Bulletin No. 2007-5January 29, 2007

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2007–5, page 378.Low-income housing credit; satisfactory bond; “bondfactor” amounts for the period January through March2007. This ruling provides the monthly bond factor amountsto be used by taxpayers who dispose of qualified low-incomebuildings or interests therein during the period January throughMarch 2007.

Rev. Rul. 2007–6, page 393.LIFO; price indexes; department stores. The November2006 Bureau of Labor Statistics price indexes are acceptedfor use by department stores employing the retail inventoryand last-in, first-out inventory methods for valuing inventoriesfor tax years ended on, or with reference to, November 30,2006.

T.D. 9303, page 379.REG–125632–06, page 415.Final, temporary, and proposed regulations under section 368of the Code provide guidance regarding the qualification ofcertain transactions as reorganizations described in section368(a)(1)(D) where no stock and/or securities of the acquir-ing corporation is issued and distributed in the transaction.

Notice 2007–9, page 401.This notice provides guidance under section 954(c)(6) of theCode on dividend, interest, rent and royalty payments that maybe excluded from foreign personal holding company income.

Notice 2007–13, page 410.This notice announces that the Treasury Department and theService will amend the regulations addressing substantial as-sistance rendered by a related person or persons to a con-

trolled foreign corporation (CFC). These amended regulationswill limit the types of activities that constitute substantial assis-tance to certain assistance rendered, directly or indirectly, by aUnited States person or persons to a related CFC. In addition,in light of the repeal of the foreign base company shipping in-come rules under subpart F, this notice confirms that incomethat previously was foreign base company shipping income willcontinue to be foreign base company income to the extent thatit is within the definition of a remaining category of foreign basecompany income.

EMPLOYEE PLANS

T.D. 9302, page 382.Final regulations under section 409(p) of the Code provide guid-ance concerning requirements for employee stock ownershipplans (ESOPs) holding stock of Subchapter S corporations.

Notice 2007–7, page 395.Distribution issues; multiple issues; Pension ProtectionAct of 2006. This notice provides guidance in the form ofquestions and answers with respect to certain provisions con-tained in the Pension Protection Act of 2006, Pub. L. No.109–280 (PPA ’06), that are effective in 2007 or earlier andare primarily related to distributions described in sections 303,826, 828, 829, 845, 904, 1102, and 1201 of the statute.

Notice 2007–12, page 409.Weighted average interest rate update; corporate bondindices; 30-year Treasury securities. The weighted aver-age interest rate for January 2007 and the resulting permissi-ble range of interest rates used to calculate current liability andto determine the required contribution are set forth.

(Continued on the next page)

Finding Lists begin on page ii.Index for January begins on page iv.

EXCISE TAX

Notice 2007–11, page 405.This notice answers questions raised by Notice 2006–50,2006–25 I.R.B. 1141. It also provides guidance regardingthe standard amounts for individuals and provides rules forthe Business and Nonprofit Estimation Method (EM). Notice2006–50 amplified, clarified, and modified.

ADMINISTRATIVE

Rev. Proc. 2007–18, page 413.Pursuant to section 1397E(e)(2) of the Code, this proceduresets forth the maximum face amount of Qualified Zone Acad-emy Bonds that may be issued for each state for each of thecalendar years 2006 and 2007. For this purpose, “State”includes the District of Columbia and the possessions of theUnited States.

Announcement 2007–8, page 416.This document contains corrections to temporary regulations(T.D. 9286, 2006–43 I.R.B. 750) providing rules for claimingthe railroad track maintenance credit under section 45G of theCode for qualified railroad track maintenance expenditures paidor incurred by a Class II or Class III railroad and other eligibletaxpayers during the taxable year.

Announcement 2007–9, page 417.This document contains corrections to final and temporary reg-ulations (T.D. 9278, 2006–34 I.R.B. 256) regarding the treat-ment of controlled services transactions under section 482 ofthe Code and the allocation of income from intangibles, in par-ticular with respect to contributions by a controlled party to thevalue of an intangible owned by another controlled party.

