[Federal Register Volume 68, Number 139 (Monday, July 21, 2003)]
[Rules and Regulations]
[Pages 42970-42977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-18210]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9081]
RIN 1545-BC33


Prohibited Allocations of Securities in an S Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations concerning 
requirements for employee stock ownership plans (ESOPs) holding stock 
of Subchapter S corporations. The temporary regulations provide 
guidance on identifying disqualified persons and determining whether a 
plan year is a nonallocation year under Section 409(p) and on the 
definition of synthetic equity under section 409(p)(5). These temporary 
regulations would generally affect plan sponsors of, and participants 
in, ESOPs holding stock of Subchapter S corporations. The text of the 
temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking on this 
subject in the Proposed Rules section in this issue of the Federal 
Register.

DATES: Effective Date: These regulations are effective July 21, 2003.
    Applicability Date: These temporary regulations are applicable with 
respect to plan years ending after October 20, 2003.

FOR FURTHER INFORMATION CONTACT: John T. Ricotta at (202) 622-6060 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    Section 4975(e)(7) provides that an ESOP is a defined contribution 
plan that is designed to invest primarily in qualifying employer 
securities and that is either a stock bonus plan which is qualified, or 
a stock bonus plan and money purchase pension plan both of which are 
qualified, under section 401(a). Section 4975(e)(7) authorizes the 
Secretary to issue regulations imposing additional requirements for 
ESOPs (see Sec.  54.4975-11 of the Excise Tax Regulations). A plan is 
not treated as an ESOP under the Code unless it meets the following 
requirements, to the extent applicable: Section 409(h) (relating to 
participants' right to receive employer securities; put options); 
section 409(o) (relating to participants' distribution rights and 
payment requirements); section 409(n) (relating to securities received 
in transactions to which section 1042 applies); section 409(p) 
(relating to prohibited allocations of securities in an S corporation); 
section 664(g) (relating to qualified gratuitous transfers of qualified 
employer securities); and section 409(e) (relating to participants' 
voting rights if the employer has a registration-type class of 
securities). As authorized by section 4975(e)(7), additional 
requirements are imposed under Sec.  54.4975-11.
    Section 1361(b)(1)(D) provides that a Subchapter S corporation (S 
corporation) may not have more than one class of stock. Section 
1361(b)(1)(B) provides that an S corporation may not have as a 
shareholder a person that is not an estate, a trust described in 
section 1361(c)(2), an organization described in section 1361(c)(6), or 
an individual. In 1996, section 1361(c)(6) was amended to permit a 
qualified plan under section 401(a) to be a shareholder in an S 
corporation. Section 1316(a) of the Small Business Job Protection Act 
of 1996 (SBJPA) (110 Stat. 1755) (1996).
    Section 511(a)(1) imposes a tax on the unrelated business taxable 
income (as defined in section 512(a)) of organizations described in 
section 511(a)(2), which include plans that qualify under section 
401(a). Section 512(e)(1) provides that if an organization described in 
section 1361(c)(6) holds stock in an S corporation, the interest is 
treated as an interest in an unrelated trade or business and, 
notwithstanding the organization's general tax-exempt status, all items 
of income, loss, or deduction taken into account under section 1366(a) 
and any gain or loss on the disposition of the stock in the S 
corporation are taken into account in computing the unrelated business 
taxable income of the organization. In 1997, section 512(e) was amended 
to provide that section 512(e) does not apply to employer securities 
(within the meaning of section 409(l)) held by an ESOP described in 
section 4975(e)(7). Section 1523 of the Taxpayer Relief Act of 1997 
(TRA `97) (111 Stat. 788) (1997). Accordingly, S corporation income 
allocable to stock held by an ESOP is not subject to regular income or 
unrelated business income tax, but S corporation income allocable to 
stock held by any other qualified plan or tax-exempt entity under 
section 501(c)(3) is subject to the unrelated business income tax under 
section 511.
    Congress became aware that the tax exemption for earnings on S 
corporation stock held by an ESOP may lead to

[[Page 42971]]

inappropriate tax deferral or avoidance in some cases. In order to 
address these concerns, Congress enacted section 409(p) as part of the 
Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (115 
Stat. 38) (2001). Section 409(p) is intended to limit the tax benefits 
of ESOPs maintained by S corporations unless the ESOP provides 
meaningful benefits to rank-and-file employees. As explained in the 
legislative history:

    The Committee continues to believe that S corporations should be 
able to encourage employee ownership through an ESOP. The Committee 
does not believe, however, that ESOPs should be used by S 
corporation owners to obtain inappropriate tax deferral or 
avoidance.
    Specifically, the Committee believes that the tax deferral 
opportunities provided by an S corporation ESOP should be limited to 
those situations in which there is broad-based employee coverage 
under the ESOP and the ESOP benefits rank-and-file employees as well 
as highly compensated employees and historical owners.

