Compliance December 20, 2006

Final Regs Issued Concerning Prohibited ESOP Allocations

The Internal Revenue Service (IRS) and Treasury Department have issued final regulations that provide guidance concerning prohibited allocations and disqualified person requirements under section 409(p) of the Internal Revenue Code for employee stock ownership plans (ESOPs) holding stock of Subchapter S corporations.

Reported by

Rebecca Moore

Section 409, intended to prevent the concentration of ownership among ESOP participants, provides that, during an allocation year, no employer securities may accrue (or be allocated directly or indirectly) for the benefit of a disqualified person. In general, a disqualified person is any person whose deemed-owned ESOP shares are at least 10% of the number of deemed-owned shares held by an ESOP, or for whom the aggregate number of shares owned by the person and members of the person’s family is at least 20% of deemed-owned ESOP shares.

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A non-allocation year, under the section, includes any plan year during which the ownership of the S corporation is so concentrated among disqualified persons that they own or are deemed to own at least 50% of its shares.

Under the final regulations, in the event of a non-allocation year, S corporation shares held in a disqualified person’s account and all other ESOP assets attributable to S corporation stock, including distributions, sales proceeds, and earnings, are treated as an impermissible accrual whether attributable to contributions in the current year or a prior year.

If there is a prohibited allocation during a non-allocation year, the ESOP ceases to be an ESOP, according to the final regulations. As a result, the exemption from the excise tax on prohibited transactions for loans to leveraged ESOPs would also cease to apply to any loan, and the employer would owe an excise tax with respect to any previously exempt loan. In addition, a prohibited allocation is a deemed distribution that is not an eligible rollover distribution.

The final regulations clarify that a prohibited allocation would also result in plan disqualification. The IRS and Treasury provide an example of the impact of the final rules on S Corporations.

Guidance on prevention of a non-allocation year is included in the publication, as well as guidance on the calculation of number of shares of synthetic equity to which a person is entitled for purposes of determining whether he or she is a disqualified person.

The regulations generally are applicable for plan years beginning on or after January 1, 2006, but retain the 2004 regulations for plan years beginning before January 1, 2006.

The publication of 26 CFR Part 1 is scheduled to be in the Federal Register for December 20, 2006.