S Corporation 409(p)
Anti-Abuse Rules
SEPTEMBER 10, 2015
PRESENTED BY:
VICKI GRAFT, ESOP PARTNERS L LC
BRIAN L . ANDERSON, DEWIT T ROSS & STEVENS S.C.
Overview of the Session
What does Section 409(p) exist?
What does Section 409(p) say?
Testing for Section 409(p)
What happens if Section 409(p) is violated?
Preventing Violations
2
Why does Section 409(p) exist?
Internal Code Section 409(p) was enacted by Congress to curb
abuses involving ESOPs owning S Corporation stock
Congress wants such ESOPs to benefit a broad group of employees,
not just a few
3
Why does Section 409(p) exist?
Since 1997, a retirement plan (or a tax-exempt organization) can be a
shareholder of an S corporation
Except in the case of an ESOP, any such shareholder (i.e., retirement
plan or tax-exempt organization) is subject to unrelated business
income taxation (UBIT) on the proportionate share of the S
corporation’s income
An S corporation ESOP thus has a tremendous advantage: no income
taxes are owed with respect to its share of the profits generated by the
corporation
Although Congress created that tremendous advantage, it is intended
to benefit a broad group of employees
4
What does Section 409(p) say?
General Rule
None of the employer stock held by an S corporation ESOP may be
allocated to a “disqualified person” (DQP) during a “nonallocation year”
5
Definition of
“Nonallocation Year”
Nonallocation Year occurs when:
DQPs own 50% or more of the outstanding shares of stock in the S
corporation, including “deemed-owned” shares
OR
DQPs own 50% or more of the outstanding stock in the S corporation,
including “deemed-owned” shares, plus synthetic equity owned by the DQPs
Test includes the ownership of deemed-owned shares, synthetic equity,
and shares owned outside the ESOP, either directly or by family
attribution
6
Definition of
“Disqualified Person”
Disqualified Person – an individual is a DQP if one of the following
occurs:
He owns at least 10% of all deemed-owned shares (allocated and
unallocated shares)
His deemed-owned shares, plus his synthetic equity, are at least 10% of all
deemed-owned shares plus his synthetic equity
He (and his family’s) deemed-owned shares are at least 20% of all deemedowned shares
His (and his family’s) deemed-owned shares, plus their synthetic equity, are
at least 20% of all deemed-owned shares plus synthetic equity owned by
him/her (and his/her family)
7
IRC Section 409(p)(4)(D)
Member of Family Chart
Individual
Being Tested
IRC Section 409(p)(4)(D) Member of family
For purposes of this paragraph, the term “member of the family” means, with
respect to any individual—
IRC Section 409(p)(4)(D)
Member of Family Chart
Individual
Being Tested
Spouse of
Participant
Being Tested
IRC Section 409(p)(4)(D) Member of family
For purposes of this paragraph, the term “member of the family” means, with
respect to any individual—
(i) The spouse of the individual,
A spouse of an individual who is legally separated from such individual under a decree of divorce or separate
maintenance shall not be treated as such individual’s spouse for purposes of this subparagraph.
IRC Section 409(p)(4)(D)
Member of Family Chart
Ancestors
Ancestors
Individual
Being Tested
Spouse of
Participant
Being Tested
Lineal
Descendants
Lineal
Descendants
IRC Section 409(p)(4)(D) Member of family
For purposes of this paragraph, the term “member of the family” means, with
respect to any individual—
(i) The spouse of the individual,
(ii) An ancestor or lineal descendant of the individual,
A spouse of an individual who is legally separated from such individual under a decree of divorce or separate
maintenance shall not be treated as such individual’s spouse for purposes of this subparagraph.
IRC Section 409(p)(4)(D)
Member of Family Chart
Ancestors
Ancestors
Siblings
Individual
Being Tested
Spouse of
Participant
Being Tested
Siblings
Lineal
Descendants
Lineal
Descendants
Lineal
Descendants
Lineal
Descendants
IRC Section 409(p)(4)(D) Member of family
For purposes of this paragraph, the term “member of the family” means, with
respect to any individual—
(i) The spouse of the individual,
(ii) An ancestor or lineal descendant of the individual,
(iii) A brother or sister of the individual and any lineal descendant of the brother or
sister,
A spouse of an individual who is legally separated from such individual under a decree of divorce or separate
maintenance shall not be treated as such individual’s spouse for purposes of this subparagraph.
