S Status of ESOP-Owned Company May Trigger Severe Penalties
November 25, 2008
David O'Leary - Chicago
If you are an S corporation considering the establishment of an ESOP or an ESOP-owned C corporation considering a change from C corporation status to S corporation status, care must be taken to ensure that you don’t run afoul of the IRS anti-abuse rules. Many S corporations and their advisors have been quite upset to learn that their actions have triggered draconian penalties as a result of their violation of Section 409(p) of the Internal Revenue Code.
The Rules
In 2001, Congress enacted “anti-abuse” legislation intended to curtail abusive transactions involving S corporations owned by ESOPs in which the only participants were highly paid individuals. The anti-abuse rules are generally set forth in Section 409(p) of the Code and provide that, if “disqualified persons” own 50 percent or more of the company’s outstanding shares (counting shares held directly, “deemed owned shares,” “attributed” shares and synthetic equity); then there is a “nonallocation year,” which means that the anti-abuse rules have been violated and tax penalties will be imposed.
A “disqualified person” is anyone who owns more than 10 percent of the “deemed owned shares” of the company or, collectively, with his or her family, owns 20 percent of the “deemed owned shares.”
“Deemed owned shares” are (a) shares allocated to the individual’s ESOP account, (b) unallocated shares that will be allocated to the individual as the ESOP loan is paid off , and (c) the individual’s share of synthetic equity, including stock options and warrants, phantom stock, stock appreciation rights and other forms of deferred compensation.
Interestingly, a “disqualified person” can be an individual who has received no allocation of shares owned by the ESOP but has been awarded stock options (synthetic equity) that permits the individual to acquire more than 10 percent of the stock of the company.
The example below contained in the 409(p) regulations illustrates these rules.
Example:
(i) Facts. An S corporation has 800 outstanding shares, of which 100 are owned by individual O and 700 are held in an employee stock ownership plan (ESOP) during 2006, including 200 shares held in the ESOP account of O, 65 shares held in the ESOP account of participant P, 65 shares held in the ESOP account of participant Q, who is P’s spouse, and 14 shares held in the ESOP account of R, who is the daughter of P and Q. There are no unallocated suspense account shares in the ESOP. The S corporation has no synthetic equity.
(ii) Conclusion. Under paragraph (d)(1)(i) of this section, O is a disqualified person during 2006 because O’s account in the ESOP holds at least 10% of the shares owned by the ESOP (200 is 28.6% of 700). During 2006, neither P, Q, nor R is a disqualified person under paragraph (d)(1)(i) of this section, because each of their accounts holds less than 10% of the shares owned by the ESOP. However, each of P, Q, and R is a disqualified person under paragraph (d)(1)(iii) of this section because P and members of P’s family own at least 20% of the deemed-owned ESOP shares (144 (the sum of 65, 65 and 14) is 20.6% of 700). As a result, disqualified persons own at least 50% of the outstanding shares of the S corporation during 2006 (O’s 100 directly owned shares, O’s 200 deemed-owned shares, P’s 65 deemed-owned shares, Q’s 65 deemed-owned shares, and R’s 14 deemed-owned shares are 55.5% of 800).
The Penalties
The penalties for violating Section 409(p) are extremely severe. If disqualified persons own more than 50 percent of the stock of the company, a nonallocation year will occur resulting in the following consequences:
1. The ESOP will be treated as having made a distribution to the disqualified person of his or her entire ESOP account balance resulting in taxable income to him or her and, if the individual is under age 59½, the imposition of a 10 percent premature distribution penalty.
2. The company will be subject to a 50 percent excise tax on (a) the entire amount of the disqualified individual’s account balance and (b) the present value of the disqualified person’s deferred compensation (synthetic equity).
3. The ESOP will fail to satisfy the requirements of Section 4975 and cease to be an ESOP, resulting in the imposition of an excise tax on the prohibited transaction.
4. The plan will fail to satisfy the qualification requirements under Section 401(a) for not operating the plan in accordance with its terms to reflect Section 409(p).
5. The company will lose its Scorporation status.
Quick Test
Determine if any individual is a disqualified person. Taking into account only shares allocated to the individual’s ESOP account, the individual’s share of unallocated shares owned by the ESOP and the individual’s synthetic equity, does the individual own more than 10 percent of the total shares owned by the ESOP plus any synthetic equity? If the answer is no, but the individual’s family members are also participants in the ESOP, do the individual and his family own more than 20 percent of the total shares owned by the ESOP, plus any synthetic equity? If the answer to both questions is “no,” then no further analysis is necessary. If it is determined that there is a disqualified person, further testing must be done to ensure that disqualified persons do not own more than 50 percent of the company’s outstanding shares, thereby triggering a “nonallocation year” with resulting penalties.
For more information, contact:
David O’Leary
312.715.5851
david.oleary@hklaw.com
toll free: 1.888.688.8500
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