Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 42.—Low-Income Housing Credit

Low-income housing credit; satis- factory bond; “bond factor” amounts for the period January through March 2007. This ruling provides the monthly bond factor amounts to be used by taxpayers who dispose of qualified low-income buildings or interests therein during the period January through March 2007.

Rev. Rul. 2007–5

In Rev. Rul. 90–60, 1990–2 C.B. 3, the Internal Revenue Service provided

guidance to taxpayers concerning the general methodology used by the Treasury Department in computing the bond factor amounts used in calculating the amount of bond considered satisfactory by the Secretary under § 42(j)(6) of the Internal Revenue Code. It further announced that the Secretary would publish in the Internal Revenue Bulletin a table of bond factor amounts for dispositions occurring during each calendar month.

Rev. Proc. 99–11, 1999–1 C.B. 275, established a collateral program as an alternative to providing a surety bond for taxpayers to avoid or defer recapture of

the low-income housing tax credits under § 42(j)(6). Under this program, taxpayers may establish a Treasury Direct Account and pledge certain United States Treasury securities to the Internal Revenue Service as security.

This revenue ruling provides in Table 1 the bond factor amounts for calculating the amount of bond considered satisfactory under § 42(j)(6) or the amount of United States Treasury securities to pledge in a Treasury Direct Account under Rev. Proc. 99–11 for dispositions of qualified low-income buildings or interests therein during the period January through March 2007.

DRAFTING INFORMATION

The principal author of this revenue ruling is David McDonnell of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling,

For a list of bond factor amounts applicable to dispositions occurring during other calendar years, see: Rev. Rul. 98–3, 1998–1 C.B. 248; Rev. Rul. 2001–2, 2001–1 C.B. 255; Rev. Rul. 2001–53, 2001–2 C.B. 488; Rev. Rul. 2002–72, 2002–2 C.B. 759; Rev. Rul. 2003–117,

2003–2 C.B. 1051; Rev. Rul. 2004–100, 2004–2 C.B. 718; Rev. Rul. 2005–67, 2005–2 C.B. 771; and Rev. Rul. 2006–51, 2006–41 I.R.B. 632.

2007–5 I.R.B. 378 January 29, 2007

ties, and other properties received by such transferor corporation, as well as the other properties of such transferor corporation, are distributed in pursuance of the plan of reorganization.

Further, section 356 provides that if section 354 or 355 would apply to an exchange but for the fact that the property received in the exchange consists not only of property permitted by section 354 or 355 without the recognition of gain or loss but also of other property or money, then the gain, if any, to the recipient shall be recognized, but not in excess of the amount of money and fair market value of such other property. Accordingly, in the case of an acquisitive transaction, there can only be a distribution to which section 354 or 356 applies where the target shareholder(s) receive at least some property permitted to be received by section 354.

Notwithstanding the requirement in section 368(a)(1)(D) that “stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356”, the IRS and the courts have not required the actual issuance and distribution of stock and/or securities of the transferee corporation in circumstances where the same person or persons own all the stock of the transferor corporation and the transferee corporation. In such circumstances, the IRS and the courts have viewed an issuance of stock to be a “meaningless gesture” not mandated by sections 368(a)(1)(D) and 354(b).

In Revenue Ruling 70–240, 1970–1 C.B. 81 (see §601.601(d)(2) of this chapter), B owned all of the stock of both corporation X and corporation Y. X sold its operating assets to Y for $34x dollars, which represented the fair market value of X’s assets. X had $33x of other assets, consisting generally of cash, accounts receivables, and investments in stocks and bonds, so that the assets sold by X to Y constituted approximately 51% of X’s total assets. Following the sale to Y, X paid its debts, which amounted to $38x, and then liquidated, distributing $29x to B, while Y continued to conduct the business formerly operated by X. The IRS concluded that “although no actual shares of the stock of Y were distributed to B as a result of the transaction, B is treated as having received Y stock since he already owned all the stock of Y.” Accordingly,

contact Mr. McDonnell at (202) 622–3040 (not a toll-free call).

Section 368.—Definitions Relating to Corporate Reorganizations

26 CFR 1.368–2: Definition of terms.

T.D. 9303

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Corporate Reorganizations; Distributions Under Sections 368(a)(1)(D) and 354(b)(1)(B)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains temporary regulations under section 368 of the Internal Revenue Code of 1986 (Code). The temporary regulations provide guidance regarding the qualification of certain transactions as reorganizations described in section 368(a)(1)(D) where no stock and/or securities of the acquiring corporation is issued and distributed in the transaction. These regulations affect corporations engaging in such transactions and their shareholders. The text of the temporary regulations also serves as the text of the proposed regulations (REG–125632–06) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin.

DATES: Effective Date: These regulations are effective on December 19, 2006.

Applicability Date: For dates of applicability, see §1.368–2T(l)(4)(i).

FOR FURTHER INFORMATION CONTACT: Bruce A. Decker at (202) 622–7550 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

The IRS and Treasury Department have received requests for immediate guidance regarding whether certain acquisitive transactions can qualify as reorganizations described in section 368(a)(1)(D) where no stock of the transferee corporation is issued and distributed in the transaction. Currently, the IRS and Treasury Department are undertaking a broad study of issues related to acquisitive section 368(a)(1)(D) reorganizations. In the interest of efficient tax administration, the IRS and Treasury Department are issuing these temporary regulations to provide the requested certainty for taxpayers regarding these acquisitive transactions pending the broader study of issues. Although these rules also are being proposed in this issue of the Bulletin, the IRS and Treasury Department contemplate that the proposed rules may change upon completion of this broader study and the comments received.

The Code provides general nonrecognition treatment for reorganizations specifically described in section 368(a). Section 368(a)(1)(D) describes as a reorganization a transfer by a corporation (transferor corporation) of all or a part of its assets to another corporation (transferee corporation) if, immediately after the transfer, the transferor corporation or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the transferee corporation; but only if stock or securities of the controlled corporation are distributed in pursuance of a plan of reorganization in a transaction that qualifies under section 354, 355, or 356. Section 354(a)(1) provides that no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. Section 354(b)(1)(B) provides that section 354(a)(1) shall not apply to an exchange in pursuance of a plan of reorganization described in section 368(a)(1)(D) unless the transferee corporation acquires substantially all of the assets of the transferor corporation, and the stock, securi

January 29, 2007 379 2007–5 I.R.B.

itive reorganizations, including issues addressed by these temporary regulations. The IRS and Treasury Department are issuing these temporary regulations in order to provide certainty for taxpayers while these issues are under study.

The IRS and Treasury Department believe that these temporary regulations are a reasonable interpretation of section 368(a)(1)(D) and section 354(b)(1)(B) given the history of those provisions and the manner in which they have previously been interpreted by the courts and the IRS. However, no inference should be drawn from these temporary regulations regarding the law prior to the effective date of these temporary regulations. In this issue of the Bulletin, the IRS and Treasury Department are requesting comments on several issues relating to acquisitive reorganizations described in section 368(a)(1)(D). In addition, the IRS and Treasury Department note that these temporary regulations do not expressly implement Prop. Reg. §1.368–1(f)(4) (FR 70, 11903–11912), which provides that there must be an exchange of net value except in the case of a transaction that would otherwise qualify as a reorganization described in section 368(a)(1)(D), provided that the fair market value of the property transferred to the acquiring corporation by the target corporation exceeds the amount of liabilities of the target corporation immediately before the exchange (including any liabilities cancelled, extinguished, or assumed in connection with the exchange), and the fair market value of the assets of the acquiring corporation equals or exceeds the amount of its liabilities immediately after the exchange. The solvency requirement remains the IRS’s and Treasury Department’s proposal but the IRS and Treasury Department continue to consider whether this solvency requirement should be applied to the transactions described in these temporary regulations.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter

the IRS held that the sale of the operating assets by X to Y, followed by the liquidation and distribution of X’s assets to B, resulted in a reorganization under section 368(a)(1)(D) and a distribution under section 356(a), despite the absence of an actual issuance and distribution of Y stock.

When considering a similar transaction between two corporations owned in identical proportions by a husband and wife, the Tax Court concluded that there was in substance an exchange of stock which meets the requirements of section 354 and 356, and stated, “[t]he issuance of further stock would have been a meaningless gesture, and we cannot conclude that the statute requires such a vain act.” James Armour, Inc. v. Commissioner, 43 T.C. 295, 307 (1964). See also Wilson v. Commissioner, 46 T.C. 334 (1966). The IRS has also applied this meaningless gesture doctrine to circumstances where the transferor corporation and the transferee corporation are wholly owned by a single party directly or indirectly through subsidiaries, or as a result of family attribution pursuant to section 318(a)(1).

However, the application of this meaningless gesture doctrine has generally been limited to situations in which there is identical shareholder identity and proportionality of interest in the transferor corporation and the transferee corporation. For example, in Warsaw Photographic Asso- ciates, Inc. v. Commissioner, 84 T.C. 21 (1985), there was no issuance of stock by the transferee corporation to the transferor corporation, and the stock ownership in the two corporations was not identical. On the basis of these facts, the Tax Court concluded that the distribution of stock would not be a mere formality and refused to apply the meaningless gesture doctrine. Accordingly, the transaction failed to qualify as a section 368(a)(1)(D) reorganization because there was no distribution of stock of the transferee corporation under sections 368(a)(1)(D) and 354(b)(1)(B).

