Section 409(p): Excise Tax, Form 5330, and Prevention

Section 409(p) of the Internal Revenue Code prevents a small group of owners, family members, or highly compensated insiders from capturing the tax benefits of an S corporation ESOP. It does that by testing ownership concentration inside the plan every day of the year: if disqualified persons collectively own at least 50 percent of the company’s shares (counting both real stock and certain synthetic equity), the plan year becomes a “nonallocation year” and no ESOP assets may be allocated or accrued for any disqualified person. Violating the rule triggers a 50 percent excise tax on the S corporation and forces the disqualified individuals to recognize the prohibited allocation as ordinary income.

Who Counts as a Disqualified Person

A disqualified person is anyone whose ownership concentration in the S corporation crosses one of two thresholds, measured in “deemed-owned shares.” Deemed-owned shares are the shares already allocated to a person’s ESOP account, that person’s proportionate share of unallocated stock in the ESOP suspense account, and any synthetic equity attributed to them.

The 20 percent family threshold. A person is disqualified if the combined deemed-owned shares of that person and their family members reach at least 20 percent of all deemed-owned shares. Every family member who holds deemed-owned shares also becomes a disqualified person by association.¹
The 10 percent individual threshold. A person who does not already trip the family test is still disqualified if their own deemed-owned shares alone reach at least 10 percent of the total.¹

The definition of family is wider than most people expect. It covers the spouse, ancestors, lineal descendants, brothers and sisters (including a spouse’s siblings), lineal descendants of those siblings, and the spouses of any of them. A spouse legally separated under a decree of divorce or separate maintenance is not counted.¹ A father, daughter, and son-in-law who each hold modest ESOP balances may look fine individually and still cross the 20 percent line collectively.

Synthetic Equity Counts as Ownership

The ownership test would be easy to game if it only counted actual stock. Someone could keep allocated shares below the threshold while holding options, phantom stock, or deferred compensation that carries the same economic interest. Section 409(p) closes that door by treating synthetic equity as deemed-owned shares.

The statute defines synthetic equity to include stock options, warrants, restricted stock, deferred issuance stock rights, stock appreciation rights, phantom stock units, and similar rights to a future cash payment tied to the stock’s value.¹ The Treasury regulations also treat nonqualified deferred compensation as synthetic equity.²

Every form of synthetic equity gets translated into shares for the test. Divide the value of the synthetic equity by the fair market value of one share of S corporation stock on the determination date. A phantom stock arrangement worth $500,000 in a company whose shares are worth $100 each converts to 5,000 synthetic equity shares. The determination date for synthetic equity has to match the date used for deemed-owned ESOP shares so the numbers are compared on the same footing.²

This is where companies most often stumble. A deferred compensation plan set up years before the ESOP, or an executive arrangement nobody thinks of as “stock,” can push someone’s deemed-owned share count well past the threshold. Compliance requires inventorying every arrangement that gives anyone an economic interest tied to the company’s value.

When a Nonallocation Year Is Triggered

A nonallocation year is any plan year during which disqualified persons collectively own at least 50 percent of the shares of the S corporation.¹ The regulation runs two parallel counts: one that looks only at outstanding shares, and a second that adds synthetic equity owned by disqualified persons. If either count hits 50 percent, the year is a nonallocation year.³

The sequence is straightforward. First, identify every disqualified person under the 10 percent and 20 percent thresholds, applying family attribution and synthetic equity. Then aggregate the shares those people own or are deemed to own. If the total reaches 50 percent, the year is tainted. The statute measures concentration “at any time during such plan year,” so a single day of noncompliance can taint the entire year.

What a Violation Costs

The consequences hit the company and the disqualified individuals at the same time.

The 50 Percent Excise Tax on the Company

Section 4979A imposes a 50 percent excise tax on the “amount involved.” The S corporation pays it, not the individuals.⁴ What the amount involved actually is depends on the type of violation:

For a prohibited allocation, it is the amount allocated to a disqualified person’s account in violation of 409(p)(1).
For synthetic equity ownership by a disqualified person, it is the value of the shares on which the synthetic equity is based.
For the first nonallocation year, it is the total value of all deemed-owned shares of all disqualified persons, not just the current year’s allocations.⁴

That first-year rule catches people off guard. If disqualified persons collectively hold $4 million in deemed-owned shares when the first nonallocation year hits, the excise tax is $2 million, regardless of how small that year’s actual allocation was.

