As part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), very complex S corporation ESOP anti-abuse provisions were enacted into the Internal Revenue Code in the form of new Code section 409(p).
The purpose of the anti-abuse rules is to permit S corporation ESOP tax benefits for some companies, but eliminate abusive ownership and equity arrangements. ESOP tax benefits, such as corporate profits free from income taxes to the extent of the ESOP’s ownership of S corporation capital stock, are meant to be available only in ESOPs that provide broad-based employee coverage and benefit rank and file employees more so than shareholders that may be seen to be in control of the corporation.
Treasury Regulations were issued in 2006 to specify with enormous complexity the testing mechanics and the related definitions that for over 20 years have become a fundamental compliance concern for all S corporation ESOPs. Over time ESOP advisors have become accustomed to these tests, but not without significant effort in many cases.
The Anti-Abuse Rule
The Code section 409(p) test for S corporation ESOPs, which we will simply refer to as the anti-abuse rule, is a test that all S corporation ESOPs must pass each year. Basically, the anti-abuse rule is an “ownership concentration test.” An ESOP that holds employer securities of an S corporation is prohibited from accruing or allocating any portion of the ESOP’s assets to certain persons who identified as “Disqualified Persons” (DQP’s) during any “Nonallocation Year.” DQP’s in the aggregate may not own 50% or more of the S corporation’s stock inside or outside the ESOP combined and they may not own too much “synthetic equity” in the S corporation if it could also cause them to fail the test. In general a DQP is (1) any person who is deemed to own at least 10% of the ESOP held shares or synthetic equity (2) any person and his or her family members who are deemed to own 20% or more of the ESOP held shares or synthetic equity. (See the S Corporation ESOP Anti-Abuse Rule Definitions at the bottom of the article.)
Not only do you need to know directly who owns stock and how much allocated and unallocated stock in the ESOP each participant is deemed to own, you must include all other “synthetic equity” owned by any ESOP participant or non-ESOP shareholder. You need to know who their family members are and who the family members of the family members are even if they are not in the ESOP.
Consequences of Violating the Anti-Abuse Rule
The consequences of violating the rule are so compelling that no S corporation ESOP or S corporation ESOP sponsor can afford to wait to see whether it will pass the test. Violating the anti-abuse rule can bring hefty income and excise taxes for the participant and the plan sponsor (and S corporation if different). It affects the DQPs since any prohibited allocations in a nonallocation year are treated as distributions and are currently taxable to the DQP. For the first year of a violation, the entire ESOP account of a disqualified person is treated as a taxable prohibited allocation.
It also affects the ESOP sponsor/S corporation, which must pay an excise tax equal to 50% of the prohibited allocations of securities to the DQPs’ ESOP stock accounts. For the first nonallocation year, this is based on the total value of all of the DQPs’ deemed- owned shares.
Finally, the ESOP would lose its status as an ESOP.
How Is the Anti-Abuse Rule Violated?
Generally, there are thought to be two main ways to violate the anti-abuse rule:
- Have too much stock in the accounts of DQPs that as a group own 50% or more of the S corporation’s stock inside or outside the plan or both; or
- Have too much synthetic equity in the hands of a small number of ESOP participants that as a group own 50% or more of the S corporation’s stock with synthetic equity considered as if it were outstanding shares of the company.
Some S corporations will clearly have enough participants in their plan to avoid the concentration of ESOP stock that results in these penalties. For other companies, it may not be clear for a number of reasons.
First, due to the expanded and complex family attribution rules that are built into the anti-abuse rule, enough stock ownership may be attributed to certain individuals to push them into the DQP category or to cause ownership to aggregate inside and outside the ESOP and, thus, fail the test.
Second, certain incentive arrangements may be deemed to be “synthetic equity” even though no stock is currently issued under those arrangements, which is otherwise permissible under the S corporation regulations and can result in a penalty even though the design of the incentive compensation is clearly to benefit non-historical owners.
The Effect of Synthetic Equity
A central element of this regulation is the concept of “synthetic equity,” which plays a significant role in determining disqualified persons and control thresholds. Synthetic equity refers to financial arrangements or instruments that, while not traditional equity interests, economically mirror equity holdings. These instruments mimic the economic benefits of actual stock ownership, such as voting rights, dividends, or appreciation, without constituting formal equity interests under corporate law. Common examples include options, warrants, convertible debt, and other derivative instruments that can convert or be exercised to create an equity-like stake.
Regulators scrutinize synthetic equity because individuals can use it to circumvent ownership and control limitations. When disqualified persons—defined under IRC Section 409(p)—hold such instruments, they can artificially inflate ownership percentages or control, undermining the statute’s anti-abuse intent. By including synthetic equity in the definition of disqualified persons, the regulation treats these instruments as actual ownership interests for the 50% or more control test. As a result, synthetic equity can cause an ESOP to fail the control test. This approach tightens control criteria and prevents entities from using synthetic instruments to bypass ownership restrictions.
The regulation requires converting synthetic equity into a common stock equivalent for the control test. This process involves evaluating potential value, voting rights, and any other benefits that would arise upon exercise or settlement.