Explanation of Provisions

These temporary regulations provide guidance regarding the circumstances in which the distribution requirement under sections 368(a)(1)(D) and 354(b)(1)(B) is deemed satisfied despite the fact that no stock and/or securities are actually issued

in a transaction otherwise described in section 368(a)(1)(D). In cases where the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions, these temporary regulations provide that the distribution requirement under sections 368(a)(1)(D) and 354(b)(1)(B) will be treated as satisfied even though no stock is actually issued in the transaction. For purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions, these temporary regulations provide that an individual and all members of his family that have a relationship described in section 318(a)(1) will be treated as one individual. The temporary regulations also provide that the distribution requirement under sections 368(a)(1)(D) and 354(b)(1)(B) will be treated as satisfied in the absence of any issuance of stock and/or securities where there is a de minimis variation in shareholder identity or proportionality of ownership in the transferor and transferee corporations. Further, stock described in section 1504(a)(4) is disregarded for purposes of determining whether the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions.

Under these temporary regulations, in each case where it is determined that the same person or persons own all of the stock of the transferor and transferee corporations in identical proportions, a nominal share of stock of the transferee corporation will be deemed issued in addition to the actual consideration exchanged in the transaction. The nominal share of stock in the transferee corporation will then be deemed distributed by the transferor corporation to its shareholders and, in appropriate circumstances, further transferred to the extent necessary to reflect the actual ownership of the transferor and transferee corporations.

These temporary regulations are being issued in response to requests for immediate guidance regarding whether transactions otherwise described in section 368(a)(1)(D) qualify as reorganizations where no stock and/or securities of the transferee corporation are actually issued in the transaction. The IRS and Treasury Department currently are undertaking a broad study of issues related to acquis

2007–5 I.R.B. 380 January 29, 2007

and S4 is a direct or indirect subsidiary of P. Further, all of the requirements of section 368(a)(1)(D) other than the requirement that stock or securities be distributed in a transaction to which section 354 or 356 applies are satisfied. The examples are as follows:

Example 1. A owns all the stock of T and S. The T stock has a fair market value of $100x. T sells all of its assets to S in exchange for $100x of cash and immediately liquidates. Because there is complete shareholder identity and proportionality of ownership in T and S, under paragraph (l)(2)(i) of this section, the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to paragraph (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition to the $100x of cash actually exchanged for the T assets, and T will be deemed to distribute all such consideration to A. The transaction qualifies as a reorganization described in section 368(a)(1)(D).

Example 2. The facts are the same as in Exam- ple 1 except that C, A’s son, owns all of the stock of S. Under paragraph (l)(2)(ii) of this section, A and C are treated as one individual. Accordingly, there is complete shareholder identity and proportionality of ownership in T and S. Therefore, under paragraph (l)(2)(i) of this section, the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to paragraph (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition to the $100x of cash actually exchanged for the T assets, and T will be deemed to distribute all such consideration to A. A will be deemed to transfer the nominal share of S stock to C. The transaction qualifies as a reorganization described in section 368(a)(1)(D). Example 3. P owns all of the stock of S1 and S2. S1 owns all of the stock of S3, which owns all of the stock of T. S2 owns all of the stock of S4, which owns all of the stock of S. The T stock has a fair market value of $70x. T sells all of its assets to S in exchange for $70x of cash and immediately liquidates. Under paragraph (l)(2)(ii) of this section, there is indirect, complete shareholder identity and proportionality of ownership in T and S. Accordingly, the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to paragraph (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition to the $70x of cash actually exchanged for the T assets, and T will be deemed to distribute all such consideration to S3. S3 will be deemed to distribute the nominal share of S stock to S1, which, in turn, will be deemed to distribute the nominal share of S stock to P. P will be deemed to transfer the nominal share of S stock to S2, which, in turn, will be deemed to transfer such share of S stock to S4. The transaction qualifies as a reorganization described in section 368(a)(1)(D). Example 4. A, B, and C own 34%, 33%, and 33%, respectively, of the stock of T. The T stock has a fair market value of $100x. A, B, and C each own 33% of the stock of S. D owns the remaining 1% of the stock of S. T sells all of its assets to S in exchange for $100x of cash and immediately liquidates. For purposes of

5. does not apply to these regulations. For the applicability of the Regulatory Flexibility Act, please refer to the cross-reference notice of proposed rulemaking published elsewhere in this Bulletin. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Bruce A. Decker of the Office of the Associate Chief Counsel (Corporate).

- - - -

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.368–2 is amended by revising paragraph (l) to read as follows:

§1.368–2 Definition of terms.

• • • • (l) [Reserved]. For further guidance, see §1.368–2T(l).

Par. 3. Section 1.368–2T is added to read as follows:

§1.368–2T Definition of terms (temporary).

(a) through (k) [Reserved]. For further guidance, see §1.368–2(a) through (k).

(l) Certain transactions treated as reorganizations described in section 368(a)(1)(D) —(1) General rule . In order to qualify as a reorganization under section 368(a)(1)(D), a corporation (transferor corporation) must transfer all or part of its assets to another corporation (transferee corporation) and immediately after the transfer the transferor corporation, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, must be in control of the transferee corporation; but only if, in

pursuance of the plan, stock or securities of the transferee are distributed in a transaction which qualifies under section 354, 355, or 356. (2) Distribution requirement —(i) In general . For purposes of paragraph (l)(1) of this section, a transaction otherwise described in section 368(a)(1)(D) will be treated as satisfying the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) notwithstanding that there is no actual issuance of stock and/or securities of the transferee corporation if the same person or persons own, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions. In such cases, the transferee corporation will be deemed to issue a nominal share of stock to the transferor corporation in addition to the actual consideration exchanged for the transferor corporation’s assets. The nominal share of stock in the transferee corporation will then be deemed distributed by the transferor corporation to its shareholders and, where appropriate, further transferred through chains of ownership to the extent necessary to reflect the actual ownership of the transferor and transferee corporations.

(ii) Attribution . For purposes of paragraph (l)(2)(i) of this section, ownership of stock will be determined by applying the principles of section 318(a)(2) without regard to the 50 percent limitation in section 318(a)(2)(C). In addition, an individual and all members of his family described in section 318(a)(1) shall be treated as one individual.

(iii) De minimis variations in owner- ship and certain stock not taken into ac- count . For purposes of paragraph (l)(2)(i) of this section, the same person or persons will be treated as owning, directly or indirectly, all of the stock of the transferor and transferee corporations in identical proportions notwithstanding the fact that there is a de minimis variation in shareholder identity or proportionality of ownership. Additionally, for purposes of paragraph (l)(2)(i) of this section, stock described in section 1504(a)(4) is not taken into account. (3) Examples. The following examples illustrate the principles of paragraph (l) of this section. For purposes of these examples, each of A, B, C, and D is an individual, T is the acquired corporation, S is the acquiring corporation, P is the parent corporation, and each of S1, S2, S3,

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Applicability Dates: These regulations are generally applicable with respect to plan years beginning on or after January 1, 2006. See the Effective Date section of the preamble for specific information.

FOR FURTHER INFORMATION CONTACT: John T. Ricotta or Veronica A. Rouse at (202) 622–6090 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations (26 CFR Part 1) under section 409(p) of the Internal Revenue Code (Code).

Section 409(p)(1) requires an ESOP holding employer securities consisting of stock in an S corporation to provide that, during an allocation year, no portion of the assets of the plan attributable to, or allocable in lieu of, the employer securities may accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of section 401(a)) for the benefit of any disqualified person. Section 409(p)(3)(A) provides that a nonallocation year includes any plan year during which the ownership of the S corporation is so concentrated among disqualified persons that they own or are deemed to own at least 50 percent of its shares. Section 409(p)(4) provides, in general, that a disqualified person is any person whose deemed-owned ESOP shares (allocated ESOP shares and proportion of suspense account shares) are at least 10 percent of the number of deemed-owned shares of S corporation stock held by an ESOP or for whom the aggregate number of shares owned by such person and the members of such person’s family is at least 20 percent of deemed-owned ESOP shares. Under section 409(p)(5), the determination of whether a person is a disqualified person and whether a plan year is a nonallocation year is also made separately taking into account synthetic equity if such treatment results in treating the person as a disqualified person or the year as a nonallocation year.

Temporary regulations (T.D. 9081, 2003–2 C.B. 420) under section 409(p) were issued on July 21, 2003, (68 FR 42970). The text of those temporary regulations also served as the text of a notice of proposed rulemaking (REG–129709–03,

determining whether the distribution requirement of sections 368(a)(1)(D) and 354(b)(1)(B) is met, under paragraph (l)(2)(iii) of this section, D’s ownership of a de minimis amount of stock of S is disregarded and the transaction is treated as if there is complete shareholder identity and proportionality of ownership in T and S. Because there is complete shareholder identity and proportionality of ownership in T and S, under paragraph (l)(2)(i) of this section, the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to paragraph (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition to the $100x of cash actually exchanged for the T assets, T will be deemed to distribute all such consideration to A, B, and C, and the nominal S stock will be deemed transferred among the S shareholders to the extent necessary to reflect their actual ownership of S. The transaction qualifies as a reorganization described in section 368(a)(1)(D).

Example 5. The facts are the same as in Ex- ample 4 except that A, B, and C own 34%, 33%, and 33%, respectively, of the common stock of T and S. D owns preferred stock in S described in section 1504(a)(4). For purposes of determining whether the distribution requirement of sections 368(a)(1)(D) and 354(b)(1)(B) is met, under paragraph (l)(2)(iii) of this section, D’s ownership of S stock described in section 1504(a)(4) is ignored and the transaction is treated as if there is complete shareholder identity and proportionality of ownership in T and S. Because there is complete shareholder identity and proportionality of ownership in T and S, under paragraph (l)(2)(i) of this section, the requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are treated as satisfied notwithstanding the fact that no S stock is issued. Pursuant to paragraph (l)(2)(i) of this section, S will be deemed to issue a nominal share of S stock to T in addition to the $100x of cash actually exchanged for the T assets, and T will be deemed to distribute all such consideration to A, B, and C. The transaction qualifies as a reorganization described in section 368(a)(1)(D). Example 6 . A and B each own 50% of the stock of T. The T stock has a fair market value of $100x. B and C own 90% and 10%, respectively, of the stock of S. T sells all of its assets to S in exchange for $100x of cash and immediately liquidates. Because complete shareholder identity and proportionality of ownership in T and S does not exist, paragraph (l)(2)(i) of this section does not apply. The requirements of sections 368(a)(1)(D) and 354(b)(1)(B) are not satisfied, and the transaction does not qualify as a reorganization described in section 368(a)(1)(D).

