Nonleveraged ESOP, 409(n) question

[JRN]

Company makes cash contribution to ESOP. Owner is a participant under the ESOP and receives an allocation of the cash contribution. The ESOP purchases shares from the Owner -- non-leveraged transaction -- and Owner makes 1042 election with respect to those shares. The Owner's account under the ESOP does not share in the purchase of the shares, because under Code Section 409(n) (and terms of Plan) no portion of the 1042 shares may be allocated to his ESOP account. Rather, the Owner's account remains invested in cash. Next year, the Company again makes a cash contribution to the ESOP and again a portion of the cash contribution is allocated to the Owner in accordance with the terms of the ESOP. The ESOP again uses a portion of the cash contribution to purchase a block of shares from the Owner. Again, no portion of the cash which has been allocated to the Owner is used to purchase the 1042 shares. Rather, the Owner's account stays invested in cash.

Have we somehow violated the prohibited allocation rule under Section 409(n)? Certainly, no 1042 shares of stock have been allocated to the Owner's account under the ESOP. But, should 409(n) be read so broadly as to mean that once the Owner elects 1042 treatment, he is in effect out of the ESOP as an ongoing participant -- can't share in the non-leveraged cash contributions -- for the 10 year nonallocation period.

This seems like an overly broad reading of 409(n) to me, but am interested in others' view.

Thanks.

[namealreadyinuse]

Subchapter S? When did they S? When did they 1042?

[JRN]

No, not an S corp. (Are you thinking 409(p) rather than 409(n)?) Owner sold shares and elected 1042 treatment in 2006. Thanks.

[namealreadyinuse]

Oh, yeah - I forgot to mind my p's and n's. Sorry. Carry on . . .

[RLL]

IRC section 409(n)(1) provides (in part) as follows:

"...no portion of the assets of the plan or cooperative attributable to (or allocable in lieu of) employer securities acquired by the plan or cooperative in a sale to which section 1042 applies may accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of section 401(a))..."

It appears that the pattern of annually contributing cash to the ESOP for use in annually purchasing stock in a 1042 transaction would result in a violation of section 409(n) to the extent that a portion of that cash is allocated to the shareholder who has elected 1042 treatment.

It's clear that section 409(n) was intended to be a broadly interpreted allocation prohibition. Note the statutory language "(or allocable in lieu of)" and "allocated directly or indirectly."

The consequences of violating section 409(n) can be so onerous (including plan disqualification) that it's not worth taking risks here.

[JRN]

RLL

I think you're probably right here. Thanks.

JRN