MEMORANDUM FOR DANIEL R. JONES, MANAGER, EP DETERMINATIONS QUALITY ASSURANCE

FROM: Andrew E. Zuckerman, Director, Employee Plans Rulings and Agreements

SUBJECT: Response to Technical Assistance Request (#3)

This Memorandum is in response to your Request for Technical Assistance, dated April 2, 2009, with regard to the timing of an amendment of an employee stock ownership plan (as defined in Internal Revenue Code (“Code”) section 4975(e)(7)), (“ESOP”), of an S corporation, and the language required in such amendment, for purposes of the ESOP’s compliance with Code section 409(p).

Issues:

I. Whether an amendment to an S corporation ESOP that imposes the general statutory prohibitions of Code section 409(p) on allocations to accounts of “disqualified persons”, without defining specific terms set forth in the statute, satisfies the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) good faith amendment requirement and enables the EGTRRA remedial amendment period for the plan to remain intact until the expiration of the plan’s initial five- or six-year remedial amendment cycle within the meaning of Rev. Procedures 2005-66 and 2007-44, provided that the plan is amended to comply with subsequent changes in the law which are applicable to the plan.

II. Whether an ESOP must be amended by the close of the EGTRRA remedial amendment cycle to define certain terms set forth in Code section 409(p) and the regulations thereunder. Specifically, whether an ESOP plan document that is intended to comply with Code section 409(p) must set forth (A) the general statutory prohibition of Code section 409(p) on allocations to the account of a disqualified person during a nonallocation year, and (B) the definition of certain terms set forth in Code section 409(p) or the regulations thereunder including, but not limited to, the following:

i. Disqualified Person
ii. Nonallocation Year
iii. Deemed-Owned Shares
iv. Deemed 10% Shareholder
v. Synthetic Equity
vi. Impermissible Allocation
vii. Impermissible Accrual

Additionally, if a plan is required to define the term “nonallocation year”, must the definition also include language that sets forth the attribution rules of Code section 409(p)(3)(B)?

III. Whether a (A) failure to timely amend a plan to comply with Code section 409(p), either on a good-faith basis or by the close of the plan’s initial five- or six year remedial amendment cycle, or (B) failure to comply with Code section 409(p) in operation by permitting an allocation of assets to the account of a disqualified person during a nonallocation year, will cause the plan to fail the qualification requirements of Code section 401(a).

Background and General Statement of the Law:

Code section 409(p)(1) provides that an ESOP holding securities consisting of stock in an S corporation must provide that no portion of the assets of the ESOP attributable to (or allocable in lieu thereof) 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 Code section 401(a)) for the benefit of any disqualified person.

Code section 409(p)(2) provides that if a plan fails to meet the requirements of Code section 409(p)(1), the plan will be treated as having distributed to any disqualified person the amount allocated to the disqualified person’s account, at the time of such allocation.

Code section 409(p)(3)(A) defines “nonallocation year” as any plan year of an ESOP if, at any time during such plan year, the plan holds employer securities consisting of S corporation stock and disqualified persons own at least fifty percent (50%) of the number of shares of stock in the S corporation.

Code section 409(p)(3)(B) provides that, subject to certain exceptions, the attribution rules of Code section 318(a) generally apply in the determination of stock ownership for purposes of Code section 409(p)(3)(A).

Code section 409(p)(4)(A) provides that the term “disqualified person” means any person if (i) the aggregate number of deemed-owned shares of such person and the members of such person’s family is at least twenty percent (20%) of the number of deemed-owned shares of stock in the S corporation, or (ii) in the case of a person not described in clause (i), the number of deemed-owned shares of such person is at least ten percent (10%) of the number of deemed-owned shares of stock in the S corporation.

Code section 409(p)(4)(B) provides that any member of a disqualified person’s family with deemed-owned shares shall be treated as a disqualified person if not otherwise so treated under Code section 409(p)(4)(A). The definition of “deemed owned shares” is set forth in Code section 409(p)(4)(C). The definition of “member of the family”, for purposes of Code section 409(p)(4), is set forth in Code section 409(p)(4)(D).

Code section 409(p)(5) provides that, for purposes of paragraphs (3) and (4) of Code section 409(p), in the case of a person who owns synthetic equity in the S corporation, except to the extent provided in the regulations, the shares of stock in the S corporation on which the synthetic equity is based shall be treated as outstanding stock in such corporation and deemed-owned shares of such person if such treatment of synthetic equity of one or more persons results in (A) the treatment of any person as a disqualified person, or (B) the treatment of any year as a nonallocation year.

