United States

When synthetic equity makes a real difference

S corporation broadly held test includes more than ESOP stock


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Section 409(p) is an anti-abuse provision that applies to all S corporations with an ESOP owner. Although the most abusive S corporation ESOP structure relates to a 100 percent ESOP-owned S corporation, where the structure is entirely tax-exempt, section 409(p) applies to and must be analyzed by any ESOP-owned S corporation, regardless of the percentage owned by the ESOP. The provision is often referred to as the “broadly held test” because its purpose is to ensure that the ESOP ownership is allocated among a broad group of employees rather than being concentrated in the hands of only a few employees.

Although this concept seems simple, the actual test to determine whether ownership is broadly held is quite complicated. The provision requires a two-step analysis: (1) determining whether any persons are considered “disqualified persons,” and (2) determining whether those disqualified persons own at least 50 percent of the S corporation. If the S corporation confirms that disqualified persons own at least 50 percent of the S corporation, a nonallocation year results, and the rules prohibit allocations to the disqualified persons’ accounts. The consequences of making prohibited allocations can be catastrophic and include: (1) tax and an early withdrawal penalty assessed on the recipient of the prohibited allocation; (2) loss of the ESOP’s qualified plan status under section 401(a); (3) loss of the prohibited transaction exemption for any loan the ESOP has;  (4) a 50 percent excise tax on prohibited allocations and a 50 percent excise tax on the fair market value of synthetic equity held by a disqualified person, both assessed on the corporation; and (5) because the ESOP is no longer a qualified plan and, thus, a qualified shareholder, loss of S corporation status.

Even though limited corrective actions can be taken after a prohibited allocation occurs, given the extreme cost of failure, it is prudent to monitor section 409(p) compliance to ensure awareness of a nonallocation year before allocations occur. Also, a 50 percent excise tax is imposed on the deemed ESOP shares of disqualified persons even if no prohibited allocation occurs. This article explains the section 409(p) hurdles in more detail and then focuses on the importance of synthetic equity in the test.

Who is a disqualified person?

An individual owning 10 percent or more, or members of a family owning 20 percent or more, “deemed owned shares” under the following formula:

Percent owned =    

Person’s/family’s deemed-owned shares

All ESOP shares + person’s/family’s synthetic shares


Note that the synthetic shares in the denominator include only those belonging to the person or family in the numerator. The formula is not diluted for deemed-owned shares of other persons. In addition, this formula does not include shares of the corporation owned by parties outside of the ESOP. Disqualified person status is determined based solely on ESOP ownership and deemed-owned shares (see definition below).

An ESOP-owned S corporation needs to fully understand any family relationships among employees because any family member with deemed-owned shares becomes a disqualified person if the family together owns 20 percent of the deemed-owned shares. Family relationships for purposes of section 409(p) include spouses; ancestors and lineal descendants of the individual and their spouse; brothers and sisters and their lineal descendants; and the spouses of any of the above. This definition of family is broader than those used in most other provisions of the tax code.

What is a nonallocation year?

If disqualified persons exist, a nonallocation year results if the total corporate ownership of disqualified persons is 50 percent or more. While this seems straightforward, it is not as simple as adding the percentages of disqualified persons together. The following formula is used to determine a nonallocation year:

Percent owned =    

Actual (non-ESOP) ownership + deemed ownership of disqualified persons

Total shares outstanding + synthetic shares of disqualified persons

The important distinction here is that non-ESOP ownership is now included in the calculation. Therefore, if the ESOP does not own 100 percent of the S corporation, any disqualified person who owns shares directly in the S corporation needs to include those shares in the calculation of their ownership percentage for purposes of making the nonallocation year determination.

However, it should be noted that a person has to first be a disqualified person to be included in the nonallocation year calculation.Therefore, if a person owns shares outside of the ESOP, but has no ESOP participation and holds nothing qualifying as deemed-owned shares, then that person is not a disqualified person and therefore not considered for  nonallocation year purposes.

What are deemed-owned shares?

For purposes of determining whether a person is disqualified, deemed-owned shares are defined to include the following:

  • ESOP shares allocated to an individual’s ESOP account
  • An individual’s share of the unallocated ESOP shares. For purposes of dividing the unallocated shares among participants prior to their actual release, the prior year’s stock allocation percentage is used. For example, if an individual received 1 percent of the 2014 stock allocation, the individual would be allocated 1 percent of the unallocated shares for purposes of calculating 2015 ownership for section 409(p)
  • Synthetic equity

Because this definition includes synthetic equity, individuals who do not actually participate in the ESOP may need to be considered since they could be treated as having deemed-owned shares.

What is synthetic equity?

