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 the use of S corporation employee stock ownership plans (ESOPs) as abusive tax shelters and to ensure that a broad range of rank and file employees benefit from ESOP tax advantages. 

IRC Section 409(p) prohibits disqualified persons (DPs) from receiving allocations or accruals of ESOP assets during a non-allocation year. A non-allocation year occurs when DPs collectively own or are deemed to own at least 50 percent of the ESOP’s shares. A DP is any person who owns or is deemed to own at least 10% of the ESOP shares (or 20% when aggregating the number of shares owned by such person and the members of such person’s family).

For the purposes of IRC Section 409(p), stock ownership includes allocated and yet-to-be allocated ESOP shares, stock options, warrants, or similar interests or rights that provide a participant with the opportunity to receive stock.  

IRC Section 409(p) prevention methods are important considerations for ESOP plan design and operation, because there are no prescribed correction methods to address these violations.  IRC Section 409(p) violations may result in excise taxes on the employer, deemed distributions to DPs, plan qualification failures, and loss of S corporation status. A Chief Counsel Advice (CCA) issued on September 14, 2017, analyzed various plan provisions designed to prevent IRC Section 409(p) violations. This Issue Snapshot explores methods for preventing an IRC Section 409(p) violation, including those that were the subject of the CCA.

IRC Sections and Treas. Regulations

Other Resources



Why was IRC Section 409(p) enacted? 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) to give ESOP 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 that excluded rank-and-file employees from benefitting from ESOP provisions. In 2001, Congress added IRC Section 409(p) to prevent the  use of S corporation ESOPs as a tax shelter and provide rules that ensure this tax advantage benefits a broad group of rank-and-file employees of S corporation ESOPs. 

Plan Design Requirements

In order to comply with IRC Section 409(p), ESOP plan documents must contain plan language that expressly provides that no portion of employer stock held by an S corporation ESOP may be allocated to a DP during a nonallocation year. ESOPs may not incorporate this requirement into the plan document by reference. Similarly, ESOP plan documents must also expressly define certain definitions that appear in IRC Section 409(p), including “disqualified person” and “nonallocation year.” For more information about which terms must be expressly defined in an ESOP plan document, see Response to Technical Assistance Request #3 (referenced above).

Treas. Reg. Section 1.409(p)-1(b)(2)(v) provides a prevention method, known as the “transfer method,” which directs the plan administrator to transfer assets from an ESOP account to a non-ESOP account for any participant who would otherwise become a DP. This method also provides an exemption from certain nondiscrimination requirements 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 include language consistent with the final regulations under IRC Section 409(p), and this language cannot be incorporated by reference. The transfer method provisions need to be both adopted and effective before a nonallocation year occurs. 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 IRC Section 409(p). As will be discussed below, there are additional prevention methods that may be used in operation by the plan sponsor to satisfy IRC Section 409(p) without adopting the transfer method.

Chief Counsel Advice Memorandum 201747007

CCA 201747007 addresses different types of plan language designed to prevent 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 used 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 different 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 transferred back to the ESOP when they would no longer cause a nonallocation year or a prohibited allocation under Section 409(p)?

    The CCA determined that such plan language would not be appropriate.  The transfer should only be made from the ESOP to the non-ESOP plan or portion of the plan and only to avoid a nonallocation year or prohibited allocation. The CCA stated 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 Treas. Reg. 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 of the plan to violate Treas. Reg. Section 1.401(a)(4)-4.
  2. Could an ESOP include plan language that provides for other methods to avoid a nonallocation year? The preamble to the final IRC Section 409(p) regulations indicates that plans could also prevent a nonallocation year by:
    • excluding allocations to only highly compensated employees (HCEs) who would become DPs;
    • excluding allocations to all HCEs;
    • expanding allocations to nonhighly compensated employees (NHCEs) (who are not DPs) with less than 1,000 hours of service;
    • 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;
    • expanding allocations to NHCEs (who are not DPs);
    • including more than one nonallocation year prevention method in the plan document; and
    • including a failsafe provision that would preclude any allocations to a specific individual or the individual’s family members if it would cause the person to become a DP.

    The CCA concluded that these seven specific prevention methods are acceptable but each of them must satisfy any other legal requirements that apply, 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 written plan requirement under Treas. Reg. Section 1.401-1(a)(2), and 
    • the definite predetermined allocation formula requirement under Treas. Reg. Section 1.401-1(b)(1)(ii).

    The CCA further noted:

    • The plan’s prevention method(s) must be detailed enough to guide the plan administrator and avoid any employer discretion.
    • An ESOP with more than one prevention method should clearly specify the order in which each method would be applied to prevent a nonallocation year. 
    • The prevention methods must be effective before the nonallocation year occurs.
  3. Could an ESOP include plan language which provides that the stock initially allocated to HCEs be reallocated until the total amount of stock allocated to HCEs, as a percentage of compensation, does not exceed the lowest percentage allocated to an NHCE?

    The CCA concluded that this plan language is not acceptable, because 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 IRC Section 409(p) describes two additional methods that a plan could use to prevent 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
  • sell their S corporation securities, provided the plan allows for in-service distributions.

Neither method is required, and neither method should be included in the plan document to satisfy IRC Section 409(p). The plan must still meet the IRC Section 409(p) plan language requirements, and these two methods are not a substitute for the plan language requirements.  Further, the different prevention methods discussed in CCA  201747007 are also not a substitute for IRC Section 409(p) compliance.  For example, the facts analyzed in CCA  201747007 did not include the possibility that an NHCE could have become a DP.  If that happened, the alternative methods in the CCA could fail to prevent a nonallocation year.  Thus, while plans can use several different methods to avoid a nonallocation year, the only plan language allowed to prevent an IRC 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 IRC and Treasury Regulations.

Issue Indicators or Audit Tips:

S corporation ESOP employers should design testing and frequently monitor their plans to avoid the consequences of an IRC Section 409(p) violation. Upon examination, this testing verifies that an S corporation ESOP satisfies the requirements of IRC Section 409(p). Our focus is to ensure that both disqualified persons and rank-and-file employees benefit appropriately from the ESOP provisions that IRC 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 required IRC Section 409(p) provisions and request the plan’s current and prior year IRC Section 409(p) testing.

The audit of a plan’s IRC Section 409(p) compliance should include 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 review both parts of the test.  When determining DPs, carefully analyze 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 990-T to verify 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.  As mentioned previously, verify the provisions satisfied all other legal requirements that apply.