Welcome Guidance for S-Corporation ESOPs

By Peter J. Shuler and Mark D. Swanson, J.D.
In order to promote the benefits of employee stock ownership plans (ESOPs) sponsored by S corporations, Congress enacted the anti-abuse provisions contained in IRC Section 409(p). The rules are designed to prevent a group of disqualified persons from collectively owning 50% or more of an S corporation’s stock.

The term “stock” includes shares held directly and deemed-owned shares. Deemed-owned shares are shares allocated to participant accounts in the ESOP (including the allocation of shares held in the suspense account based on the most recent allocation) and shares deemed owned through synthetic equity (such as warrants, nonqualified deferred compensation plans, phantom stock, and similar arrangements).

A disqualified person is defined as a person who owns 10% or more of the deemed-owned shares or part of a family group that owns 20% or more of the deemed-owned shares. If disqualified persons own at least 50% of the stock, a nonallocation year results, and the resulting penalties and taxes are large and numerous. Compliance with 409(p) rests on prevention. If a nonallocation year results, no correction methods are available to remedy the situation. Given the punitive nature of the penalties, it is imperative that prevention measures are in an organization’s plan document and followed operationally.

Issue Snapshot

In March 2019, the IRS provided several important reminders to S-corporation ESOPs and practitioners regarding an acceptable method for complying with the 409(p) requirements in its “Issue Snapshot – Preventing the Occurrence of a Nonallocation Year Under Section 409(p).” An Issue Snapshot is a research summary issued by the IRS that gives IRS employees an overview of a technical issue. It is not a formal pronouncement by the IRS and does not have formal precedential value.

The transfer method discussed in the Issue Snapshot would transfer shares in the ESOP stock account of a participant who otherwise would be a disqualified person to a non-ESOP stock account of the same person. The plan document must contain specific transfer provisions and be in place before a nonallocation year occurs. The IRS has issued sample language that can be included in the plan document and used to comply with the transfer method to prevent failure. While the transfer method is the only method prescribed by the IRS to ensure compliance, practitioners have wondered whether other methods may be used to prevent a nonallocation year without adopting the transfer method.

Chief Counsel Advice

Plan language also is the subject of Chief Counsel Advice (CCA) Memorandum 201747007. The CCA includes guidance on whether an ESOP document could contain alternative language to prevent a nonallocation year. Example language includes provisions to exclude allocations to highly compensated employees who would become disqualified persons and to all highly compensated employees, to expand allocations to nonhighly compensated employees, and other variations that would limit or expand allocations to certain groups. The CCA concludes that the prevention methods remain acceptable but cautions that each also must satisfy other applicable legal requirements, including, but not limited to, the nondiscrimination and anti-cutback rules as well as the requirement of a written plan and a definite predetermined allocation formula. Additionally, if a plan provides for more than one prevention method, the plan should specify the order in which each would be applied to prevent a nonallocation year.

The CCA also addresses the issue of plan language providing for multiple reallocations of stock initially allocated to highly compensated employees until the total amount of stock allocated to highly compensated employees, as a percentage of compensation, does not exceed the lowest percentage allocated to a nonhighly compensated employee. The CCA concludes that multiple reallocations are not acceptable since reallocating stock that already has been allocated to participants’ accounts would result in an impermissible forfeiture of accrued benefits in violation of Section 411(d)(6) anti-cutback provisions.

CCA is an umbrella term that encompasses any written advice prepared by any national office component of the Office of Chief Counsel or division counsel headquartered in Washington, D.C., and that is issued to IRS counsel or field office employees to convey a legal interpretation or IRS counsel position or policy regarding a revenue provision. A CCA is not to be used or cited as precedent; however, its analyses and conclusions provide important issues to consider.

Proceed with caution

The guidance provides welcome information on where the IRS stands with various prevention options for S-corporation ESOPs. Taxpayers should proceed cautiously, however, when working to comply with the anti-abuse provisions found in Section 409(p).

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Pete Shuler
Principal, Benefit Plan Tax Services Leader