S Corporation Anti-Abuse TestingWednesday, April 13, 2016: 11:15 a.m. – 12:00 p.m.

Presented by:

Nancy DittmerNewport Group2900 100th Street, Suite 303Urbandale, IA 50322-3855Phone: 515-318-6210 Email: nancy.dittmer@newportgroup.com

Richard M. Acheson, Esq., CPA BSI - A Menke Company 12121 Wilshire Boulevard, Suite 310 Los Angeles, CA 90025 800-BSI-2001; 310-207-8776 Email: racheson@bsiesop.com

Overview of the Session

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• Code Section 409(p) Description/Purpose

• Consequences of Violation• Definitions• Rules regarding Synthetic Equity• Preventive Measures• Planning and Possible Solutions• Examples• Important Points

Due to the severe consequences of

noncompliance with the provisions of Section

409(p), steps must be taken prior to yearend to

assure compliance.

Code Section 409(p) – Compliance

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Code Section 409(p) – Purpose

To restrict S Corporation ESOP structures

that provide the available tax benefit to a

limited number of persons.

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Code Section 409(p) – General Rule

No portion of the assets of the ESOP attributable to (or allocable in lieu of) the stock in an S corporation may, during a NONALLOCATION YEAR, accrue (or be allocated directly or indirectly under any qualified plan of the EMPLOYER) for the benefit of any DISQUALIFIED PERSON.

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Code Section 409(p)- Consequences of Violation

Plan is DISQUALIFIED due to failure to operate in accordance with its terms and ceases to be an ESOP. It probably loses its basic qualification status under Section 401(a) as well.

S corporation election terminates due to disqualified plan not being an eligible S corporation shareholder. The Corporation is taxed as a regular C Corporation.

Any exempt loan being repaid by the ESOP loses its prohibited transaction exemption and becomes a prohibited transaction and excise tax is due

The plan becomes subject to the tax on Unrelated Business Taxable Income (UBTI)

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Code Section 409(p) Consequences of Violation (continued)

Disqualified Persons (DQPs) owe income tax based on the Prohibited Allocation

• Prohibited Allocation is deemed to be currently distributed to the DQP –but no rollover treatment is available

• 10% excise tax on premature distributions if the DQP is under age 59 1/2

Employer owes excise tax

• 50% excise tax on FMV of Prohibited Allocations

• 50% excise tax on value of the shares on which the SYNTHETIC EQUITY is based that is held by DQPs

• Special rule for first NONALLOCATION YEAR-50% excise tax on FMV of all DEEMED-OWNED SHARES held by DQPs

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DISQUALIFIED PERSON (DQP) – an individual is a DQP if:

• The individual’s deemed-owned ESOP shares are at least 10% of all deemed-owned ESOP shares OR

• The individual’s deemed-owned ESOP shares plus synthetic equity are at least 10% of all deemed-owned ESOP shares plus the individual’s synthetic equity OR

• The individual’s and his family’s deemed-owned ESOP shares are at least 20% of all deemed-owned ESOP shares OR

• The individual’s and his family’s deemed-owned ESOP shares plus their synthetic equity are at least 20% of all deemed-owned shares plus synthetic equity owned by the individual and his family.

Code Section 409(p)- Definitions

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DISQUALIFIED PERSON (DQP) – an individual is a DQP if he or she is a family member of a DQP (see Family Member Chart on next slide)

Family Members include:

1) spouse of individual,2) ancestor or lineal descendant of individual or individual’s spouse3) brother or sister of individual or individual’s spouse and any lineal

descendant of brother or sister, and4) spouse of any individual in (2) or (3)

• To be a DQP by virtue of family membership, the individual must have deemed-owned ESOP shares or synthetic equity

• Stepsiblings or cousins may be included in family of individual through a person who has no involvement with the ESOP or its sponsor

• Parents-in-law rule: family members of the person being tested do not include the parents-in-law of the person’s descendants

Code Section 409(p)- Definitions (continued)

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S-CORP ESOP IRC SECTION 409(p)(4)(D)FAMILY MEMBER CHART

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ANYANCESTOR

ANYANCESTOR

INDIVIDUAL BEING TESTED SPOUSE

BROTHEROR

SISTER

BROTHEROR

SISTER

ANY LINEALDESCENDANT

ANY LINEALDESCENDANT

ANY LINEALDESCENDANT

ANY LINEALDESCENDANT

*

* * *

*

*

*

COPYRIGHT ©2016 BSI

NONALLOCATION YEAR occurs if the ESOP owns S corporation stock and

• DQPs own 50% or more of the outstanding stock in the S corporation, including deemed-owned ESOP shares OR

• DQPs own 50% or more of the outstanding stock in the S corporation, including deemed-owned ESOP shares, plus synthetic equity owned by DQPs.

