rr-04-4.pdf

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Part I
Section 409.--Prohibited Allocations of Securities in an S Corporation
26 CFR 1.409(p)-1T: Prohibited allocation of securities in an S corporation.
(Also, §§ 1361, 4975, 4979A, 6011, 6111, and 6112; §§ 54.4975-11, 1.6011-4,
301.6111-2, and 301.6112-1.)

Rev. Rul. 2004-4

ISSUES
In the three situations described below, (1) are the individuals disqualified
persons within the meaning of § 409(p)(4) of the Internal Revenue Code (the Code), (2)
does the related employee stock ownership plan (ESOP) have a nonallocation year
within the meaning of § 409(p)(3), and (3) are any disqualified persons treated as
owning synthetic equity within the meaning of § 409(p)(5)?

FACTS

Situation 1

Before 2003, Individuals A and B own, either directly or indirectly, in whole or in
part, a domestic professional services corporation. In addition, before 2003, individuals
C, D, and E each owns, either directly or indirectly, in whole or in part, his or her own
domestic professional services corporation. A, B, C, D, and E (Taxpayers) are
employees of their respective domestic professional services corporations (Service
Recipient Corporations).

In 2003, a new corporation (S Corp) is formed, and elects to be treated as a
subchapter S corporation. S Corp forms a subsidiary corporation for each Taxpayer
(QSubs A through E), and files a qualified subchapter S subsidiary (QSub) election for
each subsidiary. S Corp contributes cash in exchange for 100 percent of the issued
and outstanding stock of each QSub. Each Taxpayer is designated as an officer and
investment manager for Taxpayer’s respective QSub. In addition, each QSub grants its
respective Taxpayer a nonqualified stock option to acquire substantially all or a majority
of the shares of the QSub.

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At the same time that S Corp is formed, it establishes a plan (ESOP) which is
designed to be an employee stock ownership plan (within the meaning of § 4975(e)(7))
and which holds 100 percent of the stock of S Corp. All the employees of S Corp and
the QSubs participate in the ESOP, with the exception of Taxpayers A through E.

Taxpayers A through E and their support staff terminate their existing
employment relationship with their respective Service Recipient Corporations and
become employees of the respective QSub. The customers of Taxpayers A through E
stop doing business with the Service Recipient Corporations and begin doing business
with the respective QSub of Taxpayers A through E.

Taxpayers A through E receive salary payments from their respective QSub, in
an amount substantially less than the income to S Corp generated by the business
activities of that Taxpayer after deduction for expenses. S Corp treats the subsidiaries
as valid QSubs, and treats the income generated by each QSub each year, and
earnings thereon, as earned by S Corp. The payments to the Taxpayers for current
salary are deducted by S Corp as an ordinary and necessary business expense.
However, since S Corp is wholly owned by an ESOP holding S corporation stock, S
Corp’s net earnings are not taxed currently.

Amounts of income to S Corp generated by the business activities of each
Taxpayer (net of expenses) but not paid to Taxpayers within 2½ months after the end of
the year accumulate in each Taxpayer’s respective QSub, for example, in a brokerage
account in each subsidiary, over which the respective Taxpayer has investment control
as the investment manager of the subsidiary. A through E can access the amounts
accumulated in their respective QSub by exercising their option to purchase shares in
the QSub. If each Taxpayer’s option to purchase shares of QSub stock were synthetic
equity of S Corp (determined in accordance with § 1.409(p)-1T(f)(4)(ii)), then each
Taxpayer would own at least 10 percent of the sum of the outstanding shares of S Corp
plus the synthetic equity shares of S Corp.

Situation 2

The facts are the same as in Situation 1
, except that instead of 5 individuals,
there are 11 individuals (Taxpayers A through K) each of whom is an employee of a
Service Recipient Corporation owned either directly or indirectly, in whole or in part, by
that Taxpayer. As in Situation 1
, amounts of income to S Corp generated by the
business activities of each Taxpayer (net of expenses) but not paid to the Taxpayer
accumulate in each Taxpayer’s respective QSub, and each Taxpayer has the right to
acquire stock in that Taxpayer’s QSub under the same terms as described in Situation

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1
. If each Taxpayer’s option to purchase shares of QSub stock were synthetic equity of
S Corp, then each Taxpayer would own less than 10 percent of the sum of the
outstanding shares of S Corp plus the synthetic equity shares of S Corp.

