\[4830-01-p\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

\[TD 9081 \]

RIN 1545-BC33

Prohibited Allocations of Securities in an S Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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

DATES: [Effective Date]{.underline}: These regulations are effective
July 21, 2003.

[Applicability Date]{.underline}: These temporary regulations are
applicable with respect to plan years ending after October 20, 2003.

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

SUPPLEMENTARY INFORMATION:

**Background**

Section 4975(e)(7) provides that an ESOP is a defined contribution plan
that is designed to invest primarily in qualifying employer securities
and that is either a stock bonus plan which is qualified, or a stock
bonus plan and money purchase pension plan both of which are qualified,
under section 401(a). Section 4975(e)(7) authorizes the Secretary to
issue regulations imposing additional requirements for ESOPs (see
§ 54.4975-11 of the Excise Tax Regulations). A plan is not treated as an
ESOP under the Code unless it meets the following requirements, to the
extent applicable: section 409(h) (relating to participants' right to
receive employer securities; put options); section 409(o) (relating to
participants' distribution rights and payment requirements); section
409(n) (relating to securities received in transactions to which section
1042 applies); section 409(p) (relating to prohibited allocations of
securities in an S corporation); section 664(g) (relating to qualified
gratuitous transfers of qualified employer securities); and section
409(e) (relating to participants' voting rights if the employer has a
registration-type class of securities). As authorized by section
4975(e)(7), additional requirements are imposed under § 54.4975-11.

Section 1361(b)(1)(D) provides that a Subchapter S corporation (S
corporation) may not have more than one class of stock. Section
1361(b)(1)(B) provides that an S corporation may not have as a
shareholder a person that is not an estate, a trust described in section
1361(c)(2), an organization described in section 1361(c)(6), or an
individual. In 1996, section 1361(c)(6) was amended to permit a
qualified plan under section 401(a) to be a shareholder in an S
corporation. Section 1316(a) of the Small Business Job Protection Act of
1996 (SBJPA) (110 Stat. 1755) (1996).

Section 511(a)(1) imposes a tax on the unrelated business taxable income
(as defined in section 512(a)) of organizations described in section
511(a)(2), which include plans that qualify under section 401(a).
Section 512(e)(1) provides that if an organization described in section
1361(c)(6) holds stock in an S corporation, the interest is treated as
an interest in an unrelated trade or business and, notwithstanding the
organization's general tax-exempt status, all items of income, loss, or
deduction taken into account under section 1366(a) and any gain or loss
on the disposition of the stock in the S corporation are taken into
account in computing the unrelated business taxable income of the
organization. In 1997, section 512(e) was amended to provide that
section 512(e) does not apply to employer securities (within the meaning
of section 409(l)) held by an ESOP described in section 4975(e)(7).
Section 1523 of the Taxpayer Relief Act of 1997 (TRA '97) (111 Stat.
788) (1997). Accordingly, S corporation income allocable to stock held
by an ESOP is not subject to regular income or unrelated business income
tax, but S corporation income allocable to stock held by any other
qualified plan or tax-exempt entity under section 501(c)(3) is subject
to the unrelated business income tax under section 511.

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

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

H.R. Rep. No. 107-51, part 1, at 100 (2001).

Section 409(p)(1) requires an ESOP holding employer securities
consisting of stock in an S corporation to provide that no portion of
the assets of the plan attributable to (or allocable in lieu of) such
employer securities may, during a nonallocation year, accrue (or be
allocated directly or indirectly under any plan of the employer meeting
the requirements of section 401(a)) for the benefit of any disqualified
person, as defined in section 409(p).[^1]

Section 409(p)(3)(A) provides that a "nonallocation year" includes any
plan year during which the ownership of the S corporation is so
concentrated among disqualified persons that they own at least 50
percent of its shares. Section 409(p)(3)(B) provides that, in
determining the shares owned by an individual for purposes of section
409(p)(3)(A), the attribution rules of section 318(a) apply, with
certain exceptions, and the individual is treated as owning his or her
deemed-owned ESOP shares.

Under section 409(p)(4)(C)(i), the term [deemed-owned
shares]{.underline} includes, with respect to any person, the stock in
the S corporation constituting employer securities of an ESOP which is
allocated to that person under the ESOP, and that person's share of the
stock in the S corporation which is held by the ESOP but which is not
allocated to participants under the ESOP. Suspense account stock is
deemed to be allocated to participants in the same proportion as the
most recent plan allocation.