This test takes into account ownership of deemed-owned ESOP shares, synthetic equity and shares outside, the ESOP owned directly or by attribution

Code Section 409(p)- Definitions (continued)

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DEEMED-OWNED ESOP SHARES • Allocated ESOP shares • Pro rata portion of shares in ESOP loan

suspense account based on most recent share release and allocation

• If no prior release pro rata portion is based on a reasonable estimate of the shares that would be released and allocated in the first year of a loan repayment

Code Section 409(p)- Definitions (continued)

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SYNTHETIC EQUITY • Stock option• Warrant • Restricted stock • Deferred issuance stock right • Similar interest or right that gives holder the right

to acquire or receive stock, but, if conditions met, not

• a right of first refusal to buy stock from the ESOP • a right to acquire stock held by a person other than the

ESOP, the S corporation or a related entity, if person is taxable

Code Section 409(p)- Definitions (continued)

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SYNTHETIC EQUITY (continued):• Stock Appreciation Right (SAR)• Phantom Stock• Similar right to future cash payment based on value of

stock or appreciation of value• Right to acquire stock or assets of a related entity• Nonqualified deferred compensation (NQDC) (2 ½ month

rule)•• vesting provisions are ignored

• Split dollar life insurance

But SYNTHETIC EQUITY can only be used to make an individual a DQP or a year a NONALLOCATION YEAR- not to avoid either

Code Section 409(p)- Definitions (continued)

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Prohibited Allocation occurs if

• During a NONALLOCATION YEAR, there is an (A) IMPERMISSIBLE ACCRUAL or an (B) IMPERMISSIBLE ALLOCATION

• (A) IMPERMISSIBLE ACCRUAL consists of stock of the S corporation and assets attributable thereto, including distributions made on the stock, earnings thereon, and proceeds from the sale of stock, that is held under the ESOP for the benefit of a DQP during a NONALLOCATION YEAR

• The included items are included whether attributable to contributions in the current or prior years.

• (B) IMPERMISSIBLE ALLOCATION means any allocation, direct or indirect, for the benefit of a DQP during a NONALLOCATION YEAR or any in lieu of allocation, if it would have been added to DQP’s ESOP STOCK account BUT FOR an ESOP provision precluding such allocations. IMPERMISSIBLE ALLOCATION also includes an investment in stock during the NONALLOCATION YEAR.

Code Section 409(p)- Definitions (continued)

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Related Entity

• Any right to acquire stock or assets of a related entity (partnership, trust, Q-sub, or a disregarded eligible entity), to the extent of the S corporation’s ownership in the entity, constitutes SYNTHETIC EQUITY.

Pro rata Rule

• If the ESOP owns less than 100% of the S corporation, the value of SYNTHETIC EQUITY as otherwise determined is reduced by the same percentage of the Company not owned by the ESOP (provided the other owners are taxable)

Code Section 409(p) - Rules Regarding Synthetic Equity

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If SYNTHETIC EQUITY is in reference to S corporation stock, but payment is to be made in cash or other property (e.g., SAR, phantom stock, etc.):

• Holder is treated as owning the number of shares having a fair market value equal to the cash/property entitlement on the measurement date.

• EXAMPLE: An SAR is granted with regard to 100 shares of S corporation stock - the shares the holder is deemed to own equals the number of shares having a value equal to the appreciation at the time of measurement (without regard to lapse restrictions).

Code Section 409(p)- Rules Regarding Synthetic Equity (continued)

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SYNTHETIC EQUITY not based on stock is converted to a number of shares equal to the present value of the SYNTHETIC EQUITY divided by the fair market value of the S corp stock

Preamble to Final Regulations: no specific discount rate, but assumptions must be reasonable

Code Section 409(p)- Rules Regarding Synthetic Equity (continued)

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Valuing SYNTHETIC EQUITY that is not stock-based, e.g., cash-based nonqualified deferred compensation

ESOP may provide that value to be determined annually, rather than daily (required by the Regulations)

• Provision must be included in the ESOP plan document and consistently applied to all persons

• FMV of stock on determination date must be representative of value throughout the year

Code Section 409(p)- Rules Regarding Synthetic Equity (continued)

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Triennial Recalculations

• ESOP may provide that value will be fixed as of a determination date until the day before the third anniversary of the determination date

• Provision must be included in the ESOP plan document and consistently applied to all persons

• Additional accruals, allocations, or grants are not considered until each determination date anniversary

Code Section 409(p)- Rules Regarding Synthetic Equity (continued)

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Triennial determination date for non-stock-based synthetic equity may be accelerated prospectively if:

• Plan amendment adopted before new date and

• The new date must be earlier than the triennial date and

• Change adopted in connection with a change in plan year or a merger, consolidation or transfer of plan assets of the ESOP (which resulted in no reduction in participant accounts)

