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ESOP Update: Section 409(p): Letter Ruling

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April 11, 2008

IRS Issues First Private Letter Ruling on Section 409(p) of the Code

On January 25, 2008, the IRS published the first ruling on the S corporation ESOP antiabuse rules codified in Section 409(p) of the code since the rules became law in 2001. Because the rules were complicated and left many questions unanswered, in 2003 the Treasury Department issued temporary and proposed regulations to provide guidance on the application of the provisions of Section 409(p) of the code. On December 17, 2004, a new set of temporary and proposed regulations were issued to
clarify, expand and modify the 2003 regulations; these regulations were ultimately finalized in December 2006. Despite these actions by the Treasury Department, it has taken the IRS more than seven years to first interpret these complicated and draconian rules.

Section 409(p) of the code generally provides that if a person is deemed to own 10 percent or more of an S corporation’s equity, the individual is a disqualified person. If disqualified persons, in the aggregate, are deemed to own 50 percent or more of the S corporation’s equity, a nonallocation year has occurred and confiscatory tax penalties are assessed. Under the tests of Section 409(p) of the code, if several members of a family own equity in an S corporation, the IRS aggregates the family members’ deemed ownership to determine whether the family group is a disqualified person under Section 409(p) of the code.

At issue in Private Letter Ruling (PLR) 200804023 was a family-owned S corporation owned in part by an ESOP, with a cousin and the cousin’s child involved in the business. Although the PLR did not contain the actual percentages of the individuals’ deemed ownership in question, it was represented that no individuals were deemed to own 10 percent or more of the company and that the family group’s deemed ownership, in the aggregate, was less than 20 percent of the company. It was further represented that there was no outstanding synthetic equity involved. The primary request in the PLR was a determination of whether a nonallocation year had occurred under Section 409(p) of the code.

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In testing whether the cousin and the cousin’s child were disqualified persons for purposes of Section 409(p) of the code, the IRS appropriately applied the family deemedownership aggregation rules of Section 409(p)(4)(D) of the code. Under the facts in the PLR, the only family members who were aggregated under the rules of Section 409(p) of the code were the cousin and that individual’s child.
Since the aggregate number of shares in the ESOP accounts of these two individuals is less than 20 percent of the number of deemedowned shares of stock of the company, neither of these two individuals constitutes a disqualified person. In addition, the IRS found that no other individuals in the company had deemedowned shares which were at least 10 percent of the deemedowned shares. Most significantly, the PLR makes it clear that the corporate family attribution rules set forth in Section 318 of the code are not used in determining whether an individual is a disqualified person. The Section 318 attribution rules are only applied in the determination of whether a nonallocation year has occurred once the disqualified persons have been identified (using only the aggregation rules under Section 409(p)(4)(D) of the code). Consequently, in this PLR, the IRS appropriately ruled that a nonallocation year had not occurred because there were no disqualified persons involved with the S corporation.

This PLR confirms practitioners’ understanding as to how deemed ownership is calculated for purposes of the Section 409(p) tests and the determination as to whether a nonallocation year has occurred. More importantly, the PLR confirms the IRS’s position that the Section 318 stock ownership attribution rules only apply in determining whether a nonallocation year has occurred and are not used in connection with the determination as to whether an individual is a disqualified person.

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