Section 409(p)(4) provides, in general, that whether someone is a
"disqualified person" depends on a person\'s ownership of deemed-owned
shares of S corporation stock held by an ESOP (deemed-owned ESOP
shares). Section 409(p)(4) provides, in general, that a "disqualified
person" means any person whose deemed-owned ESOP shares are at least 10
percent of the number of deemed-owned ESOP or for whom the aggregate
number of deemed-owned ESOP shares of such person and the members of
such person\'s family is at least 20 percent of the number of
deemed-owned ESOP shares.

The determination of whether someone is a disqualified person and
whether a plan year is a nonallocation year is made without regard to
"synthetic equity" attributable to that person and is also made
separately taking into account synthetic equity. Synthetic equity is a
general classification unique to section 409(p). The provisions relating
to synthetic equity do not modify the rules relating to S corporations,
e.g., the circumstances in which options or similar interests are
treated as creating a second class of stock. H.R. Conf. Rep. No. 107-84,
at 102 n.52. Under section 409(p)(6)(C), synthetic equity is defined as:

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

Under the rules for the treatment of synthetic equity at section
409(p)(5), if a person owns synthetic equity in an S corporation, then
the shares of stock in such corporation on which such synthetic equity
is based are generally treated as outstanding stock in such corporation,
and as deemed‑owned shares of such person, if such treatment of
synthetic equity results either in the treatment of any person as a
disqualified person or the treatment of any year as a nonallocation
year. Accordingly, if a person is treated as a disqualified person or a
year is treated as a nonallocation year without regard to synthetic
equity, then the inclusion of synthetic equity as outstanding stock does
not cause the person to fail to be treated as a disqualified person or
the year to fail to be treated as a nonallocation year.

Section 409(p)(7)(A) authorizes the Secretary to prescribe such
regulations as may be necessary to carry out the purposes of section
409(p). As indicated by the legislative history above, section 409(p) is
intended to limit the tax benefits of ESOPs maintained by S corporations
unless the ESOP provides meaningful benefits to rank-and-file employees.
See H.R. Rep. No. 107-51, part 1, at 100 (2001). Section 409(p)(7)(B)
provides that the Secretary may, by regulation or other guidance of
general applicability, provide that a nonallocation year occurs in any
case in which the principal purpose of the ownership structure of an S
corporation constitutes an avoidance or evasion of section 409(p). "For
example, this might apply if more than 10 independent businesses are
combined in an S corporation owned by an ESOP in order to take advantage
of the income tax treatment of S corporations owned by an ESOP." H.R.
Conf. Rep. No. 107-84, at 277 (2001).

Under section 656 of EGTRRA, section 409(p) is effective for plan years
ending after March 14, 2001, except for those ESOPs eligible for a
delayed effective date applicable to certain ESOPs that were established
on or before March 14, 2001. See Rev. Rul. 2003-6, 2003-3 I.R.B. 286.

Section 4979A imposes a 50 percent excise tax in certain cases,
including an allocation of employer securities that is prohibited by
section 409(p), the ownership of any synthetic equity by a disqualified
person during a nonallocation year, and the occurrence of the first
nonallocation year of an ESOP, as described in section 4979A(e)(2)(C).

**Explanation of Provisions**

[Overview]{.underline}

Section 409(p) was enacted to address concerns about ownership
structures involving S corporations and ESOPs that concentrate the
benefits of the ESOP in a small number of persons. Under the statute as
amended, an ESOP is still permitted to hold S corporation stock,
provided that the ESOP benefits a sufficiently broad-based group of
employees.

These temporary regulations reflect the statutory language under section
409(p)(1) prohibiting an accrual or allocation in a nonallocation year,
but do not provide additional guidance on what constitutes a prohibited
accrual or allocation. It is expected that this issue will be addressed
in additional regulations.

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

[Synthetic Equity]{.underline}

As discussed above, disqualified persons and nonallocation years are
identified both with and without synthetic equity. Section 409(p)
defines synthetic equity very broadly. Synthetic equity includes
restricted stock, rights to acquire stock in the corporation, such as
stock options or warrants, and other similar interests. It also includes
payments denominated in share value, including a phantom stock unit,
stock appreciation right, or similar interest.

In addition, under these temporary regulations, synthetic equity
includes two other categories of interests or payments: nonqualified
deferred compensation (even though it is neither payable in, nor
calculated by reference to, stock in the S corporation) and rights to
acquire interests in certain related entities. In each case, treatment
of these interests as synthetic equity is necessary to carry out the
Congressional purpose of section 409(p) of limiting the tax deferral
opportunities provided by an S corporation ESOP to those situations in
which the benefits of the ESOP ownership are available, at a minimum, to
a broad group of rank-and-file employees who have the opportunity to be
the primary beneficiaries of the growth of the business through the
ESOP. Unless these interests are treated as synthetic equity, the
benefits associated with ownership of an interest in an S Corporation by
means of the ESOP could be concentrated in a small group, and diverted
away from the rank-and-file employees, through use of these interests.
In this respect, these interests have the same effect as stock
appreciation rights payable in cash, which are explicitly included in
synthetic equity by statute.

