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Hot Off the Presses: IRS Issues Final Regs on S-corp ESOPs
By Peter J. Shuler New Internal Revenue Service (IRS) regulations clarify the anti-abuse testing required of S corporations that sponsor employee stock ownership plans (ESOPs). Author Pete Shuler discusses the impact of the regulations on S-corp banks with ESOPs, including the intricacies of the testing and the costly consequences of failure. The IRS recently released final regulations governing the required anti-abuse testing for S corporations that sponsor ESOPs. With more financial institutions converting to S-corp status for the tax benefits, the regulations have become increasingly relevant to the banking industry. Trend Toward ESOP Ownership To gain the greatest tax advantages, many S corporations are shifting their entire ownership to their ESOPs. Generally, S-corps do not incur federal taxes at the corporate level, and ESOPs are tax-exempt shareholders. Thus, when an ESOP holds all of a company’s shares, the result is a pass-through entity that can attribute its income to a tax-exempt entity, which pays no federal income taxes. Anti-abuse Testing Section 409(p) of the Internal Revenue Code (IRC) aims to prevent tax avoidance abuses by ensuring that an ESOP’s shares are allocated to many employees, rather than just a few. It specifically prohibits the holding of stock in the ESOP accounts of “disqualified persons” in plan years during which they own 50 percent or more of the company’s stock — so-called “nonallocation years.” This prohibition includes stock accumulated in the ESOP accounts at the beginning of the nonallocation year, and stock added to the accounts during the nonallocation year. Disqualified persons are defined as those who:
Banks that offer deferred compensation plans should ensure that their advisers are factoring these plans into the testing. As indicated above, in addition to regular company stock, the test encompasses synthetic equity, which includes such share-based deferred compensation as phantom stock, restricted stock, and stock options, as well as dollar-based deferred compensation. Such synthetic equity is considered to be owned when granted, even if it has not yet vested or, if applicable, been exercised. Banks often find the correct calculation of synthetic equity extremely complicated, making the test itself difficult to perform. Clarification of the Testing Rules The regulations also outline methods to prevent a nonallocation year if one appears on the horizon, such as through the reduction of synthetic equity and transfer of shares to a non-ESOP plan or a non-ESOP component of the ESOP. Any corrective method must satisfy the general nondiscrimination requirements under IRC Section 401(a)(4); transfers to a non-ESOP plan or non-ESOP component of the ESOP will automatically be deemed to meet these requirements. Selling ESOP shares from a disqualified person’s account to either other ESOP participants (often referred to as reshuffling) or buyers outside of the ESOP will not merit special relief from nondiscrimination rules. The new regulations also offer advice on long-term methods to prevent a nonallocation year, such as reducing contributions to highly compensated employees (HCEs) and mandating diversification for those HCEs who are eligible to diversify. Severe Tax Consequences If a nonallocation year occurs, the bank is subject to a 50-percent excise tax on the fair market value of the prohibited allocations, which include all shares in the accounts of disqualified persons, whether allocated to them in current or prior years. If disqualified persons own synthetic equity during a nonallocation year, the bank also becomes subject to a 50-percent excise tax on the share-equivalent value of that equity. Additionally, the fair market value of prohibited allocations will be treated as income to disqualified persons. Perhaps equally important, prohibited allocation during a nonallocation year causes the plan to lose its status as an ESOP. While ESOPs are the only retirement plans allowed to borrow funds to acquire assets, due to a special exemption, if the plan loses ESOP status, the exemption is lost. As a result, any such borrowings become prohibited transactions subject to excise taxes. A prohibited allocation also would preclude the plan from qualifying as a tax-qualified retirement plan under IRC Sections 401(a). The bank would lose all deductions ever taken for contributions to the plan, and all amounts in the plan would become immediately taxable to the participants. The final regulations further stipulate that, because the plan would no longer function as a tax-qualified retirement plan, it is not eligible to hold S-corp stock, triggering an excise tax under IRC Section 4979A and terminating the S-corp election. Do You Pass? S-corp banks with ESOPs must ensure they comply with the anti-abuse testing rules. In particular, those that offer deferred compensation and incentive programs should evaluate the programs for the new regulations’ synthetic equity provisions. Special care should also be taken to include “fail-safe” language in the ESOP plan document. Such language automatically triggers the permitted correction outlined above if a failure appears on the horizon. Peter J. Shuler is an executive specializing in qualified retirement plans with Crowe Chizek and Company LLC in Columbus, Ohio. He can be reached at 614.280.5208 or pshuler@crowechizek.com. Download PDF Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer. 
Archives Crowe Tax Notes (December 2009) |