Situation 3

Before 2003, Corporation M is an S corporation with 200 employees, wholly
owned by an ESOP that was established after March 14, 2001, in which substantially all
of its employees participate. Before 2003, Individual A (Taxpayer) operated a
professional services corporation as a separate business. In 2003, Corporation M
forms a QSub for A by contributing cash in exchange for 100 percent of the issued and
outstanding stock of the QSub. As in Situation 1
, A and A’s support staff terminate their
existing employment relationship with A’s Service Recipient Corporation and become
employees of the QSub; A’s customers become customers of the QSub; amounts of
income to S Corp generated by the business activities of A (net of expenses) but not
paid to A accumulate in A’s QSub; and A has the right to acquire stock in the QSub
under the same terms as described in Situation 1. A does not participate in the
Corporation M ESOP. If A’s option to purchase shares of the QSub were synthetic
equity of S Corp, then A would own less than 10 percent of the total of the outstanding
shares stock of S Corp plus the synthetic equity shares of S Corp.

LAW

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 § 401(a). A plan is not treated as an ESOP under the
Code unless it meets the following requirements, to the extent applicable: § 409(h)
(relating to participants’ right to receive employer securities; put options); § 409(o)
(relating to participants’ distribution rights and payment requirements); § 409(n) (relating
to securities received in transactions to which § 1042 applies); § 409(p) (relating to
prohibited allocations of securities in an S corporation); § 664(g) (relating to qualified
gratuitous transfers of qualified employer securities); and § 409(e) (relating to
participants’ voting rights if the employer has a registration-type class of securities). As
authorized by § 4975(e)(7), additional requirements are imposed under § 54.4975-11 of
the Excise Tax Regulations.

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Section 1361(b)(1)(B) provides that an S corporation may not have as a
shareholder a person that is not an estate, a trust described in § 1361(c)(2), an
organization described in § 1361(c)(6), or an individual. In 1996, § 1361(c)(6) was
amended to permit a qualified plan under § 401(a) to be a shareholder in an S
corporation. Section 1316(a) of the Small Business Job Protection Act of 1996 (SBJPA)
(110 Stat. 1755) (1996).

Section 1361(b)(3)(A) provides that, for purposes of title 26 of the U.S. Code, a
corporation that is a qualified Subchapter S subsidiary will not be treated as a separate
corporation and all assets, liabilities, and items of income, deduction and credit of the
corporation are treated as assets, liabilities, and such items (as the case may be) of the
S corporation.

Section 511(a)(1) imposes a tax on the unrelated business taxable income (as
defined in § 512(a)) of organizations described in § 511(a)(2), which include plans that
qualify under § 401(a). Section 512(e)(1) provides that if an organization described in §
1361(c)(6) holds stock in an S corporation, the interest is treated as an interest in an
unrelated trade or business and, notwithstanding the organization’s general tax-exempt
status, all items of income, loss, or deduction taken into account under § 1366(a) and
any gain or loss on the disposition of the stock in the S corporation are taken into
account in computing the unrelated business taxable income of the organization. In
1997, § 512(e) was amended to provide that § 512(e) does not apply to employer
securities (within the meaning of § 409(l)) held by an ESOP described in § 4975(e)(7).
Section 1523 of the Taxpayer Relief Act of 1997 (TRA ‘97) (111 Stat. 788) (1997).
Accordingly, S corporation income allocable to stock held by an ESOP is not subject to
regular income or unrelated business income tax.

Congress became aware that the tax exemption for earnings on S corporation
stock held by an ESOP may lead to inappropriate tax deferral or avoidance in some
cases. In order to address these concerns, Congress enacted § 409(p) as part of the
Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (115 Stat. 38)
(2001). Section 409(p) is effective for plan years beginning after December 31, 2004.
However, pursuant to section 656(d)(2) of EGTRRA, § 409(p) of the Code is effective
for plan years ending after March 14, 2001, for an ESOP that is established after that
date, or if the employer securities held by the plan consist of stock in an S corporation
that did not have an S election in effect on that date. Notice 2002-2, Q&A–15, 2002-1
C.B. 285, provides that an S corporation does not have an election in effect on March
14, 2001, unless a valid election was actually filed on or before that date and is effective
with respect to such corporation on or before that date. Temporary and proposed
regulations under § 409(p) were issued on July 21, 2003 (2003-35 I.R.B. 420, 506,
September 2, 2003), effective generally for plan years ending after October 20, 2003.

