[Federal Register Volume 69, Number 242 (Friday, December 17, 2004)]
[Rules and Regulations]
[Pages 75455-75468]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-27294]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9164]
RIN 1545-BC33


Prohibited Allocations of Securities in an S Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

-----------------------------------------------------------------------

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 the definition and effects of a prohibited allocation under 
section 409(p), identification of disqualified persons and 
determination of a nonallocation year, calculation of synthetic equity 
under section 409(p)(5), and standards for determining whether a 
transaction is an avoidance or evasion of section 409(p). These 
temporary regulations 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 December 17, 
2004.
    Applicability Dates: These temporary regulations are applicable 
with respect to plan years beginning on or after January 1, 2005, but 
see Sec.  1.409-1T(i)(2) for specific exceptions.

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

SUPPLEMENTARY INFORMATION:

Background

    Section 409(p) was enacted as part of the Economic Growth and Tax 
Relief Reconciliation Act of 2001 (EGTRRA) (115 Stat. 38) (2001) to 
address concerns about ownership structures involving S corporations 
and ESOPs that concentrate the benefits of the ESOP, directly or 
indirectly, in a small number of persons. Under the statute, an ESOP is 
generally permitted to hold S corporation stock, provided that the ESOP 
benefits a sufficiently broad-based group of employees.
    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). A plan is not treated as an ESOP under 
the Internal Revenue Code (Code) unless it meets the following 
requirements, to the extent applicable: Section 409(e) (relating to 
participants' voting rights if the employer has a registration-type 
class of securities); 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); and section 664(g) 
(relating to qualified gratuitous transfers of qualified employer 
securities). As authorized by section 4975(e)(7), additional 
requirements for ESOPs are imposed under Sec.  54.4975-11 of the Excise 
Tax Regulations.
    Section 511 imposes an income tax on unrelated business taxable 
income (UBTI), as defined in section 512. Section 512(e)(1) generally 
provides that an interest in an S corporation held by an organization 
described in section 1361(c)(6), including a qualified plan, is treated 
as an interest in an unrelated trade or business. However, section 
512(e)(3) has an exception for employer securities held by an ESOP, so 
that an ESOP of an S corporation generally does not have UBTI under 
section 512 with respect to the S corporation stock held by the ESOP.
    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). 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 or are deemed to own at least 50 percent of its 
shares. Section 409(p)(4) provides, in general, that whether someone is 
a ``disqualified person'' depends on a person's 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 shares 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 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 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

[[Page 75456]]

shares of stock in such corporation on which such synthetic equity is 
based are treated as outstanding stock in such corporation, and as 
deemed-owned shares of such person, ``if such treatment of synthetic 
equity of 1 or more such persons results in . . . the treatment of any 
person as a disqualified person or * * * the treatment of any year as a 
nonallocation year.'' [Emphasis added.]
    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). 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).
    Section 4979A imposes a 50 percent excise tax on certain prohibited 
allocations in an ESOP, including any allocation of employer securities 
that violates section 409(p), and on any synthetic equity owned by a 
disqualified person during a nonallocation year under section 409(p). 
In addition, section 4979A includes special rules for the first 
nonallocation year of an ESOP under which the excise tax applies with 
respect to all deemed-owned ESOP shares and all synthetic equity of 
disqualified persons, even if there is no prohibited allocation in that 
year. Section 4979A(a)(3), (a)(4), and (e)(2)(C). Thus, for example, 
any unallocated shares in an ESOP loan suspense account that are 
treated as deemed-owned shares of a disqualified person pursuant to 
section 409(p)(4)(C) are taken into account in determining the amount 
involved under 4979A(e)(2)(C). In addition, under section 
4979A(e)(3)(D), a special statute of limitations applies to the first 
year of an ESOP that is a nonallocation year.
    Temporary regulations under section 409(p) were issued on July 21, 
2003 (68 FR 42970). The text of those temporary regulations also served 
as the text of a notice of proposed rulemaking published at 68 FR 
43058. The 2003 regulations provide guidance on identifying 
disqualified persons, determining whether an ESOP has a nonallocation 
year, and on the definition of synthetic equity under section 
409(p)(5).
    In January 2004, the IRS issued Rev. Rul. 2004-4 (2004-6 I.R.B. 
414) which addresses three factual situations involving an S 
corporation with qualified subchapter S subsidiaries (QSUBs). Pursuant 
to the authority of section 409(p)(7)(B) and Sec.  1.409(p)-1T(c)(3) of 
the 2003 regulations, Rev. Rul. 2004-4 states that a nonallocation year 
occurs and the individual is a disqualified person in any case in which 
(i) shares of an S corporation are employer securities held by an ESOP, 
(ii) the profits of the S corporation generated by the business 
activities of a specific individual are accumulated and held for the 
benefit of that individual in a QSUB or similar entity (such as a 
limited liability company), (iii) these profits are not paid to the 
individual as compensation within 2\1/2\ months after the end of the 
year in which earned, and (iv) the individual has rights to acquire 
shares of stock (or similar interests) of the QSUB or similar entity 
representing 50 percent or more of the fair market value of the stock 
of such QSUB or similar entity. Rev. Rul. 2004-4 also provides that 
such individual's right to acquire shares of stock (or similar 
interests) of the QSUB or similar entity is synthetic equity. 
Accordingly, Rev. Rul. 2004-4 holds in each of the three factual 
situations that, for purposes of sections 409(p) and 4979A, certain 
individuals are disqualified persons, the ESOP has a nonallocation 
year, and the disqualified persons are treated as owning synthetic 
equity in the form of their options to acquire shares of the 
corresponding QSUB.\1\
---------------------------------------------------------------------------

    \1\ Rev. Rul. 2004-4 also states that arrangements that are the 
same as, or substantially similar to, the following transaction are 
identified as ``listed transactions'' for purposes of Sec. Sec.  
1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2), effective 
January 23, 2004: any transaction in which (i) at least 50 percent 
of the outstanding shares of an S corporation are employer 
securities held by an ESOP, (ii) the profits of the S corporation 
generated by the business activities of a specific individual are 
accumulated and held for the benefit of that individual in a QSUB or 
similar entity (such as a limited liability company), (iii) these 
profits are not paid to the individual as compensation within 2\1/2\ 
months after the end of the year in which earned, and (iv) the 
individual has rights to acquire shares of stock (or similar 
interests) of the QSUB or similar entity representing 50 percent or 
more of the fair market value of the stock of such QSUB or similar 
entity.
---------------------------------------------------------------------------

    Rev. Rul. 2004-4 also stated that Treasury and the IRS intend to 
reflect the guidance in that revenue ruling in regulations under 
section 409(p), effective for plan years ending after October 20, 2003, 
and that it is expected that the regulations would apply to similar 
transactions that have the effect of reserving profits from an 
individual's business activities to provide similar tax benefits to the 
individual, either with the use of a QSUB or through the use of another 
method.
    Comments were received on the 2003 regulations. A public hearing on 
the 2003 regulations was held on November 17, 2003. After consideration 
of comments received and views expressed at the hearing, and taking 
into account Rev. Rul. 2004-4 and that section 409(p) applies to all 
ESOPs for plan years beginning on or after January 1, 2005, these new 
temporary regulations are being issued effective generally for plan 
years that begin on or after January 1, 2005, subject to a number of 
special effective date and transition rules that are described in this 
preamble under the heading Effective date.

Explanation of Provisions

Definition of Prohibited Allocation

    In order to satisfy section 409(p), 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 
under the ESOP, or be allocated directly or indirectly under any plan 
of the employer (including the ESOP) meeting the requirements of 
section 401(a), for the benefit of any disqualified person. This 
requirement has two elements; it prohibits accruals and allocations. 
These regulations provide two new terms, impermissible accrual and 
impermissible allocation, to reflect these two elements. Under the 
regulations, if there is an impermissible accrual or an impermissible 
allocation, then there is a prohibited allocation in violation of this 
requirement.
    Under the definition of impermissible accrual in these regulations, 
there is a prohibited allocation to the extent (and only to the extent) 
that employer securities consisting of stock in an S corporation owned 
by the ESOP and any assets attributable thereto are held under the ESOP 
for the benefit of a disqualified person during a nonallocation year. 
This rule was recommended by a commentator. For this purpose, assets 
attributable to S corporation securities include not only S corporation 
stock held in a disqualified person's account in the ESOP, but also any 
distributions, within the meaning of section 1368, made on S 
corporation stock held in a disqualified person's account in the ESOP 
(including earnings thereon), plus any proceeds from the sale of S 
corporation securities held for a disqualified person's account in the 
ESOP (including any earnings thereon).
    Under the definition of impermissible allocation, prohibited 
allocations include any allocation for a disqualified person directly 
or indirectly under any plan of the employer qualified under section 
401(a) that occurs during a nonallocation year to the extent that a 
contribution or other annual addition is

[[Page 75457]]

made, or the disqualified person otherwise accrues additional benefits, 
under the ESOP or any other plan of the employer qualified under 
section 401(a) (including a release and allocation of assets from a 
suspense account, as described at Sec.  54.4975-11(c) and (d)) that, 
for the nonallocation year, would otherwise have been added to the 
account of the disqualified person under the ESOP and invested in 
employer securities consisting of stock in an S corporation owned by 
the ESOP but for a provision in the ESOP to comply with section 409(p).