Code Section 409(p)- Rules Regarding Synthetic Equity (continued)

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Code Section 409(p)- Preventive Measures

Any preventive measure must be otherwise permissible – cannot violate other qualified plan rules

Must prevent, not correct – if correcting, penalties will apply

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Code Section 409(p)- Preventive Measures

Transfer of stock from potential DQP’s account to a non-ESOP account or a non-ESOP plan

• No violation of 401(a)(4)• Affirmative action taken no later than the date of transfer• Subsequent actions (including benefit statements) must be

consistent with the transfer having occurred on that date• Clarifies that transfer cannot be done retroactively• Tax on UBTI applies

IRS/Treasury has allowed in some cases a procedure for correcting 409(p) violations. The corrective steps are effective but costly.

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Code Section 409(p)- Examples

Example 1

• ESOP owns 100% of the S corporation’s shares

• All ESOP shares are allocated

• No SYNTHETIC EQUITY

• 4 employees have 14%, 12%, 10%, and 5%, respectively, of

total DEEMED-OWNED SHARES

• No employees are related

• No NONALLOCATION YEAR -- 3 DQPs, but in the

aggregate they own less than 50% of all S corporation shares

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Code Section 409(p)- Examples

Example 2

• ESOP owns 40% of the S corporation’s shares • 3 unrelated employees each have 4% of S corporation’s

shares allocated to them in the ESOP (i.e., 10% of ESOP’s shares each)

• Same 3 employees also directly own 15% each of the S corporation’s issued and outstanding stock

• NONALLOCATION YEAR – Why?• 3 employees are DQPs (each has 10% of DEEMED-

OWNED SHARES, i.e., ESOP shares – 4% out of 40%)• 3 DQPs in the aggregate own at least 50% of all S

corporation shares (12% in ESOP + 45% outside the ESOP)

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Code Section 409(p)- Examples

Example 3

• ESOP owns 60% of the S corporation’s 100 shares • 4 unrelated employees each have 3 of S corporation’s shares allocated to

them in the ESOP (i.e., 5% of ESOP’s shares each)• Same 4 employees also have grants of synthetic equity of 5% or 5 shares of

the Company each• Same 4 employees each own 10%, or 10 shares each of the Company

outside the ESOP• There is no NONALLOCATION YEAR --

• 4 employees are not DQPs (each has only 5% of DEEMED-OWNED ESOP SHARES before synthetic equity, i.e., ESOP shares)

• 4 employees each hold 9.52% DEEMED-OWNED ESOP SHARES after pro-rating synthetic equity to the ESOP’s ownership rate3 shares + (5 shares * 60%) / [60 shares + (5 shares * 60%)] = 3 shares + 3 shares/60 shares + 3 shares= 6 shares/63 shares= 9.52%

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Code Section 409(p)- ExamplesExample 4

100% ESOP owned S-corporation (1000 shares outstanding) ESOP aggregate allocations are limited to 9.9% of stock

owned by ESOP (99 shares) and Joe, Bob and Sue each have that amount allocated

Joe, Bob and Sue each have options to purchase 150 shares

There is a NONALLOCATION YEAR. 409(p) Analysis: Joe, Bob and Sue are each DQPs because of options. DQP analysis: 99 ESOP shares + 150 options = 249

DEEMED-OWNED SHARES. 249/1150 = 21.6% = DQP Nonallocation analysis: (249 + 249 + 249)/1450 =

51.5% NOTE: If the ESOP owns less than 100% of the S-Corp,

the S/E calculation will be different.

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Code Section 409(p)-Planning and Possible Solutions

Allow for in-service distributions Reshuffle/rebalance participant accounts (e.g., “sell” the S

corporation stock held in DQPs’ accounts within the ESOP) Cut back SYNTHETIC EQUITY (i.e., by cancelling or

distributing some or all of it—see “relief” under Code Section 409A regulations on this topic)

Transfer some stock to non-ESOP qualified plan or to separate portion of the plan that is not an ESOP—but the recipient plan is subject to tax on unrelated business taxable income under Code Section 512. This method is allowed by the Regulations.

Targeted “sale” of DEEMED-OWNED SHARES in DQP’s account – to the S corporation or other accounts.

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Code Section 409(p) -Planning and Possible Solutions

Relax eligibility requirements prior to testing year

Change stock ownership structure — ESOP purchase (leveraged or non-leveraged) company redeems and retires shares of company stock current direct ownership sold to others

Revoke the S election (convert to a C corporation)

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Important Points

Avoid failure - penalties are too high

Make sure those who are fully aware of all the equity and other compensation arrangements are providing input

Daily monitoring – test the effect of a change BEFORE implementing

Know who is responsible for testing.

Do you understand the results?

Watch out for potential future failure – for example, a majority owner that has close to 10% of the deemed-owned shares

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