What Are the Section 409(p) Anti-Abuse Rules?

An S Corporation Employee Stock Ownership Plan (ESOP) is a type of retirement plan that invests primarily in the stock of the sponsoring employer. For S corporations, this structure offers significant tax advantages, as the portion of the company owned by the ESOP is generally exempt from federal income tax. This benefit is intended to encourage broad-based employee ownership, allowing workers to share in the company’s success.

To ensure these tax benefits serve their intended purpose, Internal Revenue Code (IRC) Section 409(p) provides anti-abuse rules. These rules are designed to prevent S Corp ESOPs from primarily benefiting a small, concentrated group of owners or highly compensated employees. The regulations are intricate and require continuous monitoring to avoid substantial penalties.

Defining a Disqualified Person

Section 409(p) centers on the concept of a “disqualified person,” which identifies individuals whose ownership concentration is under scrutiny. An individual is classified as a disqualified person if they are deemed to own at least 10% of the total “deemed-owned shares” of the S corporation held by the ESOP. This test focuses on individual ownership levels within the plan.

The rules extend beyond individual ownership through a family aggregation rule. If family members collectively are deemed to own 20% or more of the total deemed-owned shares, every member of that family is treated as a disqualified person. This applies regardless of their individual ownership percentage and prevents the division of shares among relatives to circumvent the 10% individual threshold.

Understanding “deemed-owned shares” is fundamental to this analysis. This term includes two main components for an individual. The first is the S corporation stock allocated to that person’s account within the ESOP. The second is the individual’s proportional share of the S corporation stock the ESOP holds but has not yet allocated to participant accounts.

Another element in the ownership calculation is “synthetic equity.” Synthetic equity refers to rights that are not actual stock but can replicate its economic benefits or lead to future stock ownership. The IRS defines this broadly to include instruments like stock options, warrants, stock appreciation rights (SARs), and certain forms of nonqualified deferred compensation tied to the value of the company’s stock.

For example, if an executive holds stock options, those options are treated as if exercised, and the underlying shares are added to their ownership total for the 409(p) calculation. This prevents a scenario where an insider could hold significant economic value through synthetic instruments while keeping their formal stock ownership below the 10% threshold. The inclusion of synthetic equity ensures the test reflects economic reality rather than just the shares held in an ESOP account.

Understanding the Nonallocation Year Trigger

A “nonallocation year” is the event that activates the penalties under Section 409(p). A nonallocation year occurs if, at any point during the plan year, all disqualified persons as a group own at least 50% of the S corporation’s total shares. This aggregate test is designed to prevent insiders from controlling the majority of the company’s equity through the ESOP.

The 50% ownership calculation is comprehensive. It includes all S corporation shares owned by disqualified persons, which consists of their deemed-owned ESOP shares, any synthetic equity they hold, and any shares they own directly outside of the ESOP. It is a snapshot test that must be met every day of the plan year, meaning a company could be compliant one day and in violation the next. This makes continuous monitoring a necessity.

Consider a hypothetical S corporation with an ESOP. The company has three executives who have been identified as disqualified persons. Executive A is deemed to own 15% of the company’s shares, Executive B owns 20%, and Executive C owns 12%.

To test for a nonallocation year, their ownership percentages are added together, totaling 47% (15% + 20% + 12%). Since this is below the 50% aggregate threshold, a nonallocation year has not occurred. However, if the company were to grant Executive A a stock appreciation right equivalent to another 4% of the company’s stock, that synthetic equity would be added to the total. The aggregate ownership would then become 51%, triggering a nonallocation year.

Penalties for Noncompliance

The consequences of triggering a nonallocation year impact the disqualified individuals, the ESOP, and the S corporation. The primary penalty is a prohibition on allocations. During a nonallocation year, any allocation or accrual of S corporation stock or assets from the ESOP to the account of a disqualified person is deemed a “prohibited allocation.”

When a prohibited allocation occurs, its fair market value is treated as a taxable distribution to the disqualified person. This amount is immediately taxable as ordinary income and is not eligible for a tax-free rollover into an IRA or another retirement plan. If the disqualified person is under the age of 59½, the distribution is also subject to an additional 10% early withdrawal tax.

Beyond the personal tax consequences, the S corporation faces excise taxes. The IRS can impose a 50% excise tax on the corporation, calculated on the fair market value of any prohibited allocations made to disqualified persons during the nonallocation year.

A separate 50% excise tax is levied on the corporation based on the concentration of ownership. For the first nonallocation year, this tax is calculated on the total value of all deemed-owned shares held by all disqualified persons. This penalty applies based on the ownership that caused the violation, regardless of whether any prohibited allocations occurred.

Annual Compliance Testing

To avoid the penalties associated with a nonallocation year, S corporations with ESOPs must engage in regular compliance testing. This process is an ongoing requirement to ensure the plan remains compliant with Section 409(p). Testing should be performed at least annually, and ideally before any new allocation of shares is made to participant accounts for the plan year.

The first step in the annual compliance process is to identify all individuals and family groups who could potentially be considered disqualified persons. This involves reviewing ownership records, family relationships, and management positions to create a pool of individuals for detailed testing.

Next, the plan administrator must gather all necessary data to perform the ownership calculations. This data includes:

• The total number of outstanding company shares
• The specific number of shares allocated to each ESOP participant
• The amount of unallocated shares held in the ESOP’s suspense account
• A comprehensive list of all forms of synthetic equity, such as stock options or SARs

With the data collected, the administrator performs the detailed ownership calculations for each potential disqualified person. This involves determining their deemed-owned shares by combining their allocated shares, their pro-rata portion of unallocated shares, and the share equivalents of any synthetic equity they hold.

The final step is to sum the ownership percentages of all individuals confirmed as disqualified persons and test this aggregate percentage against the 50% threshold. If the total is 50% or more, a nonallocation year is triggered. This systematic annual review is the primary mechanism for an S corporation to manage its 409(p) risk.