H.R. Rep. No. 107-51, part 1, at 100 (2001).
    Section 409(p)(1) requires an ESOP holding employer securities 
consisting of stock in an S corporation to provide that no portion of 
the assets of the plan attributable to (or allocable in lieu of) such 
employer securities may, during a nonallocation year, accrue (or be 
allocated directly or indirectly under any plan of the employer meeting 
the requirements of section 401(a)) for the benefit of any disqualified 
person, as defined in section 409(p).\1\
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    \1\ This definition is different from the definition of 
disqualified person for purposes of section 4975.
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    Section 409(p)(3)(A) provides that a ``nonallocation year'' 
includes any plan year during which the ownership of the S corporation 
is so concentrated among disqualified persons that they own at least 50 
percent of its shares. Section 409(p)(3)(B) provides that, in 
determining the shares owned by an individual for purposes of section 
409(p)(3)(A), the attribution rules of section 318(a) apply, with 
certain exceptions, and the individual is treated as owning his or her 
deemed-owned ESOP shares.
    Under section 409(p)(4)(C)(i), the term deemed-owned shares 
includes, with respect to any person, the stock in the S corporation 
constituting employer securities of an ESOP which is allocated to that 
person under the ESOP, and that person's share of the stock in the S 
corporation which is held by the ESOP but which is not allocated to 
participants under the ESOP. Suspense account stock is deemed to be 
allocated to participants in the same proportion as the most recent 
plan allocation.
    Section 409(p)(4) provides, in general, that whether someone is a 
``disqualified person'' depends on a person's ownership of deemed-owned 
shares of S corporation stock held by an ESOP (deemed-owned ESOP 
shares). Section 409(p)(4) provides, in general, that a ``disqualified 
person'' means any person whose deemed-owned ESOP shares are at least 
10 percent of the number of deemed-owned ESOP or for whom the aggregate 
number of deemed-owned ESOP shares of such person and the members of 
such person's family is at least 20 percent of the number of deemed-
owned ESOP shares.
    The determination of whether someone is a disqualified person and 
whether a plan year is a nonallocation year is made without regard to 
``synthetic equity'' attributable to that person and is also made 
separately taking into account synthetic equity. Synthetic equity is a 
general classification unique to section 409(p). The provisions 
relating to synthetic equity do not modify the rules relating to S 
corporations, e.g., the circumstances in which options or similar 
interests are treated as creating a second class of stock. H.R. Conf. 
Rep. No. 107-84, at 102 n.52. Under section 409(p)(6)(C), synthetic 
equity is defined as:

    any stock option, warrant, restricted stock, deferred issuance 
stock right, or similar interest or right that gives the holder the 
right to acquire or receive stock of the S corporation in the 
future. Except to the extent provided in regulations, synthetic 
equity also includes a stock appreciation right, phantom stock unit, 
or similar right to a future cash payment based on the value of such 
stock or appreciation in such value.

Under the rules for the treatment of synthetic equity at section 
409(p)(5), if a person owns synthetic equity in an S corporation, then 
the shares of stock in such corporation on which such synthetic equity 
is based are generally treated as outstanding stock in such 
corporation, and as deemed-owned shares of such person, if such 
treatment of synthetic equity results either in the treatment of any 
person as a disqualified person or the treatment of any year as a 
nonallocation year. Accordingly, if a person is treated as a 
disqualified person or a year is treated as a nonallocation year 
without regard to synthetic equity, then the inclusion of synthetic 
equity as outstanding stock does not cause the person to fail to be 
treated as a disqualified person or the year to fail to be treated as a 
nonallocation year.
    Section 409(p)(7)(A) authorizes the Secretary to prescribe such 
regulations as may be necessary to carry out the purposes of section 
409(p). As indicated by the legislative history above, section 409(p) 
is intended to limit the tax benefits of ESOPs maintained by S 
corporations unless the ESOP provides meaningful benefits to rank-and-
file employees. See H.R. Rep. No. 107-51, part 1, at 100 (2001). 
Section 409(p)(7)(B) provides that the Secretary may, by regulation or 
other guidance of general applicability, provide that a nonallocation 
year occurs in any case in which the principal purpose of the ownership 
structure of an S corporation constitutes an avoidance or evasion of 
section 409(p). ``For example, this might apply if more than 10 
independent businesses are combined in an S corporation owned by an 
ESOP in order to take advantage of the income tax treatment of S 
corporations owned by an ESOP.'' H.R. Conf. Rep. No. 107-84, at 277 
(2001).
    Under section 656 of EGTRRA, section 409(p) is effective for plan 
years ending after March 14, 2001, except for those ESOPs eligible for 
a delayed effective date applicable to certain ESOPs that were 
established on or before March 14, 2001. See Rev. Rul. 2003-6, 2003-3 
I.R.B. 286.
    Section 4979A imposes a 50 percent excise tax in certain cases, 
including an allocation of employer securities that is prohibited by 
section 409(p), the ownership of any synthetic equity by a disqualified 
person during a nonallocation year, and the occurrence of the first 
nonallocation year of an ESOP, as described in section 4979A(e)(2)(C).