(4) Effective date. (i) In general. This section applies to transactions occurring on or after March 19, 2007, except that they do not apply to any transaction occurring pursuant to a written agreement which is binding before December 19, 2006, and at all times thereafter. A taxpayer may apply the provisions of these temporary regulations to transactions occurring before March 19, 2007. However, the transferor corporation, the transferee corporation, any direct or indirect transferee of transferred basis property from either of

the foregoing, and any shareholder of the transferor or transferee corporation may not apply the provisions of these temporary regulations unless all such taxpayers apply the provisions of the temporary regulations.

(ii) Expiration. This section expires on or before December 18, 2009.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement.

Approved December 6, 2006.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on December 18, 2006, 8:45 a.m., and published in the issue of the Federal Register for December 19, 2006, 71 F.R. 75879)

Section 409.—Qualifi- cations for Tax Credit Employee Stock Own- ership Plans

26 CFR 1.409(p)–1: Prohibited allocation of securi- ties in an S corporation.

T.D. 9302

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Prohibited Allocations of Securities in an S Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide guidance concerning requirements under section 409(p) of the Internal Revenue Code for employee stock ownership plans (ESOPs) holding stock of Subchapter S corporations. These final regulations generally affect plan sponsors of, and participants in, ESOPs holding stock of Subchapter S corporations.

DATES: Effective Date: These regulations are effective December 20, 2006.

2007–5 I.R.B. 382 January 29, 2007

that is not an eligible rollover distribution. These regulations also add that same rule to the list of distributions that are not eligible rollover distributions in the regulations under section 402(c) (at §1.402(c)–2 of the Treasury Regulations). As a result, under recently proposed regulations relating to designated Roth contributions under section 402A, a deemed distribution as a result of a section 409(p) prohibited allocation with respect to a designated Roth account would not constitute a qualified distribution for purposes of section 402A. See proposed §1.402A–1, A–11, at 71 FR 4320 (January 26, 2006).

Prevention of Nonallocation Year

The preamble to the 2004 regulations described methods that a plan might use to prevent the occurrence of a nonallocation year, including (1) a reduction of synthetic equity (for example, through cancellation or distribution), (2) a sale of the S corporation securities held in the participant’s ESOP account before a nonallocation year occurs so that the account is not invested in S corporation stock, or (3) a transfer of the S corporation securities held for the participant under the ESOP into a separate portion of the plan that is not an ESOP or to another qualified plan of the employer that is not an ESOP.

Any methods of preventing a nonallocation year must satisfy applicable legal and qualification requirements, including the nondiscrimination requirements of section 401(a)(4) (including the rules at §1.401(a)(4)–4 relating to benefits, rights and features), and implementation of these methods must be completed before a nonallocation year occurs. These regulations retain the special rule provided in the 2004 regulations for applying the nondiscrimination requirements under section 401(a)(4) for a plan that uses the transfer method. Thus, these regulations provide that, if a transfer is made from an ESOP to a separate portion of the plan (or to another qualified plan of the employer) that is not an ESOP in order to prevent a nonallocation year, then both the ESOP and the plan that is not an ESOP will not fail to satisfy the requirements of §1.401(a)(4)–4 merely because of the transfer. Similarly, these regulations provide that, subsequent to the transfer, the plan will not fail to satisfy the requirements of §1.401(a)(4)–4 merely be

2003–2 C.B. 506) published at 68 FR 43058. The 2003 regulations provided guidance on identifying disqualified persons, determining whether an ESOP has a nonallocation year, and defining synthetic equity under section 409(p)(5), and reserved some issues, including the definition of a prohibited allocation, the tax effect of a prohibited allocation, and certain issues relating to the definition of synthetic equity.

A public hearing on the 2003 regulations was held on November 17, 2003. New temporary regulations under section 409(p) (T.D. 9164, 2005–1 C.B. 320) were published in the Federal Register on December 17, 2004, (69 FR 75455). The new temporary regulations (2004 temporary regulations) addressed certain issues raised in the comments, as well as addressing the topics reserved in the 2003 temporary regulations. The text of the 2004 temporary regulations also served as the text for a notice of proposed rulemaking (REG–129709–03, 2005–1 C.B. 351) published at 69 FR 75492.

A public hearing on the 2004 proposed regulations was held on April 20, 2005. After consideration of the comments received, these final regulations adopt the provisions of the proposed regulations with certain modifications discussed in this preamble.

Explanation of Provisions

Definition of Prohibited Allocation

These regulations retain the rule of the 2004 temporary regulations concerning prohibited allocations under which there is an impermissible accrual to the extent employer securities consisting of stock in an S corporation are held under the ESOP for the benefit of a disqualified person during a nonallocation year. Thus, in the event of a nonallocation year, S corporation shares held in a disqualified person’s account and all other ESOP assets attributable to S corporation stock, including distributions, sales proceeds, and earnings, are treated as an impermissible accrual whether attributable to contributions in the current year or a prior year. A commentator questioned whether the definition of prohibited allocation in the 2004 temporary regulations should include account balances of disqualified

persons from prior years. The rule of the 2004 temporary regulations has been retained because it is consistent with the intent of the statute, and the IRS and Treasury Department believe it is necessary to prevent the concentration of ownership interests that section 409(p) was intended to prevent.

A commentator also questioned the treatment of proceeds from the sale of stock previously allocated to a disqualified person’s account under the 2004 temporary regulations. The commentator expressed concern that treating the sales proceeds as an impermissible accrual when the original allocation of stock is already a prohibited allocation is a double penalty. The final regulations do not change this rule in the 2004 temporary regulations. An allocation of sales proceeds from stock held for the benefit of a disqualified person back into the account of the disqualified person is as valuable an accrual for the disqualified person as an investment in employer stock. This treatment is also consistent with the prohibition in section 409(p)(1) with respect to amounts that are “allocable in lieu of” employer stock.

Effect of a Prohibited Allocation

These regulations retain the rule of the 2004 regulations that if there is a prohibited allocation during a nonallocation year, the ESOP fails to satisfy the requirements of section 4975(e)(7) and ceases to be an ESOP. As a result, the exemption from the excise tax on prohibited transactions for loans to leveraged ESOPs contained in section 4975(d)(3) would cease to apply to any loan (with the result that the employer would owe an excise tax with respect to the previously exempt loan). These regulations clarify that an additional result would be the plan’s failure to satisfy the qualification requirements under section 401(a) for not operating the plan in accordance with its terms to reflect section 409(p). Other consequences include imposition of an excise tax on the S corporation under section 4979A. An example has been added to these final regulations to illustrate the impact of these rules on an S corporation ESOP.

These regulations include the rule from the 2004 regulations under which a prohibited allocation is a deemed distribution

January 29, 2007 383 2007–5 I.R.B.

tion 318 rules in certain cases, such as in determining a nonallocation year, but commentators pointed out that the section 318 rules did not apply for purposes of the disqualified person definition, which was not reflected in an example. Another commentator pointed out that the rules for determining whether family members are disqualified persons varies according to the individual being tested. For example, the technical language of section 409(p)(4)(D) treats parents-in-law as members of a married child’s family when testing whether a child is a disqualified person, but not as members of the same family as the child’s parents when testing whether the child’s parents are disqualified persons. In response to comments, the regulations have been modified to clarify these rules, including revisions in the examples to illustrate the application of the rules to specific factual patterns.

Determination of Number of Shares of Non-Stock-Based Synthetic Equity

These regulations retain the rules from both the 2003 and the 2004 regulations regarding calculation of the number of shares of synthetic equity that are not determined by reference to shares of stock of the S corporation. These regulations provide that the person who is entitled to the synthetic equity is treated as owning a number of shares of stock in the S corporation equal to the present value of the synthetic equity (with such value determined without regard to any lapse restriction as defined under the section 83 regulations) divided by the fair market value of a share of the S corporation’s stock as of the same date. These regulations also retain the special rule under the 2004 regulations that permits the ESOP to provide, on a reasonable and consistent basis for all persons, for the number of synthetic equity shares treated as owned on a determination date to remain constant for up to a 3-year period from that date (triennial method). This rule addresses concerns raised in comments to the 2003 regulations regarding the volatility of the number of shares of synthetic equity where that calculation is based on the value of an S corporation share.

A commentator questioned whether the triennial method of the 2004 regulations should be expanded to permit a more flex

cause of the benefits, rights, and features with respect to the transferred benefits if those benefits, rights, and features would satisfy the requirements of §1.401(a)(4)–4 if the mandatory disaggregation rule for ESOPs at §1.410(b)–7(c)(2) did not apply. These regulations clarify that any such transfers must be effectuated by an affirmative action taken no later than the date of the transfer, and all subsequent actions (including benefit statements) must be consistent with the transfer having occurred on that date. Further, in order to use the transfer method to prevent a nonallocation year, the plan must provide for the transfer of the stock to the non-ESOP portion of the plan.

A commentator described another method of preventing a nonallocation year under which stock of a participant is exchanged for cash or other assets, which are already in the accounts of other participants in order to change the stock holdings among participants before a nonallocation year occurs, but which does not change the overall stock holding of the ESOP trust. This method has been referred to as reshuffling. The commentator requested that relief from the nondiscriminatory availability requirements be extended to this method.

