Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 75455

Authority: 49 U.S.C. 106(g), 40103, 40113, 

40120; E. O. 10854, 24 FR 9565, 3 CFR, 1959–

1963 Comp., p. 389.

§ 71.1 [Amended]

■ 2. The incorporation by reference in 14 

CFR part 71.1 of the Federal Aviation 

Administration Order 7400.9M, 

Airspace Designations and Reporting 

Points, dated August 30, 2004, and 

effective September 16, 2004, is 

amended as follows:

Paragraph 6005 Class E airspace areas 

extending upward from 700 feet or more 

above the surface of the earth.

* * * * *

ANM OR E5 Lexington, OR [Add] 

Lexington Airport, Lexington, OR 

(Lat. 45°27′15′′N., long. 119°41′25′′W.)

The airspace extending upward from 700 

feet above the surface of the earth within a 

7.0 mile radius of the Lexington Airport; that 

airspace extending upward from 1200 feet 

above the surface of the earth beginning at 

lat. 45°14′00′′N., long 119°33′00′′W.; to lat. 

45°39′26′′N., long. 121°08′59′′W.; to lat. 

45°48′00′′N., long. 121°06′30′′W.; to lat. 

45°38′52′′N., long. 120°09′08′′W.; to lat. 

45°36′12′′N., long. 119°45′28′′W.; to lat. 

45°43′09′′N., long. 119°11′57′′W.; to lat. 

45°31′26′′N., long. 119°06′04′′W.; thence to 

the beginning; excluding that airspace within 

Federal airways.

* * * * *

Issued in Seattle, Washington, on 

November 26, 2004. 

Suzanne Alexander, 

Acting Area Director, Western En Route and 

Oceanic Operations.

[FR Doc. 04–27686 Filed 12–16–04; 8:45 am] 

BILLING CODE 4910–13–M

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 § 1.409–1T(i)(2) 

for specific exceptions.

FOR FURTHER INFORMATION CONTACT: John 

T. Ricotta at (202) 622–6060 (not a tollfree 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 § 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 deemedowned 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 

75456 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

1Rev. 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 §§ 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 21⁄2

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.

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 deemedowned 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 § 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 21⁄2 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

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 

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 75457

2See § 1.72(p)–1, Q&A–11 and 12.

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.

4Further, any sale or transfer of plan assets must 

comply with the requirements of part 4 of subtitle 

B of title I of ERISA.

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 § 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 591⁄2

(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.

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.

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 § 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 § 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 § 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 § 1.401(a)(4)–4 if the mandatory 

disaggregation rule for ESOPs at 

§ 1.410(b)–7(c)(2) did not apply.

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 

75458 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

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 nonESOP 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 § 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-byperson 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 § 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, 

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 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 

75460 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

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

■ 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 revised 

to read as follows:

§ 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 

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 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 § 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 § 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 § 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 

§ 1.401(a)(4)–4 merely because of the 

benefits, rights, or features with respect 

to the transferred benefits if those 

75462 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

benefits, rights, or features would satisfy 

the requirements of § 1.401(a)(4)–4 if the 

mandatory disaggregation rule for 

ESOPs at § 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 deemedowned 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

§ 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 § 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 deemedowned 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 deemedowned 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 

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 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 § 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 § 1.83–3(i) by the end of the plan year 

in which transferred; and a split-dollar 

life insurance arrangement under 

§ 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 § 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 § 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 

75464 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

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 § 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 § 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 § 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 § 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 § 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 redetermined 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 

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 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:

1

Shareholders 

2

Deemed-owned ESOP shares

(total of 1,000) 

3

Percentage deemed-owned

ESOP shares 

4

Disqualified

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 shares) ................. 1 or less ................................................... No. 

(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 deemedowned ESOP shares, plus C’s 145 deemedowned 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 

75466 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

example 2, individuals E and F have options to acquire 110 and 130 shares, respectively, 

of the common stock of X from X:

1

Shareholders

2

Deemed-owned

ESOP shares

(total of 1,000) 

3

Percentage 

deemed-owned 

ESOP shares 

4

Options

(240) 

5

Shareholder percentage of 

deemed-owned ESOP plus 

synthetic equity shares 

6

Disqualified

person 

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] divided 

by 1,091.7).