Although actual shares owned outside of the ESOP are not included in the determination of a disqualified person, synthetic equity that is held outside of the ESOP is included. Synthetic equity includes:

  • Stock options
  • Warrants
  • Restricted stock
  • Deferred issuance stock rights
  • Any similar interest giving the holder the right to acquire or receive stock or assets of the S corporation or a related party in the future
  • Stock appreciation rights
  • Phantom stock units
  • Similar rights to future cash payments based upon the value or appreciation of such stock

In general, this list covers rights to future stock ownership and payments tied to stock value. Although small companies do not generally have these types of synthetic equity, they are not uncommon in ESOP companies. Many of these items are compensatory devices used to incentivize managers by aligning their compensation with the company’s performance. Actual stock allocated to managers through an ESOP also has this alignment, but since the ESOP is a qualified plan, ESOP allocations have inherent limits. Therefore, many companies use these synthetic equity devices to provide management with equity-based compensation beyond their ESOP allocations. Warrants are also not uncommon in ESOP-owned companies to give selling shareholders an overall return that makes up for the risk they take by being subordinated to other lenders when providing seller financing on the sale of their shares.

Reviewing the list of synthetic equity vehicles, one can see why Congress chose to include these as items to consider in determining whether an ESOP is adequately benefiting a broad category of participants. These devices dilute the value of ESOP shares held by employees and transfer that value to those persons holding the synthetic equity. Even though shares held directly outside the ESOP also have an effect on ESOP share value, restrictions and contingencies associated with the above devices make them much more commonly used for compensation since they do not have the same rights as outright shares. In addition, the intent of section 409(p) is to prevent abuses involving the use of devices to exploit the tax-exempt nature of the ESOP ownership structure for a small group of participants. Shares held directly outside of the ESOP do not avoid tax, because they are held by taxable entities or individuals.

Another category included in synthetic equity is deferred compensation, which is not generally tied to equity value like the above devices. Nonetheless, the regulations include the following in the definition of synthetic equity for section 409(p) purposes:

  • Remuneration to which section 404(a)(5) applies,1
  • Remuneration to which section 404(a)(5) would apply if separate accounts were maintained,
  • Rights to receive property in a future year to which section 832 applies,
  • Property transfers for services under section 83,
  • Split-dollar life insurance arrangements related to the performance of services, and
  • Any other remuneration that results in receipt after the 15th day of the third month of the entity’s taxable year in which services are provided (except for eligible retirement plans).

Because deferred compensation is generally paid in cash, equity dilution is not as direct as with other synthetic equity components. However, imagine a scenario in which an ESOP owns 100 percent of an S corporation and, thus, benefits from paying no income tax currently on any of the corporation’s earnings. This tax benefit is provided by way of the ESOP being a qualified retirement plan that is meant to benefit employees on a nondiscriminatory basis. Most deferred compensation plans are not qualified plans because they are provided only to management and are meant to be discriminatory. With a nonqualified plan, the employer does not receive a current tax deduction. However, in a 100 percent owned S corporation ESOP situation, the deferred tax deduction is not an issue.

Note that although the above equity-related items and deferred compensation are included in the determination of disqualified persons, a person is still not disqualified unless the person’s ownership percentage is 10 percent or more or the person is a member of a family that owns 20 percent or more under the above formula. Therefore, S corporations with ESOP ownership are not prevented from using synthetic equity components, but they must measure each person’s and family’s share for purposes of this test to ensure the ownership percentages do not cause a section 409(p) violation. In fact, most companies provide levels of synthetic equity that would not cause section 409(p) violations even in the absence of its requirements because it generally is not a good business practice to provide such high levels of synthetic equity.

Nonetheless, the section 409(p) requirements can make ESOP ownership impossible or make any level of synthetic equity components an automatic violation in very small companies with few employees. For example, imagine an S corporation with 1,000 shares outstanding, of which an ESOP owns 500 shares. The S corporation has 10 employees that all earn the same compensation, and each employee gets 10 percent of the ESOP share allocations. Each employee is a disqualified person because they each own 10 percent of the ESOP shares. In addition, every year would be a nonallocation year because those disqualified persons own at least 50 percent of the corporation. Both of these tests are confirmed even assuming there is no synthetic equity and none of the employees own any shares outside of the ESOP. If either of those factors were present, the S corporation may even have a few more than 10 employees but still violate section 409(p). As the number of employees increases, or the number of shares held outside of the ESOP increases in comparison to the number of shares held inside the ESOP, it becomes less likely for either disqualified persons or a nonallocation year to be present. Likewise, higher levels of synthetic equity could exist in S corporations in these scenarios because there is more room to increase the test percentages without causing failure.

How is synthetic equity measured?

The formulas for disqualified persons and a nonallocation year are denominated in a number of shares, either the shares held in the ESOP or total shares outstanding. Synthetic equity must therefore be translated into a number of shares for purposes of testing compliance with section 409(p). Some synthetic equity components are already issued in reference to a number of shares. For example, an executive may be granted stock options that provide rights to purchase a certain number of shares. An option to purchase one share is treated as one share for section 409(p).