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Section 409(p) is intended to limit the tax benefits of ESOPs maintained by S
corporations unless the ESOP provides meaningful benefits to rank-and-file employees.
As explained in the legislative history:

The Committee continues to believe that S corporations should be
able to encourage employee ownership through an ESOP. The
Committee does not believe, however, that ESOPs should be used by S
corporation owners to obtain inappropriate tax deferral or avoidance.

Specifically, the Committee believes that the tax deferral
opportunities provided by an S corporation ESOP should be limited to
those situations in which there is broad-based employee coverage under
the ESOP and the ESOP benefits rank-and-file employees as well as
highly compensated employees and historical owners.

H.R. Rep. No. 107-51, part 1, at 100 (2001).

Sections 409(p) and 4979A apply if a nonallocation year occurs in an employee
stock ownership plan, as defined in § 4975(e)(7), that holds shares of stock of an S
corporation that are employer securities as defined in § 409(l). Section 409(p)(1)
requires that 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
(or be allocated directly or indirectly under any plan of the employer meeting the
requirements of § 401(a)) for the benefit of any disqualified person, as defined in §
409(p).

Under § 409(p)(3), (4), and (5), 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: 1) 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 2) disqualified persons own at least 50 percent of the
aggregate number of outstanding shares of stock (including deemed-owned ESOP
shares) and synthetic equity in the S corporation. For these purposes, the rules of §
318(a) apply to determine ownership of shares in the S corporation (including deemed-
owned ESOP shares) and synthetic equity. However, § 318(a)(4) (relating to options to
acquire stock) is disregarded and, in applying § 318(a)(1), the members of an
individual’s family include members of the individual’s family specified in § 409(p)(4)(D).
In addition, an individual is treated as owning deemed-owned ESOP shares of that
individual notwithstanding the employee trust exception in § 318(a)(2)(B)(i).

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As indicated by the legislative history above, § 409(p) is intended to limit the tax
benefits of ESOPs maintained by S corporations unless the ESOP provides broad
based coverage for, and meaningful benefits to, rank-and-file employees. See H.R.
Rep. No. 107-51, part 1, at 100 (2001). Accordingly, Congress added § 409(p)(7),
recognizing that the structure of § 409(p) was not expected to be sufficient in all cases
to ensure broad-based coverage for, and meaningful benefits to, rank-and-file
employees. Section 409(p)(7)(A) thus authorizes the Secretary to prescribe such
regulations as may be necessary to carry out the purposes of § 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 § 409(p). The legislative history to § 409(p) includes the following with
respect to exercise of this authority:

For example, this might apply if more than 10 independent businesses are
combined in an S corporation owned by an ESOP in order to take advantage of the
income tax treatment of S corporations owned by an ESOP.
H.R. Conf. Rep. No. 107-84, at 277 (2001).

Pursuant to § 409(p)(7)(B), § 1.409(p)-1T(c)(3) of the Temporary Income Tax
Regulations provides that the Commissioner, in revenue rulings, notices and other
guidance published in the Internal Revenue Bulletin, 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 § 409(p). For any year that is a
nonallocation year, taking into account the legislative history cited above, § 1.409(p)-
1T(c)(3) also provides that this exercise of authority includes the authority to treat any
person as a disqualified person.

Under § 409(p)(4), a disqualified person is any person for whom: 1) the number
of such person’s deemed-owned ESOP shares is at least 10 percent of the number of
deemed-owned ESOP shares of the S corporation; 2) the aggregate number of such
person’s deemed-owned ESOP shares and synthetic equity shares is at least 10
percent of the aggregate number of deemed-owned ESOP and synthetic equity shares
of the S corporation; 3) the aggregate number of 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 4) the aggregate number of
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 aggregate number of
deemed-owned ESOP and synthetic equity shares of the S corporation.

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Section 409(p)(4)(C) defines "deemed-owned ESOP shares" to 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 most recent stock allocation under the
ESOP).

