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Prohibited Allocations of Company Stock in an S Corporation ESOP

David Johanson

November 1999

In an attempt to broaden the ownership of S corporation employee stock ownership plan (ESOP) companies and prevent certain abuses (i.e., one-participant ESOP companies) made possible when Congress originally permitted employee stock ownership trusts ("ESOTs") to own stock in such companies in legislation passed in 1996 and 1997, Senator Breaux of Louisiana recently developed an anti-abuse legislative proposal. It is not clear whether such legislative proposal actually will become law but it is likely that something of this nature will become law within the next year. Although it is probably not worthwhile to dwell on Senator Breaux's legislative proposal until it becomes law, a brief review of such proposed legislation is instructive for ESOP companies and their advisors who are considering an S corporation election or who already have become S corporations.

New Section 409(p) of the Internal Revenue Code of 1986, as amended (the "Code")(existing subsection (p) will be redesignated as subsection (q)), consists of the following basic provisions. "Disqualified persons" need to be identified. This term includes the following persons: (a) a person and members of such person's family who own at least 20% of the "deemed-owned" shares of stock in the S corporation; or (b) in the case of a person not described in (a), a person who owns at least 10% of the deemed-owned shares of stock in the S corporation. For purposes of identifying disqualified persons, family members include a spouse, any ancestor or lineal descendant of the person or the person's spouse, a brother or sister of the person or the person's spouse and any lineal descendants of the brother or sister and the spouse of any person described above (except for the person who, of course, already would be a disqualified person). Also for purposes of identifying disqualified persons, "deemed-owned" shares of S corporation stock include (a) stock in the S corporation constituting employer securities of the ESOT which is allocated to the person's account under the ESOP; (b) such person's share of unallocated shares of S corporation stock; and (c) "synthetic equity." "Synthetic equity" is defined very broadly to include: "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." It is interesting to note that company stock owned outside of an ESOT (other than "synthetic equity") does not constitute deemed-owned shares of stock in an S corporation. This will make it easier for ESOP companies to make plans to comply with new Section 409(p) of the Code.

Once disqualified persons are identified, the percentage of company stock allocated to such persons during a "nonallocation year" needs to be determined. A "nonallocation year" is any plan year during which an ESOT holds employer securities consisting of stock in an S corporation. In order to avoid "confiscatory" or "draconian" tax consequences to the S corporation and the disqualified persons, disqualified persons must not own at least 50% of the number of shares of company stock in the S corporation (including "deemed-owned" shares) during a nonallocation year.

If disqualified persons own at least 50% of the shares of company stock in an S corporation (including deemed-owned shares) during a nonallocation year, two significant consequences occur. The first significant consequence is a 50% excise tax that is imposed on the S corporation on the "amount involved." It is not exactly clear what constitutes the "amount involved." The "amount involved" with respect to any allocation of employer securities that violates the provisions of Section 409(p) of the Code, or any "nonallocation year" with respect to an ESOP, is the "amount allocated to the account of any person in violation of section 409(p)(1)." Some professionals have speculated that this refers not just to the amount exceeding 49% of the number of shares of company stock in the S corporation (including deemed-owned shares) but also applies to the first 49% of such shares that may be allocated to disqualified persons under new Section 409(p) of the Code. If this interpretation is correct, the excise tax would be unacceptable to all S corporation ESOP companies. It is, however, premature to leap to this conclusion based upon the proposed statutory language. Nevertheless, the "amount involved" under this aspect of the 50% excise tax for the first nonallocation year of any ESOP also shall be determined by taking into account the total value of all deemed-owned shares of S corporation stock of all disqualified persons with respect to the ESOP. The "amount involved" with respect to any synthetic equity owned by a disqualified person in any nonallocation year is the value of the shares of S corporation stock on which the synthetic equity is based. This aspect of the 50% excise tax is substantial and material under any interpretation.

The second significant consequence of disqualified persons owning at least 50% of the shares of company stock in an S corporation (including deemed-owned shares) during a nonallocation year is to treat the ESOT "as having distributed to any disqualified person the amount allocated to such person in violation of (new) paragraph (1) (of new Section 409(p) of the Code) at the time of such allocation." Again, this could be interpreted in a number of ways and the statutory language is not entirely clear. Some professionals have interpreted this consequence in a very conservative fashion that would result in drastic tax consequences to a disqualified person who is deemed to have received a distribution. The statute also provides little guidance with respect to how to allocate the deemed distributed amounts to multiple disqualified persons.

The effective dates for Senator Breaux's proposed anti-abuse legislation are as follows: First, the legislation would apply to plan years after December 31, 2000. Second, in the case of any ESOP established after July 14, 1999, or any ESOP established before such date if employer securities held by the ESOT consist of C corporation stock on such date, Senator Breaux's proposed anti-abuse legislation would apply to plan years beginning after July 14, 1999.

Although it is too early to make any definite conclusions with respect to how ESOP companies (and their advisors) that already have become S corporations or those that are considering becoming S corporations respond (from a planning perspective) to Senator Breaux's proposed anti-abuse legislation, a review of the proposed statutory language is instructive. Furthermore, it is clear that ESOP companies with a small number of participants will have to make some changes in response to the proposed legislation if it becomes law.

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