IRC Section 409(p)(4)(D)
Member of Family Chart
Ancestors
and
Spouses
Ancestors
and
Spouses
Siblings and
Spouses
Individual
Being Tested
Spouse of
Participant
Being Tested
Siblings and
Spouses
Lineal
Descendants
and Spouses
Lineal
Descendants
and Spouses
Lineal
Descendants
and Spouses
Lineal
Descendants
and Spouses
IRC Section 409(p)(4)(D) Member of family
For purposes of this paragraph, the term “member of the family” means, with
respect to any individual—
(i) The spouse of the individual,
(ii) An ancestor or lineal descendant of the individual or the individual’s spouse,
(iii) A brother or sister of the individual or the individual’s spouse and any lineal
descendant of the brother or sister, and
(iv) The spouse of any individual described in clause (ii) or (iii).
A spouse of an individual who is legally separated from such individual under a decree of divorce or separate
maintenance shall not be treated as such individual’s spouse for purposes of this subparagraph.
Testing Terminology
Disqualified Person’s “Family” for 409(p) purposes – very broad definition!
Spouse
Ancestor or lineal descendent of individual or individual’s spouse
Brother or sister of individual or individual’s spouse and any lineal descendant of any
brothers or sisters
Spouse of any individual in (2) or (3)
Cousins and Step-siblings
Parents-in-law rule: family members of the person being tested do not include
the parents-in-law of the person’s descendants
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Testing Terminology
Deemed-Owned Shares include:
Allocated ESOP shares
Shares in suspense account allocated pro rata based on the most recent share release
and allocation
Use a reasonable estimate of the shares that will be released and allocated in the first year of the
loan repayment if no prior release exists
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Testing Terminology
Synthetic Equity – something that looks like “equity” but is artificial
Examples:
 Stock options
 Warrant
 Phantom Stock
 Stock Appreciation Rights (SARs)
 Right to future cash payment based on the value of stock or appreciation in value
 Nonqualified deferred compensation (NQDC)
 Split dollar life insurance
15
Synthetic Equity Rules
Synthetic Equity (SE) can only cause the participant being tested to be
considered a DQP; it can’t be counted in the total shares denominator when
determining whether another participant is a DQP
SE is converted to shares based on the type of SE
 If SE is payable in shares of stock, then it’s a one-to-one conversion
 If SE is valued based on the value of the stock but payable in cash, the anticipated cash
payment is converted into shares at the current FMV
 If SE is in the form of NQDC, its present value is converted into shares based on current
FMV (reasonable discount rate)
16
Synthetic Equity Rules
If the ESOP owns less than 100% of the S Corporation, then the number of
shares of SE is reduced ratably. For example, if the ESOP owns 80% of the S
Corporation, then 80% of the SE would be used to determine whether
participants are DQPs
ESOP may provide that the value of the SE is to be determined annually rather
than daily
Provision must be in ESOP document and applied consistently
FMV to be used must be representative of value throughout the year
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Synthetic Equity Rules
Triennial Recalculations
ESOP may provide that the value will be fixed as of a determination date until the day
before the third anniversary of the determination date
Additional accruals are considered on the determination date that occurs on or next
follows the date of accrual or grant
Provision must be in ESOP document and applied consistently
Triennial determination date for non-stock based SE may be accelerated
prospectively if:
Plan amendment adopted before new date
The new date must be earlier than the triennial date
Change adopted as a result of change in plan year or a merger, consolidation or
transfer of plan assets
18
Prohibited Allocation in a
Nonallocation Year
Prohibited Allocation - means an impermissible accrual or an impermissible
allocation. The amount of the prohibited allocation is equal to the sum of the
amount of the impermissible accrual plus the amount of the impermissible
allocation.
Impermissible Accrual – occurs when S Corporation stock owned by the ESOP,
and any other ESOP assets attributable to the stock, including distributions,
sales proceeds, and earnings, are held in the account of a DQP during a
nonallocation year.
19
Prohibited Allocation in a
Nonallocation Year
Impermissible Allocation – occurs during a nonallocation year to the extent that
a contribution or other annual addition is made with respect to the account of a
DQP (directly or indirectly) under the ESOP. It also includes an addition under
any other qualified plan if the amount would have been added to the account
of the DQP in the ESOP but for plan provisions precluding such additions.