Section 1.409(p)-1T(f)(1), interpreting § 409(p)(5), provides that the
determination of whether someone is a disqualified person and whether a plan year is a
nonallocation year is made without regard to “synthetic equity” attributable to that
person and is also made separately taking into account synthetic equity. For purposes
of § 409(p) and § 1.409(p)-1T, 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 §
318(a)(2) and (3).

Section 409(p)(6)(C) defines "synthetic equity" to include 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. 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 or
appreciation in such value, such as 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.

Section 1.409(p)-1T(f)(2)(iv) provides a rule treating nonqualified deferred
compensation as synthetic equity. Specifically, that section of the temporary regulations
provides that synthetic equity also includes any remuneration for services rendered to
the S corporation, or a related entity, to which § 404(a)(5) applies (including
remuneration for which a deduction would be permitted under § 404(a)(5) if separate
accounts were maintained), any right to receive property (to which § 83 applies) in a
future year for the performance of services to an S corporation, or related entity, and
any transfer of property (to which § 83 applies) in connection with the performance of
services to an S corporation, or a related entity, to the extent that the property is not
substantially vested within the meaning of § 1.83-3(i) of the Income Tax Regulations by
the end of the plan year in which transferred. Section 1.409(p)-1T(f)(2)(iv) also provides
that synthetic equity includes any other remuneration for services rendered to the S
corporation, or a related entity, under a plan, method or arrangement, deferring the
receipt of compensation to a date that is after the 15th day of the 3d calendar month
after the end of entity's taxable year in which the related services are rendered, other
than a plan that is an eligible retirement plan within the meaning of § 402(c)(7)(B).

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Pursuant to the authority in § 409(p)(7), §1.409(p)-1T(f)(2)(iii)(A) provides that
synthetic equity also includes a right to acquire stock or other similar interests in a
related entity if such interests in the related entity are the only significant asset of the S
corporation and the S corporation is the only significant owner of the related entity.
Whether an asset is the only significant asset of the S corporation or the S corporation
is the only significant owner of the related entity depends on the relevant facts and
circumstances. Section 1.409(p)-1T(f)(2)(iii)(A)(4) provides that a 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 the Procedure and Administration Regulations or a Qualified
Subchapter S Subsidiary under § 1361(b)(3).

Pursuant to the authority in § 409(p)(7), § 1.409(p)-1T(f)(2)(iii)(C) provides that
the Commissioner may, if necessary to carry out the purposes of § 409(p), through
revenue rulings, notices, and other guidance published in the Internal Revenue Bulletin,
provide that synthetic equity includes a right to acquire stock or other similar interests in
a related entity in cases in which such interests in the related entity are not the only
significant asset of the S corporation or the S corporation is not the only significant
owner of the related entity.

Section 1.409(p)-1T(f)(4)(ii) provides that, in the case of synthetic equity that is
determined by reference to shares of stock (or other similar interests) in a related entity,
the person who is entitled to the synthetic equity is treated as owning shares of stock in
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)).

Section 4979A imposes a 50 percent excise tax in certain cases, including an
allocation of employer securities that is prohibited by § 409(p), the ownership of any
synthetic equity by a disqualified person during a nonallocation year, and the
occurrence of the first nonallocation year of an ESOP, as described in § 4979A(e)(2)(C).
Section 4979(A)(c)(1)(A) provides for this excise tax to be paid by the employer
sponsoring the ESOP.

ANALYSIS

In each situation described above, the ownership structure of the S corporation is
designed to allow one or more Taxpayers, each operating a business for that
Taxpayer’s own benefit, to take advantage of the tax-exempt status of the S corporation
that results from the ownership of its outstanding stock by the ESOP. The ownership
structure thereby avoids current taxation of the profits of each Taxpayer’s separate
business, while each Taxpayer retains the right to at least 50 percent of the business

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through the right to acquire shares in the QSub. Because the profits of each business
are being segregated and accumulated in each Taxpayer's QSub, the ESOP is owner of
the business only in form, not in substance, to the extent that the Taxpayer has a right
to the profits by exercising the Taxpayer’s option to acquire the shares of the QSub.
Thus, the ESOP is not providing benefits to rank-and-file employees that reflect its
ownership share in the S corporation.