Yes (col. 5). 

F ............................................ 20 .......................................... 2 ....................... 130 11.6% ([20 + 108.3] divided 

by 1,108.3).

Yes (col. 5). 

Other participants .................. 400 (none exceeds 10 

shares).

1 or less ........... ........................ ............................................... No. 

(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 deemedowned 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 deemedowned 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:

1

Determination date 

2

Present value of nonqualified deferred compenstion 

3

Share value on

determination date 

4

New shares of 

synthetic

equity on

determination 

5

Aggregate 

number of 

synthetic

equity shares 

January 1, 2005 ............... A grant is made on 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.

$10 per share .................. 100 100 

January 1, 2006 ............... An additional grant 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.

$8 per share .................... 200 300 

January 1, 2007 ............... No new grants made .................................................. $12 per share .................. ........................ 300 

January 1, 2008 ............... An additional grant 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.

$15 per share .................. 200 450 

January 1, 2009 ............... No new grants are made ........................................... $11 per share .................. ........................ 450 

January 1, 2010 ............... No new grants are made ........................................... $22 per share .................. ........................ 450 

January 1, 2011 ............... No new grants are made. The grants made during 

2005 through 2008 have an aggregate present 

value on January 1, 2011 of $7,600.

$20 per share .................. ........................ 380 

(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.

Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 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), 

§ 1.409(p)–1T as in effect prior to 

December 17, 2004 (see § 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 § 1.409(p)–

1T as in effect prior to December 17, 

2004 (see § 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.

75468 Federal Register / Vol. 69, No. 242 / Friday, December 17, 2004 / Rules and Regulations 

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

DEPARTMENT OF THE TREASURY

Office of Foreign Assets Control 

31 CFR Parts 515, 538 and 560 

Cuban Assets Control Regulations, 

Sudanese Sanctions Regulations, and 

Iranian Transactions Regulations

AGENCY: Office of Foreign Assets 

Control, Treasury.

ACTION: Final rule.

SUMMARY: The Office of Foreign Assets 

Control (‘‘OFAC’’) of the U.S. 

Department of the Treasury is revising 

the Cuban Assets Control Regulations, 

the Sudanese Sanctions Regulations, 

and the Iranian Transactions 

Regulations to add general licenses 

pertaining to certain publishing 

activities.

DATES: Effective Date: December 17, 

2004. Comments may be submitted at 

any time.

ADDRESSES: You may submit comments 

by any of the following methods: 

• Federal eRulemaking Portal:

http://www.regulations.gov. Follow the 

instructions for submitting comments. 

• Agency Web Site: http://

www.treas.gov/offices/enforcement/

ofac/comment.html.

• Fax: Chief of Records, 202/622–

1657. 

• Mail: Chief of Records, ATTN: 

Request for Comments, Office of Foreign 

Assets Control, Department of the 

Treasury, 1500 Pennsylvania Avenue, 

NW., Washington, DC 20220. 

Instructions: All submissions received 

must include the agency name and the 

FR Doc. number that appears at the end 

of this document. Comments received 

will be posted without change to

http://www.treas.gov/ofac, including 

any personal information provided. For 

detailed instructions on submitting 

comments and additional information 

on the rulemaking process, see the 

‘‘Public Participation’’ heading of the 

SUPPLEMENTARY INFORMATION section of 

this document. To read background 

documents or comments received, go to 

http://www.treas.gov/ofac.

FOR FURTHER INFORMATION CONTACT:

Chief of Policy Planning and Program 

Management, tel. 202/622–2500, Chief 

of Licensing, tel.: 202/622–2480, Chief 

of Compliance, tel. 202/622–2490, or 

Chief Counsel, tel.: 202/622–2410, 

Office of Foreign Assets Control, 

Department of the Treasury, 

Washington, DC 20220 (not toll free 

numbers).

SUPPLEMENTARY INFORMATION: 

Electronic and Facsimile Availability 

This file is available for download 

without charge in ASCII and Adobe 

Acrobat readable (*.PDF) formats at 

GPO Access. GPO Access supports 

HTTP, FTP, and Telnet at 

fedbbs.access.gpo.gov. It may also be 

accessed by modem dialup at 202/512–

1387 followed by typing ‘‘/GO/FAC.’’