A stock appreciation right (SAR), on the other hand, provides an employee the right to a payment based upon a formula that uses a certain number of shares times the appreciation of the share price over a given base price at the time of measurement. Although a SAR is also tied to a number of shares, the appreciation piece is translated to a number of shares based on the current share price for purposes of section 409(p). For example, imagine the current share price is $10 per share, and that is the base amount of an employee’s SARs for 100 shares. Upon grant, since there is no appreciation yet, there are zero shares for purposes of section 409(p). Assume that the following year the share price rises to $12, and each SAR now has $2 of appreciation associated with it. That $2 of appreciation now represents one-sixth of a share for section 409(p) purposes because one-sixth of a share is worth $2 now.

Deferred compensation requires yet another translation since it is not tied to a number of shares, but instead is a dollar amount. In this case, the person with the deferred compensation is treated as owning the number of shares equal to the present value of the deferred compensation. Imagine an employee who will receive a $500,000 payment five years from now. If the present value of that payment is $450,000 and the current share price is $1,000, the employee is deemed to own 450 shares.

A couple of rules make the translation of deferred compensation easier to administer than it might otherwise be when the present value and share price could be constantly changing. The ESOP plan document must include these provisions for them to apply, but if included, there is an annual rule and a three-year rule. The annual rule allows deferred compensation amounts to be translated to a number of shares annually on any reasonable date during the year, even though section 409(p) generally applies at any time during the year, which may require testing more than once during the year. This annual date is referred to as the determination date. The three-year rule further allows the number of deferred compensation shares for a given arrangement to be fixed for up to three years from the original determination date. Any new deferred compensation arrangements issued during the year would be calculated on the annual determination date, but any arrangements existing at the previous determination date would not be recalculated until the determination date three years from the original calculation of that specific arrangement.

Overall, the number of synthetic equity shares is adjusted downward if the ESOP does not own 100 percent of the S corporation. For example, if all of the synthetic equity components are identified and translated into 1,000 shares in total and the ESOP owns 50 percent of the S corporation, then only 500 shares are used for the section 409(p) formulas.

Synthetic equity considerations

The inclusion of synthetic equity in section 409(p) makes familiarity with the rules important for S corporations as they operate their businesses. Compliance with section 409(p) is required on every day of the year. Thus, as new agreements are being entered with employees, and perhaps other parties, the tests for determining disqualified persons and the existence of a nonallocation year must be reperformed. Because the consequences of failing section 409(p) are so drastic, the corporation should ensure the issuance of a new arrangement will not cause failure prior to issuing it.

As can be seen, the definition of synthetic equity is broad and covers arrangements that are very commonly used by employers of all sizes. While far from inclusive, the following list contains example scenarios that would require careful consideration with respect to section 409(p) compliance:

  • Warrants are commonly issued to selling shareholders who finance a portion of the ESOP share purchase through a seller loan to either the company or the ESOP. In many cases, the seller may sell all of his or her shares at once and may no longer be an employee of the company. Therefore, he or she would not generally be included in measuring equity ownership of the company, but the warrants he or she holds would be synthetic equity and, therefore, likely make the selling shareholder a disqualified person. As long as the warrants represented less than 50 percent of the outstanding equity value of the corporation and there were no other disqualified persons, there would not be a nonallocation year. However, the value of the warrants would need to be carefully considered if there were other disqualified persons.
  • When issuing new synthetic equity arrangements, employers should consider the number of shares required to be included in the section 409(p) tests before choosing the type of synthetic equity to issue. For example, the SAR example above resulted in one-sixth of a share being included in the test. A stock option with a $10 strike price would provide the same $2 of economic value to the employee, but would cause one full share to be included in the section 409(p) test since options and SARs are translated into a number of shares differently.
  • The corporation’s changing share price may cause the section 409(p) test result to change simultaneously if certain synthetic equity components are outstanding. For example, since deferred compensation is translated by dividing by the current fair market value of shares, a declining share price would lead to an increased number of shares attributable to the deferred compensation (depending, of course, on the measurement dates used for deferred compensation, as discussed above).


ESOP-owned S corporations receive great tax benefits and can provide value to employees, selling shareholders, and corporations. However, the tax benefits come with the cost of complying with section 409(p). Passing the section 409(p) tests is not often difficult for companies with at least 15 employees, reasonable levels of employee compensation arrangements, and little family ownership among employees. Nonetheless, performing the test calculations to prove compliance is important and complicated. S corporations with ESOP owners need to be aware of the rules and consult with their advisors to document compliance and to prevent a violation.

[1] Section 404(a)(5) generally applies to payments for services provided in one year that are received in a subsequent year, except for payments associated with qualified retirement plans. In general, this category is nonqualified deferred compensation agreements.

[2] Section 83 applies to property transferred for the provision of services. Generally, property transfers are subject to restrictions at the original time of grant to the employee and have a deferred nature. However, section 83 applies broadly to all property transfers for services, and some current payments may also be included.


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