Explanation of Provisions

Overview

    Section 409(p) was enacted to address concerns about ownership 
structures involving S corporations and ESOPs that concentrate the 
benefits of the ESOP in a small number of persons. Under the statute as 
amended, an ESOP is still permitted to hold S corporation stock, 
provided that the ESOP benefits a sufficiently broad-based group of 
employees.
    These temporary regulations reflect the statutory language under 
section 409(p)(1) prohibiting an accrual or allocation in a 
nonallocation year, but do not provide additional guidance on what 
constitutes a prohibited accrual or allocation. It is expected that 
this issue will be addressed in additional regulations.
    An ESOP has a nonallocation year for any plan year during which, at 
any time,

[[Page 42972]]

disqualified persons hold at least 50 percent of the outstanding shares 
of stock in the S corporation or 50 percent of the outstanding shares 
of stock and synthetic equity in the S corporation. These temporary 
regulations provide guidance on the rules applicable for this purpose. 
In addition, pursuant to section 409(p)(7)(B), these temporary 
regulations authorize the Commissioner to provide that a nonallocation 
year exists in any year in which the principal purpose of the ownership 
structure is avoidance or evasion of section 409(p). These temporary 
regulations also provide guidance on identification of disqualified 
persons.

Synthetic Equity

    As discussed above, disqualified persons and nonallocation years 
are identified both with and without synthetic equity. Section 409(p) 
defines synthetic equity very broadly. Synthetic equity includes 
restricted stock, rights to acquire stock in the corporation, such as 
stock options or warrants, and other similar interests. It also 
includes payments denominated in share value, including a phantom stock 
unit, stock appreciation right, or similar interest.
    In addition, under these temporary regulations, synthetic equity 
includes two other categories of interests or payments: Nonqualified 
deferred compensation (even though it is neither payable in, nor 
calculated by reference to, stock in the S corporation) and rights to 
acquire interests in certain related entities. In each case, treatment 
of these interests as synthetic equity is necessary to carry out the 
Congressional purpose of section 409(p) of limiting the tax deferral 
opportunities provided by an S corporation ESOP to those situations in 
which the benefits of the ESOP ownership are available, at a minimum, 
to a broad group of rank-and-file employees who have the opportunity to 
be the primary beneficiaries of the growth of the business through the 
ESOP. Unless these interests are treated as synthetic equity, the 
benefits associated with ownership of an interest in an S Corporation 
by means of the ESOP could be concentrated in a small group, and 
diverted away from the rank-and-file employees, through use of these 
interests. In this respect, these interests have the same effect as 
stock appreciation rights payable in cash, which are explicitly 
included in synthetic equity by statute.

Nonqualified Deferred Compensation as Synthetic Equity

    Since the addition of section 409(p), arrangements have been 
promoted to taxpayers in which an S corporation that is either entirely 
or substantially owned by an ESOP is used to shelter the income of an 
active business while the profits of the business are primarily 
provided for certain management employees of the business through 
various obligations to make future payments to the employees. Typically 
in these arrangements, the obligation to make future payments to the 
management employees suppresses the value of the company's stock that 
is allocated to rank-and-file employees through the ESOP, depriving 
them of the opportunity to be the primary beneficiaries of the growth 
of the business through the ESOP.
    For example, under some of these arrangements, the owners of the 
operating company establish a management company and the operating 
company agrees to pay management fees equal to substantially all (or 
most) of the profits of the operating company. The management company 
agrees to provide future compensation to certain executives or other 
employees of the operating company or the management company in an 
amount equal to substantially all of the profits of the management 
company. Finally, the management company elects to be treated as an S 
corporation and transfers all, or a substantial portion, of its stock 
to an ESOP established to cover rank-and-file employees. Under this 
arrangement, the operating company claims a deduction for the fees paid 
to the management corporation. The management corporation in turn 
retains these fees to satisfy its obligations to pay future 
compensation. Although the stock of the management corporation is owned 
by the ESOP, the ownership interest held for rank-and-file employees 
through the ESOP has a substantially reduced value. Rather than being a 
mechanism for the transfer of not only ownership, but also the rights 
associated with ownership, to the employees of the S corporation, the 
ESOP is used as part of a structure designed to shelter profits that 
will be paid as future compensation for a small group of executives or 
management employees.
    These temporary regulations treat nonqualified deferred 
compensation provided by the S corporation or certain related entities 
as synthetic equity, including deferred compensation that is neither 
payable in stock of the S corporation nor calculated by reference to 
stock of the S corporation. S Corporations that do not maintain ESOPs 
typically do not provide nonqualified deferred compensation to owners. 
By treating nonqualified deferred compensation provided by the S 
corporation (or certain related entities) as synthetic equity, these 
temporary regulations address ownership structures that are designed to 
avoid or evade section 409(p) and provide guidance allowing individuals 
to determine when these interests result in a failure to comply with 
section 409(p). Nonqualified deferred compensation is appropriately 
characterized as synthetic equity because it functions similarly to 
other forms of synthetic equity by diverting value away from 
shareholders, thereby reducing the value of the S corporation and 
diminishing the ESOP's interest in the value that, absent the 
nonqualified deferred compensation, would be reflected in the shares of 
the S corporation held by the ESOP. This effect occurs even if the 
nonqualified deferred compensation is a fixed dollar amount, and even 
if such deferred compensation is not payable in stock of the S 
corporation or measured by reference to that stock (directly, such as a 
stock appreciation right payable in cash, or less directly, such as 
percentage of the future profits of the S corporation).

