Regulation Section 1.409(p)- 1(e)(2). IRC 409(p)(5).

15 31RY-15 ESOP ANTI-ABUSE TESTING FOR S CORPORATIONS Performing the Nonallocation Year Test The nonallocation year test is also known as the 50% Test. Before working through a couple of examples to see how a violation might arise under IRC 409(p), it is important to understand that having one or more disqualified persons does not in and of itself result in any penalties or taxes. Penalties accrue only if the aggregate ownership of the disqualified persons causes a nonallocation year to occur. In determining how many shares are owned by disqualified persons under the nonallocation year test, the shares the person was considered as owning for purposes of determining whether such person was a disqualified person continue to be taken into account. In addition, shares owned outright 123 by the person must be included as well as shares the person is treated as owning constructively or by attribution. 124 A disqualified person is treated as constructively owning the shares owned by his family members, 125 including their deemed-owned shares. 126 But if a family member has deemed-owned shares, then that family member is himself a disqualified person 127 if he is part of a 20% family group. This means that, for the purpose of performing the nonallocation year test, a disqualified person s share ownership consists of one or more of the following: 1. Stock owned outright and option shares deemed owned by the person; 2. All stock allocated to the person s account in the ESOP or other qualified plan; 3. The person s share of stock in any unallocated stock account in the ESOP; 4. Synthetic equity owned by the person; 5. Stock owned by a family member of the person; 6. All stock allocated to the account of a family member of the person in the ESOP or other qualified plan; 7. The family member s share of stock in any unallocated stock account in the ESOP; 8. Synthetic equity owned by a family member of the person; 9. Stock owned by a partnership in which the person is a partner, an S corporation in which the person is a shareholder, an estate or a trust of which the person is a beneficiary or a corporation in which the person is at least a 50% owner; and 10. The person s share of synthetic equity owned by a partnership in which the person is a partner, an S corporation in which the person is a shareholder, an estate or a trust of which the person is a beneficiary, or a corporation in which the person is at least a 50% owner. A disqualified person is treated as owning stock he has an option to acquire if, at all times during the period such option is effective, the stock he has the right to acquire is from persons subject to federal income taxes, other than the ESOP, the S corporation, or a related entity, and that stock is issued and outstanding, provided such treatment results in a nonallocation year. 128 But these same shares are not treated as synthetic equity 129 that would otherwise be included as deemed-owned shares to help classify him as a disqualified person. If a disqualified person has an option to purchase issued and outstanding shares from a family member, he is treated as owning those shares 130 and those shares will be included as part of the 50% IRC 409(p)(3)(A)(ii). IRC 409(p)(3)(B). IRC 409(p)(3)(B)(i)(I). IRC 409(p)(3)(B); IRC 318(a)(5)(A). IRC 409(p)(4)(B). Regulation Section 1.409(p)-1(c)(4). Regulation Section 1.409(p)-1(f)(2)(i). Regulation Section 1.409(p)-1(c)(4)(i).