s corp esop

[Guest mbrand]

can an esop which invests in employer stock of a s corporation include a plan term which limits the stock held in a participant's account (e.g., by investing the "excess" in other plan investment options, if the participant's percentage ownership of the deemed-owned esop shares exceeds a certain "ceiling" percentage such as 9%) so that the participant is not and does not become a code section 409(p) disqualified person?

[Guest DMZ]

Yes, but the ability to have a greater exposure to other investments as opposed to stock is a benefit, right or feature that the IRS has said is subject to passing general nondiscrim testing on. In other words, you could maybe do it, but if all your limited participants are HCEs you would fail nondiscrimination because that exposure to cash vs. stock would be discriminatory against other NHCE participants.

[Guest tmills]

We have put language in plans that says if an allocation of forfeitures results in a participant becoming a Disqualified Person or results in a non-allocation year then the allocation will not be made to that person. We also give the administrator the ability to look forward to the next year and if the projected allocation for the year will result in a non-allocation year to exchange shares of DQPs for cash. Of course we don't have a letter yet from the IRS on saying anything about these approaches. Has DMZ heard/read anything specific from the IRS regarding language like mbrand is proposing or we are using or is your comment a general one about benefits rights and features? If it matters, the plans I am thinking of really only have stock and cash as investment options so perhaps the ability to invest in other options would not be an issue.

[Guest DMZ]

I think that Treas. Reg. 1.409(p)-1T made it pretty clear that any 409(p) "fixes" that are attempted are going to have to be done on a nondiscriminatory basis. See below exerpt from preamble to Treas. Reg. 1.409(p)-1T:

A plan might choose to take a number of steps before the beginning of a year in

order to ensure that the year is not a nonallocation year, such as steps to prevent an individual from becoming a disqualified person. These include:

• Reduction of synthetic equity, e.g., by cancellation or distribution of the synthetic equity.

• A sale of the S corporation securities held in the participant’s ESOP account so

that the account is not invested in S corporation stock.

• A distribution of the S corporation securities held in the participant’s account from the ESOP to the participant. Such a distribution is only permissible to the extent the amount is otherwise permitted to be distributed (e.g., for amounts that are subject to section 401(k), the distribution does not violate the distribution

restrictions of section 401(k)(2)(B)(i)).

• A transfer of the S corporation securities held for the participant under the ESOP into a separate portion of the plan that is not an ESOP (as permitted under

§54.4975-11(a)(5) of the Excise Tax Regulations) or to another qualified plan of

the employer that is not an ESOP.

Any of these steps must satisfy applicable legal and qualification requirements,

including the nondiscrimination requirements of section 401(a)(4).4 These regulations provide that, if a transfer is made from an ESOP to a separate portion of the plan or to another qualified plan of the employer that is not an ESOP in order to prevent a nonallocation year, then both the ESOP and the plan that is not an ESOP will not fail to satisfy the requirements of §1.401(a)(4)-4 merely because of the transfer. Further, subsequent to the transfer, the plan that is not an ESOP will not fail to satisfy the requirements of §1.401(a)(4)-4 merely because of the benefits, rights, or features with respect to the transferred benefits if those benefits, rights, or features would satisfy the requirements of 1.401(a)(4)-4 if the mandatory disaggregation rule for ESOPs at §1.410(b)-7©(2) did not apply.

In the event of such a transfer, the transferee plan would be subject to tax on

unrelated business taxable income with respect to its pro rata share of income from the S corporation securities, with that expense to be charged to the account holding the transferred amount. However, the ESOP would be able to continue to satisfy the requirements of section 4975(e)(7) and the allocations could be made for the participant for the year.

Note that they give a special pass to the situation of transfering the stock to a nonESOP plan or portion of the plan, but then you have to pay UBIT. Moving DQPs into cash out of stock is going to have to pass 401(a)(4). The right to have your investments invested more in "cash" instead of "stock" is a benefit that the nonDQPs (also most likley NHCEs) are not getting that the DQPs (most likley HCEs) are getting. So you can't just put DQPs into cash to the extent to pass the test. You would also have to move some NHCEs into cash to prove that the benefit of investment in cash was nondiscriminatory.

At the annual ESOP conference in DC in the legislative update session the IRS representative also reminded us that any reallocations within the ESOP to prevent 409(p) fail would have to prove nondiscriminatory.

Unfortunatley there seem to be no easy answers for preventing failure. You can do the amendment, but it probably needs to be adjusted that it will be done in a manner that 401(a)(4) is met, and that some NHCEs will also be moved into cash to meet that requirement.