Right To Acquire Assets as Synthetic Equity

    Under these temporary regulations, rights to acquire stock or other 
similar interests in a related entity are treated as synthetic equity 
if the ownership of such interests in the related entity is the only 
significant asset of the S corporation and the S corporation is the 
only significant holder of stock (or other similar interests) of the 
related entity. For this purpose, related entities are entities in 
which the S corporation holds an interest and with respect to which 
income is passed through to the S corporation. These rights are 
properly treated as synthetic equity because they provide the holders 
of these rights with an opportunity to benefit from the S corporation 
ESOP structure that is comparable to the opportunity provided through 
synthetic equity issued directly by the S corporation. Taking rights to 
acquire stock or other similar interests in a related entity into 
account as synthetic equity provides a method for identifying 
situations in which the interests in the S corporation (and its assets) 
have, directly or indirectly, become concentrated in a manner that 
should result in a nonallocation year under section 409(p).
    These temporary regulations provide that synthetic equity does not 
include rights to acquire goods or services at fair market value in the 
ordinary course of business. The temporary regulations do not address, 
at this time, rights to acquire other assets of the S Corporation

[[Page 42973]]

or assets of the related entity or other related entities. This absence 
should not be interpreted as a conclusion that a right to acquire these 
other assets cannot be synthetic equity. It may be appropriate to treat 
the right to acquire assets of the S Corporation, other than its 
interest in a related entity (such as its ownership of a manufacturing 
plant), as synthetic equity. It may also be appropriate to treat rights 
to acquire assets held by the related entity as synthetic equity.
    The temporary regulations also do not address rights to acquire 
interests in related entities if the ownership of such interests in the 
related entity is not the only significant asset of the S corporation 
or the S corporation is not the only significant holder of stock (or 
other similar interests) of the related entity. Rights to acquire 
interests in other related entities is reserved because, for example, 
it may be appropriate in cases in which a related entity is not the 
only significant asset of the S Corporation to treat as synthetic 
equity only a portion of the value of the rights to acquire stock or 
other similar interests in the related entity.
    The IRS and Treasury intend to issue additional regulations 
providing guidance on the definition of synthetic equity on a number of 
issues, including issues identified as reserved in these temporary 
regulations. For example, the IRS and Treasury intend to issue 
additional guidance relating to rights to acquire interests in other 
related entities and rights to acquire assets of an S corporation or 
related entity. The additional regulations are expected to address the 
treatment of these interests, including how any such interests treated 
as synthetic equity should be converted into shares of synthetic equity 
in the S corporation and whether such conversion should take into 
account the extent to which income of the related entity is allocated 
to a shareholder that is subject to regular income tax or unrelated 
trade or business income tax. These items are reserved in order to 
allow for additional consideration of these issues, including 
consideration of comments on the proposed regulations accompanying 
these regulations. The additional regulations are expected to be issued 
in conjunction with guidance on prohibited accruals or allocations to 
disqualified persons in a nonallocation year, which is also identified 
as reserved in these temporary regulations.
    In the meantime, these temporary regulations provide an anti-abuse 
provision treating acquisition rights as synthetic equity in certain 
situations. Specifically, this treatment applies to an option or right 
to acquire assets of the S corporation, or a related person, that is 
part of a structure that provides rights to the holder comparable to 
the rights provided by arrangements identified as synthetic equity 
under these temporary regulations and in which the principal purpose of 
the structure is the avoidance or evasion of section 409(p). In 
addition, the temporary regulations delegate authority to the 
Commissioner to provide, through revenue rulings, notices and other 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), that synthetic equity includes a 
right to acquire stock or other similar interests in a related entity 
in cases in which the S corporation's interest in the related entity is 
not the only significant asset of the S corporation or the S 
corporation is not the only significant owner of the related entity.

Rights To Acquire Shares of Stock That Are Issued and Outstanding

    The definition of synthetic equity provides that rights to acquire 
shares in an S corporation with respect to shares that are, at all 
times during the period when such rights are effective, both issued and 
outstanding and held by persons other than the ESOP, S corporation, or 
a related entity are not synthetic equity. These arrangements include, 
for example, rights of first refusal held by one shareholder in the S 
corporation with respect to the shares of another taxable shareholder 
(i.e., shares held outside the tax-exempt structure created by the 
ESOP). However, in certain limited cases, a disqualified person who has 
the right to acquire such issued and outstanding stock is treated as 
owning the stock if such treatment results in a nonallocation year.

Conversion of Synthetic Equity

    Synthetic equity that is determined by reference to shares of S 
corporation stock is treated as the corresponding number of shares of 
stock. Synthetic equity that is determined by reference to shares of 
stock (or similar interests) in a related entity is converted into an 
equivalent number of shares of stock of the S corporation with the same 
aggregate value as the number of shares of stock (or similar interests) 
of the related entity (with such value determined without regard to any 
lapse restriction as defined at Sec.  1.83-3(i)). The value of any 
other synthetic equity interest, such as fixed dollar nonqualified 
deferred compensation, is converted into an equivalent number of shares 
of stock in the S corporation based on the present value of the 
interest or right to nonqualified deferred compensation (with such 
value determined without regard to any lapse restriction as defined at 
Sec.  1.83-3(i)) and the fair market value of the S corporation shares 
on the determination date (with both values determined as of any 
reasonable date during the plan year).