[Nonqualified Deferred Compensation as Synthetic Equity]{.underline}

Since the addition of section 409(p), arrangements have been promoted to
taxpayers in which an S corporation that is either entirely or
substantially owned by an ESOP is used to shelter the income of an
active business while the profits of the business are primarily provided
for certain management employees of the business through various
obligations to make future payments to the employees. Typically in these
arrangements, the obligation to make future payments to the management
employees suppresses the value of the company\'s stock that is allocated
to rank-and-file employees through the ESOP, depriving them of the
opportunity to be the primary beneficiaries of the growth of the
business through the ESOP.

For example, under some of these arrangements, the owners of the
operating company establish a management company and the operating
company agrees to pay management fees equal to substantially all (or
most) of the profits of the operating company. The management company
agrees to provide future compensation to certain executives or other
employees of the operating company or the management company in an
amount equal to substantially all of the profits of the management
company. Finally, the management company elects to be treated as an S
corporation and transfers all, or a substantial portion, of its stock to
an ESOP established to cover rank-and-file employees. Under this
arrangement, the operating company claims a deduction for the fees paid
to the management corporation. The management corporation in turn
retains these fees to satisfy its obligations to pay future
compensation. Although the stock of the management corporation is owned
by the ESOP, the ownership interest held for rank-and-file employees
through the ESOP has a substantially reduced value. Rather than being a
mechanism for the transfer of not only ownership, but also the rights
associated with ownership, to the employees of the S corporation, the
ESOP is used as part of a structure designed to shelter profits that
will be paid as future compensation for a small group of executives or
management employees.

These temporary regulations treat nonqualified deferred compensation
provided by the S corporation or certain related entities as synthetic
equity, including deferred compensation that is neither payable in stock
of the S corporation nor calculated by reference to stock of the S
corporation. S Corporations that do not maintain ESOPs typically do not
provide nonqualified deferred compensation to owners. By treating
nonqualified deferred compensation provided by the S corporation (or
certain related entities) as synthetic equity, these temporary
regulations address ownership structures that are designed to avoid or
evade section 409(p) and provide guidance allowing individuals to
determine when these interests result in a failure to comply with
section 409(p). Nonqualified deferred compensation is appropriately
characterized as synthetic equity because it functions similarly to
other forms of synthetic equity by diverting value away from
shareholders, thereby reducing the value of the S corporation and
diminishing the ESOP's interest in the value that, absent the
nonqualified deferred compensation, would be reflected in the shares of
the S corporation held by the ESOP. This effect occurs even if the
nonqualified deferred compensation is a fixed dollar amount, and even if
such deferred compensation is not payable in stock of the S corporation
or measured by reference to that stock (directly, such as a stock
appreciation right payable in cash, or less directly, such as percentage
of the future profits of the S corporation).

[Right to Acquire Assets as Synthetic Equity]{.underline}

Under these temporary regulations, rights to acquire stock or other
similar interests in a related entity are treated as synthetic equity if
the ownership of such interests in the related entity is the only
significant asset of the S corporation and the S corporation is the only
significant holder of stock (or other similar interests) of the related
entity. For this purpose, related entities are entities in which the S
corporation holds an interest and with respect to which income is passed
through to the S corporation. These rights are properly treated as
synthetic equity because they provide the holders of these rights with
an opportunity to benefit from the S corporation ESOP structure that is
comparable to the opportunity provided through synthetic equity issued
directly by the S corporation. Taking rights to acquire stock or other
similar interests in a related entity into account as synthetic equity
provides a method for identifying situations in which the interests in
the S corporation (and its assets) have, directly or indirectly, become
concentrated in a manner that should result in a nonallocation year
under section 409(p).

These temporary regulations provide that synthetic equity does not
include rights to acquire goods or services at fair market value in the
ordinary course of business. The temporary regulations do not address,
at this time, rights to acquire other assets of the S Corporation or
assets of the related entity or other related entities. This absence
should not be interpreted as a conclusion that a right to acquire these
other assets cannot be synthetic equity. It may be appropriate to treat
the right to acquire assets of the S Corporation, other than its
interest in a related entity (such as its ownership of a manufacturing
plant), as synthetic equity. It may also be appropriate to treat rights
to acquire assets held by the related entity as synthetic equity.

