Issue Snapshot - Preventing the Occurrence of a Nonallocation Year under Section 409(p)


Congress enacted IRC Section 409(p) in 2001 (P.L. 107-16 Sec. 656) to prevent S corporation employee stock ownership plans (ESOPs) from continuing to be used as abusive tax shelters. The rules under IRC Section 409(p) are designed to prevent a group of “disqualified persons” (DPs) from collectively owning 50% or more of an S corporation’s stock (i.e., the definition of a “nonallocation year”).  Since there are no prescribed correction methods to address Section 409(p) violations, prevention methods are important considerations for both ESOP plan design and operation.  A Chief Counsel Advice (CCA) issued on September 14, 2017, analyzed various plan provisions designed to prevent Section 409(p) violations.  This Issue Snapshot explores methods for preventing a Section 409(p) violation including those that were the subject of the CCA.

IRC Sections and Treas. Regulations

Other Resources



Why does IRC Section 409(p) exist? Beginning in 1998, Congress allowed S corporations to be owned by an ESOP trust and exempted the S corporation ESOP trust from unrelated business income tax (UBIT) under IRC Section 512(e)(3) with the intention that the ESOP gives rank-and-file employees a meaningful stake in the S corporation.  After the 1998 change, there was a surge in abusive taxpayer use of the new provision having the effect of excluding rank-and-file employees from benefitting from ESOP provisions.  In 2001 Congress added Section 409(p) to contain rules that ensure this tax advantage benefits a broad group of rank-and-file employees of S corporation ESOPs and can no longer be used as an abusive tax shelter.

Plan Design Requirements

Under IRC Section 409(p)(1), none of the employer stock held by an S corporation ESOP may be allocated to a DP during a nonallocation year, a requirement that must be expressly stated in the plan document.  A plan document must include all the provisions under Section 409(p), which cannot be incorporated by reference.  Refer to TA #3 (noted above) regarding plan terms. Treas. Reg. Section 1.409(p)-1(b)(2)(v) provides for a prevention method, known as the “transfer method,” which directs the plan administrator to transfer a formulated number of shares for any participant who would otherwise become a DP from their ESOP account to a non-ESOP account and provides an exemption to certain nondiscrimination provisions under Treas. Reg. Section 1.401(a)(4)-4.  If an S corporation ESOP employer chooses to use this transfer method to avoid a nonallocation year, the plan document must contain language consistent with the regulations and it cannot be incorporated by reference.  The transfer method provisions need to be both adopted and effective prior the occurrence of a nonallocation year.  The and ESOP LRM links above contain sample language that plans may use to adopt this prevention method.  This transfer method is the only prescribed prevention method that may be adopted to ensure compliance in form with Section 409(p).  As will be discussed below, there are additional prevention methodologies that may be utilized in operation by the plan sponsor to ultimately satisfy Section 409(p) without adopting the transfer method.

Chief Counsel Advice Memorandum 201747007

This CCA addressed a request for advice concerning variations of plan language designed to prevent the occurrence of an IRC Section 409(p) nonallocation year.  As with all CCAs, it is not to be used or cited as precedent, however, its analyses and conclusions provide important issues to consider.  The CCA specifically discussed the following scenarios:

1.      After an ESOP utilized the Treas. Reg. Section 1.409(p)-1(b)(2)(v)(A) "transfer method" to avoid a nonallocation year by transferring employer securities to a non-ESOP plan of the employer or a separate portion of the ESOP that was not an ESOP, could plan language allow those securities to be subsequently transferred back to the ESOP when they no longer would cause a nonallocation year or a prohibited allocation for purposes of Section 409(p).

The CCA concluded that such plan language would not be appropriate.  The transfer should strictly be from the ESOP to the non-ESOP plan of the employer and only for the limited purpose specifically allowable under the regulation (i.e., to avoid a nonallocation year or prohibited allocation). 
The CCA reasoned, that while the regulations provide a special exception to the requirements of Treas. Reg. Section 1.401(a)(4)-4 for transfers made pursuant to Section 1.409(p)-1(b)(2)(v)(A), there is no related exception for a subsequent transfer back transaction. The CCA explained that without this exception to the current availability rules, the transfer back would likely cause the ESOP and non-ESOP portion to violate Section 1.401(a)(4)-4.