Identification of Disqualified Persons

    Under these temporary regulations, a person is a disqualified 
person based either on deemed-owned ESOP shares or deemed-owned ESOP 
shares combined with synthetic equity. Whether there is a nonallocation 
year is then determined by taking into account the holdings of all 
disqualified persons, first based only on outstanding shares of stock 
of the corporation and then based on outstanding shares of stock and 
synthetic equity of the corporation. In accordance with the last 
sentence of section 409(p)(5), synthetic equity cannot result in a 
person who is treated as a disqualified person for a year, or a year 
that is treated as a nonallocation year, not being so treated. In 
addition, these temporary regulations provide that, in any year in 
which the Commissioner provides that a nonallocation year occurs 
because the principal purpose of the ownership structure of the S 
corporation is an avoidance or evasion of section 409(p), the 
Commissioner may also treat any individual as a disqualified person.
    As a result of the provisions of these temporary regulations 
relating to synthetic equity, employees who benefit from nonqualified 
deferred compensation arrangements or who hold rights to acquire 
interests in certain related entities will be treated as owning 
synthetic equity and may be treated as disqualified persons. As a 
result, certain plan years of the ESOP may be treated as nonallocation 
years. This result will not occur unless the aggregate interest held by 
disqualified persons--through synthetic equity, direct share ownership, 
and deemed-owned ESOP shares--constitutes at least half of the value of 
the outstanding stock and synthetic equity of the S corporation.

Effective Date

    In the case of an ESOP holding stock in an S corporation that is 
eligible for the delayed effective date under section 656(d)(2) of 
EGTRRA applicable to certain ESOPs established on or before March 14, 
2001, these temporary regulations do not apply until plan years 
beginning on or after January 1, 2005. For an ESOP to which the delayed 
effective date is not applicable, these temporary regulations are 
applicable with respect to plan years ending after

[[Page 42974]]

October 20, 2003. The temporary regulations permit S corporations to 
avoid having nonqualified deferred compensation treated as synthetic 
equity under paragraph (f)(2)(iv) of these temporary regulations by 
distributing the deferred compensation by July 21, 2004.

Request for Comments in Proposed Regulations and Future Guidance

    See the preamble of the cross-reference notice of proposed 
rulemaking published elsewhere in this issue of the Federal Register, 
which asks for comments with respect to issues raised by S corporation 
ESOPs.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
refer to the Special Analyses section of the preamble to the cross-
referencing notice of proposed rulemaking published in the Proposed 
Rules section in this issue of the Federal Register. Pursuant to 
section 7805(f) of the Internal Revenue Code, these temporary 
regulations will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on their impact.

Drafting Information

    The principal author of these regulations is John T. Ricotta of the 
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and 
Treasury participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
1. The authority citation for part 1 continues to read in part as 
follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.409(p)-1T is also issued under 26 U.S.C. 409(p)(7). * 
* *

0
2. Section 1.409(p)-1T is added to read as follows:


Sec.  1.409(p)-1T  Prohibited allocation of securities in an S 
corporation (temporary).

    (a) Organization of this section. Sections 409(p) and 4979A apply 
if a nonallocation year occurs in an employee stock ownership plan 
(ESOP), as defined in section 4975(e)(7), that holds shares of stock of 
a Subchapter S corporation (S corporation) that are employer securities 
as defined in section 409(l). Paragraph (b) of this section sets forth 
the general rule under section 409(p)(1) and (2) prohibiting an 
allocation to a disqualified person in a nonallocation year. Paragraph 
(c) of this section sets forth rules under section 409(p)(3), (5), and 
(7) for determining whether a year is a nonallocation year, generally 
based on whether disqualified persons own at least 50 percent of the 
shares of the S corporation, either taking into account only the 
outstanding shares of the S corporation (including shares held by the 
ESOP) or taking into account both the outstanding shares and synthetic 
equity of the S corporation. Paragraphs (d), (e), and (f) of this 
section contain definitions of a disqualified person under section 
409(p)(4) and (5), deemed-owned ESOP shares under section 409(p)(4)(C), 
and synthetic equity under section 409(p)(6)(C).
    (b) Prohibited accruals in a nonallocation year--(1) General rule. 
An ESOP holding employer securities consisting of stock in an S 
corporation must provide that no portion of the assets of the plan 
attributable to (or allocable in lieu of ) such employer securities 
may, during a nonallocation year, accrue (or be allocated directly or 
indirectly under any plan of the employer meeting the requirements of 
section 401(a)) for the benefit of any disqualified person.
    (2) Additional rules. [Reserved.]
    (c) Nonallocation year--(1) Definition generally. A nonallocation 
year means a plan year of an ESOP during which, at any time, the ESOP 
holds any employer securities that are shares of an S corporation and 
either--
    (i) Disqualified persons own at least 50 percent of the number of 
outstanding shares of stock in the S corporation (including deemed-
owned ESOP shares), or
    (ii) Disqualified persons own at least 50 percent of the aggregate 
number of outstanding shares of stock (including deemed-owned ESOP 
shares) and synthetic equity in the S corporation.
    (2) Attribution rules. For purposes of this paragraph (c), the 
rules of section 318(a) apply to determine ownership of shares in the S 
corporation (including deemed-owned ESOP shares) and synthetic equity. 
However, for this purpose, section 318(a)(4) (relating to options to 
acquire stock) is disregarded and, in applying section 318(a)(1), the 
members of an individual's family include members of the individual's 
family under paragraph (d)(2) of this section. In addition, an 
individual is treated as owning deemed-owned ESOP shares of that 
individual notwithstanding the employee trust exception in section 
318(a)(2)(B)(i). If the attribution rules in paragraph (b)(1) of this 
section apply, those rules must be followed before applying the rules 
in this paragraph (c)(2).
    (3) Special rule for avoidance or evasion. Under section 
409(p)(7)(B), the Commissioner, in revenue rulings, notices, and other 
guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(B) of this chapter), may provide that a nonallocation 
year occurs in any case in which the principal purpose of the ownership 
structure of an S corporation constitutes an avoidance or evasion of 
section 409(p). For any year that is a nonallocation year under this 
paragraph (c)(3), the Commissioner may treat any person as a 
disqualified person.
    (4) Special rule for certain stock rights. (i) For purposes of 
paragraph (c)(1) of this section, a person is treated as owning stock 
that the person has a right to acquire if, at all times during the 
period when such rights are effective, the stock that the person has 
the right to acquire is both issued and outstanding and is held by 
persons other than the ESOP, the S corporation, or a related entity (as 
defined in paragraph (f)(2)(iii)(A)(4) of this section).
    (ii) This paragraph (c)(4) applies only if treating persons as 
owning the shares described in paragraph (c)(4)(i) results in a 
nonallocation year. This paragraph (c)(4) does not apply to a right 
that, under Sec.  1.1361-1(l)(2)(iii) or (l)(4)(iii)(C), would not be 
taken into account in determining if an S corporation has a second 
class of stock, and does not apply for purposes of determining 
ownership of deemed-owned ESOP shares or whether an interest 
constitutes synthetic equity (see the last sentence of paragraph 
(f)(2)(i)).
    (d) Disqualified persons--(1) General rule. A disqualified person 
is any person for whom--
    (i) The number of such person's deemed-owned ESOP shares is at 
least 10 percent of the number of deemed-owned ESOP shares of the S 
corporation;
    (ii) The aggregate number of such person's deemed-owned ESOP shares 
and synthetic equity shares is at least 10 percent of the aggregate 
number of