Effect of a Prohibited Allocation

    Under section 409(p)(2) and these regulations, if there is a 
prohibited allocation, then the amount of the prohibited allocation is 
treated as distributed to the disqualified person at the time of the 
prohibited allocation. Accordingly, the fair market value of the 
disqualified person's account under the ESOP would generally be 
included in his or her gross income (to the extent in excess of his or 
her allocable investment in the contract, if any, under section 72). 
The additional income tax imposed by section 72(t) would also apply if 
the disqualified person is less than age 59\1/2\ (and no other 
exception applies).
    Like a deemed distribution under section 72(p),\2\ a deemed 
distribution under section 409(p) is not an actual distribution from 
the ESOP. Thus, the amount of the prohibited allocation is not an 
eligible rollover distribution and, for purposes of applying sections 
72 and 402 with respect to any subsequent distribution from the ESOP, 
the amount previously taken into account by the disqualified person as 
income as a result of the deemed distribution is treated as an 
investment in the contract.
---------------------------------------------------------------------------

    \2\ See Sec.  1.72(p)-1, Q&A-11 and 12.
---------------------------------------------------------------------------

    Under these regulations, if there is a nonallocation year and there 
are prohibited allocations in that year, the plan would fail to satisfy 
the requirements of section 4975(e)(7) and would cease to be an ESOP. 
As a result, not only would the plan lose the prohibited transaction 
exemption for loans to an ESOP under section 4975(d)(3) of the Code and 
section 408(b)(3) of Title I of the Employee Retirement Income Security 
Act of 1974, as amended (ERISA), but also the exception in section 
512(e)(3) would cease to apply to the plan, so that the plan would owe 
income tax as a result of unrelated business taxable income under 
section 512 with respect to S corporation stock held by the plan from 
and after the date of the prohibited allocation. \3\ Other consequences 
include imposition of an excise tax under section 4979A and, assuming 
that the plan's provisions do not permit a prohibited allocation under 
section 409(p), loss of tax qualification for failure to operate the 
plan in accordance with its terms.
---------------------------------------------------------------------------

    \3\ It should be noted that transactions that give rise to loss 
of the prohibited transaction exemptions under section 4975(d)(3) of 
the Internal Revenue Code and section 408(b)(3) of Title I of ERISA 
for loans to an ESOP could also give rise to other prohibited 
transactions under section 4975 of the Internal Revenue Code, as 
well as violations of Title I of ERISA, including prohibited 
transactions under section 406 of Title I of ERISA, resulting in, 
among other things, the assessment of additional excise taxes under 
section 4975(a) and (b) of the Internal Revenue Code, as well as 
civil penalties under section 502(i) of ERISA.
---------------------------------------------------------------------------

Prevention of a Nonallocation Year

    As part of the regulations that were proposed in 2003, comments 
were requested with respect to issues raised by S corporation ESOPs 
established by March 14, 2001, that will need to comply with the 
requirements of section 409(p) beginning in 2005, including transition 
approaches for ESOPs that become subject to section 409(p) in 2005. One 
commentator requested a transition rule under which nonqualified 
deferred compensation would be disregarded if it was granted at a time 
when it was not synthetic equity and was distributed within 12 months 
after it became synthetic equity.
    These issues are particularly important because compliance with the 
requirements of section 409(p) is required on a current operational 
basis, as well as a plan document basis. Thus, for example, if S 
corporation shares are held in a disqualified person's account during a 
nonallocation year, then there is a failure to satisfy section 409(p), 
without regard to whether the terms of the ESOP prohibit such actions 
or require preventative action to be taken. Factors that might be 
considered in determining whether there has been a failure to comply 
with the requirements of section 409(p) on a current operational basis 
include, for example, the exercise of voting rights of shares in the 
disqualified person's account, distributions from the S corporation to 
the disqualified person's account, and plan account statements showing 
allocations to the disqualified person's account.
    A plan might choose to take a number of steps before the beginning 
of a year in order to ensure that the year is not a nonallocation year, 
such as steps to prevent an individual from becoming a disqualified 
person. These include:
     Reduction of synthetic equity, e.g., by cancellation or 
distribution of the synthetic equity.
     A sale of the S corporation securities held in the 
participant's ESOP account so that the account is not invested in S 
corporation stock.
     A distribution of the S corporation securities held in the 
participant's account from the ESOP to the participant. Such a 
distribution is only permissible to the extent the amount is otherwise 
permitted to be distributed (e.g., for amounts that are subject to 
section 401(k), the distribution does not violate the distribution 
restrictions of section 401(k)(2)(B)(i)).
     A transfer of the S corporation securities held for the 
participant under the ESOP into a separate portion of the plan that is 
not an ESOP (as permitted under Sec.  54.4975-11(a)(5) of the Excise 
Tax Regulations) or to another qualified plan of the employer that is 
not an ESOP.
    Any of these steps must satisfy applicable legal and qualification 
requirements, including the nondiscrimination requirements of section 
401(a)(4).\4\ These regulations provide that, if a transfer is made 
from an ESOP to a separate portion of the plan or to another qualified 
plan of the employer that is not an ESOP in order to prevent a 
nonallocation year, then both the ESOP and the plan that is not an ESOP 
will not fail to satisfy the requirements of Sec.  1.401(a)(4)-4 merely 
because of the transfer. Further, subsequent to the transfer, the plan 
that is not an ESOP will not fail to satisfy the requirements of Sec.  
1.401(a)(4)-4 merely because of the benefits, rights, or features with 
respect to the transferred benefits if those benefits, rights, or 
features would satisfy the requirements of Sec.  1.401(a)(4)-4 if the 
mandatory disaggregation rule for ESOPs at Sec.  1.410(b)-7(c)(2) did 
not apply.
---------------------------------------------------------------------------

    \4\ Further, any sale or transfer of plan assets must comply 
with the requirements of part 4 of subtitle B of title I of ERISA.
---------------------------------------------------------------------------

    In the event of such a transfer, the transferee plan would be 
subject to tax on unrelated business taxable income with respect to its 
pro rata share of income from the S corporation securities, with that 
expense to be charged to the account holding the transferred amount. 
However, the ESOP would be able to continue to satisfy the requirements 
of section 4975(e)(7) and the allocations could be made for the 
participant for the year.

Determination of Nonallocation Year

    Under section 409(p), a nonallocation year generally means a plan 
year during

[[Page 75458]]

which on any date disqualified persons own 50 percent or more of the 
stock in the S corporation, separately applied by taking into account 
all outstanding shares of stock in the S corporation (including shares 
held by the ESOP) and by taking into account all outstanding shares of 
stock in the S corporation and synthetic equity. These regulations 
include some changes from the rules in the 2003 regulations for 
purposes of determining whether there is a nonallocation year.
    The 2003 regulations generally treat a person as owning outstanding 
non-ESOP stock that the person has the right to acquire, but only in 
very limited cases. These regulations treat a person as owning 
outstanding non-ESOP stock that the person has the right to acquire 
unless the actual owner is a person who is subject to Federal income 
tax, the right is one that would not be taken into account in 
determining whether an S corporation has a second class of stock under 
Sec.  1.1361-1(l)(2)(iii) or (l)(4)(iii)(C), and a principal purpose of 
the right is not to avoid or evade a nonallocation year under section 
409(p).
    Other differences from the 2003 regulations include a change 
relating to synthetic equity (discussed in this preamble under the 
heading Determination of disqualified persons on person-by-person 
basis) and, in response to comments, clarification that, if any share 
is treated as owned by more than one person, then that share is counted 
as a single share and that share is treated as owned by disqualified 
persons if any of the owners is a disqualified person.