The temporary regulations also do not address rights to acquire
interests in related entities if the ownership of such interests in the
related entity is not the only significant asset of the S corporation or
the S corporation is not the only significant holder of stock (or other
similar interests) of the related entity. Rights to acquire interests in
other related entities is reserved because, for example, it may be
appropriate in cases in which a related entity is not the only
significant asset of the S Corporation to treat as synthetic equity only
a portion of the value of the rights to acquire stock or other similar
interests in the related entity.

The IRS and Treasury intend to issue additional regulations providing
guidance on the definition of synthetic equity on a number of issues,
including issues identified as reserved in these temporary regulations.
For example, the IRS and Treasury intend to issue additional guidance
relating to rights to acquire interests in other related entities and
rights to acquire assets of an S corporation or related entity. The
additional regulations are expected to address the treatment of these
interests, including how any such interests treated as synthetic equity
should be converted into shares of synthetic equity in the S corporation
and whether such conversion should take into account the extent to which
income of the related entity is allocated to a shareholder that is
subject to regular income tax or unrelated trade or business income tax.
These items are reserved in order to allow for additional consideration
of these issues, including consideration of comments on the proposed
regulations accompanying these regulations. The additional regulations
are expected to be issued in conjunction with guidance on prohibited
accruals or allocations to disqualified persons in a nonallocation year,
which is also identified as reserved in these temporary regulations.

In the meantime, these temporary regulations provide an anti-abuse
provision treating acquisition rights as synthetic equity in certain
situations. Specifically, this treatment applies to an option or right
to acquire assets of the S corporation, or a related person, that is
part of a structure that provides rights to the holder comparable to the
rights provided by arrangements identified as synthetic equity under
these temporary regulations and in which the principal purpose of the
structure is the avoidance or evasion of section 409(p). In addition,
the temporary regulations delegate authority to the Commissioner to
provide, through revenue rulings, notices and other guidance published
in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this
chapter), that synthetic equity includes a right to acquire stock or
other similar interests in a related entity in cases in which the S
corporation's interest in the related entity is not the only significant
asset of the S corporation or the S corporation is not the only
significant owner of the related entity.

[Rights to Acquire Shares of Stock That are Issued and
Outstanding]{.underline}

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

[Conversion of Synthetic Equity]{.underline}

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

[Identification of Disqualified Persons]{.underline}

Under these temporary regulations, a person is a disqualified person
based either on deemed-owned ESOP shares or deemed-owned ESOP shares
combined with synthetic equity. Whether there is a nonallocation year is
then determined by taking into account the holdings of all disqualified
persons, first based only on outstanding shares of stock of the
corporation and then based on outstanding shares of stock and synthetic
equity of the corporation. In accordance with the last sentence of
section 409(p)(5), synthetic equity cannot result in a person who is
treated as a disqualified person for a year, or a year that is treated
as a nonallocation year, not being so treated. In addition, these
temporary regulations provide that, in any year in which the
Commissioner provides that a nonallocation year occurs because the
principal purpose of the ownership structure of the S corporation is an
avoidance or evasion of section 409(p), the Commissioner may also treat
any individual as a disqualified person.

As a result of the provisions of these temporary regulations relating to
synthetic equity, employees who benefit from nonqualified deferred
compensation arrangements or who hold rights to acquire interests in
certain related entities will be treated as owning synthetic equity and
may be treated as disqualified persons. As a result, certain plan years
of the ESOP may be treated as nonallocation years. This result will not
occur unless the aggregate interest held by disqualified persons \--
through synthetic equity, direct share ownership, and deemed‑owned ESOP
shares \-- constitutes at least half of the value of the outstanding
stock and synthetic equity of the S corporation.

[Effective Date]{.underline}

In the case of an ESOP holding stock in an S corporation that is
eligible for the delayed effective date under section 656(d)(2) of
EGTRRA applicable to certain ESOPs established on or before March 14,
2001, these temporary regulations do not apply until plan years
beginning on or after January 1, 2005. For an ESOP to which the delayed
effective date is not applicable, these temporary regulations are
applicable with respect to plan years ending after October 20, 2003. The
temporary regulations permit S corporations to avoid having nonqualified
deferred compensation treated as synthetic equity under paragraph
(f)(2)(iv) of these temporary regulations by distributing the deferred
compensation by July 21, 2004.

[Request for Comments in Proposed Regulations and Future
Guidance]{.underline}

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

**Special Analyses**

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

**Drafting Information**

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

**List of Subjects in 26 CFR Part 1**

Income taxes, Reporting and recordkeeping requirements.