Absent a special rule for applying the nondiscrimination requirements of section 401(a)(4), it will be difficult for a plan to prevent a nonallocation year through reshuffling without violating section 401(a)(4). The right of each participant to have or not have a particular investment in his or her account (either as a participant-directed investment or as a trustee-directed investment) is a plan right or feature that is subject to the current and effective availability requirements of §1.401(a)(4)–4. Accordingly, if assets in the accounts of one or more non-highly compensated employees (NHCEs) are mandatorily exchanged, then, in the absence of other relevant factors, the plan would generally be expected to fail to satisfy the nondiscriminatory availability requirements of §1.401(a)(4)–4.

The IRS and Treasury Department do not believe that it would be appropriate to provide a special rule that would materially weaken the standard for nondiscriminatory availability of participant rights to a particular investment under the plan. By contrast, the special nondiscrimina

tion rules for stock transferred out of the ESOP do not change the rights of NHCEs to any particular investment in the plan as a whole, but simply allow the transfer and allow the rights of participants whose stock is transferred out of the ESOP to be taken into account in determining whether the rights of participants whose stock remains in the ESOP satisfy the nondiscriminatory availability requirements of §1.401(a)(4)–4.

An S corporation may be able to achieve the same result as reshuffling by reducing contributions for HCEs who are or may become disqualified persons, by providing additional benefits to NHCEs who are not disqualified persons, by expanding coverage to include all employees, or by diversifying out of employer stock for HCEs who are or may become disqualified persons and who are qualified participants within the meaning of section 401(a)(28)(B)(iii) (that is, by mandating diversification using one of the diversification options that are offered to all qualified participants, for which there is an existing special nondiscrimination rule at §1.401(a)(4)–4(d)(6)). Thus, in addition to plan transfers, any of these actions may help prevent the concentration of deemed-owned ESOP shares that section 409(p) prohibits, without the nondiscrimination problems otherwise associated with reshuffling. Of course, any transfer or other method used to ensure compliance with section 409(p) must also satisfy any other legal requirements that may apply, including section 407(b)(2) of the Employee Retirement Income Security Act of 1974 (ERISA) (88 Stat. 829) Public Law 93–406 (which, in relevant part, generally prohibits a plan from investing more than 10 percent of elective deferral accounts in employer stock, unless the plan is an ESOP, the investment is at the direction of the participant, or another exception applies).

Treatment of Family Members as Disqualified Persons

The 2004 regulations included a number of attribution rules, which these regulations retain, including the application of the section 318 attribution rules to ownership of synthetic equity in determining who is a disqualified person. Section 409(p) contains references to the sec

2007–5 I.R.B. 384 January 29, 2007

however, other personnel from the IRS and Treasury participated in their development.

- - - -

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding an entry to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.409(p)–1 is also issued under 26 U.S.C. 409(p)(7). - * * Par. 2. Section 1.402(c)–2, A–4, is revised by redesignating paragraph (g) as (h) and adding a new paragraph (g) to read as follows:

§1.402(c)–2 Eligible rollover distributions; questions and answers.

• • • • A–4. - - (g) Prohibited allocations that are treated as deemed distributions pursuant to section 409(p). - * *

Par. 3. Section 1.409(p)–1 is added to read as follows:

§1.409(p)–1 Prohibited allocation of securities in an S corporation.

(a) Organization of this section and def- inition —(1) Organization of this section . Section 409(p) applies if a nonallocation year occurs in an ESOP that holds shares of stock of an S corporation that are employer securities. Paragraph (b) of this section sets forth the general rule under section 409(p)(1) and (2) prohibiting any accrual or allocation to a disqualified person in a nonallocation year. Paragraph (c) of this section sets forth rules under section 409(p)(3), (5), and (7) for determining whether a year is a nonallocation year, generally based on whether disqualified persons own at least 50 percent of the shares of the S corporation, either taking into account only the outstanding shares of the S corporation (including shares held by the

ible triennial period that allows for the acceleration or delay of the triennial determination date. The commentator argued that, since the triennial method’s purpose is to eliminate the risk attributable to volatility of the present value of the nonqualified deferred compensation stock and the risk attributable to the fair market value of company stock, the inability to delay or accelerate the date, automatically and daily if necessary, weakens the purpose of the method.

These regulations include changes in the triennial methodology to permit the ability, during the 3-year period, to accelerate a determination date prospectively in the event of a change in the plan year or any merger, consolidation, or transfer of ESOP assets under section 414(l). However, a determination date may not be changed retroactively and the change must be effectuated by a plan amendment adopted before the new determination date. ¹

A commentator also requested clarification regarding how shares of synthetic equity are calculated with respect to nonqualified deferred compensation. Specifically, the commentator wanted to know what discount rate should be used to calculate the present value of nonqualified deferred compensation, and how to determine the number of equivalent shares for a split-dollar life insurance arrangement. These regulations do not mandate a specific discount rate for calculating the present value of nonqualified deferred compensation or a specific method for determining the equivalent number of shares for a split dollar arrangement. However, any assumptions used for such purposes must be reasonable.

Finally, a commentator asked whether an individual S corporation shareholder’s right of first refusal to acquire S corporation stock from an ESOP for its fair market value is considered synthetic equity. The regulations have been revised to clarify that the right of first refusal to acquire stock held by an ESOP is not treated as a right to acquire stock of an S corporation under these regulations if the right to acquire stock would not be taken into account under §1.1361–1(l)(2)(iii)(A) in determining whether an S corporation

has a second class of stock and the price at which the stock is acquired under the right of first refusal is not less than the price determined for purposes of the put right required by section 409(h). See §54.4975–11(d)(5) of the Excise Tax Regulations. Of course, any right of first refusal must comply with the requirements of §54.4975–7(b)(9) of the Excise Tax Regulations. In addition, these regulations give the Commissioner the authority to treat a right of first refusal as synthetic equity if the Commissioner determines, based on the facts and circumstances, that the right to acquire stock held by the ESOP constitutes an avoidance or evasion of section 409(p).

Effective Dates

These regulations generally are applicable for plan years beginning on or after January 1, 2006. However, these regulations retain, by cross reference, the 2004 regulations for plan years beginning before January 1, 2006.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulation does not impose a collection of information requirement upon small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the temporary and proposed regulations preceding these final regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are John T. Ricotta and Veronica A. Rouse of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities);

1 As indicated in Notice 2005–95, 2005–2 C.B. 1172, dated December 19, 2005, the general deadline for discretionary amendments in Rev. Proc. 2005–66, 2005–2 C.B. 509, does not apply if a statute or regulation specifically provides an earlier deadline. These regulations provide such an earlier deadline.

January 29, 2007 385 2007–5 I.R.B.

investment in employer securities during a nonallocation year.

(iv) Effects of prohibited alloca- tion —(A) Deemed distribution . If a plan year is a nonallocation year, the amount of any prohibited allocation in the account of a disqualified person as of the first day of the plan year, as determined under this paragraph (b)(2), is treated as distributed from the ESOP (or other plan of the employer) to the disqualified person on the first day of the plan year. In the case of an impermissible accrual or impermissible allocation that is not in the account of the disqualified person as of the first day of the plan year, the amount of the prohibited allocation, as determined under this paragraph (b)(2), is treated as distributed on the date of the prohibited allocation. Thus, the fair market value of assets in the disqualified person’s account that constitutes an impermissible accrual or allocation is included in gross income (to the extent in excess of any investment in the contract allocable to such amount) and is subject to any additional income tax that applies under section 72(t). A deemed distribution under this paragraph (b)(2)(iv)(A) is not an actual distribution from the ESOP. Thus, the amount of the prohibited allocation is not an eligible rollover distribution under section 402(c). However, for purposes of applying sections 72 and 402 with respect to any subsequent distribution from the ESOP, the amount that the disqualified person previously took into account as income as a result of the deemed distribution is treated as investment in the contract.

(B) Other effects . If there is a prohibited allocation, then the plan fails to satisfy the requirements of section 4975(e)(7) and ceases to be an ESOP. In such a case, the exemption from the excise tax on prohibited transactions for loans to leveraged ESOPs contained in section 4975(d)(3) would cease to apply to any loan (with the result that the employer would owe an excise tax with respect to the previously exempt loan). As a result of these failures, the plan would lose the prohibited transaction exemption for loans to an ESOP under section 4975(d)(3) of the Code and section 408(b)(3) of Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Finally, a plan that does not operate in accordance with its terms to reflect section 409(p) fails to satisfy the qualification requirements

ESOP) or taking into account both the outstanding shares and synthetic equity of the S corporation. Paragraphs (d), (e), and (f) of this section contain definitions of disqualified person under section 409(p)(4) and (5), deemed-owned ESOP shares under section 409(p)(4)(C), and synthetic equity under section 409(p)(6)(C). Paragraph (g) of this section contains a standard for determining when the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of section 409(p).

(2) Definitions . The following definitions apply for purposes of section 409(p) and this section, as well as for purposes of section 4979A, which imposes an excise tax on certain events.

(i) Deemed-owned ESOP shares has the meaning set forth in paragraph (e) of this section.

(ii) Disqualified person has the meaning set forth in paragraph (d) of this section.

(iii) Employer has the meaning set forth in §1.410(b)–9.

(iv) Employer securities means employer securities within the meaning of section 409(l).

(v) ESOP means an employee stock ownership plan within the meaning of section 4975(e)(7).

(vi) Prohibited allocation has the meaning set forth in paragraph (b)(2) of this section.

(vii) S corporation means S corporation within the meaning of section 1361.

(viii) Synthetic equity has the meaning set forth in paragraph (f) of this section.