[[Page 42975]]

deemed-owned ESOP and synthetic equity shares of the S corporation;
    (iii) The aggregate number of deemed-owned ESOP shares of such 
person and of the members of such person's family is at least 20 
percent of the number of deemed-owned ESOP shares of the S corporation; 
or
    (iv) The aggregate number of deemed-owned ESOP shares and synthetic 
equity shares of such person and of the members of such person's family 
is at least 20 percent of the aggregate number of deemed-owned ESOP and 
synthetic equity shares of the S corporation.
    (2) Treatment of family members; definition. (i) Each member of the 
family of any person who is a disqualified person under paragraph 
(d)(1)(iii) or (iv) of this section is a disqualified person. Member of 
the family means, with respect to an individual--
    (A) The spouse of the individual;
    (B) An ancestor or lineal descendant of the individual or the 
individual's spouse;
    (C) A brother or sister of the individual or of the individual's 
spouse and any lineal descendant of the brother or sister; and
    (D) The spouse of any individual described in paragraph (d)(2)(ii) 
or (iii) of this section.
    (ii) A spouse of an individual who is legally separated from such 
individual under a decree of divorce or separate maintenance is not 
treated as such individual's spouse for purposes of this paragraph 
(d)(2).
    (3) Special rule for certain nonallocation years. See paragraph 
(c)(3) of this section (relating to avoidance or evasion of section 
409(p)) for a special rule permitting any person to be treated as a 
disqualified person in certain nonallocation years.
    (e) Deemed-owned ESOP shares. A person is treated as owning his or 
her deemed-owned ESOP shares. Deemed-owned ESOP shares mean, with 
respect to any person--
    (1) Any shares of stock in the S corporation constituting employer 
securities that are allocated to such person's account under the ESOP; 
and
    (2) Such person's share of the stock in the S corporation that is 
held by the ESOP but is not allocated to the account of any participant 
or beneficiary (with such person's share to be determined in the same 
proportion as the most recent stock allocation under the ESOP).
    (f) Synthetic equity--(1) Ownership of synthetic equity. For 
purposes of section 409(p) and this section, synthetic equity is 
treated as owned by a person in the same manner as stock is treated as 
owned by a person, directly or under the rules of section 318(a)(2) and 
(3). Synthetic equity means the rights described in paragraph (f)(2) of 
this section.
    (2) Synthetic equity--(i) Rights to acquire stock of the S 
corporation. Synthetic equity includes any stock option, warrant, 
restricted stock, deferred issuance stock right, stock appreciation 
right payable in stock, or similar interest or right that gives the 
holder the right to acquire or receive stock of the S corporation in 
the future. Rights to acquire stock in an S corporation with respect to 
stock that is, at all times during the period when such rights are 
effective, both issued and outstanding and held by persons other than 
the ESOP, the S corporation, or a related entity, are not synthetic 
equity (but see paragraph (c)(4) of this section).
    (ii) Special rule for certain stock rights. Synthetic equity also 
includes a right to a future payment (payable in cash or any other form 
other than stock of the S corporation) from an S corporation that is 
based on the value of the stock of the S corporation or appreciation in 
such value, such as a stock appreciation right with respect to stock of 
an S corporation that is payable in cash or a phantom stock unit with 
respect to stock of an S corporation that is payable in cash.
    (iii) Rights to acquire assets of an S corporation or related 
entity--(A) Rights to acquire interests in a related entity--(1) 
Treatment as synthetic equity. Synthetic equity includes a right to 
acquire stock or other similar interests in a related entity that is 
described in this paragraph (f)(2)(iii)(A).
    (2) Significant interests. Synthetic equity includes a right to 
acquire stock or other similar interests in a related entity if such 
interests in the related entity are the only significant asset of the S 
corporation and the S corporation is the only significant owner of the 
related entity. Whether an asset is the only significant asset of the S 
corporation or the S corporation is the only significant owner of the 
related entity depends on the relevant facts and circumstances.
    (3) Rights to acquire interests in other related entities. 
[Reserved]
    (4) Related entity. For purposes of this section, related entity 
means any entity in which the S corporation holds an interest and which 
is a partnership, a trust, an eligible entity that is disregarded as an 
entity that is separate from its owner under Sec.  301.7701-3 of this 
chapter or a Qualified Subchapter S Subsidiary under section 
1361(b)(3).
    (B) Rights to acquire assets of an S corporation or related entity 
other than rights to acquire stock or similar interests in a related 
entity--(1) General rule. [Reserved]
    (2) Exception for rights to acquire goods or services in ordinary 
course of business. Synthetic equity does not include rights to acquire 
goods or services at fair market value in the ordinary course of 
business.