**Amendments to the Regulations**

Accordingly, 26 CFR part 1 is amended as follows:

PART 1\--INCOME TAXES

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). \* \* \*

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

[§1.409(p)-1T Prohibited allocation of securities in an S corporation
(temporary)]{.underline}.

\(a\) [Organization of this section]{.underline}. Sections 409(p) and
4979A apply if a nonallocation year occurs in an employee stock
ownership plan (ESOP), as defined in section 4975(e)(7), that holds
shares of stock of a Subchapter S corporation (S corporation) that are
employer securities as defined in section 409(l). Paragraph (b) of this
section sets forth the general rule under section 409(p)(1) and (2)
prohibiting an allocation to a disqualified person in a nonallocation
year. Paragraph (c) of this section sets forth rules under section
409(p)(3), (5), and (7) for determining whether a year is a
nonallocation year, generally based on whether disqualified persons own
at least 50 percent of the shares of the S corporation, either taking
into account only the outstanding shares of the S corporation (including
shares held by the ESOP) or taking into account both the outstanding
shares and synthetic equity of the S corporation. Paragraphs (d), (e),
and (f) of this section contain definitions of a disqualified person
under section 409(p)(4) and (5), deemed-owned ESOP shares under section
409(p)(4)(C), and synthetic equity under section 409(p)(6)(C).

\(b\) [Prohibited accruals in a nonallocation year]{.underline}\--(1)
[General rule]{.underline}. An ESOP holding employer securities
consisting of stock in an S corporation must provide that no portion of
the assets of the plan attributable to (or allocable in lieu of ) such
employer securities may, during a nonallocation year, accrue (or be
allocated directly or indirectly under any plan of the employer meeting
the requirements of section 401(a)) for the benefit of any disqualified
person.

\(2\) [Additional rules]{.underline}. \[Reserved\]

\(c\) [Nonallocation year]{.underline} \-- (1) [Definition
generally]{.underline}. A [nonallocation year]{.underline} means a plan
year of an ESOP during which, at any time, the ESOP holds any employer
securities that are shares of an S corporation and either \--

\(i\) Disqualified persons own at least 50 percent of the number of
outstanding shares of stock in the S corporation (including deemed-owned
ESOP shares), or

\(ii\) Disqualified persons own at least 50 percent of the aggregate
number of outstanding shares of stock (including deemed-owned ESOP
shares) and synthetic equity in the S corporation.

\(2\) [Attribution rules]{.underline}. 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]{.underline}. Under section
409(p)(7)(B), the Commissioner, in revenue rulings, notices, and other
guidance published in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(B) of this chapter), may provide that a nonallocation
year occurs in any case in which the principal purpose of the ownership
structure of an S corporation constitutes an avoidance or evasion of
section 409(p). For any year that is a nonallocation year under this
paragraph (c)(3), the Commissioner may treat any person as a
disqualified person.

\(4\) [Special rule for certain stock rights]{.underline}. (i) For
purposes of paragraph (c)(1) of this section, a person is treated as
owning stock that the person has a right to acquire if, at all times
during the period when such rights are effective, the stock that the
person has the right to acquire is both issued and outstanding and is
held by persons other than the ESOP, the S corporation, or a related
entity (as defined in paragraph (f)(2)(iii)(A)([4]{.underline}) of this
section).

\(ii\) This paragraph (c)(4) applies only if treating persons as owning
the shares described in paragraph (c)(4)(i) results in a nonallocation
year. This paragraph (c)(4) does not apply to a right that, under
§1.1361-1(l)(2)(iii) or (l)(4)(iii)(C), would not be taken into account
in determining if an S corporation has a second class of stock, and does
not apply for purposes of determining ownership of deemed-owned ESOP
shares or whether an interest constitutes synthetic equity (see the last
sentence of paragraph (f)(2)(i)).

\(d\) [Disqualified persons]{.underline} \-- (1) [General
rule]{.underline}. A [disqualified person]{.underline} is any person for
whom \--

\(i\) The number of such person's deemed-owned ESOP shares is at least
10 percent of the number of deemed-owned ESOP shares of the S
corporation;

\(ii\) The aggregate number of such person's deemed-owned ESOP shares
and synthetic equity shares is at least 10 percent of the aggregate
number of deemed-owned ESOP and synthetic equity shares of the S
corporation;

\(iii\) The aggregate number of deemed-owned ESOP shares of such person
and of the members of such person's family is at least 20 percent of the
number of deemed-owned ESOP shares of the S corporation; or

\(iv\) The aggregate number of deemed-owned ESOP shares and synthetic
equity shares of such person and of the members of such person's family
is at least 20 percent of the aggregate number of deemed-owned ESOP and
synthetic equity shares of the S corporation.