Determination of Disqualified Persons on Person-by-Person Basis

    Under the 2003 regulations, a person's synthetic equity shares are 
added to his or her deemed-owned ESOP shares to determine whether he or 
she is a disqualified person. This total number of shares is then 
compared with the total outstanding synthetic equity shares in 
determining whether that person is a disqualified person. The 2003 
regulations were criticized for this approach in the case of options 
because it allowed options held by other shareholders to dilute the 
interests of the person being tested and prevent them from being 
treated as a disqualified person.
    These regulations change this approach by looking only at the 
synthetic equity of the person being tested to determine if he or she 
is a disqualified person. In addition, a nonallocation year occurs as a 
result of synthetic equity if the total share ownership of disqualified 
persons (actual ownership, deemed-owned ESOP shares, plus synthetic 
equity) is at least 50 percent of the total shares outstanding plus the 
synthetic equity of disqualified persons. This `person-by-person 
approach' is more consistent with the statutory rule that synthetic 
equity is counted for one person if it results in any person being 
treated as a disqualified person.
    The person-by-person approach applies to synthetic equity in the 
form of nonqualified deferred compensation, as well as in the form of 
options or other rights related to stock. This approach prevents 
dilution of the disqualified person's ownership and also addresses a 
known abuse identified by several commentators involving stock options 
or stock appreciation rights that are unlikely to be exercised. In this 
abuse, the S corporation issues a large number of stock options or 
stock appreciation rights to lower paid employees which are only 
exercisable at a strike price far exceeding even the likely future 
value of the shares or the strike price is periodically reset to exceed 
the expected value during the term of the option or right. These 
options or rights would never be exercised by the employees, but are 
designed to count as synthetic equity shares in order to prevent 
shareholders who actually have the right to own 10 percent or more of 
the S corporation from being treated as disqualified persons. Several 
commentators urged Treasury and the IRS to prevent this abuse. Under 
the person-by person approach adopted in these regulations, these 
options or rights would be ignored in determining whether other 
shareholders were disqualified persons and would not prevent persons 
who have actual rights to become 10 percent shareholders from being 
treated as disqualified persons.

Synthetic Equity

    These regulations are generally similar to the 2003 regulations 
regarding what constitutes synthetic equity. Differences include the 
expansion of the definition of synthetic equity to include the right to 
acquire stock or assets of a related entity and an exclusion for 
nonqualified deferred compensation that was taken into account before 
January 1, 2005, for purposes of the Federal Insurance Contributions 
Act (FICA) and that was outstanding before the first date on which the 
ESOP acquired any employer securities.

Determination of Number of Shares of Synthetic Equity

    The 2003 regulations include rules under which the number of 
synthetic equity shares attributed for a stock option is based on the 
number of shares that are subject to that option. The same rule also 
applies to any other synthetic equity that is determined by reference 
to shares of stock of the S corporation but for which payment is made 
in cash or other property. These regulations provide that in the case 
of synthetic equity determined by reference to shares of stock in the S 
corporation, the number of shares of synthetic equity depends on the 
gross number of shares deliverable pursuant to the synthetic equity. In 
the case of synthetic equity determined by reference to S corporation 
shares but payable in cash or other property (other than S corporation 
shares), the number of synthetic equity shares treated as owned is 
equal to the number of shares of stock having a fair market value equal 
to the cash or other property paid (disregarding lapse restrictions as 
described in Sec.  1.83-3(i)). Accordingly, the number of shares of 
synthetic equity attributed for a stock appreciation right (payable in 
stock or in cash) equals the number of shares having a value equal to 
the appreciation at the time of measurement (determined without regard 
to lapse restrictions).
    In addition, the 2003 regulations provide that rights to acquire 
stock or interests in an entity related to the S corporation are 
treated as synthetic equity if the interests in the related entity are 
the only significant assets of the S corporation and the S corporation 
is the only significant owner of the related entity. These regulations 
broaden that rule by providing that synthetic equity includes all 
rights to acquire stock or similar interests in a related entity to the 
extent of the S corporation's ownership. The regulations provide that 
synthetic equity also includes a right to acquire assets of an S 
corporation or a related entity other than either rights to acquire 
goods, services, or property at fair market value in the ordinary 
course of business or fringe benefits excluded from gross income under 
section 132.
    In the case of synthetic equity that is not determined by reference 
to shares of stock of the S corporation (or shares of stock or similar 
interests in a related entity), the 2003 regulations provided that 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 under the section 83 
regulations) divided by the fair market value of a share of the S 
corporation's stock as of the same date. These regulations include a 
similar rule,

[[Page 75459]]

but include three rules that were not in the 2003 regulations.
    First, these regulations include a special rule with respect to 
voting rights. While sections 409(l) and 4975(e)(7) generally require 
that the employer securities of an ESOP have voting rights at least 
equal to the voting rights of that class of common stock having the 
greatest voting rights (assuming the employer has no stock readily 
traded on an established securities market), there might be rights to 
acquire a class of shares that are not currently outstanding and that 
have greater voting rights. Under these regulations, if a synthetic 
equity right includes (directly or indirectly) a right to purchase or 
receive shares of S corporation stock that have per-share voting rights 
greater than the per-share voting rights of one or more shares of S 
corporation stock held by the ESOP, then the number of shares of deemed 
owned synthetic equity attributable to such right is at least equal to 
the number of shares that would have the same voting rights if such 
shares had the same per-share voting rights as shares held by the ESOP.
    Second, like the 2003 regulations, these regulations permit the 
number of synthetic equity shares for nonqualified deferred 
compensation (that is not determined by reference to shares of stock of 
the S corporation or shares of stock or similar interests in a related 
entity) 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 ESOP for this purpose for all persons. 
These regulations require that the date used be reasonably 
representative of the share value of the S corporation's stock. 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. In addition, these regulations 
include a new rule intended to address concerns expressed in the 
comments regarding administrative and planning difficulties that arise 
from a daily, or even annual, determination of synthetic equity shares 
where the number is affected both by the potential volatility of the S 
corporation stock value and separately by the potential volatility of 
the nonqualified deferred compensation. Under these regulations, the 
ESOP may provide, on a reasonable and consistent basis used by the ESOP 
for this purpose for all persons, that the number of shares of 
synthetic equity treated as owned on an identified determination date 
remain constant for the period from that determination date until the 
date that is immediately preceding the third anniversary of the 
identified determination date. As new grants are made during this 
three-year period, the appropriate number of shares of synthetic equity 
resulting from the new grant would be determined at the next 
determination date, which would likewise remain constant during the 
remainder of the same three-year period. However, the ESOP must 
recalculate the number of shares of this type of synthetic equity at 
least every three years, based on the S corporation share value on the 
applicable determination date and the aggregate present value of 
nonqualified deferred compensation on that determination date. The 
regulations include an example illustrating this rule.
    Third, these regulations include a new rule for cases in which the 
ESOP does not own all of the stock of the S corporation. This rule 
reflects the view that the dilutive effect of synthetic equity only 
affects an ESOP to the extent of the ESOP's ownership interest in the S 
corporation. Under this rule, the number of synthetic shares otherwise 
determined is reduced ratably to the extent that shares of the S 
corporation are owned by a person who is not an ESOP (and who is 
subject to Federal income taxes). For example, if an S corporation has 
200 outstanding shares, of which individual A owns 50 shares and the 
ESOP owns the other 150 shares, and individual B would be treated as 
owning 200 synthetic equity shares of the S corporation but for the 
special rule for cases in which the ESOP does not own all of the stock 
of the S corporation, then the number of synthetic shares treated as 
owned by B is decreased from 200 to 150 (because the ESOP only owns 75% 
of the outstanding stock of the S corporation, rather than 100%).