Paper copies of this document can be 

obtained by calling the Government 

Printing Office at 202/512–1530. This 

document and additional information 

concerning the programs of the Office of 

Foreign Assets Control are available for 

downloading from the Office’s Internet 

Home Page: http://www.treas.gov/ofac,

or via FTP at ofacftp.treas.gov.

Facsimiles of information are available 

through the Office’s 24-hour fax-ondemand service: call 202/622–0077 

using a fax machine, fax modem, or 

(within the United States) a touch-tone 

telephone.

Background 

The Cuban Assets Control 

Regulations, 31 CFR part 515 (the 

‘‘CACR’’), were issued by the U.S. 

Government on July 8, 1963, under the 

Trading with the Enemy Act (50 U.S.C. 

App. 5 et seq.) (TWEA), in response to 

certain hostile actions by the Cuban 

Government. Since that time, U.S. 

policy toward Cuba has been to 

encourage a rapid and peaceful 

transition to democracy. The TWEA 

sanctions are intended to isolate the 

Cuban Government economically and 

deprive it of U.S. dollars that the Cuban 

Government would otherwise use to 

maintain or strengthen its repressive 

apparatus, enforce its information 

blockade on the Cuban people, and 

arrange for a succession and the 

continuation of the totalitarian 

Communist government. 

The Sudanese Sanctions Regulations, 

31 CFR part 538 (the ‘‘SSR’’), implement 

Executive Order 13067, issued on 

November 3, 1997, pursuant to, inter 

alia, the International Emergency 

Economic Powers Act (50 U.S.C. 1701–

1706) (IEEPA). In the order, the 

President declared a national emergency 

with respect to the policies and actions 

of the Government of Sudan, ‘‘including 

continued support for international 

terrorism; ongoing efforts to destabilize 

neighboring governments; and the 

prevalence of human rights violations, 

including slavery and the denial of 

religious freedom.’’ To deal with this 

national emergency, Executive Order 

13067 imposed trade sanctions with 

respect to Sudan and blocked all 

property and interests in property of the 

Government of Sudan in the United 

States or within the possession or 

control of U.S. persons. 

The Iranian Transactions Regulations, 

31 CFR part 560 (the ‘‘ITR’’), implement 

a series of Executive orders, beginning 

with Executive Order 12957, issued on 

March 15, 1995. In that order, the 

President declared a national emergency 

pursuant to IEEPA to deal with the 

unusual and extraordinary threat to the 

national security, foreign policy, and 

economy of the United States 

constituted by the actions and policies 

of the Government of Iran, including its 

support for international terrorism, its 

efforts to undermine the Middle East 

peace process and its efforts to acquire 

weapons of mass destruction and the 

means to deliver them. To deal with this 

threat, Executive Order 12957 imposed 

prohibitions on certain transactions 

with respect to the development of 

Iranian petroleum resources. On May 6, 

1995, the President issued Executive 

Order 12959 imposing comprehensive 

trade sanctions to further respond to 

this threat, and on August 19, 1997, the 

President issued Executive Order 13059 

consolidating and clarifying the 

previous orders. 

The Treasury Department’s Office of 

Foreign Assets Control (‘‘OFAC’’) is 

amending the CACR, SSR and ITR to 

authorize certain activities relating to 

publishing that otherwise entail the 

prohibited exportation of services to, or 

prohibited importation of services from, 

Cuba, Sudan or Iran. 

With certain exceptions, the 

exportation and importation of 

information and informational materials 

to or from any country are exempt from 

regulation by the President under 

TWEA and IEEPA. See 50 U.S.C. App. 

5(b)(4) and 50 U.S.C. 1702(b)(3), 

respectively. OFAC is issuing the new 

general licenses set forth at 31 CFR 

515.577, 31 CFR 538.529 and 31 CFR 

560.538 to authorize transactions not 

already exempt from regulation that 

directly support the publishing and 

marketing of manuscripts, books, 

journals, and newspapers, in paper or 

electronic format. 

Each of the general licenses is similar 

in structure and scope, authorizing a 

variety of activities relating to 

publishing with appropriate exceptions, 

such as those for the governments of