In Situation 1
, each Taxpayer is using options on QSub stock to retain ownership
of his or her separate business, with the profits of that business being segregated from
the profits of the businesses of the other QSubs. In this way, the structure is designed
to divert the profits of each business away from the ESOP. If each QSub were an S
corporation directly owned by an ESOP, each Taxpayer’s right to acquire shares of that
corporation would be synthetic equity pursuant to § 409(p)(6)(C). Accordingly, the
structure described in Situation 1
is similar to other forms of synthetic equity, such as
the right to acquire stock in a related entity that is the only significant asset of an S
Corporation (owned by an ESOP). Further, the economic effect is similar to
nonqualified deferred compensation for services rendered to the QSub which is
declared to be synthetic equity in § 1.409(p)-1T(f)(2)(iv).

Consequently, the options granted to each Taxpayer in Situation 1
to acquire
shares in the QSub for that Taxpayer’s business should be treated as synthetic equity in
S Corp. Accordingly, pursuant to the authority in § 1.409(p)-1T(f)(2)(iii)(C), the
Commissioner in this revenue ruling provides that the options are synthetic equity.
Because these options are synthetic equity in Situation 1, each Taxpayer is a 10
percent owner of the number of deemed-owned shares of S Corp, Taxpayers A through
E are thus disqualified persons, and, because disqualified persons A through E own an
aggregate of at least 50 percent of the shares, 2003 is a nonallocation year for the
ESOP.

A group of individuals with the same right to acquire the accumulated profits of
their businesses as described in Situation 1
should not avoid the application of § 409(p)
merely because each individual’s right to acquire the accumulated profits of that
individual’s business does not have a value equal to at least 10 percent of the value of
S Corp because more than 10 separate businesses are combined (as described in
Situation 2
). In fact, Congress anticipated the combining of more than 10 businesses as
a means of avoiding the application of § 409(p) and gave this ownership structure as an
example of the type of situation where exercise of the authority granted in §
409(p)(7)(B) would be appropriate.

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Further, an individual with the same right to acquire the accumulated profits of
that individual’s business, similar to the rights described in Situation 1
, should not avoid
the application of § 409(p) merely because the business is combined, as in Situation 3
,
with the business of an S corporation owned by an ESOP that otherwise fulfills
Congressional intent by providing broad-based coverage and benefits to rank-and-file
employees. The rank-and-file employees in Situation 3
are not sharing in the profits of
the Taxpayer’s separate business through the ESOP's ownership share to the extent
that the profits of that business are being accumulated for the benefit of that Taxpayer.
With respect to that Taxpayer’s separate business, the ownership structure of the S
corporation is designed to avoid or evade the application of § 409(p).

In all three situations, the accumulation of profits for the benefit of a specific
individual is comparable to the operation of an S corporation owned by an ESOP.
Moreover, as in Situation 1
, if any one of these businesses were the only business
activity of S Corp, the option held by the taxpayers would be synthetic equity which
would result in a nonallocation year and each taxpayer being a disqualified person if
those shares of synthetic equity were at least 50 percent of the shares of stock of S
Corp plus the total synthetic equity shares.

Accordingly, pursuant to the authority of § 409(p)(7)(B) and § 1.409(p)-1T(c)(3),
the Commissioner provides in this revenue ruling 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 2½ 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. In addition,
pursuant to the authority in § 1.409(p)-1T(f)(2)(iii)(C), the Commissioner in this revenue
ruling provides that such individual’s right to acquire shares of stock (or similar interests)
of the QSub or similar entity is synthetic equity. For purposes of this paragraph, the
rights of the individual are determined after taking into account the attribution rules of §
409(p).

As a result, in Situations 2 and 3
, the Taxpayer’s right to acquire the shares of
the QSub is synthetic equity, each individual Taxpayer (A through K in Situation 2, and
A in Situation 3
) is a disqualified person, and a nonallocation year occurs. The
respective Taxpayers in Situations 2 and 3
are disqualified persons regardless of
whether, at any time, a particular Taxpayer owns synthetic equity shares of S Corp
equal to at least 10 percent of the sum of the outstanding shares of S Corp plus the
synthetic equity shares of S Corp.

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The same conclusions would apply with respect to Situations 1, 2, and 3
even if
the support staff of the Taxpayers were to continue to be employed by their respective
Service Recipient Corporations, the Service Recipient Corporations were to continue to
provide substantially the same services for their customers, any of the Taxpayers or
their support staff were to be employees of S Corp (instead of employees of a QSub), or
any of the Taxpayers were to participate in the ESOP.