January 29, 2007 2007–5 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2007–5 I.R.B. January 29, 2007

Place missing child here.

January 29, 2007 2007–5 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 42.—Low-IncomeHousing Credit

Low-income housing credit; satis-factory bond; “bond factor” amountsfor the period January through March2007. This ruling provides the monthlybond factor amounts to be used by taxpay-ers who dispose of qualified low-incomebuildings or interests therein during theperiod 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 gen-eral methodology used by the TreasuryDepartment in computing the bond factoramounts used in calculating the amount ofbond considered satisfactory by the Secre-tary under § 42(j)(6) of the Internal Rev-enue Code. It further announced that theSecretary would publish in the InternalRevenue Bulletin a table of bond factoramounts for dispositions occurring duringeach calendar month.

Rev. Proc. 99–11, 1999–1 C.B. 275,established a collateral program as an al-ternative to providing a surety bond fortaxpayers to avoid or defer recapture of

the low-income housing tax credits under§ 42(j)(6). Under this program, taxpayersmay establish a Treasury Direct Accountand pledge certain United States Treasurysecurities to the Internal Revenue Serviceas security.

This revenue ruling provides in Table1 the bond factor amounts for calculatingthe amount of bond considered satisfactoryunder § 42(j)(6) or the amount of UnitedStates Treasury securities to pledge in aTreasury Direct Account under Rev. Proc.99–11 for dispositions of qualified low-in-come buildings or interests therein duringthe period January through March 2007.

Table 1Rev. Rul. 2007–5

Monthly Bond Factor Amounts for Dispositions ExpressedAs a Percentage of Total Credits

Calendar Year Building Placed in Serviceor, if Section 42(f)(1) Election Was Made,

the Succeeding Calendar Year

Month ofDisposition

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Jan ’07 17.39 32.44 45.52 56.97 66.95 69.23 71.86 74.74 78.09 81.82 85.82Feb ’07 17.39 32.44 45.52 56.97 66.95 69.08 71.70 74.56 77.89 81.60 85.57Mar ’07 17.39 32.44 45.52 56.97 66.95 68.92 71.53 74.39 77.71 81.40 85.33

Table 1 (cont’d)Rev. Rul. 2007–5

Monthly Bond Factor Amounts for Dispositions ExpressedAs a Percentage of Total Credits

Calendar Year Building Placed in Serviceor, if Section 42(f)(1) Election Was Made,

the Succeeding Calendar Year

Month ofDisposition

2004 2005 2006 2007

Jan ’07 89.79 93.41 96.70 97.21Feb ’07 89.50 93.07 96.27 97.21Mar ’07 89.22 92.75 95.89 97.21

For a list of bond factor amounts ap-plicable to dispositions occurring duringother 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.

DRAFTING INFORMATION

The principal author of this revenueruling is David McDonnell of the Officeof Associate Chief Counsel (Passthroughsand Special Industries). For further in-formation regarding this revenue ruling,

2007–5 I.R.B. 378 January 29, 2007

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

Section 368.—DefinitionsRelating to CorporateReorganizations26 CFR 1.368–2: Definition of terms.

T.D. 9303

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Corporate Reorganizations;Distributions Under Sections368(a)(1)(D) and 354(b)(1)(B)

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final and temporary regula-tions.

SUMMARY: This document containstemporary regulations under section 368of the Internal Revenue Code of 1986(Code). The temporary regulations pro-vide guidance regarding the qualificationof certain transactions as reorganizationsdescribed in section 368(a)(1)(D) whereno stock and/or securities of the acquiringcorporation is issued and distributed inthe transaction. These regulations affectcorporations engaging in such transac-tions and their shareholders. The textof the temporary regulations also servesas the text of the proposed regulations(REG–125632–06) set forth in the noticeof proposed rulemaking on this subject inthis issue of the Bulletin.