Avoidance or Evasion of Section 409(p)

    These regulations include a standard for determining whether the 
principal purpose of the ownership structure of an S corporation 
involving synthetic equity constitutes an avoidance or evasion of 
section 409(p). Under this standard, whether the principal purpose of 
the ownership structure of an S corporation involving synthetic equity 
constitutes an avoidance or evasion of section 409(p) is determined by 
taking into account all the surrounding facts and circumstances. An 
avoidance or evasion of section 409(p) does not occur where the ESOP 
receives the economic benefits of ownership in the S corporation, 
taking into account all features of the ownership of the S 
corporation's outstanding stock and related obligations (including 
synthetic equity), any shareholders who are taxable entities, and the 
rights of the ESOP, to determine whether, to the extent of the ESOP's 
stock ownership, the ESOP receives the economic benefits of ownership 
in the S corporation that occur during the period that stock of the S 
corporation is owned by the ESOP. Among the factors indicating that the 
ESOP receives these economic benefits include shareholder voting 
rights, the right to receive distributions made to shareholders, and 
the right to benefit from the profits earned by the S corporation, 
including the extent to which actual distributions of profits are made 
from the S corporation to the ESOP and the extent to which the ESOP's 
ownership interest in undistributed profits and future profits is 
subject to dilution as a result of synthetic equity, for example, the 
ESOP's ownership interest is not subject to dilution if the total 
amount of synthetic equity is a relatively small portion of the total 
number of shares and deemed-owned shares of the S corporation.
    This standard is promulgated pursuant to the authority of Treasury 
and the IRS to act promptly to issue guidance to prevent ownership 
structures that deny an ESOP the economic benefits of ownership and, in 
addition, these regulations identify certain specific ownership 
structures that constitute an avoidance or evasion of section 409(p). 
Specifically, the regulations identify the transactions described in 
Rev. Rul. 2004-4 as being an avoidance or evasion of section 409(p) and 
provide that there is a nonallocation year not only in the situations 
described in the revenue ruling but also in situations in which profits 
are segregated using a method other than QSUBs. Under the regulations, 
the principal purpose of the ownership structure of an S corporation 
constitutes an avoidance or evasion of section 409(p), and a 
nonallocation year results, in any case in which (i) the profits of the 
S corporation generated by the business activities of a specific 
individual or individuals are substantially accumulated and held for 
the benefit of that individual or individuals on a tax-deferred basis 
within an entity related to the S corporation, such as a partnership, 
trust, or corporation (such as in a subsidiary that is a disregarded 
entity), or through any other method that has the same effect of 
segregating profits for the

[[Page 75460]]

benefit of such individual or individuals (such as nonqualified 
deferred compensation), (ii) the individual or individuals for whom 
profits are segregated have rights to acquire 50 percent or more of 
those profits directly or indirectly (for example, by purchase of the 
subsidiary), and (iii) a nonallocation year would occur if this section 
were separately applied with respect to either the separate entity or 
whatever method has the effect of segregating profits of the individual 
or individuals, treating such entity as a separate S corporation owned 
by an ESOP (or in the case of any other method of segregation of 
profits by treating those profits as the only assets of a separate S 
corporation owned by an ESOP). This conclusion both reflects the 
holding in Rev. Rul. 2004-4 (discussed in this preamble under the 
heading Background) and treats similar transactions as resulting in a 
nonallocation year, as Rev. Rul. 2004-4 indicated would be reflected in 
these regulations.

Effective Dates

    These temporary regulations are applicable for plan years beginning 
on or after January 1, 2005. However, there are a number of special 
effective date and transition rules.
    These regulations preserve the rules of the 2003 temporary 
regulations with respect to plan years beginning before January 1, 
2005, with the new rules in these regulations to apply thereafter. 
However, as described in this section, the rules in these regulations 
dealing with ownership structures that constitute an avoidance or 
evasion of section 409(p), including the rules relating to structures 
similar to those addressed in Rev. Rul. 2004-4, apply for plan years 
ending on or after December 31, 2004.
    Under the transition rules, ESOP shares that are held for a 
disqualified person before the first plan year beginning on or after 
January 1, 2005 will not be treated as an impermissible accrual in 2005 
if the shares are disposed of before July 1, 2005 (e.g., by 
distribution or transfer to a non-ESOP) and no amount is contributed 
for the benefit of the disqualified person under any plan of the 
employer intended to meet the requirements of section 401(a) (including 
the ESOP) during the period from the first day of the first plan year 
beginning on or after January 1, 2005 through June 30, 2005. However, 
even if no amount is allocated to a disqualified person during this 
period, but this period is part of the first nonallocation year of the 
ESOP, an excise tax will apply under section 4979A with respect to 
either ESOP shares held for a disqualified person or synthetic equity 
that is treated as owned under these regulations on the first day of 
the plan year, regardless of whether there is an impermissible accrual 
or impermissible allocation. See section 4979A(a)(3), (a)(4), and 
(e)(2)(C).
    Under another transition rule, the new person-by-person rules in 
these regulations on how to determine whether a person is a 
disqualified person and whether a year is a nonallocation year 
generally do not go into effect until July 1, 2005. However, comments 
indicated that the 2003 regulations could be easily avoided or evaded 
by granting options or stock appreciation rights with artificially high 
strike prices or where the strike price is periodically increased to 
exceed the expected value before the option or right is to expire. 
Thus, with respect to the period from (and including) December 31, 2004 
through June 30, 2005, the new rules apply to plans under which a 
nonallocation year would occur under the 2003 temporary regulations if 
synthetic equity were to exclude stock options, stock appreciation 
rights, or similar rights to acquire shares of the S corporation or a 
related entity where the facts and circumstances indicate that there is 
no reasonable likelihood that the holder of the right will receive the 
shares (or equivalent value), e.g., cases in which the option is based 
on an exercise price that is more than 200% of the fair market value of 
the shares on the date of grant or a stock appreciation right is 
payable only if the appreciation exceeds 100% of the fair market value 
of the shares on the date of grant. This special rule applies for plan 
years ending on or after December 31, 2004 in order to ensure that an 
employer cannot avoid or evade the purposes of section 409(p)--even for 
the calendar year 2004--by using artificial grants that are unlikely to 
ever be paid.
    Under a third transition rule, the new rules in these regulations, 
including the rules relating to the right to receive shares with 
disproportional voting rights, do not go into effect until July 1, 
2005, if there would be no prohibited allocation before then under 
these regulations if the new rules in these regulations relating to the 
right to receive shares with disproportional voting rights were 
disregarded.
    Further, the IRS will permit plans to rely on the exception for 
pre-ESOP nonqualified deferred compensation for periods before January 
1, 2005, (described in this preamble under the heading Synthetic 
Equity).

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
Paragraph 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
Par. 2. Section 1.409(p)-1T is revised to read as follows:


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

    (a) Organization of this section. Section 409(p) applies 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 an S 
corporation, as defined in section 1361, 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 any 
accrual or allocation to a disqualified person in a nonallocation year. 
Paragraph (c) of this section sets forth rules under section

[[Page 75461]]