Code section 409(p)(6) provides the definitions of “employee stock ownership plan”, “employer security”, and “synthetic equity”, for purposes of Code section 409(p).

Notice 2001-42 provides that a plan provision is designated as a disqualifying provision under section 1.401(b)-1(b) of the Income Tax Regulations if:

(A) the plan provision either (1) causes the plan to fail to satisfy the qualification requirements of the Code because of a change in those requirements made by EGTRRA, or (2) is integral to a qualification requirement that has been changed by EGTRRA; and

(B) if a “good faith” EGTRRA plan amendment is required to be in effect with respect to the plan provision, the provision was added or changed by a “good faith” EGTRRA plan amendment adopted no later than the later of (1) the end of the plan year in which the EGTRRA change in the qualification requirements is required to be, or is optionally, put into effect under the plan or (2) the end of the GUST remedial amendment period for the plan.

Notice 2001-42 provides that the EGTRRA remedial amendment period under Code section 401(b) for a disqualifying provision described above shall not end prior to the last day of the first plan year beginning on or after January 1, 2005. Revenue Procedure 2007-44 further extends the EGTRRA remedial amendment period to the end of the initial five-year or six-year remedial amendment cycle, as applicable.

Notice 2001-42 further provides that a plan is required to have a “good faith” EGTRRA amendment in effect for a year if:

(A) the plan is required to implement a provision of EGTRRA for the year, or the plan sponsor chooses to implement an optional provision of EGTRRA for the year, and
(B) the plan language, prior to the amendment, is not consistent either with the provision of EGTRRA or with the operation of the plan in a manner consistent with EGTRRA, as applicable.

For purposes of Notice 2001-42, a plan amendment is a “good faith” EGTRRA plan amendment if the amendment represents a “reasonable effort” to take into account all of the requirements of the applicable EGTRRA provision and does not reflect an unreasonable or inconsistent interpretation of the provision. The Notice further provides that a plan amendment that merely incorporates by reference an EGTTRA change in a qualification requirement that would not otherwise be permitted to be incorporated by reference is not a “good faith” EGTTRA plan amendment.

MEMORANDUM FOR DANIEL R. JONES, MANAGER, EP DETERMINATIONS QUALITY ASSURANCE

FROM: Andrew E. Zuckerman, Director, Employee Plans Rulings and Agreements

SUBJECT: Response to Technical Assistance Request (#2)

This Memorandum is in response to your Request for Technical Assistance, dated March 6, 2009, with regard to the language that is required under Internal Revenue Code section 401(a)(28) to be included in an employee stock ownership plan (within the meaning of Internal Revenue Code section 4975(e)(7)).

Issues:

1. For purposes of meeting the requirements of Internal Revenue Code (“Code”) section 401(a)(28), may an employee stock ownership plan (“ESOP”):

(a) Define “qualified participant”, in part, as “a participant or former participant”, instead of as “an employee”?

(b) Define “qualified participant” as an employee who has completed at least 10 “years of service” instead of 10 “years of participation”?

(c) Permit a participant who has attained age 55 but who has completed less than 10 years of participation in the plan to be treated as a “qualifiedparticipant”?

(d) Permit a participant with 10 or more years of participation who has a severance from employment before attaining age 55 to be treated as a “qualified participant” upon his or her attaining age 55 after severance from employment?

If the above definitions are permitted, does the special ESOP rule under section 1.401(a)(4)-4(d)(6) of the Income Tax Regulations (the “Regulations”) still apply in each case to the plan?

2. May an ESOP require a participant to complete at least 1,000 hours of service in order to be credited with a “year of participation”? May an ESOP define “year of participation” as a plan year in which a participant has an account balance under the ESOP (regardless of whether he or she is actively employed in such year and eligible for a contribution/allocation under the plan, and/or regardless of whether he or she has competed at least 1,000 hours of service (or other minimum) during such period?

3. In the event that an alternative definition of “qualified participant” as described above violates Code section 401(a)(28) – what relief, if any, would be available to a plan sponsor whose ESOP utilizes such definition, particularly if the plan sponsor has reliance on a determination letter which approves such definition?

Background and General Statement of the Law:

Code section 401(a)(28) was added to the Code by section 1175(a) of the Tax Reform Act of 1986 (“TRA ‘86”), and sets forth certain requirements that must be satisfied by an ESOP in order for the ESOP to be qualified under Code section 401(a).

Code section 401(a)(28)(B) provides that an ESOP must allow each “qualified participant” to elect, within 90 days after the close of each plan year in the “qualified election period”, to direct the plan to diversify a certain percentage of the qualified participant’s account.