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

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

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

SUPPLEMENTARY INFORMATION:

Background

The IRS and Treasury Department havereceived requests for immediate guidanceregarding whether certain acquisitivetransactions can qualify as reorganizationsdescribed in section 368(a)(1)(D) whereno stock of the transferee corporationis issued and distributed in the transac-tion. Currently, the IRS and TreasuryDepartment are undertaking a broad studyof issues related to acquisitive section368(a)(1)(D) reorganizations. In the in-terest of efficient tax administration, theIRS and Treasury Department are issuingthese temporary regulations to provide therequested certainty for taxpayers regard-ing these acquisitive transactions pendingthe broader study of issues. Althoughthese rules also are being proposed in thisissue of the Bulletin, the IRS and TreasuryDepartment contemplate that the proposedrules may change upon completion of thisbroader study and the comments received.

The Code provides general nonrecogni-tion treatment for reorganizations specif-ically described in section 368(a). Sec-tion 368(a)(1)(D) describes as a reorgani-zation a transfer by a corporation (trans-feror corporation) of all or a part of its as-sets to another corporation (transferee cor-poration) if, immediately after the transfer,the transferor corporation or one or moreof its shareholders (including persons whowere shareholders immediately before thetransfer), or any combination thereof, is incontrol of the transferee corporation; butonly if stock or securities of the controlledcorporation are distributed in pursuance ofa plan of reorganization in a transactionthat qualifies under section 354, 355, or356.

Section 354(a)(1) provides that no gainor loss shall be recognized if stock or se-curities in a corporation a party to a reor-ganization are, in pursuance of the plan ofreorganization, exchanged solely for stockor securities in such corporation or in an-other corporation a party to the reorgani-zation. Section 354(b)(1)(B) provides thatsection 354(a)(1) shall not apply to an ex-change in pursuance of a plan of reorga-nization described in section 368(a)(1)(D)unless the transferee corporation acquiressubstantially all of the assets of the trans-feror corporation, and the stock, securi-

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

Further, section 356 provides that if sec-tion 354 or 355 would apply to an ex-change but for the fact that the property re-ceived in the exchange consists not only ofproperty permitted by section 354 or 355without the recognition of gain or loss butalso of other property or money, then thegain, if any, to the recipient shall be recog-nized, but not in excess of the amount ofmoney and fair market value of such otherproperty. Accordingly, in the case of anacquisitive transaction, there can only bea distribution to which section 354 or 356applies where the target shareholder(s) re-ceive at least some property permitted tobe received by section 354.

Notwithstanding the requirement insection 368(a)(1)(D) that “stock or securi-ties of the corporation to which the assetsare transferred are distributed in a trans-action which qualifies under section 354,355, or 356”, the IRS and the courts havenot required the actual issuance and dis-tribution of stock and/or securities of thetransferee corporation in circumstanceswhere the same person or persons ownall the stock of the transferor corporationand the transferee corporation. In suchcircumstances, the IRS and the courtshave viewed an issuance of stock to be a“meaningless gesture” not mandated bysections 368(a)(1)(D) and 354(b).

In Revenue Ruling 70–240, 1970–1C.B. 81 (see §601.601(d)(2) of this chap-ter), B owned all of the stock of bothcorporation X and corporation Y. X soldits operating assets to Y for $34x dollars,which represented the fair market valueof X’s assets. X had $33x of other assets,consisting generally of cash, accounts re-ceivables, and investments in stocks andbonds, so that the assets sold by X to Yconstituted approximately 51% of X’stotal assets. Following the sale to Y, Xpaid its debts, which amounted to $38x,and then liquidated, distributing $29x toB, while Y continued to conduct the busi-ness formerly operated by X. The IRSconcluded that “although no actual sharesof the stock of Y were distributed to B asa result of the transaction, B is treated ashaving received Y stock since he alreadyowned all the stock of Y.” Accordingly,

January 29, 2007 379 2007–5 I.R.B.

the IRS held that the sale of the oper-ating assets by X to Y, followed by theliquidation and distribution of X’s assetsto B, resulted in a reorganization undersection 368(a)(1)(D) and a distributionunder section 356(a), despite the absenceof an actual issuance and distribution of Ystock.