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 
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). Paragraph (g) of this section contains a standard for 
determining when the principal purpose of the ownership structure of an 
S corporation constitutes an avoidance or evasion of section 409(p). 
The definitions used in section 409(p) and this section are also 
applicable for purposes of section 4979A, which imposes an excise tax 
on certain events, including a nonallocation year under section 409(p).
    (b) Prohibited allocation 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 under the ESOP, or be allocated 
directly or indirectly under any plan of the employer (including the 
ESOP) meeting the requirements of section 401(a), for the benefit of 
any disqualified person (a prohibited allocation).
    (2) Additional rules--(i) Prohibited allocation definition. For 
purposes of section 409(p)(2)(A) and paragraph (b)(1) of this section, 
there is a prohibited allocation (i.e., assets accrue or are allocated 
as prohibited under paragraph (b)(1) of this section) if there is 
either an impermissible accrual as defined in paragraph (b)(2)(ii) of 
this section or an impermissible allocation as defined in paragraph 
(b)(2)(iii) of this section. The amount of the prohibited allocation is 
equal to the sum of the impermissible accrual plus the amount of the 
impermissible allocation (if any).
    (ii) Impermissible accrual. There is an impermissible accrual to 
the extent (and only to the extent) that employer securities consisting 
of stock in an S corporation owned by the ESOP and any assets 
attributable thereto are held under the ESOP for the benefit of a 
disqualified person during a nonallocation year. For this purpose, 
assets attributable to S corporation securities include any 
distributions, within the meaning of section 1368, made on S 
corporation stock held in a disqualified person's account in the ESOP 
(including earnings thereon), plus any proceeds from the sale of S 
corporation securities held for a disqualified person's account in the 
ESOP (including any earnings thereon). Thus, for example, in the event 
of a nonallocation year, all S corporation shares and all other ESOP 
assets attributable to S corporation stock, including distributions, 
sales proceeds, and earnings on either the distribution or proceeds, 
held for the account of such disqualified person in the ESOP during 
that year are an impermissible accrual for the benefit of that person, 
whether attributable to contributions in the current year or in prior 
years.
    (iii) Impermissible allocation. An impermissible allocation means 
any allocation for a disqualified person directly or indirectly under 
any plan of the employer qualified under section 401(a) that occurs 
during a nonallocation year to the extent that a contribution or other 
annual addition is made, or the disqualified person otherwise accrues 
additional benefits, under the ESOP or any other plan of the employer 
qualified under section 401(a) (including a release and allocation of 
assets from a suspense account, as described at Sec.  54.4975-11(c) and 
(d) of this chapter) that, for the nonallocation year, would otherwise 
have been added to the account of the disqualified person under the 
ESOP and invested in employer securities consisting of stock in an S 
corporation owned by the ESOP but for a provision in the ESOP to comply 
with section 409(p).
    (iv) Effects of prohibited allocation--(A) Deemed distribution. If 
there is a prohibited allocation, the amount of the prohibited 
allocation, as determined under this paragraph (b)(2), is treated as 
distributed from the ESOP (or other plan of the employer) to the 
disqualified person on the first day of the plan year on which there is 
an impermissible accrual or on the date of the allocation in the case 
of an additional impermissible accrual or impermissible allocation 
during the plan year but after the first day of the plan year. Thus, 
the fair market value of assets in the disqualified person's account 
that constitutes an impermissible accrual or allocation is included in 
gross income (to the extent in excess of any investment in the contract 
allocable to such amount) and is subject to any additional income tax 
that applies under section 72(t). A deemed distribution under this 
paragraph (b)(2)(iv)(A) is not an actual distribution from the ESOP. 
Thus, the amount of the prohibited allocation is not an eligible 
rollover distribution under section 402(c). However, for purposes of 
applying sections 72 and 402 with respect to any subsequent 
distribution from the ESOP, the amount that the disqualified person 
previously took into account as income as a result of the deemed 
distribution is treated as an investment in the contract.
    (B) Other effects. If there is a prohibited allocation, then the 
plan fails to satisfy the requirements of section 4975(e)(7) and ceases 
to be an ESOP. In such a case, the exemption from the excise tax on 
prohibited transactions for loans to leveraged ESOPs contained in 
section 4975(d)(3) would cease to apply to any loan (with the result 
that the employer would owe an excise tax with respect to the 
previously exempt loan) and, further, the exception in section 
512(e)(3) would not apply to the plan (with the result that the plan 
may owe income tax as a result of unrelated business taxable income 
under section 512 with respect to S corporation stock held by the 
plan). See also section 4979A(a) which imposes an excise tax in certain 
events, including a prohibited allocation under section 409(p).
    (v) Prevention of prohibited allocation.--(A) Transfer of account 
to non-ESOP. An ESOP may prevent a nonallocation year or a prohibited 
allocation during a nonallocation year by permitting assets (including 
S corporation securities) allocated to the account of a disqualified 
person (or a person reasonably expected to become a disqualified person 
absent a transfer described in this paragraph (b)(2)(v)(A)) to be 
transferred into a separate portion of the plan that is not an ESOP, as 
described in Sec.  54.4975-11(a)(5) of this chapter, or to another plan 
of the employer that satisfies the requirements of section 401(a) (and 
that is not an ESOP). In the event of such a transfer involving S 
corporation securities, the recipient plan is subject to tax on 
unrelated business taxable income under section 512.
    (B) Relief from nondiscrimination requirement. Pursuant to this 
paragraph (b)(2)(v)(B), if a transfer described in paragraph 
(b)(2)(v)(A) of this section is made from an ESOP to a separate portion 
of the plan or to another qualified plan of the employer that is not an 
ESOP, then both the ESOP and the plan or portion of a plan that is not 
an ESOP will not fail to satisfy the requirements of Sec.  1.401(a)(4)-
4 merely because of the transfer. Further, subsequent to the transfer, 
that plan will not fail to satisfy the requirements of Sec.  
1.401(a)(4)-4 merely because of the benefits, rights, or features with 
respect to the transferred benefits if those

[[Page 75462]]

benefits, rights, or features would satisfy the requirements of Sec.  
1.401(a)(4)-4 if the mandatory disaggregation rule for ESOPs at Sec.  
1.410(b)-7(c)(2) did not apply.
    (c) Nonallocation year--(1) Definition generally. For purposes of 
section 409(p) and this section, 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 sum of:
    (A) The outstanding shares of stock in the S corporation (including 
deemed-owned ESOP shares), plus
    (B) The shares of synthetic equity in the S corporation owned by 
disqualified persons.
    (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 (f)(1) of this 
section apply, then the rules of paragraph (f)(1) of this section are 
applied before the rules of this paragraph (c)(2).
    (3) Special rule for avoidance or evasion. (i) The ownership 
structures described in paragraph (g)(3) of this section result in a 
nonallocation year. In addition, under the ownership structures 
described in paragraph (g)(3) of this section, the individual referred 
to in paragraph (g)(3) of this section is treated as a disqualified 
person and that person's interest in the separate entity is treated as 
synthetic equity.
    (ii) 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. See paragraph (g) of this 
section for guidance regarding when the principal purpose of an 
ownership structure of an S corporation involving synthetic equity 
constitutes an avoidance or evasion of section 409(p).
    (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 right is 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)(3) of this section).
    (ii) This paragraph (c)(4) applies only if treating persons as 
owning the shares described in paragraph(c)(4)(i) of this section 
results in a nonallocation year. This paragraph (c)(4) does not apply 
to a right to acquire stock of an S corporation held by a shareholder 
subject to Federal income tax 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 provided that a principal 
purpose of the right is not the avoidance or evasion of section 409(p). 
Under the last sentence of paragraph (f)(2)(i) of this section, this 
paragraph (c)(4)(ii) does not apply for purposes of determining 
ownership of deemed-owned ESOP shares or whether an interest 
constitutes synthetic equity.
    (5) Application with respect to shares treated as owned by more 
than one person. For purposes of applying paragraph (c)(1) of this 
section, if, by application of the rules of paragraph (c)(2), (c)(4), 
or (f)(1) of this section, any share is treated as owned by more than 
one person, then that share is counted as a single share and that share 
is treated as owned by disqualified persons if any of the owners is a 
disqualified person.
    (6) Effect of nonallocation year. See paragraph (b) of this section 
for a prohibition applicable during a nonallocation year. See also 
section 4979A for an excise tax applicable in certain cases, including 
section 4979A(a)(3) and (4) which applies during a nonallocation year 
(whether or not there is a prohibited allocation during the year).
    (d) Disqualified persons--(1) General definition. For purposes of 
section 409(p) and this section, a disqualified person means any person 
for whom--
    (i) The number of such person's deemed-owned ESOP shares of the S 
corporation is at least 10 percent of the number of the deemed-owned 
ESOP shares of the S corporation;
    (ii) The aggregate number of such person's deemed-owned ESOP shares 
and synthetic equity shares of the S corporation is at least 10 percent 
of the sum of:
    (A) The total number of deemed-owned ESOP shares, and
    (B) The person's synthetic equity shares of the S corporation;
    (iii) The aggregate number of the S corporation's 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 the S corporation's 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 sum of:
    (A) The total number of deemed-owned ESOP shares, and
    (B) The synthetic equity shares of the S corporation owned by such 
person and the members of such person's family.
    (2) Treatment of family members; definition--(i) Rule. 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.
    (ii) General definition. For purposes of section 409(p) and this 
section, 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)(B) or (C) of this section.
    (iii) Spouse. 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 under paragraph 
(d)(2)(ii)(A) of this section.
    (iv) Attribution rules. For purposes of this paragraph (d), 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

[[Page 75463]]

include members of the individual's family under paragraph (d)(2)(ii) 
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 (f)(1) of this section apply, then the rules of 
paragraph (f)(1) of this section are applied before the rules 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 special rules permitting certain persons to be treated as 
disqualified persons in certain nonallocation years.
    (4) Example. The rules of this paragraph (d) are illustrated by the 
following example:

    Example. (i) Facts. An S corporation has 800 outstanding shares 
of which 100 are owned by individual O and 700 are held in an 
employee stock ownership plan (ESOP) during 2005, including 200 
shares held in the ESOP account of O, 65 shares held in the ESOP 
account of participant P, and 40 shares held in the ESOP account of 
participant Q who is P's spouse. The S corporation has no synthetic 
equity.
    (ii) Conclusion. O is a disqualified person during 2005 because 
O's account in the ESOP holds at least 10 percent of the shares 
owned by the ESOP (200 is 28.6 percent of 700). In addition, P is a 
disqualified person during 2005 because, under paragraph (d)(2) of 
this section, P is treated as owning the shares held by Q and P's 
total deemed-owned shares are thus at least 10 percent of the shares 
owned by the plan (65 plus 40 is more than 10 percent of 700). In 
addition, Q is a disqualified person as a result of the rules in 
paragraph (d)(2) of this section. As a result, disqualified persons 
own at least 50 percent of the outstanding shares of the S 
corporation during 2005 (O's 100 directly owned shares, O's 200 
deemed-owned shares, P's 65 deemed-owned shares, plus Q's 40 deemed 
owned shares are 50.6 percent of 800).