For example, if a warrant allows the holder to purchase stock at a fixed price, its value can be translated into a percentage of ownership based on intrinsic and time value. Similarly, convertible debt converts into a proportionate amount of stock according to the instrument’s specified conversion ratio.
Including synthetic equity in the control and disqualified person tests under IRC Section 409(p) acts as a crucial safeguard against potential abuse of ESOP structures. By recognizing the economic substance of synthetic instruments, the regulation ensures accurate representation of ownership and control, thereby preserving the integrity of ESOP qualification standards within subchapter S corporations.
Testing Complications
Before you can do the tests, there are definitions in related code sections that must be considered.
A couple of the provisions work in an “either or” fashion, which requires alternate testing to determine which denominator will cause the plan to fail the anti-abuse rule. To date, we have identified approximately 26 potential calculations or steps to completely work through the Code section, assuming both Code section 409(p)(4)(D) and Code section 318(a) governing family attribution, could result in a very small number of family ESOP accounts with otherwise very small percentages attributed and violating the rule.
The family attribution rules under Code section 318(a) are both incorporated by reference into the anti-abuse rule and expanded by adding Code section 409(p)’s Members of Family definitions. These family attribution rules can create some seemingly horrible results. For example, assume only three DQPs — a husband, wife and son — in a 100% ESOP owned company, each having only 7% of the company’s stock in their ESOP accounts. This would fail the test. How could this be? They own only 21% of the company. The non-family members own 79%. Not so!
This is because their family group as DQPs would own more than 20% of the shares in the ESOP and when aggregated under Code section 318(a)(1) they would be treated as owning collectively 63% of the company since each is treated as owning 21% by attribution and 3 times 21% = 63%. As a result, a seemingly broad-based ownership situation fails. Does this further the congressional purpose? Does it unfairly punish or is it unintended?
A Summary of Code Section 409(p) Anti-Abuse Testing Steps
The following is merely a summary of an approach to testing for potential Code section 409(p) violations. Carefully work through each factor and alternative in the Code section and the regulations as it applies to the client situation. However, you may find it to be a useful starting point.
Step 1
Determine deemed-owned shares (DOS) of DQPs counting only ESOP shares.
- Calculate ESOP accounts in shares.
- Calculate the ESOP shares that would be allocated from suspense-based on the preceding allocation date.
- Subtotal 1 and 2.
- Sort census by member of family (applying member of family definition in Code section 409(p)(4)(D)).
- Calculate family group percentages of total DOS. Tag accounts of members of 20% family groups.
- (Members of Family in this group are DQPs even if they own less than 10% individually. Members of Family are not included if the group does not reach 20%.)
- Identify 10% DQPs who are not in a 20% family group.
- Tag all DOS shares of all DQPs.
Step 2
Apply the 50% ownership test to DQPs In Step 1 to determine if there is a nonallocation year.
- Identify all DQPs from Step 1 (tagged accounts).
- Calculate the DQPs’ total S corporation ownership by applying the Code section 318(a) attribution rules as expanded in Code section 409(p) to identify attributed ownership outside and inside the ESOP. This means aggregating ESOP and non-ESOP stock.
- If DQPs have more than 50% of all S corporation shares, a nonallocation year (NAY) occurs.
Step 3
Synthetic Equity as DOS alone or when added to the ESOP DOS.
- Identify all DQPs from Step 1.
- Identify all synthetic equity offered by the company to all employees whether participating in the ESOP or not.
- Apply attribution rules of Code section 318(a)(2) and (3) to determine each individual’s deemed-owned synthetic equity.
- Subtotal DQPs’ synthetic equity and ESOP DOS shares for Total DOS (TDOS).
- Tag accounts of individual 10% DQPs based on TDOS. Note: For this DQP classification, the synthetic equity of one DQP is not counted as outstanding in testing whether another individual is a DQP, so calculate a separate denominator for each potential DQP.
- Calculate family percentages of TDOS. Do not include individuals owning more than 10% TDOS on their own. Note: The synthetic equity of one DQP is not counted as outstanding in testing whether another individual is a DQP.
- Compare DQPs based on TDOS vs. DOS in Step 1. If individuals or family groups fall out of DQP status when synthetic equity is added or counted, for example held by persons outside of the ESOP, then disregard the synthetic equity (e.g., from the denominators) to restore DQP status under Step 1 or Step 3.
Step 4
Apply the ownership test for DQPs in Step 2 to determine if there is a nonallocation year.
- Identify all DQPs from Step 3.
- Subtotal DQPs outside S corporation shares and synthetic shares as if outstanding shares.
- Apply Code section 318(a) attribution rules as expanded in Code section 409(p) to identify attributed ownership of actual and synthetic shares DQPs.
- If DQPs have more than 50% of all S corporation shares, then a Non-Allocation Year occurs.
- Compare the result in Step 4 with Step 2. If no NAY results, but did result under Step 2, follow Step 2 results. If NAY results under both, correct all DQP or synthetic equity failures.