When considering a similar transactionbetween two corporations owned in identi-cal proportions by a husband and wife, theTax Court concluded that there was in sub-stance an exchange of stock which meetsthe requirements of section 354 and 356,and stated, “[t]he issuance of further stockwould have been a meaningless gesture,and we cannot conclude that the statuterequires 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 ap-plied this meaningless gesture doctrine tocircumstances where the transferor corpo-ration and the transferee corporation arewholly owned by a single party directly orindirectly through subsidiaries, or as a re-sult of family attribution pursuant to sec-tion 318(a)(1).

However, the application of this mean-ingless gesture doctrine has generally beenlimited to situations in which there is iden-tical shareholder identity and proportion-ality of interest in the transferor corpora-tion and the transferee corporation. Forexample, in Warsaw Photographic Asso-ciates, Inc. v. Commissioner, 84 T.C. 21(1985), there was no issuance of stock bythe transferee corporation to the transferorcorporation, and the stock ownership in thetwo corporations was not identical. On thebasis of these facts, the Tax Court con-cluded that the distribution of stock wouldnot be a mere formality and refused to ap-ply the meaningless gesture doctrine. Ac-cordingly, the transaction failed to qual-ify as a section 368(a)(1)(D) reorganiza-tion because there was no distribution ofstock of the transferee corporation undersections 368(a)(1)(D) and 354(b)(1)(B).

Explanation of Provisions

These temporary regulations provideguidance regarding the circumstances inwhich the distribution requirement undersections 368(a)(1)(D) and 354(b)(1)(B) isdeemed satisfied despite the fact that nostock and/or securities are actually issued

in a transaction otherwise described in sec-tion 368(a)(1)(D). In cases where the sameperson or persons own, directly or indi-rectly, all of the stock of the transferor andtransferee corporations in identical propor-tions, these temporary regulations providethat the distribution requirement undersections 368(a)(1)(D) and 354(b)(1)(B)will be treated as satisfied even though nostock is actually issued in the transaction.For purposes of determining whether thesame person or persons own all of thestock of the transferor and transferee cor-porations in identical proportions, thesetemporary regulations provide that an in-dividual and all members of his family thathave a relationship described in section318(a)(1) will be treated as one individual.

The temporary regulations also providethat the distribution requirement undersections 368(a)(1)(D) and 354(b)(1)(B)will be treated as satisfied in the absenceof any issuance of stock and/or securitieswhere there is a de minimis variation inshareholder identity or proportionality ofownership in the transferor and transfereecorporations. Further, stock described insection 1504(a)(4) is disregarded for pur-poses of determining whether the sameperson or persons own all of the stock ofthe transferor and transferee corporationsin identical proportions.

Under these temporary regulations, ineach case where it is determined that thesame person or persons own all of the stockof the transferor and transferee corpora-tions in identical proportions, a nominalshare of stock of the transferee corpora-tion will be deemed issued in addition tothe actual consideration exchanged in thetransaction. The nominal share of stockin the transferee corporation will then bedeemed distributed by the transferor cor-poration to its shareholders and, in appro-priate circumstances, further transferred tothe extent necessary to reflect the actualownership of the transferor and transfereecorporations.

These temporary regulations are beingissued in response to requests for imme-diate guidance regarding whether trans-actions otherwise described in section368(a)(1)(D) qualify as reorganizationswhere no stock and/or securities of thetransferee corporation are actually issuedin the transaction. The IRS and TreasuryDepartment currently are undertaking abroad study of issues related to acquis-

itive reorganizations, including issuesaddressed by these temporary regulations.The IRS and Treasury Department are is-suing these temporary regulations in orderto provide certainty for taxpayers whilethese issues are under study.