(b) Prohibited allocation in a nonallo- cation year —(1) General rule . Section 409(p)(1) provides 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 under the ESOP, or be allocated directly or indirectly under any plan of the employer (including the ESOP) meeting the requirements of section 401(a), for the benefit of any disqualified person.

(2) Additional rules —(i) Prohibited allocation definition . For purposes of section 409(p) and this section, a prohib- ited allocation means an impermissible accrual or an impermissible allocation. Whether there is impermissible accrual

is determined under paragraph (b)(2)(ii) of this section and whether there is an impermissible allocation is determined under paragraph (b)(2)(iii) of this section. The amount of the prohibited allocation is equal to the sum of the amount of the impermissible accrual plus the amount of the impermissible allocation.

(ii) Impermissible accrual . There is an impermissible accrual to the extent that employer securities consisting of stock in an S corporation owned by the ESOP and any assets attributable thereto are held under the ESOP for the benefit of a disqualified person during a nonallocation year. For this purpose, assets attributable to stock in an S corporation owned by an ESOP include any distributions, within the meaning of section 1368, made on S corporation stock held in a disqualified person’s account in the ESOP (including earnings thereon), plus any proceeds from the sale of S corporation securities held for a disqualified person’s account in the ESOP (including any earnings thereon). Thus, in the event of a nonallocation year, all S corporation shares and all other ESOP assets attributable to S corporation stock, including distributions, sales proceeds, and earnings on either distributions or proceeds, held for the account of such disqualified person in the ESOP during that year are an impermissible accrual for the benefit of that person, whether attributable to contributions in the current year or in prior years.

(iii) Impermissible allocation . An impermissible allocation occurs during a nonallocation year to the extent that a contribution or other annual addition (within the meaning of section 415(c)(2)) is made with respect to the account of a disqualified person, or the disqualified person otherwise accrues additional benefits, directly or indirectly under the ESOP or any other plan of the employer qualified under section 401(a) (including a release and allocation of assets from a suspense account, as described at §54.4975–11(c) and (d) of this chapter) that, for the nonallocation year, would have been added to the account of the disqualified person under the ESOP and invested in employer securities consisting of stock in an S corporation owned by the ESOP but for a provision in the ESOP that precludes such addition to the account of the disqualified person, and

2007–5 I.R.B. 386 January 29, 2007

plying section 318(a)(1), the members of an individual’s family include members of the individual’s family under paragraph (d)(2) of this section. In addition, an individual is treated as owning deemed-owned ESOP shares of that individual notwithstanding the employee trust exception in section 318(a)(2)(B)(i). If the attribution rules in paragraph (f)(1) of this section apply, then the rules of paragraph (f)(1) of this section are applied before (and in addition to) the rules of this paragraph (c)(2).

(3) Special rule for avoidance or eva- sion . (i) Any ownership structure described in paragraph (g)(3) of this section results in a nonallocation year. In addition, each individual referred to in paragraph (g)(3) of this section is treated as a disqualified person and the individual’s interest in the separate entity described in paragraph (g)(3) of this section is treated as synthetic equity.

(ii) Pursuant to section 409(p)(7)(B), the Commissioner, in revenue rulings, notices, and other guidance published in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)( b ) of this chapter), 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 section 409(p). For any year that is a nonallocation year under this paragraph (c)(3), the Commissioner may treat any person as a disqualified person. See paragraph (g) of this section for guidance regarding when the principal purpose of an ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of section 409(p).

(4) Special rule for certain stock rights . (i) For purposes of paragraph (c)(1) of this section, a person is treated as owning stock if the person has an exercisable right to acquire the stock, the stock is both issued and outstanding, and the stock is held by persons other than the ESOP, the S corporation, or a related entity (as defined in paragraph (f)(3) of this section).

(ii) This paragraph (c)(4) applies only if treating persons as owning the shares described in paragraph (c)(4)(i) of this section results in a nonallocation year. This paragraph (c)(4) does not apply to a right to acquire stock of an S corporation held by a shareholder that is subject to Federal income tax that, under

of section 401(a), which would cause the corporation’s S election to terminate under section 1362. See also section 4979A(a) which imposes an excise tax in certain events, including a prohibited allocation under section 409(p).

(C) Example . The rules of this paragraph (b)(2)(iv) are illustrated by the following example:

Example . (i) Facts . Corporation M, an S corporation under section 1361, establishes Plan P as an ESOP in 2006, with a calendar plan year. Plan P is a qualified plan that includes terms providing that a prohibited allocation will not occur during a nonallocation year in accordance with section 409(p). On December 31, 2006, all of the 1,000 outstanding shares of stock of Corporation M, with a fair market value of $30 per share, are contributed to Plan P and allocated among accounts established within Plan P for the benefit of Corporation M’s three employees, individuals A, B, and C, based on their compensation for 2006. As a result, on December 31, 2006, participant A’s account includes 800 of the shares ($24,000); participant B’s account includes 140 of the shares ($4,200); and participant C’s account includes the remaining 60 shares ($1,800). The plan year 2006 is a nonallocation year, participants A and B are disqualified persons on December 31, 2006, and a prohibited allocation occurs for A and B on December 31, 2006.

(ii) Conclusion . On December 31, 2006, participants A and B each have a deemed distribution as a result of the prohibited allocation, resulting in income of $24,000 for participant A and $4,200 for participant B. Corporation M owes an excise tax under section 4979A, based on an amount involved of $28,200. Plan P ceases to be an ESOP on the date of the prohibited allocation (December 31, 2006) and also fails to satisfy the qualification requirements of section 401(a) on that date due to the failure to comply with the provisions requiring compliance with section 409(p). As a result of having an ineligible shareholder under section 1361(b)(1)(B), Corporation M ceases to be an S corporation under section 1361 on December 31, 2006. (v) Prevention of prohibited allo- cation —(A) Transfer of account to non-ESOP . An ESOP may prevent a nonallocation year or a prohibited allocation during a nonallocation year by providing for assets (including S corporation securities) allocated to the account of a disqualified person (or a person reasonably expected to become a disqualified person absent a transfer described in this paragraph (b)(2)(v)(A)) to be transferred into a separate portion of the plan that is not an ESOP, as described in §54.4975–11(a)(5) of this chapter, or to another plan of the employer that satisfies the requirements of section 401(a) and that is not an ESOP. Any such transfer must be effectuated by an affirmative action taken no later than the date of the transfer, and all subsequent

actions (including benefit statements) generally must be consistent with the transfer having occurred on that date. In the event of such a transfer involving S corporation securities, the recipient plan is subject to tax on unrelated business taxable income under section 512.

(B) Relief from nondiscrimination re- quirement . Pursuant to this paragraph (b)(2)(v)(B), if a transfer described in paragraph (b)(2)(v)(A) of this section is made from an ESOP to a separate portion of the plan or to another qualified plan of the employer that is not an ESOP, then both the ESOP and the plan or portion of a plan that is not an ESOP do not fail to satisfy the requirements of §1.401(a)(4)–4 merely because of the transfer. Further, subsequent to the transfer, that plan will not fail to satisfy the requirements of §1.401(a)(4)–4 merely because of the benefits, rights, and features with respect to the transferred benefits if those benefits, rights, and features would satisfy the requirements of §1.401(a)(4)–4 if the mandatory disaggregation rule for ESOPs at §1.410(b)–7(c)(2) did not apply.

(c) Nonallocation year . A year is a nonallocation year if it is described in the general definition in paragraph (c)(1) of this section or if the special rule of paragraph (c)(3) of this section applies.

(1) General definition . For purposes of section 409(p) and this section, a nonallo- cation 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—

(i) 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

(ii) Disqualified persons own at least 50 percent of the sum of:

(A) The outstanding shares of stock in the S corporation (including deemed-owned ESOP shares); and

(B) The shares of synthetic equity in the S corporation owned by disqualified persons.

(2) Attribution rules . For purposes of this paragraph (c), the rules of section 318(a) apply to determine ownership of shares in the S corporation (including deemed-owned ESOP shares) and synthetic equity. However, for this purpose, section 318(a)(4) (relating to options to acquire stock) is disregarded and, in ap

January 29, 2007 387 2007–5 I.R.B.

§1.1361–1(l)(2)(iii)(A) or (l)(4)(iii)(C), would not be taken into account in determining if an S corporation has a second class of stock, provided that a principal purpose of the right is not the avoidance or evasion of section 409(p). Under the last sentence of paragraph (f)(2)(i) of this section, this paragraph (c)(4)(ii) does not apply for purposes of determining ownership of deemed-owned ESOP shares or whether an interest constitutes synthetic equity.

(5) Application with respect to shares treated as owned by more than one person . For purposes of applying paragraph (c)(1) of this section, if, by application of the rules of paragraph (c)(2), (c)(4), or (f)(1) of this section, any share is treated as owned by more than one person, then that share is counted as a single share and that share is treated as owned by disqualified persons if any of the owners is a disqualified person.

(6) Effect of nonallocation year . See paragraph (b) of this section for a prohibition applicable during a nonallocation year. See also section 4979A for an excise tax applicable in certain cases, including section 4979A(a)(3) and (4) which applies during a nonallocation year (whether or not there is a prohibited allocation during the year).

(d) Disqualified persons . A person is a disqualified person if the person is described in paragraph (d)(1), (d)(2), or (d)(3) of this section.

(1) General definition . For purposes of section 409(p) and this section, a disquali- fied person means any person for whom—

(i) The number of such person’s deemed-owned ESOP shares of the S corporation is at least 10 percent of the number of the deemed-owned ESOP shares of the S corporation;

(ii) The aggregate number of such person’s deemed-owned ESOP shares and synthetic equity shares of the S corporation is at least 10 percent of the sum of—

(A) The total number of deemed-owned ESOP shares of the S corporation; and

(B) The person’s synthetic equity shares of the S corporation;

(iii) The aggregate number of the S corporation’s 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

(iv) The aggregate number of the S corporation’s 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 sum of—

(A) The total number of deemed-owned ESOP shares of the S corporation; and

(B) The synthetic equity shares of the S corporation owned by such person and the members of such person’s family.