- Synthetic equity owned by an individual who is not a DQP is not counted as outstanding in testing whether a NAY occurs.
- If synthetic equity counted in this step would cause a NAY to not occur, for example by increasing the denominator which reduces the percentage, then disregard the synthetic equity that causes the NAY to pass (e.g., from the denominator).
There is a caveat under Step 4. If the synthetic equity counted in this last step would cause a nonallocation year to not occur, then disregard the synthetic equity that could cause the nonallocation year to pass the test. This last caveat, essentially, indicates that there are multiple consequences from this testing scheme. A nonallocation year may be found to occur under Step 2 or under Step 4. A nonallocation year could also be found to occur by operation of Step 4 with only a limited amount of synthetic equity eliminated from the appropriate denominators in the test.
In this alternative testing scenario, it is possible to have different individuals deemed to be DQPs or different amounts of synthetic equity or prohibited allocations, which could be subject to the income tax or excise taxes of the Code section. Each of the above testing steps has a distinct sequence for applying the definitions in the Code section in order to carefully and thoroughly address all of the nuances of the test.
Don’t Worry—Your TPA Has It Covered… Right?
Unlike the Code’s general nondiscrimination and coverage tests that your third-party administrator (TPA) performs each year, the anti-abuse rule is not a test performed by most qualified plan software programs. Waiting until the end of a plan year and relying on your TPA to perform the anti-abuse test as part of the current year’s annual administration is not proactive enough. Whether you pass the test may depend on the dynamics of the S corporation’s equity structure and non-ESOP compensation arrangements, which may change year to year and during the year. There may be things you can or must do in advance to the ESOP plan document or to outside compensation arrangements to avoid violating the anti- abuse rule. The test requires long-range planning.
What to Do?
There are a number of alternatives to avoid violating the anti-abuse rule, depending on the facts of each case, including plan amendments, redesigning non-ESOP stock equity plans or corporate restructuring, to name a few. The key is planning.
Our recommendation is that every S corporation ESOP should examine the test carefully, identify the areas of concern that can potentially be problems in the future, and build in safeguards for avoiding a violation of the test. Those with definite problems under the test should take steps to restructure their equity arrangements, amend their plan documents to provide for permissible and nondiscriminatory corrections of benefit allocations within the plan, and write in specific fail safe methods for avoiding future allocations that could inadvertently trip the test. On this last point, plan administrators should note that even accruals and allocations of income attributable to S corporation stock within an ESOP can deemed to be a prohibited allocation under this provision.
Plan sponsors and TPAs should contact us to analyze how these new rules affect their company and ESOP and the correction alternatives that will best suit their needs.
Glossary / Definitions
S Corporation ESOP Anti-Abuse Rule Definitions
Disqualified Person (DQP): A disqualified person (DQP) is any person who is either in a (1) deemed 20% shareholder group or a (2) deemed 10% shareholder group.
Deemed 20% Shareholder Group: A deemed 20% shareholder group is a person whose number of deemed-owned shares and his or her members of family is at least 20% of the number of deemed-owned shares of stock in the S corporation.
Member of Family: A family member of any person in a deemed 20% shareholder group will be a DQP if they have deemed-owned shares and are not otherwise treated as a DQP on his or her own. A member of family for purposes of determining nonallocation years or disqualified persons means:
- The spouse of the shareholder;
- An ancestor or lineal descendant of the shareholder or the shareholder’s spouse;
- A sibling of the shareholder or the shareholder’s spouse and any lineal descendants of such sibling; and
- The spouse of:
- an ancestor or lineal descendant of the shareholder or the share- holder’s spouse;
- a sibling of the shareholder or the shareholder’s spouse and any lineal descendants of such sibling; and
- a spouse of an individual who is legally separated under a decree of divorce or separation isn’t treated as the individual’s spouse for pur- poses of identifying family members.
Deemed 10% Shareholder: A deemed 10% shareholder is a person who is not a member of a deemed 20% shareholder group and whose deemed-owned shares is at least 10% of the number of deemed-owned shares of stock in the S corporation.
Deemed-owned Shares: Deemed-owned shares” (DOS) are:
- Shares allocated to a participant’s ESOP account or that would be allocated to his account, in the case of ESOPs that are allocated by cash rather than by shares.
- The participant’s proportion of the shares in any unallocated account, such as a loan suspense account or a Code section 4980(d) suspense account, assuming that all such shares become allocated in the same proportion as the most recent annual stock allocation under the plan.
- Any synthetic equity owned by the participant.
- Deemed-owned shares do not include shares held outright by an individual outside the plan.
Synthetic Equity: Synthetic equity is any stock option, warrant, restricted stock, deferred issuance stock right, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity also includes a stock appreciation right, phantom stock unit, or similar right to a future cash payment based on the value of such stock or appreciation in such value.
Nonallocation Year: A nonallocation year is any plan year during which at any time during such plan year:
- The plan holds company stock in an S corporation and
- DQPs own at least 50% of the number of shares of stock in the S corporation potentially including synthetic equity.
