One critical aspect of employee stock ownership plans (ESOPs) that some companies find intimidating is regulatory compliance — and it’s easy to see why.

Section 409 of the Internal Revenue Code includes definitive criteria for tax credit employee stock ownership plans. In other words, it provides nearly all the information needed to develop an ESOP that complies with requirements to continue to qualify for tax credit.

That’s important information to understand, but not everyone is comfortable or competent with regulatory language. And regulatory code often cites other codes, so it can take a lot of time and effort to really understand requirements. 

For example, Section 409 cites Section 401(a), which sets out the qualification requirements for a trust created or organized in the U.S. and forming a part of a stock bonus, pension, or profit-sharing plan. Section 401 is the part of the U.S. Code where the 401(k) plan gets its name — so when it comes to qualified retirement plans, it’s some key regulatory information to know.

If your company is in the process of becoming ESOP-owned, or if your business is an ESOP company, compliance with Section 409 is of the utmost importance.

Why? Designing and administering a compliant ESOP helps protect both your company and your employees from substantial tax penalties. Here’s what you should know.

IRC Section 409: Qualifications for tax credit employee stock ownership plans

While IRC Section 4975(e)(7) defines what constitutes an ESOP, Section 409 explains in detail the requirements an ESOP must meet in order to maintain its tax-qualified status.

Of notable importance is Section 409(p). The purpose of this section is to limit the establishment of S corporation ESOPs to those providing broad-based employee coverage that benefits rank-and-file employees in a way that doesn’t unfairly benefit highly compensated employees and historical owners of the business. 

Section 409(p) prohibits disqualified persons (DPs) from receiving allocations or accruals of S-corporation ESOP assets during a non-allocation year. This anti-abuse compliance requirement is complex and must be met every day of the plan year. Penalties are severe, so failure is not a practical option.

A disqualified person is any person who owns or is deemed to own 10% or more of the ESOP’s shares — or, in the case of family members in an ESOP (i.e. spouse, siblings, ancestors or lineal descendants, and spouses of any siblings, ancestors and lineal descendants) who own 20% when aggregated.

A non-allocation year happens when DPs collectively own or are deemed to own 50% or more of the ESOP’s shares. Allocating ESOP shares to DPs in a non-allocation year puts an ESOP out of compliance with anti-abuse rules.

It’s important to note that the “stock” referred to in Section 409(p) includes allocated and yet-to-be allocated shares, synthetic equity of the S corporation, and any directly held shares (in the case of less-than-100% ESOP-owned companies).

Section 409 plan failures should be addressed as soon as they are identified, in order to protect the ESOP and its participants.

What is IRC Section 409A?

Section 409A, inclusion in gross income of deferred compensation under nonqualified deferred compensation plans, applies to nonqualified deferred compensation. The rules of Section 409A went into effect in 2004, and were an effort by Congress to tighten regulations around deferred compensation.

NQDC can include nonqualified retirement plans (such as supplemental executive retirement plans, or SERPs), elective deferrals of compensation like long-term commission programs, severance payments, deferred bonus payments, stock options, other equity incentives, and certain employment agreements.

Employers can find themselves out of compliance with Section 409A when, for example:

  • A severance plan is not properly documented in writing
  • Payment form and timing are not established and documented when deferred compensation is granted
  • Documented payment form and/or timing is not followed
  • Bonus or severance payment is deferred beyond the limits described in the rules

While this section typically doesn’t apply to an ESOP, it can — due to a plan design failure.

At the heart of Section 409A is this: an ESOP plan failure, such as an ESOP allocation to  a disqualified person, makes that allocation NQDC, and likely, a violation of Section 409A.

That type of violation results in substantial tax penalties for the affected employee:

  • The nonqualified deferred compensation is fully taxable as soon as the employee has a vested right to receive it, whether or not it is distributed at that time
  • A 20% tax penalty on the value of the nonqualified deferred compensation is imposed
  • Interest on taxes and penalties may be imposed

Section 409A doesn’t have a correction system comparable to the Employee Plans Compliance Resolution System (EPCRS), but the IRS has published a series of correction methods to correct errors, which can help plan participants reduce or delay their tax liabilities, and possibly avoid penalty charges. See IRS Notices 2008-113, 2010-6, and 2010-80 for details.

Yes, an ESOP Can Be Complex — So Don’t Go it Alone

The complicated ESOP regulatory requirements can be intimidating, but the benefits and advantages of an ESOP are significant. And working closely with an expert third-party administrator can ease fiduciary risks, simplify regulatory compliance, and make the day-to-day operation of your ESOP much easier on your leadership team.

It’s also key to make sure your plan documents, including your distribution policy, follow applicable rules and are documented in writing. Our free eBook can get you started. Just click the link below to download your free copy today.

ESOP Distribution Policy eBOOK