    (e) Deemed-owned ESOP shares. For purposes of section 409(p) and 
this section, 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 shares released and allocated from a suspense 
account, as described at Sec.  54.4975-11(c) and (d) of this chapter, 
under the ESOP for the most recently ended plan year for which there 
were shares released and allocated from a suspense account, or if there 
has been no such prior release and allocation from a suspense account, 
then determined in proportion to a reasonable estimate of the shares 
that would be released and allocated in the first year of loan 
repayment).
    (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 (who are 
subject to federal income taxes) 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, such as 
appreciation in such value. Thus, synthetic equity includes 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 interests in or assets of an S corporation 
or a related entity. Synthetic equity includes a right to acquire stock 
or other similar interests in a related entity to the extent of the S 
corporation's ownership. Synthetic equity also includes a right to 
acquire assets of an S corporation or a related entity other than 
either rights to acquire goods, services, or property at fair market 
value in the ordinary course of business or fringe benefits excluded 
from gross income under section 132.
    (iv) Special rule for nonqualified deferred compensation. (A) 
Synthetic equity also includes any of the following with respect to an 
S corporation or a related entity: any remuneration to which section 
404(a)(5) applies; 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 (including a 
payment to a trust described in section 402(b) or to an annuity 
described in section 403(c)) in a future year for the performance of 
services; any transfer of property (to which section 83 applies) in 
connection with the performance of services 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; and a split-
dollar life insurance arrangement under Sec.  1.61-22(b) entered into 
in connection with the performance of services (other than one under 
which, at all times, the only economic benefit that will be provided 
under the arrangement is current life insurance protection as described 
in Sec.  1.61-22(d)(3)). Synthetic equity also includes any other 
remuneration for services 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. However, synthetic 
equity does not include benefits under a plan that is an eligible 
retirement plan within the meaning of section 402(c)(8)(B).
    (B) For purposes of applying paragraph (f)(2)(iv)(A) of this 
section with respect to an ESOP, synthetic equity does not include any 
interest described in such paragraph (f)(2)(iv)(A) of this section to 
the extent that--
    (1) The interest is nonqualified deferred compensation (within the 
meaning of section 3121(v)(2)) that was outstanding on December 17, 
2004;
    (2) The interest is an amount that was taken into account (within 
the meaning of Sec.  31.3121(v)(2)-1(d) of this chapter) prior to 
January 1, 2005, for purposes of taxation under chapter 21 of the 
Internal Revenue Code (or income attributable thereto); and
    (3) The interest was held before the first date on which the ESOP 
acquires any employer securities.
    (v) No overlap among shares of deemed-owned ESOP shares or 
synthetic equity. Synthetic equity under this paragraph (f)(2) does not 
include shares that are deemed-owned ESOP shares (or any rights with 
respect to deemed-owned ESOP shares to the extent such rights are 
specifically permitted under section 409(h)). In addition, synthetic 
equity under a specific subparagraph of this paragraph (f)(2) does not 
include anything that is

[[Page 75464]]

synthetic equity under paragraph (f)(2)(i), (ii), (iii) or (iv) of this 
section.
    (3) Related entity. For purposes of this paragraph (f), 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).
    (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 
number of shares of stock deliverable pursuant to such synthetic 
equity. In the case of synthetic equity that is determined by reference 
to shares of stock of the S corporation, but for which payment is made 
in cash or other property (besides stock of the S corporation), the 
number of shares of synthetic equity treated as owned is equal to the 
number of shares of stock having a fair market value equal to the cash 
or other property (disregarding lapse restrictions as described in 
Sec.  1.83-3(i)). Where such synthetic equity is a right to purchase or 
receive S corporation shares, the corresponding number of shares of 
synthetic equity is determined without regard to lapse restrictions as 
described in Sec.  1.83-3(i) or to any amount required to be paid in 
exchange for the shares. Thus, for example, if a corporation grants an 
employee of an S corporation an option to purchase 100 shares of the 
corporation's stock, exercisable in the future only after the 
satisfaction of certain performance conditions, the employee is the 
deemed owner of 100 synthetic equity shares of the corporation as of 
the date the option is granted. If the same employee were granted 100 
shares of restricted S corporation stock (or restricted stock units), 
subject to forfeiture until the satisfaction of performance or service 
conditions, the employee would likewise be the deemed owner of 100 
synthetic equity shares from the grant date. However, if the same 
employee were granted a stock appreciation right with regard to 100 
shares of S corporation stock (whether payable in stock or in cash), 
the number of synthetic equity shares the employee is deemed to own 
equals the number of shares having a value equal to the appreciation at 
the time of measurement (determined without regard to lapse 
restrictions).
    (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--(A) General rule. In the case of any 
synthetic equity to which neither paragraph (f)(4)(i) nor paragraph 
(f)(4)(ii) of this section apply, the person who is entitled to the 
synthetic equity is treated as owning on any date a number of shares of 
stock in the S corporation equal to the present value (on that date) 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 that date.
    (B) Special rules--(1) Use of annual or more frequent determination 
dates. For purposes of this paragraph (f)(4)(iii), while the 
determination of whether there is a nonallocation year depends on day-
by-day determinations under paragraph (c) of this section, the number 
of shares of S corporation stock treated as owned by a person who is 
entitled to synthetic equity to which this paragraph (f)(4)(iii) 
applies is permitted to be determined only annually (or more 
frequently), as of the first day of the ESOP's plan year or as of any 
other reasonable determination date or dates during a plan year. If the 
ESOP so provides, the number of shares of synthetic equity to which 
this paragraph (f)(4)(iii) applies that are treated as owned by that 
person for any period from a given determination date through the date 
immediately preceding the next following determination date is the 
number of shares treated as owned on the given determination date.
    (2) Use of triannual recalculations. In addition, if the terms of 
the ESOP so provide, then the number of shares of synthetic equity with 
respect to grants of synthetic equity to which this paragraph 
(f)(4)(iii) applies may be fixed for a specified period from a 
determination date identified under the ESOP through a date that is not 
later than the day before the determination date that is on or 
immediately preceding the third anniversary of the identified 
determination date. Additional accruals, allocations, or grants (to 
which this paragraph (f)(4)(iii) applies) that are made during such 
three-year period are taken into account on each determination date 
during that period, based on the number of synthetic equity shares 
resulting from the additional accrual, allocation, or grant (determined 
as of the determination date on or next following the date of the 
accrual, allocation, or grant). However, the ESOP must provide for the 
number of shares of synthetic equity to which this paragraph 
(f)(4)(iii) applies to be re-determined not less frequently than every 
three years, based on the S corporation share value on a determination 
date that is not later than the third anniversary of the identified 
determination date and the aggregate present value of the synthetic 
equity to which this paragraph (f)(4)(iii) applies (including all 
grants made during the three-year period) on that determination date. 
See Example 3 of paragraph (h) of this section for an example 
illustrating this paragraph (f)(4)(iii)(B)(2).
    (3) Conditions for application of rules. Paragraph (f)(4)(iii)(B) 
of this section only applies with respect to grants of synthetic equity 
to which this paragraph (f)(4)(iii) applies. In addition, paragraph 
(f)(4)(iii)(B)(1) of this section applies only if the fair market value 
of a share of the S corporation securities on any determination date is 
not unrepresentative of the value of the S corporation securities 
throughout the rest of the plan year and only if the terms of the ESOP 
include provisions conforming to paragraph (f)(4)(iii)(B)(1) of this 
section which are consistently used by the ESOP for all persons. In 
addition, paragraph (f)(4)(iii)(B)(2) of this section applies only if 
the terms of the ESOP include provisions conforming to paragraphs 
(f)(4)(iii)(B)(1) and (2) of this section which are consistently used 
by the ESOP for all persons.
    (iv) Adjustment of number of synthetic equity shares where ESOP 
owns less than 100% of S corporation. Under this paragraph (f)(4)(iv), 
the number of synthetic shares otherwise determined under this 
paragraph (f)(4) is decreased ratably to the extent that shares of the 
S corporation are owned by a person who is not an ESOP (and who is 
subject to Federal income taxes). For example, if an S corporation has 
200 outstanding shares, of which individual A owns 50 shares and the 
ESOP owns the other 150 shares, and individual B would be treated under 
this paragraph (f)(4) as owning 200 synthetic equity shares of the S 
corporation but for this paragraph (f)(4)(iv), then, under the rule of 
this paragraph (f)(4)(iv), the number of synthetic shares treated as 
owned by B under this paragraph (f)(4) is decreased from 200 to 150 
(because the ESOP only owns 75% of the outstanding