\(2\) [Treatment of family members; definition]{.underline}. (i) Each
member of the family of any person who is a disqualified person under
paragraph (d)(1)(iii) or (iv) of this section is a disqualified person.
[Member of the family]{.underline} means, with respect to an individual
\--

\(A\) the spouse of the individual;

\(B\) an ancestor or lineal descendant of the individual or the
individual's spouse;

\(C\) a brother or sister of the individual or of the individual's
spouse and any lineal descendant of the brother or sister; and

\(D\) the spouse of any individual described in paragraph (d)(2)(ii) or
(iii) of this section.

\(ii\) A spouse of an individual who is legally separated from such
individual under a decree of divorce or separate maintenance is not
treated as such individual's spouse for purposes of this paragraph
(d)(2).

\(3\) [Special rule for certain nonallocation years]{.underline}. See
paragraph (c)(3) of this section (relating to avoidance or evasion of
section 409(p)) for a special rule permitting any person to be treated
as a disqualified person in certain nonallocation years.

\(e\) [Deemed-owned ESOP shares]{.underline}. A person is treated as
owning his or her deemed-owned ESOP shares. [Deemed-owned ESOP
shares]{.underline} mean, with respect to any person \--

\(1\) Any shares of stock in the S corporation constituting employer
securities that are allocated to such person's account under the ESOP;
and

\(2\) Such person's share of the stock in the S corporation that is held
by the ESOP but is not allocated to the account of any participant or
beneficiary (with such person's share to be determined in the same
proportion as the most recent stock allocation under the ESOP).

\(f\) [Synthetic equity]{.underline} \-- (1) [Ownership of synthetic
equity]{.underline}. 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]{.underline} means the
rights described in paragraph (f)(2) of this section.

\(2\) [Synthetic equity]{.underline}\-- (i) [Rights to acquire stock of
the S corporation]{.underline}. [Synthetic equity]{.underline} includes
any stock option, warrant, restricted stock, deferred issuance stock
right, stock appreciation right payable in stock, or similar interest or
right that gives the holder the right to acquire or receive stock of the
S corporation in the future. Rights to acquire stock in an S corporation
with respect to stock that is, at all times during the period when such
rights are effective, both issued and outstanding and held by persons
other than the ESOP, the S corporation, or a related entity, are not
synthetic equity (but see paragraph (c)(4) of this section).

\(ii\) [Special rule for certain stock rights]{.underline}. [Synthetic
equity]{.underline} also includes a right to a future payment (payable
in cash or any other form other than stock of the S corporation) from an
S corporation that is based on the value of the stock of the S
corporation or appreciation in such value, such as a stock appreciation
right with respect to stock of an S corporation that is payable in cash
or a phantom stock unit with respect to stock of an S corporation that
is payable in cash.

\(iii\) [Rights to acquire assets of an S corporation or related
entity]{.underline}\--(A) [Rights to acquire interests in a related
entity]{.underline} \-- ([1]{.underline}) [Treatment as synthetic
equity]{.underline}. [Synthetic equity]{.underline} includes a right to
acquire stock or other similar interests in a related entity that is
described in this paragraph (f)(2)(iii)(A).

([2]{.underline}) Significant interests. [Synthetic equity]{.underline}
includes a right to acquire stock or other similar interests in a
related entity if such interests in the related entity are the only
significant asset of the S corporation and the S corporation is the only
significant owner of the related entity. Whether an asset is the only
significant asset of the S corporation or the S corporation is the only
significant owner of the related entity depends on the relevant facts
and circumstances.

([3]{.underline}) [Rights to acquire interests in other related
entities]{.underline}. \[Reserved\]

([4]{.underline}) [Related entity]{.underline}. For purposes of this
section, [related entity]{.underline} 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 §301.7701-3 of this chapter or a Qualified Subchapter S
Subsidiary under section 1361(b)(3).

\(B\) [Rights to acquire assets of an S corporation or related entity
other than rights to acquire stock or similar interests in a related
entity]{.underline}\--([1]{.underline}) [General rule]{.underline}.
\[Reserved\]

([2]{.underline}) [Exception for rights to acquire goods or services in
ordinary course of business]{.underline}. [Synthetic equity]{.underline}
does not include rights to acquire goods or services at fair market
value in the ordinary course of business.