(2) Treatment of family members; defi- nition —(i) Rule . Each member of the family of any person who is a disqualified person under paragraph (d)(1)(iii) or (iv) of this section and who owns any deemedowned ESOP shares or synthetic equity shares is a disqualified person.

(ii) General definition . For purposes of section 409(p) and this section, member of the family means, with respect to an individual—

(A) The spouse of the individual; (B) An ancestor or lineal descendant of the individual or the individual’s spouse;

(C) A brother or sister of the individual or of the individual’s spouse and any lineal descendant of the brother or sister; and

(D) The spouse of any individual described in paragraph (d)(2)(ii)(B) or (C) of this section.

(iii) Spouse . A spouse of an individual who is legally separated from such individual under a decree of divorce or separate maintenance is not treated as such individual’s spouse under paragraph (d)(2)(ii) of this section.

(3) Special rule for certain nonalloca- tion years . See paragraph (c)(3) of this section (relating to avoidance or evasion of section 409(p)) for special rules under which certain persons are treated as disqualified persons.

(4) Example . The rules of this paragraph (d) are illustrated by the following examples:

Example 1 . (i) Facts . An S corporation has 800 outstanding shares, of which 100 are owned by individual O and 700 are held in an employee stock ownership plan (ESOP) during 2006, including 200 shares held in the ESOP account of O, 65 shares held in the ESOP account of participant P, 65 shares held in the ESOP account of participant Q who is P’s spouse, and 14 shares held in the ESOP account of R, who is the daughter of P and Q. There are no unallocated suspense account shares in the ESOP. The S corporation has no synthetic equity.

(ii) Conclusion . Under paragraph (d)(1)(i) of this section, O is a disqualified person during 2006 because O’s account in the ESOP holds at least 10%

of the shares owned by the ESOP (200 is 28.6% of 700). During 2006, neither P, Q, nor R is a disqualified person under paragraph (d)(1)(i) of this section, because each of their accounts holds less than 10% of the shares owned by the ESOP. However, each of P, Q, and R is a disqualified person under paragraph (d)(1)(iii) of this section because P and members of P’s family own at least 20% of the deemed-owned ESOP shares (144 (the sum of 65, 65 and 14) is 20.6% of 700). As a result, disqualified persons own at least 50% of the outstanding shares of the S corporation during 2006 (O’s 100 directly owned shares, O’s 200 deemed-owned shares, P’s 65 deemed-owned shares, Q’s 65 deemed-owned shares, and R’s 14 deemedowned shares are 55.5% of 800).

Example 2 . (i) Facts . An S corporation has shares that are owned by an ESOP and various individuals. Individuals S and T are married and have a son, U. Individuals V and W are married and have a daughter, X. Individuals U and X are married. Individual V has a brother Y. Their percentages of the deemed-owned ESOP shares of the S corporation are as follows: T has 6%; U has 7%; and V has 8%. Neither S, W, X, nor Y has any deemed-owned ESOP shares and the S corporation has no synthetic equity. However, individual S and individual Y each own directly a number of shares of the outstanding shares of the S corporation.

(ii) Conclusion . In this example, individual U is a disqualified person under paragraph (d)(1) of this section (because U’s family consists of S, T, U, V, W, and X, and, in the aggregate, those persons own more than 20% of the deemed-owned ESOP shares) and individual X is also a disqualified person under paragraph (d)(1) of this section (because X’s family consists of S, T, U, V, W, and X, and, in the aggregate, those persons own more than 20% of the deemed-owned ESOP shares). Further, individuals T and V are each a disqualified person under paragraph (d)(2) of this section because each is a member of a family that includes one or more disqualified persons and each has deemed-owned ESOP shares. However, individuals S, W, and Y are not disqualified persons under this paragraph (d). For example, S does not own more than 10% of the deemed-owned ESOP shares, and S’s family, which consists of S, T, U, and X, owns, in the aggregate, only 13% of the deemed-owned ESOP shares (X’s parents are not members of S’s family because the family members of a person do not include the parents-in-law of the person’s descendants). Further, note that, for purposes of determining whether the ESOP has a nonallocation year under paragraph (c) of this section, the shares directly owned by S and Y would be taken into account as shares owned by disqualified persons under the attribution rules in paragraph (c)(2) of this section.

(e) Deemed-owned ESOP shares . For purposes of section 409(p) and this section, a person is treated as owning his or her deemed-owned ESOP shares. Deemedowned ESOP shares owned by a person 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

2007–5 I.R.B. 388 January 29, 2007

nection with the performance of services to which section 83 applies to the extent that the property is not substantially vested within the meaning of §1.83–3(i) by the end of the plan year in which transferred; and a split-dollar life insurance arrangement under §1.61–22(b) entered into in connection with the performance of services (other than one under which, at all times, the only economic benefit that will be provided under the arrangement is current life insurance protection as described in §1.61–22(d)(3)). Synthetic equity also includes any other remuneration for services under a plan, method, or arrangement deferring the receipt of compensation to a date that is after the 15th day of the 3 ^rd calendar month after the end of the entity’s taxable year in which the related services are rendered. However, synthetic equity does not include benefits under a plan that is an eligible retirement plan within the meaning of section 402(c)(8)(B).

(B) For purposes of applying paragraph (f)(2)(iv)(A) of this section with respect to an ESOP, synthetic equity does not include any interest described in such paragraph (f)(2)(iv)(A) of this section to the extent that—

( 1 ) The interest is nonqualified deferred compensation (within the meaning of section 3121(v)(2)) that was outstanding on December 17, 2004;

( 2 ) The interest is an amount that was taken into account (within the meaning of §31.3121(v)(2)–1(d) of this chapter) prior to January 1, 2005, for purposes of taxation under chapter 21 of the Internal Revenue Code (or income attributable thereto); and

( 3 ) The interest was held before the first date on which the ESOP acquires any employer securities.

(v) No overlap among shares of deemed-owned ESOP shares or synthetic equity . Synthetic equity under this paragraph (f)(2) does not include shares that are deemed-owned ESOP shares (or any rights with respect to deemed-owned ESOP shares to the extent such rights are specifically provided under section 409(h)). In addition, synthetic equity under a specific subparagraph of this paragraph (f)(2) does not include anything that is synthetic equity under a preceding provision of paragraph (f)(2)(i), (ii), (iii), or (iv) of this section.

(3) Related entity . For purposes of this paragraph (f), related entity means any en

(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 shares released and allocated from a suspense account, as described at §54.4975–11(c) and (d) of the Excise Tax Regulations, under the ESOP for the most recently ended plan year for which there were shares released and allocated from a suspense account, or if there has been no such prior release and allocation from a suspense account, then determined in proportion to a reasonable estimate of the shares that would be released and allocated in the first year of a loan repayment).

(f) Synthetic equity and rights to ac- quire stock of the S corporation —(1) Own- ership of synthetic equity . For purposes of section 409(p) and this section, synthetic equity means the rights described in paragraph (f)(2) of this section. Synthetic equity is treated as owned by the person that has any of the rights specified in paragraph (f)(2) of the section. In addition, the attribution rules as set forth in paragraph (c)(2) of this section apply for purposes of attributing ownership of synthetic equity.

(2) Synthetic equity —(i) Rights to ac- quire stock of the S corporation —(A) Gen- eral rule . Synthetic equity includes 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. Rights to acquire stock in an S corporation with respect to stock that is, at all times during the period when such rights are effective, both issued and outstanding, and held by a person other than the ESOP, the S corporation, or a related entity are not synthetic equity but only if that person is subject to federal income taxes. (See also paragraph (c)(4) of this section.)

(B) Exception for certain rights of first refusal . A right of first refusal to acquire stock held by an ESOP is not treated as a right to acquire stock of an S corporation under this paragraph if the right to acquire stock would not be taken into account under §1.1361–1(l)(2)(iii)(A) in determining if an S corporation has a second class of stock and the price at which the stock is acquired under the right of first refusal

is not less than the price determined under section 409(h). See §54.4975–11(d)(5) of the Excise Tax Regulations. The right of first refusal must also comply with the requirements of §54.4975–7(b)(9) of the Excise Tax Regulations. This paragraph (f)(2)(i)(B) does not apply if, based on the facts and circumstances, the Commissioner finds that the right to acquire stock held by the ESOP constitutes an avoidance or an evasion of section 409(p). See also section 408(d) of ERISA, under which the exemption provided by section 408(e) of ERISA (and the related exemption at section 4975(d)(13) of the Code) does not apply to an owner-employee, including an employee or officer of an S corporation who is a 5 percent owner.

(ii) Special rule for certain stock rights . 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, such as appreciation in such value. Thus, for example, synthetic equity includes 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.

(iii) Rights to acquire interests in or as- sets of an S corporation or a related entity . Synthetic equity includes a right to acquire stock or other similar interests in a related entity to the extent of the S corporation’s ownership. Synthetic equity also includes a right to acquire assets of an S corporation or a related entity other than either rights to acquire goods, services, or property at fair market value in the ordinary course of business or fringe benefits excluded from gross income under section 132.