20
Performing the 409(p) Test
Start with shares balances held by participants in the ESOP at the time of the
ESOP owns 100% of the shares and all shares are
test
Name
Joe
Mary
Dion
Samantha
Ginger
Ashleigh
Mike
Suzie
George
Kate
Clint
Randy
Total
2013 Year End
Shares Balance
180
15
52
85
60
75
149
65
72
50
68
79
950
%
18.9%
1.6%
5.5%
8.9%
6.3%
7.9%
15.7%
6.8%
7.6%
5.3%
7.2%
8.3%
21
Performing the 409(p) Test
Allocate shares in Suspense account based on most recent release allocation
ESOP owns 100% of the shares with 200 shares in Suspense
2013 Year End
2013
Allocation Suspense
Name Shares Balance Allocation
%
Allocation
Joe
180
10
10.0%
20
Mary
15
5
5.0%
10
Dion
52
8
8.0%
16
Samantha
85
12
12.0%
24
Ginger
60
13
13.0%
26
Ashleigh
75
8
8.0%
16
Mike
149
2
2.0%
4
Suzie
65
6
6.0%
12
George
72
9
9.0%
18
Kate
50
8
8.0%
16
Clint
68
7
7.0%
14
Randy
79
12
12.0%
24
Total
950
100
100.0%
200
22
Performing the 409(p) Test
Add ESOP shares held and suspense account shares for “deemed-owned”
ESOP owns 100% of the shares with 200 shares in Suspense
shares
Name
Joe
Mary
Dion
Samantha
Ginger
Ashleigh
Mike
Suzie
George
Kate
Clint
Randy
Total
2013 Year End Suspense Deemed-Owned
Shares Balance Allocation
Shares
180
20
200
15
10
25
52
16
68
85
24
109
60
26
86
75
16
91
149
4
153
65
12
77
72
18
90
50
16
66
68
14
82
79
24
103
950
200
1150
23
Performing the 409(p) Test
Determine percentage of ESOP “deemed owned” shares by participant
ESOP owns 100% of the shares with 200 shares in Suspense
Name
Joe
Mary
Dion
Samantha
Ginger
Ashleigh
Mike
Suzie
George
Kate
Clint
Randy
Total
2013 Year End Suspense Deemed-Owned Individual
Shares Balance Allocation
Shares
Ownership % DQP?
180
20
200
17.4% Yes
15
10
25
2.2%
52
16
68
5.9%
85
24
109
9.5%
60
26
86
7.5%
75
16
91
7.9%
149
4
153
13.3% Yes
65
12
77
6.7%
72
18
90
7.8%
50
16
66
5.7%
68
14
82
7.1%
79
24
103
9.0%
950
200
1150
100.0%
24
Performing the 409(p) Test
Identify family members and family ownership
ESOP owns 100% of the shares with 200 shares in Suspense
2013 Year End Suspense Deemed-Owned Individual
Family
Family
Name Shares Balance Allocation
Shares
Ownership % Members Ownership
Joe
180
20
200
17.4%
1
23.1%
Mary
15
10
25
2.2%
Dion
52
16
68
5.9%
Samantha
85
24
109
9.5%
Ginger
60
26
86
7.5%
Ashleigh
75
16
91
7.9%
Mike
149
4
153
13.3%
Suzie
65
12
77
6.7%
George
72
18
90
7.8%
Kate
50
16
66
5.7%
1
23.1%
Clint
68
14
82
7.1%
Randy
79
24
103
9.0%
Total
950
200
1150
100.0%
25
Performing the 409(p) Test
Determine DQPs based on family ownership percentages
ESOP owns 100% of the shares with 200 shares in Suspense
Name
Joe
Mary
Dion
Samantha
Ginger
Ashleigh
Mike
Suzie
George
Kate
Clint
Randy
Total
2013 Year End Suspense Deemed-Owned Individual Family
Family
Shares Balance Allocation
Shares
Ownership %Members Ownership DQP?
180
20
200
17.4%
1
23.1% Yes
15
10
25
2.2%
52
16
68
5.9%
85
24
109
9.5%
60
26
86
7.5%
75
16
91
7.9%
149
4
153
13.3%
Yes
65
12
77
6.7%
72
18
90
7.8%
50
16
66
5.7%
1
23.1% Yes
68
14
82
7.1%
79
24
103
9.0%
950
200
1150
100.0%
26
Performing the 409(p) Test
Include SE in “deemed-owned” shares and determine percentages again
ESOP owns 100% of the shares; Stock options granted
Deemed-Owned
+ Synthetic Ownership % Family
Family
Deemed-Owned Synthetic
Name
Shares
Equity
Equity
with SE added Members Ownership DQP?