Ordinary Income to the Disqualified Individual

On top of the corporate excise tax, the plan is treated as having distributed the prohibited allocation to the disqualified person when it was made. That amount is included in the individual’s ordinary taxable income for the year of the violation, even though the shares are still sitting in the ESOP and the individual received no cash.¹ If the violation is severe or left uncorrected, the ESOP itself risks losing its tax-qualified status, which pulls all participants into broader tax consequences.

Reporting a Violation on Form 5330

An S corporation that owes the Section 4979A excise tax reports and pays it on IRS Form 5330. The filing deadline is the last day of the seventh month after the end of the employer’s tax year, which is July 31 for a calendar-year company. A six-month extension is available by filing Form 8868 before the deadline.⁵

Employers required to file at least 10 returns of any type during the calendar year must submit Form 5330 electronically.⁵ Missing the deadline adds a failure-to-file penalty of 5 percent of the unpaid tax per month up to 25 percent, plus a separate failure-to-pay penalty of 0.5 percent per month on the outstanding balance, also capped at 25 percent. When both apply in the same month, the failure-to-file penalty is reduced by the 0.5 percent failure-to-pay amount. Both can be waived for reasonable cause.

Preventing a 409(p) Violation

The penalties are severe enough that prevention is the only workable strategy. The IRS expects safeguards to be built into the plan document itself rather than patched in after the fact.

Required Plan Language

Every S corporation ESOP must include language explicitly prohibiting allocations to disqualified persons during a nonallocation year, and the plan must define both “disqualified person” and “nonallocation year” in its own text. The language cannot be incorporated by reference to the statute or regulations; it has to be spelled out.⁶ The IRS publishes sample language in its ESOP Listing of Required Modifications that plans can adopt.

The Transfer Method

The most common prevention tool is the transfer method in the Treasury regulations. When the plan administrator determines that a participant is a disqualified person, or is reasonably expected to become one, the plan moves that person’s assets out of the ESOP portion into a separate non-ESOP portion of the same plan, or into a different 401(a) qualified plan the employer maintains. Once transferred, those assets are no longer held in an ESOP and are no longer subject to 409(p) testing.²

Two catches. If S corporation stock is transferred to the non-ESOP plan, that plan becomes subject to unrelated business income tax on the S corporation income flowing through those shares. And the transfer requires affirmative action taken no later than the transfer date; every subsequent action, including benefit statements, must be consistent with the transfer having actually occurred then. Retroactive paper fixes do not work.² The regulations do provide relief from nondiscrimination testing for these transfers, so the mechanics of moving assets between plan portions should not create a separate compliance problem.

Testing More Often Than Once a Year

Because the test can be failed on any day of the plan year, an annual check is not enough for companies operating near the threshold. A participant’s termination, a repurchase of shares from a departing employee, a new deferred compensation arrangement, or a swing in stock valuation can push the numbers past the limit between formal testing dates. Companies with concentrated ownership or significant synthetic equity should run the test quarterly, or whenever a triggering event occurs. Discovering the problem at the next annual valuation usually means the nonallocation year was triggered months earlier and the excise tax base is already fixed.

1
Office of the Law Revision Counsel. 26 USC 409 – Qualifications for Tax Credit Employee Stock Ownership Plans
2
eCFR. 26 CFR 1.409(p)-1 – Prohibited Allocation of Securities in an S Corporation
3
eCFR. 26 CFR 1.409(p)-1T – Prohibited Allocations of Securities in an S Corporation
4
Office of the Law Revision Counsel. 26 USC 4979A – Tax on Certain Prohibited Allocations of Qualified Securities
5
Internal Revenue Service. Instructions for Form 5330
6
Internal Revenue Service. Issue Snapshot – Preventing the Occurrence of a Nonallocation Year Under Section 409(p)