[[Page 75465]]

stock of the S corporation, rather than 100%).
    (v) Special rule for shares with greater voting power than ESOP 
shares. Notwithstanding any other provision of this paragraph (f)(4), 
if a synthetic equity right includes (directly or indirectly) a right 
to purchase or receive shares of S corporation stock that have per-
share voting rights greater than the per-share voting rights of one or 
more shares of S corporation stock held by the ESOP, then the number of 
shares of deemed owned synthetic equity attributable to such right is 
not less than the number of shares that would have the same voting 
rights if the shares had the same per-share voting rights as shares 
held by the ESOP with the least voting rights. For example, if shares 
of S corporation stock held by the ESOP have one voting right per 
share, then an individual who holds an option to purchase one share 
with 100 voting rights is treated as owning 100 shares of synthetic 
equity.
    (g) Avoidance or evasion of section 409(p) involving synthetic 
equity--(1) General rule. Paragraph (g)(2) of this section sets forth a 
standard for determining whether the principal purpose of the ownership 
structure of an S corporation involving synthetic equity constitutes an 
avoidance or evasion of section 409(p). Paragraph (g)(3) of this 
section identifies certain specific ownership structures that 
constitute an avoidance or evasion of section 409(p). See also 
paragraph (c)(3) of this section for a rule under which the ownership 
structures in paragraph (g)(3) result in a nonallocation year for 
purposes of section 409(p).
    (2) Standard for determining when there is an avoidance or evasion 
of section 409(p) involving synthetic equity-- For purposes of section 
409(p) and this section, whether the principal purpose of the ownership 
structure of an S corporation involving synthetic equity constitutes an 
avoidance or evasion of section 409(p) is determined by taking into 
account all the surrounding facts and circumstances, including all 
features of the ownership of the S corporation's outstanding stock and 
related obligations (including synthetic equity), any shareholders who 
are taxable entities, and the cash distributions made to shareholders, 
to determine whether, to the extent of the ESOP's stock ownership, the 
ESOP receives the economic benefits of ownership in the S corporation 
that occur during the period that stock of the S corporation is owned 
by the ESOP. Among the factors indicating that the ESOP receives these 
economic benefits include shareholder voting rights, the right to 
receive distributions made to shareholders, and the right to benefit 
from the profits earned by the S corporation, including the extent to 
which actual distributions of profits are made from the S corporation 
to the ESOP and the extent to which the ESOP's ownership interest in 
undistributed profits and future profits is subject to dilution as a 
result of synthetic equity, for example, the ESOP's ownership interest 
is not subject to dilution if the total amount of synthetic equity is a 
relatively small portion of the total number of shares and deemed-owned 
shares of the S corporation.
    (3) Specific transactions that constitute an avoidance or evasion 
of section 409(p) involving segregated profits. Taking into account the 
standard in paragraph (g)(2) of this section, the principal purpose of 
the ownership structure of an S corporation constitutes an avoidance or 
evasion of section 409(p) in any case in which--
    (i) The profits of the S corporation generated by the business 
activities of a specific individual or individuals are not provided to 
the ESOP, but are instead substantially accumulated and held for the 
benefit of that individual or individuals on a tax-deferred basis 
within an entity related to the S corporation, such as a partnership, 
trust, or corporation (such as in a subsidiary that is a disregarded 
entity), or any other method that has the same effect of segregating 
profits for the benefit of such individual or individuals (such as 
nonqualified deferred compensation described in paragraph (f)(2)(iv) of 
this section);
    (ii) The individual or individuals for whom profits are segregated 
have rights to acquire 50 percent or more of those profits directly or 
indirectly (for example, by purchase of the subsidiary); and
    (iii) A nonallocation year would occur if this section were 
separately applied with respect to either the separate entity or 
whatever method has the effect of segregating profits of the individual 
or individuals, treating such entity as a separate S corporation owned 
by an ESOP (or in the case of any other method of segregation of 
profits by treating those profits as the only assets of a separate S 
corporation owned by an ESOP).
    (h) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. Relating to determination of disqualified persons and 
nonallocation year if there is no synthetic equity. (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       3  Percentage deemed-       4  Disqualified
          1  Shareholders            shares  (total of 1,000)       owned  ESOP shares             person
----------------------------------------------------------------------------------------------------------------
B.................................  330.......................  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 ESOP shares equal only 47.9% 
of the 1,200 outstanding shares of X).
    Example 2. Relating to determination of disqualified persons and 
nonallocation year if there is synthetic equity. (i) Facts. The 
facts are the same as in Example 1, except that, as shown in column 
4 of the table in this

[[Page 75466]]

example 2, individuals E and F have options to acquire 110 and 130 
shares, respectively, of the common stock of X from X:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                             5  Shareholder
                                       2  Deemed-owned  ESOP    3  Percentage deemed-     4  Options     percentage of deemed-   6  Disqualified  person
          1  Shareholders                shares  (total of        owned ESOP shares          (240)          owned ESOP plus
                                               1,000)                                                   synthetic equity shares
--------------------------------------------------------------------------------------------------------------------------------------------------------
B...................................  330....................  33.....................  ..............  .......................  Yes (col. 3).
C...................................  145....................  14.5...................  ..............  .......................  Yes (col. 3).
D...................................  75.....................  7.5....................  ..............  .......................  No.
E...................................  30.....................  3......................             110  11.1% ([30 + 91.7]       Yes (col. 5).
                                                                                                         divided by 1,091.7).
F...................................  20.....................  2......................             130  11.6% ([20 + 108.3]      Yes (col. 5).
                                                                                                         divided by 1,108.3).
Other participants..................  400 (none exceeds 10     1 or less..............  ..............  .......................  No.
                                       shares).
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (ii) Conclusion with respect to disqualified persons. Applying 
the rule of paragraph (f)(4)(iv) of this section, E's option to 
acquire 110 shares of the S corporation converts into 91.7 shares of 
synthetic equity (110 times the ratio of the 1,000 deemed-owned ESOP 
shares to the sum of the 1,000 deemed-owned ESOP shares plus the 200 
shares held outside the ESOP by A and B). Similarly, F's option to 
acquire 130 shares of the S corporation converts into 108.3 shares 
of synthetic equity (130 times the ratio of the 1,000 deemed-owned 
ESOP shares to the sum of the 1,000 deemed-owned ESOP shares plus 
the 200 shares held outside the ESOP by A and B). Accordingly, as 
shown in column 6 in the table above, individual E's synthetic 
equity shares are counted in determining whether E is a disqualified 
person for 2006, and individual F's synthetic equity shares are 
counted in determining whether F is a disqualified person for 2006, 
but the synthetic equity shares owned by any person do not affect 
the calculation for any other person's ownership of shares. 
Accordingly, individuals B, C, E, and F are disqualified persons for 
2006.
    (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, E's 
91.7 synthetic equity shares, F's 20 deemed-owned ESOP shares, plus 
F's 108.3 synthetic equity shares total 825, which equals 58.9% of 
1,400, which is the sum of the 1,200 outstanding shares of X and the 
200 shares of synthetic equity shares of X held by disqualified 
persons. Thus, 2006 is a nonallocation year for X's ESOP under 
section 409(p) because disqualified persons own at least 50% of the 
total shares of outstanding stock of X and the total synthetic 
equity shares of X held by disqualified persons. In addition, 
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, 
E's 30 deemed-owned ESOP shares, plus F's 20 deemed-owned ESOP 
shares equal 52.1% of the 1,200 outstanding shares of X.
    Example 3. Relating to determination of number of shares of 
synthetic equity. (i) Facts. Corporation Y is a calendar year S 
corporation that maintains an ESOP. Y has a single class of common 
stock, of which there are a total of 1,000 shares outstanding, all 
of which are owned by the ESOP. Y has no synthetic equity, except 
for four grants of nonqualified deferred compensation that are made 
to an individual during the period from 2005 through 2011, as set 
forth in column 2 in the following table, and the ESOP uses the 
special rules in paragraph (f)(4)(iii) of this section to determine 
the number of shares of synthetic equity owned by that individual, 
as shown in columns 4 and 5:

----------------------------------------------------------------------------------------------------------------
                                                                                   4  New shares   5  Aggregate
                                     2  Present value of     3  Share value on     of synthetic      number of
       1  Determination date        nonqualified deferred    determination date      equity on       synthetic
                                         compenstion                               determination   equity shares
----------------------------------------------------------------------------------------------------------------
January 1, 2005...................  A grant is made on     $10 per share........             100             100
                                     January 1, 2005 with
                                     a present value of
                                     $1,000. An
                                     additional grant of
                                     nonqualified
                                     deferred
                                     compensation with a
                                     present value of
                                     $775 is made on
                                     March 1, 2005.
January 1, 2006...................  An additional grant    $8 per share.........             200             300
                                     is made on December
                                     31, 2005 which has a
                                     present value of
                                     $800 on January 1,
                                     2006. The March 1,
                                     2005 grant has a
                                     present value on
                                     January 1, 2006 of
                                     $800.
January 1, 2007...................  No new grants made...  $12 per share........  ..............             300
January 1, 2008...................  An additional grant    $15 per share........             200             450
                                     is made on December
                                     31, 2007 which has a
                                     present value of
                                     $3,000 on January 1,
                                     2008. The grants
                                     made during 2005
                                     through 2007 have an
                                     aggregate present
                                     value on January 1,
                                     2008 of $3,750.
January 1, 2009...................  No new grants are      $11 per share........  ..............             450
                                     made.
January 1, 2010...................  No new grants are      $22 per share........  ..............             450
                                     made.
January 1, 2011...................  No new grants are      $20 per share........  ..............             380
                                     made. The grants
                                     made during 2005
                                     through 2008 have an
                                     aggregate present
                                     value on January 1,
                                     2011 of $7,600.
----------------------------------------------------------------------------------------------------------------

    (ii) Conclusion. The grant made on January 1, 2005, is treated 
as 100 shares until the determination date in 2008. The grant made 
on March 1, 2005, is not taken into account until the 2006 
determination date and its present value on that date, along with 
the then present value of the grant made on the preceding day, is 
treated as a number of shares that are based on the $8 per share 
value on the 2006 determination date, with the resulting number of 
shares continuing to apply until the determination date in 2008.

[[Page 75467]]

On the January 1, 2008, determination date, the grant made on the 
preceding day is taken into account at its present value of $3,000 
on January 1, 2008 and the $15 per share value on that date with the 
resulting number of shares (200) continuing to apply until the next 
determination date. In addition, on the January 1, 2008, 
determination date, the number of shares determined under other 
grants made between January 1, 2005 and December 31, 2007, must be 
revalued. Accordingly, the aggregate value of all nonqualified 
deferred compensation granted during that period is determined to be 
$3750 on January 1, 2008, and the corresponding number of shares of 
synthetic equity based on the $15 per share value is determined to 
be 250 shares on the 2008 determination date, with the resulting 
aggregate number of shares (450) continuing to apply until the 
determination date in 2011. On the January 1, 2011, determination 
date, the aggregate value of all nonqualified deferred compensation 
is determined to be $7,600 and the corresponding number of shares of 
synthetic equity based on the $20 per share value on the 2011 
determination date is determined to be 380 shares (with the 
resulting number of shares continuing to apply until the 
determination date in 2014, assuming no further grants are made).

    (i) Effective dates--(1) Statutory effective date. (i) Except as 
otherwise provided in paragraph (i)(1)(ii) of this section, section 
409(p) applies for plan years ending after March 14, 2001.
    (ii) 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, 
section 409(p) applies for plan years beginning on or after January 1, 
2005.
    (2) Regulation effective date--(i) General effective date. Except 
as otherwise provided in paragraph (i)(2)(ii) of this section, this 
section applies for plan years beginning on or after January 1, 2005.
    (ii) Rules for plan years beginning before January 1, 2005. (A) 
Except as provided in this paragraph (i)(2)(ii), Sec.  1.409(p)-1T as 
in effect prior to December 17, 2004 (see Sec.  1.409(p)-1T in 26 CFR 
part 1 revised as of April 1, 2004) applies for plan years ending after 
October 20, 2003, and beginning before January 1, 2005.
    (B) Paragraphs (c)(3) and (g) of this section apply for plan years 
ending on or after December 31, 2004, but do not apply with respect to 
an interest held in a qualified subchapter S subsidiary (QSUB) of an S 
corporation or another entity to which paragraph (g)(3) of this section 
applies before March 15, 2004 if:
    (1) All interests in the entity held by individuals who would be 
disqualified persons under paragraph (g)(3) of this section or under 
guidance issued by the Commissioner before March 15, 2004 are 
distributed to those individuals as compensation on or before March 15, 
2004 and
    (2) No such individual has been a participant in the ESOP of the S 
corporation at any time after October 20, 2003 and before March 15, 
2004.
    (C) Paragraph (f)(2)(iv)(B) of this section (providing that 
synthetic equity does not include certain preexisting nonqualified 
deferred compensation) applies for plan years ending before January 1, 
2005.
    (D) Paragraph (f)(4)(iv) of this section (permitting an adjustment 
of the number of synthetic equity shares where an ESOP owns less than 
100% of an S corporation) applies for plan years ending before January 
1, 2005.
    (E) In no event does this paragraph (i)(2)(ii) apply for any plan 
year ending before January 1, 2005, for an ESOP holding stock in an S 
corporation that was established on or before March 14, 2001, if the 
election under section 1362(a) with respect to that S Corporation was 
in effect on March 14, 2001.
    (iii) Transition rules. (A) Assets held in the account of a 
disqualified person as of the last day of the first plan year beginning 
before January 1, 2005, will not be treated as an impermissible accrual 
with respect to that disqualified person under paragraph (b)(2)((ii) of 
this section for the first plan year beginning on or after January 1, 
2005, to the extent those assets are not held in that person's account 
on or after July 1, 2005. Thus, for example, to the extent the assets 
allocated to the account of a disqualified person as of the last day of 
the first plan year beginning before January 1, 2005, are transferred 
to a non-ESOP portion of the plan as described in paragraph 
(b)(2)(v)(A) of this section before July 1, 2005, those assets will not 
be treated as an impermissible accrual under paragraph (b)(2)((ii) of 
this section for the period from the first day of the first plan year 
beginning on or after January 1, 2005 through June 30, 2005. However, 
see section 4979A(a)(3), (a)(4), and (e)(2)(C) for excise tax 
provisions that apply to all deemed-owned shares during the first 
nonallocation year for the ESOP.
    (B) An individual is not treated as a disqualified person during 
the period from the first day of the first plan year beginning on or 
after January 1, 2005 through June 30, 2005 if that person would not be 
a disqualified person during that period under the modified rules of 
this paragraph (i)(2)(iii)(B) as of any date during that same period. 
Further, solely for the purpose of determining whether the first plan 
year beginning on or after January 1, 2005 is a nonallocation year 
under section 409(p) and this section, if that plan year would not have 
been a nonallocation year under the modified rules of this paragraph 
(i)(2)(iii)(B), then synthetic equity that is not owned by a person on 
July 1, 2005 is disregarded during the period from the first day of the 
first plan year beginning on or after January 1, 2005 through June 30, 
2005. For purposes of this paragraph (i)(2)(iii)(B), the modified rules 
of this paragraph (i)(2)(iii)(B) are the rules in Sec.  1.409(p)-1T as 
in effect prior to December 17, 2004 (see Sec.  1.409(p)-1T in 26 CFR 
Part 1 revised as of April 1, 2004), modified to exclude from the 
definition of synthetic equity any stock option, stock appreciation 
right (payable in cash or stock), or similar rights with respect to 
shares of the S corporation or a related entity where the facts and 
circumstances indicate that there is no reasonable likelihood that the 
holder of the right will receive the shares (or equivalent value). For 
this purpose, there is no reasonable likelihood that the holder of the 
right will receive the shares (or equivalent value) in any case in 
which the option is based on an exercise price that is more than 200% 
of the fair market value of the shares on the date of grant or the 
right (in the case of a stock appreciation right or similar right to 
acquire shares of the S corporation or a related entity) is payable 
only if the appreciation exceeds 100% of the fair market value of the 
shares on the date of grant.
    (C) For the period from the first day of the first plan year 
beginning on or after January 1, 2005 through June 30, 2005, there is 
no nonallocation year under this section if there would be no 
nonallocation year under this section during that period if this 
section were applied without regard to paragraph (f)(4)(v) of this 
section (relating to voting rights).
    (D) This paragraph (iii) does not apply to an ESOP for which the 
first plan year beginning on or after January 1, 2005 begins after June 
30, 2005.


[[Page 75468]]


    Approved: December 7, 2004.
Mark M. Matthews,
Deputy Commissioner for Services and Enforcement.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 04-27294 Filed 12-16-04; 8:45 am]
BILLING CODE 4830-01-P