    (C) Authority to provide guidance. The Commissioner, in revenue 
rulings, notices, and other guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii)(B) of this chapter), may provide 
that synthetic equity includes a right to acquire stock or other 
similar interests in a related entity in cases in which such interests 
in the related entity are not the only significant asset of the S 
corporation or the S corporation is not the only significant owner of 
the related entity if necessary to carry out the purposes of section 
409(p).
    (D) Synthetic equity includes comparable rights. An option or right 
to acquire assets of the S corporation or another person is treated as 
synthetic equity if such option or right is part of a structure that 
provides rights to the holder comparable to the rights provided by 
arrangements identified as synthetic equity under this paragraph 
(f)(2)(iii) and the principal purpose of the structure is the avoidance 
or evasion of section 409(p).
    (iv) Special rule for nonqualified deferred compensation. Synthetic 
equity also includes any remuneration for services rendered to the S 
corporation, or a related entity, to which section 404(a)(5) applies 
(including remuneration for which a deduction would be permitted under 
section 404(a)(5) if separate accounts were maintained), any right to 
receive property (to which section 83 applies) in a future year for the 
performance of services to an S corporation, or related entity, and any 
transfer of property (to which section 83 applies) in connection with 
the performance of services to an S corporation, or a related entity, 
to the extent that the property is not substantially vested within the 
meaning of Sec.  1.83-3(i) by the end of the plan year in which 
transferred. Synthetic equity also includes any other remuneration for 
services rendered to the S corporation, or a related entity, under a 
plan, or method or arrangement, deferring the receipt of compensation 
to a date that is after the 15th day of the 3rd calendar month after 
the end of the entity's taxable year in which the related services are 
rendered, other than a plan that is an eligible retirement plan within 
the meaning of section 402(c)(7)(B).

[[Page 42976]]

    (3) No overlap among shares of deemed-owned ESOP shares or 
synthetic equity. Synthetic equity under this paragraph (f) does not 
include shares that are deemed-owned ESOP shares. In addition, 
synthetic equity under a specific subparagraph of this paragraph (f) 
does not include anything that is synthetic equity under a preceding 
subparagraph of this paragraph (f).
    (4) Number of synthetic shares-- (i) Synthetic equity determined by 
reference to S corporation shares. In the case of synthetic equity that 
is determined by reference to shares of stock of the S corporation, the 
person who is entitled to the synthetic equity is treated as owning the 
corresponding number of shares of stock. For example, if a corporation 
grants an employee of an S corporation an option to purchase 100 shares 
of the corporation's stock, the employee is the deemed owner of 100 
synthetic equity shares of the stock of the corporation.
    (ii) Synthetic equity determined by reference to shares in a 
related entity. In the case of synthetic equity that is determined by 
reference to shares of stock (or similar interests) in a related 
entity, the person who is entitled to the synthetic equity is treated 
as owning shares of stock of the S corporation with the same aggregate 
value as the number of shares of stock (or similar interests) of the 
related entity (with such value determined without regard to any lapse 
restriction as defined at Sec.  1.83-3(i)).
    (iii) Other synthetic equity. In the case of any other synthetic 
equity, the person who is entitled to the synthetic equity is treated 
as owning a number of shares of stock in the S corporation equal to the 
present value of the synthetic equity (with such value determined 
without regard to any lapse restriction as defined at Sec.  1.83-3(i)) 
divided by the fair market value of a share of the S corporation's 
stock as of the same date. For purposes of this paragraph (f)(4)(iii), 
the number of shares of S corporation is permitted to be determined as 
of the first day of the ESOP's plan year, or any other reasonable 
determination date or dates during a plan year that is consistently 
used by the corporation for this purpose for all persons. The number of 
shares of synthetic equity treated as owned for any period from a 
determination date through the date immediately preceding the next 
following determination date is the number of shares treated as owned 
on the first day of that period.
    (g) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. Corporation X is a calendar year S 
corporation that maintains an ESOP. X has a single class of common 
stock, of which there are a total of 1,200 shares outstanding. X has 
no synthetic equity. In 2006, individual A, who is not an employee 
of X (and is not related to any employee of X), owns 100 shares 
directly, individual B owns 100 shares directly, and the remaining 
1,000 shares are owned by an ESOP maintained by X for its employees. 
The ESOP's 1,000 shares are allocated to the accounts of individuals 
who are employees of X (none of whom are related), as set forth in 
columns 1 and 2 in the following table:

----------------------------------------------------------------------------------------------------------------
                                         2--Deemed-owned ESOP
           1--Shareholders                shares  (total of      3--Percentage deemed-    4--Disqualified person
                                                1,000)             owned ESOP shares
----------------------------------------------------------------------------------------------------------------
B....................................  33.....................  33.....................  Yes.
C....................................  145....................  14.5...................  Yes.
D....................................  75.....................  7.5....................  No.
E....................................  30.....................  3......................  No.
F....................................  20.....................  2......................  No.
Other participants...................  400 (none exceed 10      1 or less..............  No
                                        shares).
----------------------------------------------------------------------------------------------------------------

    (ii) Conclusion with respect to disqualified persons. As shown 
in column 4 in the table above, individuals B and C are disqualified 
persons for 2006 under paragraph (d)(1) of this section because each 
owns at least 10% of X's deemed-owned ESOP shares.
    (iii) Conclusion with respect to nonallocation year. However, 
2006 is not a nonallocation year under section 409(p) because 
disqualified persons do not own at least 50% of X's outstanding 
shares (the 100 shares owned directly by B, B's 330 deemed-owned 
ESOP shares, plus C's 145 deemed-owned directly by B, B's 330 deemed 
owned ESOP shares, plus C's 145 deemed-owned ESOP shares equal only 
47.9% of the 1,200 outstanding shares of X).
    Example 2. (1) Facts. The facts are the same as in Example 1, 
except that, as shown in column 4 of the table below, individual E 
has an option to acquire 500 shares of the common stock of X from X:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                            5--Percentage deemed-
                                      2--Deemed-Owned ESOP                                                     owned ESOP plus
          1--Shareholders               shares  (total of     3--Percentage deemed-   4--Synthetic equity      Synthetic equity       6--Disqualified
                                             1,000)             owned ESOP shares            (500)            shares  (total of            person
                                                                                                                    1,500)
--------------------------------------------------------------------------------------------------------------------------------------------------------
B..................................  330...................  33....................  .....................  22...................  Yes (cols. 3 and 5).
C..................................  145...................  14.5..................  .....................  9.7..................  Yes (col. 3).
D..................................  75....................  7.5...................  .....................  5....................  No.
E..................................  30....................  3.....................  500..................  35.3.................  Yes (col. 5).
F..................................  20....................  2.....................  .....................  1.3..................  No.
Other participants.................  400 (none exceed 10     1 or less.............  .....................  under 1..............  No.
                                      shares).
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (ii) Conclusion with respect to disqualified persons. E's option 
constitutes 500 shares of synthetic equity. Accordingly, as shown in 
column 6 in the table above, individuals B, C, and E are 
disqualified persons for 2006 because each owns at least 10% of X's 
deemed-owned ESOP shares or X's total deemed-owned ESOP and 
synthetic equity shares.
    (iii) Conclusion with respect to nonallocation year. The 100 
shares owned directly by B, B's 330 deemed-owned ESOP shares, C's 
145 deemed-owned ESOP shares, E's 30 deemed-owned ESOP shares, plus 
E's 500 synthetic equity shares equals 65% of the 1,700 outstanding 
and synthetic equity shares of X. Thus, 2006 is a nonallocation year 
for X's ESOP under section 409(p) because disqualified persons own 
at least 50% of X's total shares of outstanding stock and synthetic 
equity. In addition,

[[Page 42977]]

independent of the preceding conclusion, 2006 would be a 
nonallocation year because disqualified persons own at least 50% of 
X's outstanding shares because the 100 shares owned directly by B, 
B's 330 deemed-owned ESOP shares, C's 145 deemed-owned ESOP shares, 
plus E's 30 deemed-owned ESOP shares equals 50.4% of the 1,200 
outstanding shares of X.

    (h) Effective date--(1) General effective dates. Except as provided 
in paragraph (h)(2) of this section, section 409(p) applies for plan 
years ending after March 14, 2001 and this section applies for plan 
years ending after October 20, 2003, except that paragraph (f)(2)(iv) 
of this section is disregarded with respect to nonqualified deferred 
compensation that is distributed on or before July 21, 2004.
    (2) Certain ESOPs established on or before March 14, 2001. If an 
ESOP holding stock in an S corporation was established on or before 
March 14, 2001 and the election under section 1362(a) with respect to 
that S Corporation was in effect on March 14, 2001,

Robert E. Wenzel,
Deputy Commissioner of Services and Enforcement.

    Approved: July 9, 2003.
Pamela F. Olson,
Assistant Secretary of (Tax Policy).
[FR Doc. 03-18210 Filed 7-18-03; 8:45 am]
BILLING CODE 4830-01-P