\(C\) [Authority to provide guidance]{.underline}. The Commissioner, in
revenue rulings, notices, and other guidance published in the Internal
Revenue Bulletin (see §601.601(d)(2)(ii)(B) of this chapter), may
provide that [synthetic equity]{.underline} includes a right to acquire
stock or other similar interests in a related entity in cases in which
such interests in the related entity are not the only significant asset
of the S corporation or the S corporation is not the only significant
owner of the related entity if necessary to carry out the purposes of
section 409(p).

\(D\) [Synthetic equity includes comparable rights]{.underline}. An
option or right to acquire assets of the S corporation or another person
is treated as synthetic equity if such option or right is part of a
structure that provides rights to the holder comparable to the rights
provided by arrangements identified as synthetic equity under this
paragraph (f)(2)(iii) and the principal purpose of the structure is the
avoidance or evasion of section 409(p).

\(iv\) [Special rule for nonqualified deferred
compensation]{.underline}. [Synthetic equity]{.underline} also includes
any remuneration for services rendered to the S corporation, or a
related entity, to which section 404(a)(5) applies (including
remuneration for which a deduction would be permitted under section
404(a)(5) if separate accounts were maintained), any right to receive
property (to which section 83 applies) in a future year for the
performance of services to an S corporation, or related entity, and any
transfer of property (to which section 83 applies) in connection with
the performance of services to an S corporation, or a related entity, to
the extent that the property is not substantially vested within the
meaning of §1.83-3(i) by the end of the plan year in which transferred.
[Synthetic equity]{.underline} also includes any other remuneration for
services rendered to the S corporation, or a related entity, under a
plan, or method or arrangement, deferring the receipt of compensation to
a date that is after the 15th day of the 3^rd^ calendar month after the
end of the entity's taxable year in which the related services are
rendered, other than a plan that is an eligible retirement plan within
the meaning of section 402(c)(7)(B).

\(3\) [No overlap among shares of deemed-owned ESOP shares or synthetic
equity]{.underline}. Synthetic equity under this paragraph (f) does not
include shares that are deemed-owned ESOP shares. In addition, synthetic
equity under a specific subparagraph of this paragraph (f) does not
include anything that is synthetic equity under a preceding subparagraph
of this paragraph (f).

\(4\) [Number of synthetic shares]{.underline}\-- (i) [Synthetic equity
determined by reference to S corporation shares]{.underline}. In the
case of synthetic equity that is determined by reference to shares of
stock of the S corporation, the person who is entitled to the synthetic
equity is treated as owning the corresponding number of shares of stock.
For example, if a corporation grants an employee of an S corporation an
option to purchase 100 shares of the corporation\'s stock, the employee
is the deemed owner of 100 synthetic equity shares of the stock of the
corporation.

\(ii\) [Synthetic equity determined by reference to shares in a related
entity]{.underline}. 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 §1.83-3(i)).

\(iii\) [Other synthetic equity]{.underline}. In the case of any other
synthetic equity, the person who is entitled to the synthetic equity is
treated as owning a number of shares of stock in the S corporation equal
to the present value of the synthetic equity (with such value determined
without regard to any lapse restriction as defined at §1.83-3(i))
divided by the fair market value of a share of the S corporation\'s
stock as of the same date. For purposes of this paragraph (f)(4)(iii),
the number of shares of S corporation is permitted to be determined as
of the first day of the ESOP's plan year, or any other reasonable
determination date or dates during a plan year that is consistently used
by the corporation for this purpose for all persons. The number of
shares of synthetic equity treated as owned for any period from a
determination date through the date immediately preceding the next
following determination date is the number of shares treated as owned on
the first day of that period. (g) [Examples]{.underline}. The rules of
this section are illustrated by the following examples:

[Example 1]{.underline}. (i) [Facts]{.underline}. 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:

+-----------------+-----------------+-----------------+-----------------+
| 1               | 2               | 3               | 4               |
|                 |                 |                 |                 |
| Shareholders    | Deemed-Owned    | Percentage      | Disqualified    |
|                 | ESOP Shares     | Deemed-Owned    | Person          |
|                 | (total of       | ESOP Shares     |                 |
|                 | 1,000)          |                 |                 |
+-----------------+-----------------+-----------------+-----------------+
| B               | 330             | 33%             | Yes             |
+-----------------+-----------------+-----------------+-----------------+
| C               | 145             | 14.5%           | Yes             |
+-----------------+-----------------+-----------------+-----------------+
| D               | 75              | 7.5%            | No              |
+-----------------+-----------------+-----------------+-----------------+
| E               | 30              | 3%              | No              |
+-----------------+-----------------+-----------------+-----------------+
| F               | 20              | 2%              | No              |
+-----------------+-----------------+-----------------+-----------------+
| Other           | 400 (none       | 1% or less      | No              |
| participants    | exceed 10       |                 |                 |
|                 | shares)         |                 |                 |
+-----------------+-----------------+-----------------+-----------------+