(iv) Special rule for nonqualified de- ferred compensation . (A) Synthetic equity also includes any of the following with respect to an S corporation or a related entity: any remuneration to which section 404(a)(5) applies; remuneration for which a deduction would be permitted under section 404(a)(5) if separate accounts were maintained; any right to receive property, as defined in §1.83–3(e) of the Income Tax Regulations (including a payment to a trust described in section 402(b) or to an annuity described in section 403(c)) in a future year for the performance of services; any transfer of property in con

January 29, 2007 389 2007–5 I.R.B.

from a determination date identified under the ESOP through the day before a determination date that is not later than the third anniversary of the identified determination date. Thus, the ESOP must provide for the number of shares of synthetic equity to which this paragraph (f)(4)(iii) applies to be re-determined not less frequently than every three years, based on the S corporation share value on a determination date that is not later than the third anniversary of the identified determination date and the aggregate present value of the synthetic equity to which this paragraph (f)(4)(iii) applies (including all grants made during the three-year period) on that determination date.

( 2 ) However, additional accruals, allocations, or grants (to which this paragraph (f)(4)(iii) applies) that are made during such three-year period are taken into account on each determination date during that period, based on the number of synthetic equity shares resulting from the additional accrual, allocation, or grant (determined as of the determination date on or next following the date of the accrual, allocation, or grant). See Example 3 of paragraph (h) of this section for an example illustrating this paragraph (f)(4)(iii)(C).

( 3 ) If, as permitted under this paragraph (f)(4)(iii)(C), an ESOP provides for the number of shares of synthetic equity to be fixed for a specified period from a determination date to a subsequent determination date, then that subsequent determination date can be changed to a new determination date, subject to the following conditions:

( i ) The change in the subsequent determination date must be effectuated through a plan amendment adopted before the new determination date;

( ii ) The new determination date must be earlier than the prior determination date (that is, the new determination date must be earlier than the determination date applicable in the absence of the plan amendment);

( iii ) The conditions in paragraph (f)(4)(iii)(C)( 2 ) of this section must be satisfied measured from the new determination date; and

( iv ) Except to the extent permitted by the Commissioner in revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the

tity 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 this chapter, or a qualified subchapter S subsidiary under section 1361(b)(3). (4) Number of synthetic shares —(i) Synthetic equity determined by reference to S corporation shares . In the case of synthetic equity that is determined by reference to shares of stock of the S corporation, the person who is entitled to the synthetic equity is treated as owning the number of shares of stock deliverable pursuant to such synthetic equity. In the case of synthetic equity that is determined by reference to shares of stock of the S corporation, but for which payment is made in cash or other property (besides stock of the S corporation), the number of shares of synthetic equity treated as owned is equal to the number of shares of stock having a fair market value equal to the cash or other property (disregarding lapse restrictions as described in §1.83–3(i)). Where such synthetic equity is a right to purchase or receive S corporation shares, the corresponding number of shares of synthetic equity is determined without regard to lapse restrictions as described in §1.83–3(i) or to any amount required to be paid in exchange for the shares. Thus, for example, if a corporation grants an employee of an S corporation an option to purchase 100 shares of the corporation’s stock, exercisable in the future only after the satisfaction of certain performance conditions, the employee is the deemed owner of 100 synthetic equity shares of the corporation as of the date the option is granted. If the same employee were granted 100 shares of restricted S corporation stock (or restricted stock units), subject to forfeiture until the satisfaction of performance or service conditions, the employee would likewise be the deemed owner of 100 synthetic equity shares from the grant date. However, if the same employee were granted a stock appreciation right with regard to 100 shares of S corporation stock (whether payable in stock or in cash), the number of synthetic equity shares the employee is deemed to own equals the number of shares having a value equal to the appreciation at the time of measurement (determined without regard to lapse restrictions).

(ii) Synthetic equity determined by ref- erence to shares in a related entity . In the case of synthetic equity that is determined by reference to shares of stock (or similar interests) in a related entity, the person who is entitled to the synthetic equity is treated as owning shares of stock of 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)).

(iii) Other synthetic equity —(A) Gen- eral rule . In the case of any synthetic equity to which neither paragraph (f)(4)(i) of this section nor paragraph (f)(4)(ii) of this section apply, the person who is entitled to the synthetic equity is treated as owning on any date a number of shares of stock in the S corporation equal to the present value (on that date) of the synthetic equity (with such value determined without regard to any lapse restriction as defined at §1.83–3(i)) divided by the fair market value of a share of the S corporation’s stock as of that date.

(B) Use of annual or more frequent determination dates . A year is a nonallocation year if the thresholds in paragraph (c) of this section are met at any time during that year. However, for purposes of this paragraph (f)(4)(iii), an ESOP may provide that the number of shares of S corporation stock treated as owned by a person who is entitled to synthetic equity to which this paragraph (f)(4)(iii) applies is determined annually (or more frequently), as of the first day of the ESOP’s plan year or as of any other reasonable determination date or dates during a plan year. If the ESOP so provides, the number of shares of synthetic equity to which this paragraph (f)(4)(iii) applies that are treated as owned by that person for any period from a given determination date through the date immediately preceding the next following determination date is the number of shares treated as owned on the given determination date.

(C) Use of triennial recalculations . ( 1 ) Although an ESOP must have a determination date that is no less frequent than annually, if the terms of the ESOP so provide, then the number of shares of synthetic equity with respect to grants of synthetic equity to which this paragraph (f)(4)(iii) applies may be fixed for a specified period

2007–5 I.R.B. 390 January 29, 2007

including the extent to which actual distributions of profits are made from the S corporation to the ESOP and the extent to which the ESOP’s ownership interest in undistributed profits and future profits is subject to dilution as a result of synthetic equity. For example, the ESOP’s ownership interest is not subject to dilution if the total amount of synthetic equity is a relatively small portion of the total number of shares and deemed-owned shares of the S corporation.

(3) Specific transactions that constitute an avoidance or evasion of section 409(p) involving segregated profits . Taking into account the standard in paragraph (g)(2) of this section, the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of section 409(p) in any case in which—

(i) The profits of the S corporation generated by the business activities of a specific individual or individuals are not provided to the ESOP, but are instead substantially accumulated and held for the benefit of the individual or individuals on a tax-deferred basis within an entity related to the S corporation, such as a partnership, trust, or corporation (such as in a subsidiary that is a disregarded entity), or any other method that has the same effect of segregating profits for the benefit of such individual or individuals (such as nonqualified deferred compensation described in paragraph (f)(2)(iv) of this section);

(ii) The individual or individuals for whom profits are segregated have rights to acquire 50 percent or more of those profits directly or indirectly (for example, by purchase of the subsidiary); and

(iii) A nonallocation year would occur if this section were separately applied with respect to either the separate entity or whatever method has the effect of segregating profits of the individual or individuals, treating such entity as a separate S corporation owned by an ESOP (or in the case of any other method of segregation of profits by treating those profits as the only assets of a separate S corporation owned by an ESOP).

(h) Examples . The rules of this section are illustrated by the following examples:

Example 1 . Relating to determination of disquali- fied persons and nonallocation year if there is no syn- thetic equity . (i) Facts . Corporation X is a calendar year S corporation that maintains an ESOP. X has a single class of common stock, of which there are a total of 1,200 shares outstanding. X has no synthetic

change must be adopted in connection with either a change in the plan year of the ESOP or a merger, consolidation, or transfer of plan assets of the ESOP under section 414(l) (and the new determination date must be consistent with that plan year change or section 414(l) event).

( 4 ) Conditions for application of rules . This paragraph (f)(4)(iii)(C) only applies with respect to grants of synthetic equity to which this paragraph (f)(4)(iii) applies. In addition, paragraph (f)(4)(iii)(C) of this section applies only if the fair market value of a share of the S corporation securities on any determination date is not unrepresentative of the value of the S corporation securities throughout the rest of the plan year and only if the terms of the ESOP include provisions conforming to paragraph (f)(4)(iii)(C)( 1 ) of this section which are consistently used by the ESOP for all persons. In addition, paragraph (f)(4)(iii)(C)( 1 ) of this section applies only if the terms of the ESOP include provisions conforming to paragraphs (f)(4)(iii)(C)( 1 ) of this section which are consistently used by the ESOP for all persons.

(iv) Adjustment of number of synthetic equity shares where ESOP owns less than 100 Percent of S corporation . The number of synthetic shares otherwise determined under this paragraph (f)(4) is decreased ratably to the extent that shares of the S corporation are owned by a person who is not an ESOP and who is subject to Federal income taxes. For example, if an S corporation has 200 outstanding shares, of which individual A owns 50 shares and the ESOP owns the other 150 shares, and individual B would be treated under this paragraph (f)(4) as owning 100 synthetic equity shares of the S corporation but for this paragraph (f)(4)(iv), then, under the rule of this paragraph (f)(4)(iv), the number of synthetic shares treated as owned by B under this paragraph (f)(4) is decreased from 100 to 75 (because the ESOP only owns 75 percent of the outstanding stock of the S corporation, rather than 100 percent).

(v) Special rule for shares with greater voting power than ESOP shares . Notwithstanding any other provision of this paragraph (f)(4), if a synthetic equity right includes (directly or indirectly) a right to purchase or receive shares of S corporation stock that have per-share voting rights

greater than the per-share voting rights of one or more shares of S corporation stock held by the ESOP, then the number of shares of deemed owned synthetic equity attributable to such right is not less than the number of shares that would have the same voting rights if the shares had the same per-share voting rights as shares held by the ESOP with the least voting rights. For example, if shares of S corporation stock held by the ESOP have one voting right per share, then an individual who holds an option to purchase one share with 100 voting rights is treated as owning 100 shares of synthetic equity.

(g) Avoidance or evasion of section 409(p) involving synthetic equity —(1) General rule . Paragraph (g)(2) of this section sets forth a standard for determining whether the principal purpose of the ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of section 409(p). Paragraph (g)(3) of this section identifies certain specific ownership structures that constitute an avoidance or evasion of section 409(p). See also paragraph (c)(3) of this section for a rule under which the ownership structures in paragraph (g)(3) of this section result in a nonallocation year for purposes of section 409(p).

