My ESOP third party administrator (TPA) is asking me to “please verify whether you have synthetic equity and any new family groups.” Why are they asking?
The answer is that complete data on synthetic equity and family groups is critical for completing the anti-abuse testing that applies to S Corporation ESOPs.
Internal Revenue Code (“IRC”) Section 409(p) is also known as the S-Corp ESOP Anti-Abuse test. The test only pertains to ESOPs sponsored by corporations electing to be taxed for Federal purposes as a S-Corporation (“S Corp ESOPs). As you likely know there are significant tax advantages to a S Corp ESOP. Federal corporate taxes (and in many cases state corporate taxes) are not payable with respect to the shares held by the ESOP since the shares are held in a tax-exempt qualified retirement plan trust. Tax free? Sounds too good to be true. Well in a way it is and in the early stages of S Corp ESOPs there were some arrangements that were perceived as abusive and not promoting the intended goal of broad based employee ownership. As a result Section 409(p) was enacted as part of the Economic Growth and Tax Relief Reconcilation Act of 2001 (“EGTRRA”).
Section 409(p) ‘simply’ states an S Corp ESOP cannot allocate shares to disqualified persons during any nonallocation year. As such it’s important to understand three terms: Disqualfied Person, deemed-owned shares and nonallocation year. The testing itself can be simple or become complicated. What isn’t with ESOPs, right? Let’s first start with what is a “Disqualified Person” or DP? A DP is:
- A person who holds 10% or more of the deemed owned shares; or
- A person and his/her family members that hold 20% or more of the deemed owned shares. Who is considered a family member for 409(p) is quite broad and will spare you the details at this point but know there’s a reason we ask for family relationships.
Next, is to determine the deemed-owned shares.
- Actual shares allocated to a participant’s account in the ESOP
- The ‘mock allocation’ of Shares held in the suspense account not yet allocated, assuming future allocations will be the same as the most recent allocation; and
- Synthetic equity of the S corporation which are stock appreciation rights (SARs), warrants, options, deferred compensation plans, phantom stock, split dollar life insurance and similar arrangements. Synthetic equity is converted to deemed owned shares. For example, a warrant to purchase 100 shares is treated as 100 deemed owned shares. It is important to note that all synthetic equity is considered including synthetic equity held by employees who are not Participants and nonemployees.
Finally comes the determination of a nonallocation year which occurs if DPs hold 50% or more of the outstanding shares of a S Corporation owned or deemed-owned. For this purpose you include any non-ESOP shares owned by DPs so shares held outside the ESOP are only considered if they are owned (or attributed as owned) by a DP.
Here’s an example to help put it all together. here is an example of how the calculation works:
- There are 100,000 shares outstanding and all held by the ESOP.
- There are three DPs
- There are 21,000 deemed owned shares attributable to synthetic equity, of which 7,800 deemed owned shares are attributed to the DPs.
- There are 27,000 deemed owned shares in the ESOP allocated to the DPs.
- We take the total ownership of the DQPs and divide that by the total stock. You do not include the non DQP synthetic equity stock in the denominator.
- In this case 34,800/107,800 = 32.28%. Since this is less than 50% a nonallocation year did not result.
Section 409(p) states the test could fail if at any time during the year the requirements are not met. This means, in theory, the ESOP should be tested daily. Now do people do this? Likely not but it is important to do this testing anytime there is a new transaction, a change to ownership, a granting of synthetic equity, etc. It’s something that needs to be watched so if any of this happens, please reach out to complete testing.
What happens if there is a 409(p) test failure? We’ll spare the details but the consequences can be severe. Are there ways to prevent a nonallocation year from occurring? Yes but that’s a story for another day. Most Plan Documents will have prevention measures written into the document.
As with anything the adage ‘garbage in, garbage out’ applies here. Review the test to confirm any family relationships are reflected and accurate. If the ESOP does not hold 100% of the S Corp shares make sure the information on outside shareholders has been provided for the test and is accurate. Make sure any synthetic equity is properly reflected (including any held by persons or entities who are not ESOP participants). And, if you any any questions, please reach out to your ESOP professionals.