Joe
200
30
230
19.5%
1
25.7% Yes
Mary
25
25
2.2%
Dion
68
68
5.9%
Samantha
109
20
129
11.0%
Yes
Ginger
86
86
7.5%
Ashleigh
91
91
7.9%
Mike
153
153
13.3%
Yes
Suzie
77
77
6.7%
7.8%
George
90
90
Kate
66
10
76
6.6%
1
25.7% Yes
Clint
82
82
7.1%
Randy
103
103
9.0%
Total
1150
60
1210
104.5%
Samantha:
129/(1150+20) = 11.0%
27
Performing the 409(p)
Determine ownership of all shares and SE held by the DQPs
ESOP owns 88% of the shares; Stock options granted
Name
Joe
Mary
Dion
Samantha
Ginger
Ashleigh
Mike
Suzie
George
Kate
Clint
Randy
Total
Deemed-Owned
Shares
200
25
68
109
86
91
153
77
90
66
82
103
1150
Synthetic Deemed-Owned
DQP
Equity
+ Synthetic Ownership %
Non-ESOP
Total
@ 88%
Equity
with SE added DQP? Shares Ownership
26
226
18.8% Yes
150
376
2.1%
25
68
5.7%
127
10.6% Yes
127
18
86
7.1%
91
7.6%
153
153
12.7% Yes
6.4%
77
90
7.5%
75
9
75
6.2% Yes
82
6.8%
103
8.5%
53
1203
100.0%
150
731
60 x 88% = 53
28
Performing the 409(p) Test
Determine Disqualified Person Ownership Percentage
Determine DPQ Ownership Percentage:
1 Total DQP Ownership
2 Total Shares (ESOP and Non-ESOP)
3 DQP synthetic equity
4 Total denominator
5 DQP Percentage:
100%
88%
588
731
1150
60
1210
1300
53
1353
48.6%
54.0%
29
What happens if Section
409(p) is violated?
Deemed Distribution for the Disqualified Person
The amount of any prohibited accrual or allocation is treated as distributed from the
ESOP to the disqualified person and is included in gross income
The deemed distribution is subject to the 10% additional income tax that applies under
Code Section 72(t) for those under age 59 1/2
As a deemed distribution, the amount of the prohibited allocation is not an eligible
rollover distribution. As a result, the taxable amount of the deemed distributed could not
be rolled over to a Roth IRA
30
What happens if Section
409(p) is violated?
Excise Taxes on the S Corporation
Code section 4979A imposes on the S Corporation an excise tax equal to 50% on
the following items:
Amount of any prohibited allocations or accruals made to disqualified persons
Value of any SE held by any DQPs
The total value of all deemed-owned shares of all DQPs (for the first nonallocation
year)
31
What happens if Section
409(p) is violated?
Loss of ESOP Status
If there is a prohibited allocation during a nonallocation year, the ESOP will fail to satisfy the
requirements of Code Section 4975(e)(7) and therefore cease to be an employee stock
ownership plan
Loss of ESOP Loan Exemption
The exemption from the excise tax on prohibited transactions for loans to leveraged ESOPs
contained in Code Section 4975(d)(3) would cease to apply to any loan (with the result that
the employer would owe an excise tax with respect to the previously exempt loan)
32
What happens if Section
409(p) is violated?
Plan Disqualification
The plan would lose its qualified status for failure to operate the plan in accordance with its
terms (the required Code Section 409(p) provisions)
Taxation of the ESOP Trust
Loss of ESOP status would also result in the loss of the UBIT exemption making the trust
taxable. However, the corporation’s S election would also terminate, making the
corporation taxable at the entity level as a C Corporation, when the plan is disqualified
33
Preventing Violations
Any methods of preventing a nonallocation year must satisfy applicable legal
and qualification requirements (e.g., nondiscrimination requirements)
Implementation methods must be completed before a nonallocation year
occurs (i.e., prevent failures from occurring, cannot correct failures)

Monitoring and Advance Testing
34
Preventing Violations
 Methods Suggested in the Treasury Regulation Preambles
 Reduction of synthetic equity
 Sale of the S corporation stock held in a Participant’s ESOP account before
a Nonallocation Year occurs (e.g., early diversification window or inservice withdrawals), or
35
Preventing Violations
 Transfers into Non-ESOP Portion of the Plan or to another qualified plan.
 Transfers must be effectuated before the nonallocation event by an
affirmative action taken no later than the date of the transfer
 Non-ESOP portion of the Plan will be subject to unrelated business
income tax
 Sample language on IRS website: http://www.irs.gov/RetirementPlans/Sample-Plan-Language-for-Section-409p-Transfers
36
Preventing Violations
 Rebalancing or Reshuffling Accounts

Need other assets (e.g., cash) in the ESOP

Must be nondiscriminatory, not override prior diversifications and not provide a
significant detriment under the involuntary distribution rules

Language must be in the plan document, but the IRS may not issue a
determination letter.
37
Preventing Violations
 Cash Distributions vs. Redemptions
 Redemption of shares concentrates the 409(p) test results if the shares are not
recontributed or sold to the ESOP
 Plan Design (e.g., easing eligibility and allocation requirements)
 Revoke S corporation election
38
QUESTIONS?
39
Contact Information
Brian L. Anderson
Vicki Graft
DeWitt Ross & Stevens S.C.
Phone: 608-252-9340
ESOP Partners LLC
[email protected]
www.dewittross.com
Phone: 920-750-6524
[email protected]
www.esoppartners.com
40