IRC Section 409(p) Anti-Abuse Testing, History of Regulations, and Private Letter Ruling (PLR) 200804023

PLR 200804023 was published on January 25, 2008 and is the first 409(p) anti-abuse private letter ruling.

Purpose of IRC Section 409(p) Anti-Abuse Testing

The purpose of the IRC Section 409(p) anti-abuse compliance test is to ensure that an S Corporation ESOP is providing broad-based coverage that benefits rank-and-file employees. It is a very complex test that must be passed every day of the plan year and penalties are so severe that failing is not a practical option. If disqualified persons own more than 50% of deemed-owned shares, then there is a nonallocation year and the plan fails the test. Disqualified persons, deemed-owned shares, and nonallocation year are among the terms defined in the PLR Analysis section below.

History of IRC Section 409(p) Regulations

Here is a recap of the history of the IRC 409(p) regulations:

• IRC Section 409(p) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation (2001) – Section 409(p) was added to the code in 2001. For S corporation ESOPs in existence on March 14, 2001, Section 409(p) is effective for plan years beginning after December 31, 2004.
  
• Proposed and Temporary Regulations (2003) – Proposed and Temporary Regulations were issued July 21, 2003 and are generally applicable with plan years ending after October 20, 2003.
  
• Proposed and Temporary Regulations (2004) – Proposed and Temporary Regulations were issued December 16, 2004 and are generally effective for plan years beginning on or after January 1, 2005.
  
• Final Regulations (2006) – Final Regulations were issued on December 16, 2006 and generally applicable with respect to plan years beginning on or after January 1, 2006.

PLR Analysis

• Precedential status - IRC Section 6110(k)(3) - Precedential status provides that a Private Letter Ruling cannot be "used or cited as precedent."
  
  
• Disqualified person - The requesting company requested a ruling that there is not a nonallocation year because there are no disqualified person under IRC Section 409(p)(4). IRC Section 409(p)(4)(A) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Disqualified person – In general defines a disqualified person for 409(p) purposes:
  

  (A) In general
  

  The term "disqualified person" means any person if—
  

  (i) the aggregate number of deemed-owned shares of such person and the members of such person's family is at least 20 percent of the number of deemed-owned shares of stock in the S corporation, or
  

  (ii) in the case of a person not described in clause (i), the number of deemed-owned shares of such person is at least 10 percent of the number of deemed-owned shares of stock in such corporation.
  

• Synthetic equity - The submitting company is an S Corporation and does not maintain any type of non-qualified deferred compensation plan, phantom stock plan, stock option plan, restricted stock plan, stock appreciation rights plan, or other plan that constitutes synthetic equity as defined in IRC Section 409(p)(6)(C) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Definitions – Synthetic equity:
  

  (C) Synthetic equity
  

  The term "synthetic equity" means 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. Except to the extent provided in regulations, 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.
  
  

• Deemed-owned shares - The submitting company is controlled by a family and several members of the family, including cousins and a child of one of the cousins, are participants in the ESOP. No one person owns 10% or more of the deemed-owned shares (as defined in IRC Section 409(p)(4)(C) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Disqualified person – Deemed-owned shares):
  

  (C) Deemed-owned shares
  

  (i) In general The term "deemed-owned shares" means, with respect to any person—
  

  (I) the stock in the S corporation constituting employer securities of an employee stock ownership plan which is allocated to such person under the plan, and
  

  (II) such person's share of the stock in such corporation which is held by such plan but which is not allocated under the plan to participants.
  

  (ii) Person's share of unallocated stock For purposes of clause (i)(II), a person's share of unallocated S corporation stock held by such plan is the amount of the unallocated stock which would be allocated to such person if the unallocated stock were allocated to all participants in the same proportions as the most recent stock allocation under the plan.
  
  

• Family Attribution for disqualified person purposes - IRC Section 409(p)(4)(D) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Disqualified person – Member of family defines the family attribution requirements for determining a disqualified person for 409(p) purposes:
  

  (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.
  

• The Section 318 attribution rules do not apply for purposes of determining a disqualified person - The PLR confirms that the family attribution rules under IRC Section 318(a) - Constructive ownership of stock – General rule do not apply for purposes of determining a 409(p) disqualified person. Therefore, only the cousin and their child are aggregated for disqualified person determination purposes.
  
  
• Nonallocation year - Consistent with IRC Section 409(p)(3)(B) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Nonallocation year – Attribution rules, the PLR also confirms that the family attribution rules under IRC Section 318(a) - Constructive ownership of stock – General rule do apply for purposes of determining whether there is a nonallocation year as defined by IRC Section 409(p)(3)(A) - Qualifications for tax credit employee stock ownership plans - Prohibited allocations of securities in an S corporation – Nonallocation year – In general:
  

  (3) Nonallocation year
  

  For purposes of this subsection—
  

  (A) In general
  

  The term "nonallocation year" means any plan year of an employee stock ownership plan if, at any time during such plan year—
  

  (i) such plan holds employer securities consisting of stock in an S corporation, and
  

  (ii) disqualified persons own at least 50 percent of the number of shares of stock in the S corporation.
  

  (B) Attribution rules
  

  For purposes of subparagraph (A)—
  

  (i) In general The rules of section 318(a) shall apply for purposes of determining ownership, except that—
  

  (I) in applying paragraph (1) thereof, the members of an individual's family shall include members of the family described in paragraph (4)(D), and
  

  (II) paragraph (4) thereof shall not apply.
  

  (ii) Deemed-owned shares Notwithstanding the employee trust exception in section 318(a)(2)(B)(i), an individual shall be treated as owning deemed-owned shares of the individual.
  

  Solely for purposes of applying paragraph (5), this subparagraph shall be applied after the attribution rules of paragraph (5) have been applied.