2.      Could an ESOP include plan language providing for alternative methodologies, as suggested in the preamble to the final Section 409(p) regulations, that prevent a nonallocation year specifically by:

i.      excluding allocations to only highly compensated employees (HCEs) who would become DPs;

ii.     excluding allocations to all HCEs;

iii.    expanding allocations to nonhighly compensated employees (NHCEs) (who are not DPs) with less than 1,000 hours of service;

iv.     expanding allocations to NHCEs (who are not DPs) with less than 1,000 hours of service and who were employed on the last day of the plan year;

v.      expanding allocations to NHCEs (who are not DPs);

vi.     including more than one nonallocation year prevention method in the plan document; and

vii.    including a failsafe type provision that would preclude any allocations to a specific individual or the individual’s family members if it would create a DP.

3.      The CCA concluded that these seven specific prevention methods, as presented in the request for advice, remain acceptable, but added the caution that each of them must also satisfy any other applicable legal requirements, including, but not limited to the nondiscrimination rules under IRC Section 401(a)(4), the anti-cutback rules under IRC Section 411(d)(6), the requirement of a written plan under Section 1.401-1(a)(2) and the requirement of a definite predetermined allocation formula under Section 1.401-1(b)(1)(ii).  It further noted to satisfy the requirements for a written plan and definite predetermined allocation formula, the plan’s prevention method(s) must be sufficiently detailed to guide the plan administrator and avoid allowing impermissible employer discretion.  Additionally, the CCA highlighted that an ESOP that provides more than one prevention method should clearly specify the order in which each would be applied until a nonallocation year is prevented.  The CCA also indicated that for all these prevention methods, the provisions were effective in plan years prior to the allocations for such years.

Could an ESOP include plan language providing for multiple reallocations of the stock initially allocated to HCEs until the total amount of stock allocated to HCEs, as a percentage of compensation, does not exceed the lowest percentage allocated to a NHCE.

The CCA concluded that such plan language is not acceptable since reallocating stock that has already been allocated to participants’ accounts would result in an impermissible forfeiture of accrued benefits, as described in IRC Section 411(a)(7)(A)(ii).

Alternative Prevention Methods

The preamble to the final regulations under Section 409(p) describes two additional methods that a plan could potentially use to prevent the occurrence of a nonallocation year, in addition to the transfer method noted above.  A participant could reduce their synthetic equity in accordance with IRC Section 409(A) or a participant could sell their S corporation securities, provided the plan allows for in-service distributions.  Neither method is required, or appropriate, to be included in the plan document to satisfy Section 409(p). Both methods are mutually exclusive of the plan language requirement to satisfy Section 409(p) and are not a substitute for that compliance.  Likewise, the alternative prevention methodologies discussed in CCA  201747007 are also not a substitute for Section 409(p) compliance.  For example, consider that the specific fact set analyzed in CCA  201747007 did not include the possibility that a NHCE could have become a DP.  If that occurred, then the alternative methodologies discussed in the CCA could fail to prevent a nonallocation year.  Therefore, while there are various potential alternative methods for plans to avoid creating a nonallocation year, the only permissible plan language to prevent a Section 409(p) violation is the transfer method under Treas. Reg. Section 1.409(p)-1(b)(2)(v)(A).  Also, as discussed in the CCA, any of those alternative prevention methods must be otherwise permissible by satisfying applicable legal and qualification requirements under the Internal Revenue Code and Treasury Regulations.

Issue Indicators

Given the consequences for Section 409(p) violations, S corporation ESOP employers should design testing and frequently monitor their plans to avoid Section 409(p) violations, as appropriate.  Upon examination, this testing is the required substantiation needed to prove that an S corporation ESOP satisfies the requirements of Section 409(p).  The key issue remains assuring that both disqualified persons and rank-and-file employees benefit appropriately from the ESOP provisions that Section 409(p) was passed to protect.
If the Form 5500 selected for examination is filed by an S corporation ESOP, inspect the plan document to ensure that it contains the appropriate Section 409(p) provisions and request the plan’s current and prior year Section 409(p) testing.

The Section 409(p) compliance determination is a two-step test: (1) identify the “disqualified persons” in the plan and (2) test the plan’s “nonallocation year” calculation.  The plan document should provide all the definitions required to validate both elements of the test.  When determining DPs, carefully scrutinize all plan participants – both HCEs and NHCEs.

Determine if the employer used the “transfer method” and if so, when.  If used, the plan document must have been amended timely to allow for the transfer of any securities under this method.  Also, the securities moved to the non-ESOP account are subject to UBIT in the year of the transfer.  Request a copy of Form 990T to evidence that the appropriate taxes were paid on the shares moved to the non-ESOP account.

If the plan used one of the alternative preventative methods discussed above, ensure the plan document was amended timely for such provisions, where applicable.  Also, verify the provisions satisfied all other applicable legal requirements (e.g., nondiscrimination rules under IRC Section 401(a)(4), anti-cutback rules under IRC Section 411(d)(6) and the requirements for a written plan and definite predetermined allocation formula).