(2) Standard for determining when there is an avoidance or evasion of sec- tion 409(p) involving synthetic equity . For purposes of section 409(p) and this section, whether the principal purpose of the ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of section 409(p) is determined by taking into account all the surrounding facts and circumstances, including all features of the ownership of the S corporation’s outstanding stock and related obligations (including synthetic equity), any shareholders who are taxable entities, and the cash distributions made to shareholders, to determine whether, to the extent of the ESOP’s stock ownership, the ESOP receives the economic benefits of ownership in the S corporation that occur during the period that stock of the S corporation is owned by the ESOP. Among the factors indicating that the ESOP receives those economic benefits include shareholder voting rights, the right to receive distributions made to shareholders, and the right to benefit from the profits earned by the S corporation,

January 29, 2007 391 2007–5 I.R.B.

equity. In 2006, individual A, who is not an employee of X (and is not related to any employee of X), owns 100 shares directly, B, who is an employee of X, owns

100 shares directly, and the remaining 1,000 shares are owned by an ESOP maintained by X for its employees. The ESOP’s 1,000 shares are allocated to

the accounts of individuals who are employees of X (none of whom are related), as set forth in columns 1 and 2 in the following table:

(ii) Conclusion with respect to disqualified per- sons . As shown in column 4 in the table contained in paragraph (i) of Example 1, individuals B and C are disqualified persons for 2006 under paragraph (d)(1) of this section because each owns at least 10% of X’s deemed-owned ESOP shares. However, the synthetic equity shares owned by any person do not affect the calculation for any other person’s ownership of shares.

(iii) Conclusion with respect to nonallocation year . 2006 is not a nonallocation year under section 409(p) because disqualified persons do not own at least 50% of X’s outstanding shares (the 100 shares owned directly by B, B’s 330 deemed-owned ESOP shares, plus C’s 145 deemed-owned ESOP shares equal only 47.9% of the 1,200 outstanding shares of X).

Example 2 . Relating to determination of disqual- ified persons and nonallocation year if there is syn- thetic equity . (i) Facts . The facts are the same as in Example 1, except that, as shown in column 4 of the table in this Example 2, individuals E and F have options to acquire 110 and 130 shares, respectively, of the common stock of X from X:

(ii) Conclusion with respect to disqualified per- sons . Individual E’s synthetic equity shares are counted in determining whether E is a disqualified person for 2006, and individual F’s synthetic equity shares are counted in determining whether F is a disqualified person for 2006. Applying the rule of paragraph (f)(4)(iv) of this section, E’s option to acquire 110 shares of the S corporation converts under paragraph (f)(4)(iv) of this section, into 91.7 shares of synthetic equity (110 times the ratio of the 1,000 deemed-owned ESOP shares to the sum of the 1,000 deemed-owned ESOP shares plus the 200 shares held outside the ESOP by A and B). Similarly, F’s option to acquire 130 shares of the S corporation converts into 108.3 shares of synthetic equity (130 times the ratio of the 1,000 deemed-owned ESOP shares to the sum of the 1,000 deemed-owned ESOP shares plus the 200 shares held outside the ESOP by A and B). However, the synthetic equity shares owned by any person do not affect the calculation for any other person’s ownership of shares. Accord

ingly, as shown in column 6 in the table contained in paragraph (i) of Example 2, individuals B, C, E, and F are disqualified persons for 2006.

(iii) Conclusion with respect to nonalloca- tion year . The 100 shares owned directly by B, B’s 330 deemed-owned ESOP shares, C’s 145 deemed-owned ESOP shares, E’s 30 deemed-owned ESOP shares, E’s 91.7 synthetic equity shares, F’s 20 deemed-owned ESOP shares, plus F’s 108.3 synthetic equity shares total 825, which equals 58.9% of 1,400, which is the sum of the 1,200 outstanding shares of X and the 200 shares of synthetic equity shares of X held by disqualified persons. Thus, 2006 is a nonallocation year for X’s ESOP under section 409(p) because disqualified persons own at least 50% of the total shares of outstanding stock of X and the total synthetic equity shares of X held by disqualified persons. In addition, independent of the preceding conclusion, 2006 would be a nonallocation year because disqualified persons own at least 50% of X’s outstanding shares because the 100

shares owned directly by B, B’s 330 deemed-owned ESOP shares, C’s 145 deemed-owned ESOP shares, E’s 30 deemed-owned ESOP shares, plus F’s 20 deemed-owned ESOP shares equal 52.1% of the 1,200 outstanding shares of X. Example 3 . Relating to determination of number of shares of synthetic equity . (i) Facts . Corporation Y is a calendar year S corporation that maintains an ESOP. Y has a single class of common stock, of which there are a total of 1,000 shares outstanding, all of which are owned by the ESOP. Y has no synthetic equity, except for four grants of nonqualified deferred compensation that are made to an individual during the period from 2005 through 2011, as set forth in column 2 in the following table. The ESOP provides for the rules in paragraph (f)(4)(iii) of this section to determine the number of shares of synthetic equity owned by that individual with a determination date of January 1 and the triennial rule redetermining value, as shown in columns 4 and 5:

2007–5 I.R.B. 392 January 29, 2007

(ii) Conclusion . The grant made on January 1, 2005, is treated as 100 shares until the determination date in 2008. The grant made on March 1, 2005, is not taken into account until the 2006 determination date and its present value on that date, along with the then present value of the grant made on December 31, 2005, is treated as a number of shares that are based on the $8 per share value on the 2006 determination date, with the resulting number of shares continuing to apply until the determination date in 2008. On the January 1, 2008, determination date, the grant made on the preceding day is taken into account at its present value of $3,000 on January 1, 2008 and the $15 per share value on that date with the resulting number of shares (200) continuing to apply until the next determination date. In addition, on the January 1, 2008, determination date, the number of shares determined under other grants made between January 1, 2005 and December 31, 2007, must be revalued. Accordingly, the aggregate value of all nonqualified deferred compensation granted during that period is determined to be $3750 on January 1, 2008, and the corresponding number of shares of synthetic equity based on the $15 per share value is determined to be 250 shares on the 2008 determination date, with the resulting aggregate number of shares (450) continuing to apply until the determination date in 2011. On the January 1, 2011, determination date, the aggregate value of all nonqualified deferred compensation is de

termined to be $7,600 and the corresponding number of shares of synthetic equity based on the $20 per share value on the 2011 determination date is determined to be 380 shares (with the resulting number of shares continuing to apply until the day before the determination date in 2014, assuming no further grants are made).

(i) Effective dates —(1) Statutory effec- tive date . (i) Except as otherwise provided in paragraph (i)(1)(ii) of this section, section 409(p) applies for plan years ending after March 14, 2001.

(ii) If an ESOP holding stock in an S corporation was established on or before March 14, 2001, and the election under section 1362(a) with respect to that S corporation was in effect on March 14, 2001, section 409(p) applies for plan years beginning on or after January 1, 2005.

(2) Regulatory effective date . This section applies for plan years beginning on or after January 1, 2006. For plan years beginning before January 1, 2006, §1.409(p)–1T (as it appeared in the April 1, 2005, edition of 26 CFR part 1) applies.

Mark E. Matthews, Deputy Commissioner for Services and Enforcement.

Approved November 30, 2006.

Eric Solomon, Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on December 19, 2006, 8:45 a.m., and published in the issue of the Federal Register for December 20, 2006, 71 F.R. 76134)

Section 472.—Last-in, First-out Inventories

26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; department stores. The November 2006 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories

January 29, 2007 393 2007–5 I.R.B.

and include (a) 23 major groups of departments, (b) three special combinations of the major groups - soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

for tax years ended on, or with reference to, November 30, 2006.

Rev. Rul. 2007–6

The following Department Store Inventory Price Indexes for November 2006 were issued by the Bureau of Labor Statistics (BLS). The indexes are accepted by the Internal Revenue Service, under

§ 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for appropriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, November 30, 2006.

The Department Store Inventory Price Indexes are prepared on a national basis

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups Nov. 2005 Nov. 2006

Percent Change from Nov. 2005

to Nov. 2006 ¹

1. Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480.6 471.2 -2.0
2. Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508.2 478.1 -5.9
3. Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684.7 678.1 -1.0
4. Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 868.9 894.2 2.9
5. Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564.1 573.3 1.6
6. Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548.8 560.2 2.1
7. Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339.8 346.5 2.0
8. Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 582.1 542.0 -6.9
9. Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 368.3 373.5 1.4
10. Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542.1 529.6 -2.3
11. Men’s Furnishings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574.9 574.9 0.0
12. Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403.5 411.3 1.9
13. Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 861.4 893.3 3.7
14. Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 803.1 817.9 1.8
15. Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1001.0 1005.1 0.4
16. Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596.7 596.9 0.0
17. Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612.3 623.2 1.8
18. Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 701.9 689.7 -1.7
19. Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204.3 208.9 2.3
20. Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.1 34.4 -9.7
21. Recreation and Education ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77.6 76.7 -1.2
22. Home Improvements ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137.2 141.3 3.0
23. Automotive Accessories ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116.5 122.2 4.9

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561.0 561.9 0.2 Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376.2 371.2 -1.3 Groups 21–23: Misc. Goods ² . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93.1 94.2 1.2

Store Total ³ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.4 495.3 0.0

1Absence of a minus sign before the percentage change in this column signifies a price increase. 2Indexes on a January 1986 = 100 base. 3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor, tobacco, and contract departments.

DRAFTING INFORMATION

The principal author of this revenue ruling is John Roman Faron of the Office

of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, con

tact Mr. Faron at (202) 622–8142 (not a toll-free call).

2007–5 I.R.B. 394 January 29, 2007