The IRS and Treasury Departmentbelieve that these temporary regulationsare a reasonable interpretation of section368(a)(1)(D) and section 354(b)(1)(B)given the history of those provisions andthe manner in which they have previouslybeen interpreted by the courts and theIRS. However, no inference should bedrawn from these temporary regulationsregarding the law prior to the effectivedate of these temporary regulations. Inthis issue of the Bulletin, the IRS andTreasury Department are requesting com-ments on several issues relating to acquis-itive reorganizations described in section368(a)(1)(D).

In addition, the IRS and TreasuryDepartment note that these temporaryregulations do not expressly implementProp. Reg. §1.368–1(f)(4) (FR 70,11903–11912), which provides that theremust be an exchange of net value exceptin the case of a transaction that wouldotherwise qualify as a reorganization de-scribed in section 368(a)(1)(D), providedthat the fair market value of the propertytransferred to the acquiring corporation bythe target corporation exceeds the amountof liabilities of the target corporation im-mediately before the exchange (includingany liabilities cancelled, extinguished,or assumed in connection with the ex-change), and the fair market value of theassets of the acquiring corporation equalsor exceeds the amount of its liabilitiesimmediately after the exchange. The sol-vency requirement remains the IRS’s andTreasury Department’s proposal but theIRS and Treasury Department continue toconsider whether this solvency require-ment should be applied to the transactionsdescribed in these temporary regulations.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chapter

2007–5 I.R.B. 380 January 29, 2007

5) does not apply to these regulations. Forthe applicability of the Regulatory Flexi-bility Act, please refer to the cross-refer-ence notice of proposed rulemaking pub-lished elsewhere in this Bulletin. Pursuantto section 7805(f) of the Internal RevenueCode, these regulations were submitted tothe Chief Counsel for Advocacy of theSmall Business Administration for com-ment on their impact on small business.

Drafting Information

The principal author of these regula-tions is Bruce A. Decker of the Office ofthe Associate Chief Counsel (Corporate).

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 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 furtherguidance, see §1.368–2(a) through (k).

(l) Certain transactions treated asreorganizations described in section368(a)(1)(D)—(1) General rule. In or-der to qualify as a reorganization undersection 368(a)(1)(D), a corporation (trans-feror corporation) must transfer all orpart of its assets to another corporation(transferee corporation) and immediatelyafter the transfer the transferor corpora-tion, or one or more of its shareholders(including persons who were shareholdersimmediately before the transfer), or anycombination thereof, must be in control ofthe transferee corporation; but only if, in

pursuance of the plan, stock or securitiesof the transferee are distributed in a trans-action which qualifies under section 354,355, or 356.

(2) Distribution requirement—(i) Ingeneral. For purposes of paragraph (l)(1)of this section, a transaction otherwisedescribed in section 368(a)(1)(D) will betreated as satisfying the requirements ofsections 368(a)(1)(D) and 354(b)(1)(B)notwithstanding that there is no actualissuance of stock and/or securities of thetransferee corporation if the same personor persons own, directly or indirectly, allof the stock of the transferor and transfereecorporations in identical proportions. Insuch cases, the transferee corporationwill be deemed to issue a nominal shareof stock to the transferor corporation inaddition to the actual consideration ex-changed for the transferor corporation’sassets. The nominal share of stock in thetransferee corporation will then be deemeddistributed by the transferor corporationto its shareholders and, where appropriate,further transferred through chains of own-ership to the extent necessary to reflectthe actual ownership of the transferor andtransferee corporations.

