Prevention the Key to ESOPs Not Violating Nonallocation Year Rules

The IRS has published an Issue Snapshot discussing methods for preventing an Internal Revenue Code (IRC) Section 409(p) violation for S corporation employee stock ownership plans (ESOPs).

The IRS explains that the rules under IRC Section 409(p) are designed to prevent a group of “disqualified persons” (DPs) from collectively owning 50% or more of an S corporation’s stock (i.e., the definition of a “nonallocation year”).  Since there are no prescribed correction methods to address Section 409(p) violations, prevention methods are important considerations for both ESOP plan design and operation.

The IRS says beginning in 1998, Congress allowed S corporations to be owned by an ESOP trust and exempted the S corporation ESOP trust from unrelated business income tax (UBIT) under IRC Section 512(e)(3) with the intention that the ESOP gives rank-and-file employees a meaningful stake in the S corporation. However, after the 1998 change, there was a surge in abusive taxpayer use of the new provision having the effect of excluding rank-and-file employees from benefitting from ESOP provisions.  In 2001, Congress added Section 409(p) to contain rules that ensure this tax advantage benefits a broad group of rank-and-file employees of S corporation ESOPs and can no longer be used as an abusive tax shelter.

Under IRC Section 409(p)(1), none of the employer stock held by an S corporation ESOP may be allocated to a DP during a nonallocation year, a requirement that must be expressly stated in the plan document.  A plan document must include all the provisions under Section 409(p), which cannot be incorporated by reference.

The Issue Snapshot discusses a Chief Counsel Advice (CCA) issued on September 14, 2017, which analyzed various plan provisions designed to prevent Section 409(p) violations. Also, the preamble to the final regulations under Section 409(p) describes two additional methods that a plan could potentially use to prevent the occurrence of a nonallocation year. A participant could reduce their synthetic equity in accordance with IRC Section 409(A) or a participant could sell their S corporation securities, provided the plan allows for in-service distributions.  Neither method is required, or appropriate, to be included in the plan document to satisfy Section 409(p).

“Given the consequences for Section 409(p) violations, S corporation ESOP employers should design testing and frequently monitor their plans to avoid Section 409(p) violations, as appropriate.  Upon examination, this testing is the required substantiation needed to prove that an S corporation ESOP satisfies the requirements of Section 409(p).  The key issue remains assuring that both disqualified persons and rank-and-file employees benefit appropriately from the ESOP provisions that Section 409(p) was passed to protect,” the IRS says. More details are provided in the Issue Snapshot.