Treasury and the Service intend to reflect the guidance in this revenue ruling in
regulations under § 409(p), effective for plan years ending after October 20, 2003. 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.

In appropriate cases, the Service may challenge other tax benefits claimed by
any taxpayer involved in this type of business structure. For example, in the appropriate
case, the Service may take the position for income tax purposes that, even though the
Taxpayer purported to transfer his or her business (including the employment of his or
her support staff) to the QSub, the Taxpayer never relinquished ownership of his or her
business and, therefore, the Taxpayer should still be taxed on the profits. The Service
might also take the position that the subsidiary is not a QSub. Alternatively, if the
support staff of the Taxpayers were to continue to be employed by their respective
Service Recipient Corporations, and the Service Recipient Corporations were to
continue to provide substantially the same services for their customers, the Service
might assert that each Taxpayer continues to be employed by their respective Service
Recipient Corporation, with the related tax consequences.

HOLDINGS

With respect to Situation 1
, for purposes of §§ 409(p) and 4979A, (1) A through E
are disqualified persons with respect to the ESOP, (2) the ESOP has a nonallocation
year, and (3) the options to acquire stock in QSubs A through E are synthetic equity to
which the § 4979A excise tax applies.

With respect to Situation 2
, for purposes of §§ 409(p) and 4979A, (1) A through K
are disqualified persons with respect to the ESOP, (2) the ESOP has a nonallocation
year, and (3) A through K are each treated as owning synthetic equity in the form of
each individual’s option to acquire shares of the corresponding QSub.

With respect to Situation 3
, for purposes of §§ 409(p) and 4979A, (1) A is a
disqualified person with respect to the ESOP, (2) the ESOP has a nonallocation year,
and (3) A is treated as owning synthetic equity in the form of A’s option to acquire
shares of the corresponding QSub.

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EFFECTIVE DATE AND TRANSITION RULE

This revenue ruling applies for plan years ending after October 20, 2003, but this
revenue ruling (including the listing in the Listed Transactions section below) is not
effective before March 15, 2004 if (i) all interests in a QSub held by individuals who
would be disqualified persons under this revenue ruling are distributed to those
individuals as compensation on or before March 15, 2004 and (ii) no such individual has
been a participant in the ESOP at any time after October 20, 2003 and before March 15,
2004. In addition, for purposes of the excise tax under § 4979A, an individual's interest
in a QSub that constitutes synthetic equity under this revenue ruling will be disregarded
to the extent such interest is distributed to the individual as compensation on or before
March 15, 2004.

LISTED TRANSACTIONS

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, the date this
document was released to the public: 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 2½ 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. For purposes of the preceding sentence, the rights of an
individual are determined after taking into account the attribution rules of § 409(p).
These arrangements are identified as “listed transactions” with respect to the S
corporation and each individual who is a disqualified person under this revenue ruling.

Independent of their classification as “listed transactions,” transactions that are
the same as, or substantially similar to, the transactions described in the preceding
paragraph may already be subject to the disclosure requirements of § 6011 (§ 1.6011-
4), the tax shelter registration requirements of § 6111 (§§ 301.6111-1T, 301.6111-2), or
the list maintenance requirements of § 6112 (§ 301.6112-1).

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Persons required to register these tax shelters under § 6111 who have failed to
do so may be subject to the penalty under § 6707(a). Persons required to maintain lists
of investors under § 6112 who have failed to do so (or who fail to provide such lists
when requested by the IRS) may be subject to the penalty under § 6708(a). In addition,
the IRS may impose penalties on parties involved in this transaction or substantially
similar transactions, including the accuracy-related penalty under § 6662.

The Service and the Treasury recognize that some taxpayers may have filed tax
returns taking the position that they were entitled to the purported tax benefits of the
type of transaction described in this revenue ruling. These taxpayers should consult
with a tax advisor to ensure that their transactions are disclosed properly and to take
appropriate corrective action.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Robert Gertner of the Employee
Plans, Tax Exempt and Government Entities Division and John Ricotta of the Office of
Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For
further information Employee Plans’ taxpayer assistance telephone service at 1-877-
829-5500 (a toll-free call) between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time,
Monday through Friday or contact Mr. Gertner at (202) 283-9888 (not a toll-free call).