\(ii\) [Conclusion with respect to disqualified persons]{.underline}. 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]{.underline}.
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]{.underline}. (i) [Facts]{.underline}. The facts are the same
as in [Example 1]{.underline}, except that, as shown in column 4 of the
table below, individual E has an option to acquire 500 shares of the
common stock of X from X:

+-----------+-----------+-----------+-----------+-----------+-----------+
| 1         | 2         | 3         | 4         | 5         | 6         |
|           |           |           |           |           |           |
| Sha       | Deemed-   | P         | Synthetic | P         | Dis       |
| reholders | Owned     | ercentage | Equity    | ercentage | qualified |
|           | ESOP      | Deemed-   | (500)     | Deemed-   | Person    |
|           | Shares    | Owned     |           | Owned     |           |
|           | (total of | ESOP      |           | ESOP plus |           |
|           | 1,000)    | Shares    |           | Synthetic |           |
|           |           |           |           | Equity    |           |
|           |           |           |           | Shares    |           |
|           |           |           |           | (total of |           |
|           |           |           |           | 1,500)    |           |
+-----------+-----------+-----------+-----------+-----------+-----------+
| B         | 330       | 33%       |           | 22%       | Yes       |
|           |           |           |           |           | (cols. 3  |
|           |           |           |           |           | and 5)    |
+-----------+-----------+-----------+-----------+-----------+-----------+
| C         | 145       | 14.5%     |           | 9.7%      | Yes       |
|           |           |           |           |           | (col.3)   |
+-----------+-----------+-----------+-----------+-----------+-----------+
| D         | 75        | 7.5%      |           | 5%        | No        |
+-----------+-----------+-----------+-----------+-----------+-----------+
| E         | 30        | 3%        | 500       | 35.3%     | Yes (col. |
|           |           |           |           |           | 5)        |
+-----------+-----------+-----------+-----------+-----------+-----------+
| F         | 20        | 2%        |           | 1.3%      | No        |
+-----------+-----------+-----------+-----------+-----------+-----------+
| Other     | 400 (none | 1% or     |           | under 1%  | No        |
| par       | exceeds   | less      |           |           |           |
| ticipants | 10        |           |           |           |           |
|           | shares)   |           |           |           |           |
+-----------+-----------+-----------+-----------+-----------+-----------+

\(ii\) [Conclusion with respect to disqualified persons]{.underline}.
E's option constitutes 500 shares of synthetic equity. Accordingly, as
shown in column 6 in the table above, individuals B, C, and E are
disqualified persons for 2006 because each owns at least 10% of X's
deemed-owned ESOP shares or X's total deemed-owned ESOP and synthetic
equity shares.

\(iii\) [Conclusion with respect to nonallocation year]{.underline}. The
100 shares owned directly by B, B's 330 deemed-owned ESOP shares, C's
145 deemed-owned ESOP shares, E's 30 deemed-owned ESOP shares, plus E's
500 synthetic equity shares equals 65% of the 1,700 outstanding and
synthetic equity shares of X. Thus, 2006 is a nonallocation year for X's
ESOP under section 409(p) because disqualified persons own at least 50%
of X's total shares of outstanding stock and synthetic equity. In
addition, independent of the preceding conclusion, 2006 would be a
nonallocation year because disqualified persons own at least 50% of X's
outstanding shares because the 100 shares owned directly by B, B's 330
deemed-owned ESOP shares, C's 145 deemed-owned ESOP shares, plus E's 30
deemed-owned ESOP shares equals 50.4% of the 1,200 outstanding shares of
X.

\(h\) [Effective date]{.underline} \--(1) [General effective
dates]{.underline}. Except as provided in paragraph (h)(2) of this
section, section 409(p) applies for plan years ending after March 14,
2001 and this section applies for plan years ending after October 20,
2003, except that paragraph (f)(2)(iv) of this section is disregarded
with respect to nonqualified deferred compensation that is distributed
on or before July 21, 2004.

\(2\) [Certain ESOPs established on or before March 14,
2001]{.underline}. 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) and this section apply for plan years beginning on or
after January 1,

2005\.

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

Approved: July 9, 2003

> Pamela F. Olson,
>
> Assistant Secretary of Treasury (Tax Policy).

[^1]: This definition is different from the definition of disqualified
    person for purposes of section 4975.