The Internal Revenue Service (IRS) recently released an "Issue Snapshot" on preventing the occurrence of a nonallocation year for S corporation employee stock ownership plans (ESOPs) under Section 409(p) of the Internal Revenue Code of 1986, as amended (the Code). Although an Issue Snapshot is not a formal pronouncement by the IRS and does not have formal precedential value, it is a research summary that is prepared by the IRS to provide IRS employees with an overview of a technical issue.
Code Section 409(p) applies to S corporation ESOPs and was implemented to ensure that S corporation ESOPs provide benefits to a broad base of employees and to curb the use of S corporation ESOPs as a tax shelter. In the event that an S corporation ESOP does not pass the 409(p) testing for a year, a number of penalties – including the disqualification of an ESOP, loss of S corporation status, loss of prohibited transaction exemption for the ESOP loan and large excise taxes – would apply. There are no correction methods available to remedy a Code Section 409(p) violation.
The Issue Snapshot provides several important reminders to S corporation ESOPs and ESOP practitioners regarding acceptable methods for complying with the requirements of Code Section 409(p).
First, the Issue Snapshot reminds practitioners that all of the provisions of Code Section 409(p) must be explicitly stated in an ESOP plan document – the provisions cannot be incorporated by reference.
Second, the Issue Snapshot states that in order to avoid a nonallocation year under Code Section 409(p), ESOPs may adopt a "transfer method" in the plan document. Under the "transfer method," a plan administrator transfers shares of employer stock from the ESOP stock account of a participant who would otherwise be a disqualified person under Code Section 409(p) to a non-ESOP stock account of such person. This transfer method must be set forth in the ESOP document and must be in place before the occurrence of a nonallocation year. The IRS has provided sample language that a plan sponsor may use to comply. The IRS has stated that the transfer method is the only prescribed method to ensure compliance with Code Section 409(p).
A third piece of guidance in the Issue Snapshot describes alternative methods of complying with Code Section 409(p). Both the Issue Snapshot and Chief Counsel Advice Memorandum 201747007 (which is described in the Issue Snapshot) state that there are other ways to comply with Code Section 409(p) without utilizing the transfer method. The alternative methods for satisfying Code Section 409(p) are described in the preamble to the final Code Section 409(p) regulations. Rather than utilizing the "transfer method" described above, one of the alternative methodologies, such as excluding allocations to potentially disqualified persons or expanding allocations to certain nonhighly compensated employees, can be used. The IRS cautions, however, that while these methods may be used, the methods must also satisfy all other applicable qualified plan requirements, including – but not limited to – nondiscrimination, anti-cutback and definitely determinable benefit rules.
Finally, the Issue Snapshot cautions plan sponsors about expanding on the "transfer method" by potentially allowing employer securities to be transferred back to disqualified persons' accounts in later years or by not being specific enough when utilizing an alternative method so that employer discretion comes into play.
While there is no new guidance in the Issue Snapshot, it serves as an important outline for plan sponsors and practitioners as to how to avoid Code Section 409(p) violations. While the penalties for Code Section 409(p) are severe, with proper planning and regular monitoring, many of the risks can be significantly limited.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.
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