Code section 401(a)(28)(B)(iii) defines “qualified participant” as any employee who has completed at least 10 years of participation under the plan and has attained age 55.

Code section 401(a)(28)(B)(iv) defines “qualified election period” generally as the 6-plan-year period beginning with the later of —

(a) the 1st plan year in which the individual first became a qualified participant, or
(b) the first plan year beginning after December 31, 1986.

Code section 401(a)(28) does not define “year of participation”.

For purposes of the diversification requirement of Code section 401(a)(28)(B), the General Explanation of the Tax Reform Act of 1986 by the Staff of the Joint Committee on Taxation (the “Blue Book”) states, on page 835, that “[t]he diversification requirement applies with respect to participants who have separated from service with the employer.” (emphasis added).

In addition, the Blue Book provides the following example: “. . . Assume a participant in a calendar year ESOP terminated employment in 1987, when the participant has 10 years of participation and is age 54. The participant’s account balance remains in the plan. The participant will become a qualified participant beginning in 1988 (the year in which the participant attains age 55), and will be eligible to direct diversification during the annual election periods in 1989, 1990, 1991, 1992, 1993 and 1994.” (emphasis added).

MEMORANDUM FOR DANIEL R. JONES, MANAGER, EMPLOYEE PLANS DETERMINATIONS QUALITY ASSURANCE

FROM: Andrew E. Zuckerman, Director, Employee Plans Rulings and Agreements
SUBJECT: Request for Technical Assistance (#1)

This Memorandum is in response to your Request for Technical Assistance, dated March 6, 2009, concerning immediate resale provisions in employee stock
ownership plans (within the meaning of Internal Revenue Code section 4975(e)(7)) and Internal Revenue Code section 409(h).

Issues
1. Whether a distribution from an employee stock ownership plan (“ESOP”) of stock that is subject to an immediate resale provision meets the requirements of Internal Revenue Code (“Code”) section 409(h), specifically the put option requirement of Code section 409(h)(1)(B).

2. Whether the immediate resale provisions set forth in Rev. Proc. 2003-23, as modified by Rev. Proc. 2004-14, may be applied to any distributions of stock from an ESOP or are limited solely to situations involving the rollover of S corporation stock from an S corporation ESOP to an IRA.

3. Whether distributions from an ESOP of stock that is subject to immediate resale provisions, in the case of a plan under which the trustee or plan administrator has discretion to determine which participants will receive distributions in cash and which participants will receive distributions in the form of
employer securities, violates the nondiscrimination requirements of the Code.

The IRS has created a special topical area of its website devoted to ESOP Resources, and, as part of the commencement of tis area, posted 4 "Responses to Technical Assistance Request" dealing with ESOP issues that were discussed in the IRS June, 2010 telephone forum. The 4 "Responses to Technical Assistance Request" are available via the IRS website or via the downloads area of this website.

The areas addressed by the posted responses are:

Response to Technical Assistance Request #1
This memorandum, issued November 3, 2009, concludes that provisions in certain employee stock ownership plans which provide that a distribution of stock is subject to immediate, mandatory resale are consistent with Code section 409(h).

Response to Technical Assistance Request #2
This memorandum, issued November 3, 2009, discusses plan language which defines “qualified participant” as set forth in Code section 401(a)(28)(B)(iii).

Response to Technical Assistance Request #3
This memorandum, issued December 9, 2009, discusses the required timing and substance of amendments intended to comply with Code section 409(p).

Response to Technical Assistance Request #4
This memorandum, issued February 23, 2010, discusses various qualification issues presented by plan provisions concerning the mandatory transfer of employer securities into and out of participant plan accounts.

On june 24, 2010, representatives of the IRS Exempt Plans division conducted an "ESOP Update Phone Forum"

The forum was conducted by Robert Gertner (Tax Law Specialist in EP Technical Guidance and Quality Assurance, Group 1) and Clare Diefenbach (Tax Law Specialist in EP Technical Branch, Group 2.

Topics discussed included:

"Qualified participant" and "Qualified election period" as described in section 401(a)(28)(B) of the Internal Revenue Code;
the repurchase of employer security under Section 409(h)(2)(B)(i), and

issues related to the transfer of employer security and cash between plan accounts - i.e. "rebalancing."

A copy o fthe powerpoint from the presentation is available in the "Downloads" area of www.esop.us, and the IRS has indicated that a transcript of the session will be made available and posted to the IRS website. We will notify visitors to our website when this is available.