(ii) Attribution. For purposes of para-graph (l)(2)(i) of this section, ownershipof stock will be determined by applyingthe principles of section 318(a)(2) with-out regard to the 50 percent limitation insection 318(a)(2)(C). In addition, an indi-vidual and all members of his family de-scribed in section 318(a)(1) shall be treatedas 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 personswill be treated as owning, directly or indi-rectly, all of the stock of the transferor andtransferee corporations in identical propor-tions notwithstanding the fact that there isa de minimis variation in shareholder iden-tity or proportionality of ownership. Addi-tionally, for purposes of paragraph (l)(2)(i)of this section, stock described in section1504(a)(4) is not taken into account.

(3) Examples. The following examplesillustrate the principles of paragraph (l) ofthis section. For purposes of these exam-ples, each of A, B, C, and D is an indi-vidual, T is the acquired corporation, Sis the acquiring corporation, P is the par-ent corporation, and each of S1, S2, S3,

and S4 is a direct or indirect subsidiary ofP. Further, all of the requirements of sec-tion 368(a)(1)(D) other than the require-ment that stock or securities be distributedin a transaction to which section 354 or 356applies are satisfied. The examples are asfollows:

Example 1. A owns all the stock of T and S. TheT stock has a fair market value of $100x. T sellsall of its assets to S in exchange for $100x of cashand immediately liquidates. Because there is com-plete shareholder identity and proportionality of own-ership in T and S, under paragraph (l)(2)(i) of this sec-tion, the requirements of sections 368(a)(1)(D) and354(b)(1)(B) are treated as satisfied notwithstandingthe fact that no S stock is issued. Pursuant to para-graph (l)(2)(i) of this section, S will be deemed to is-sue a nominal share of S stock to T in addition to the$100x of cash actually exchanged for the T assets, andT will be deemed to distribute all such considerationto A. The transaction qualifies as a reorganization de-scribed 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 ofS. Under paragraph (l)(2)(ii) of this section, A andC are treated as one individual. Accordingly, thereis complete shareholder identity and proportionalityof ownership in T and S. Therefore, under paragraph(l)(2)(i) of this section, the requirements of sections368(a)(1)(D) and 354(b)(1)(B) are treated as satisfiednotwithstanding the fact that no S stock is issued. Pur-suant to paragraph (l)(2)(i) of this section, S will bedeemed to issue a nominal share of S stock to T inaddition to the $100x of cash actually exchanged forthe T assets, and T will be deemed to distribute allsuch consideration to A. A will be deemed to trans-fer the nominal share of S stock to C. The transac-tion qualifies as a reorganization described in section368(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 thestock of T. S2 owns all of the stock of S4, which ownsall of the stock of S. The T stock has a fair marketvalue of $70x. T sells all of its assets to S in exchangefor $70x of cash and immediately liquidates. Underparagraph (l)(2)(ii) of this section, there is indirect,complete shareholder identity and proportionality ofownership in T and S. Accordingly, the requirementsof sections 368(a)(1)(D) and 354(b)(1)(B) are treatedas satisfied notwithstanding the fact that no S stock isissued. Pursuant to paragraph (l)(2)(i) of this section,S will be deemed to issue a nominal share of S stock toT in addition to the $70x of cash actually exchangedfor the T assets, and T will be deemed to distribute allsuch consideration to S3. S3 will be deemed to dis-tribute the nominal share of S stock to S1, which, inturn, will be deemed to distribute the nominal share ofS stock to P. P will be deemed to transfer the nominalshare of S stock to S2, which, in turn, will be deemedto transfer such share of S stock to S4. The transac-tion qualifies as a reorganization described in section368(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 fairmarket value of $100x. A, B, and C each own 33% ofthe stock of S. D owns the remaining 1% of the stockof S. T sells all of its assets to S in exchange for $100xof cash and immediately liquidates. For purposes of

January 29, 2007 381 2007–5 I.R.B.

determining whether the distribution requirement ofsections 368(a)(1)(D) and 354(b)(1)(B) is met, underparagraph (l)(2)(iii) of this section, D’s ownership ofa de minimis amount of stock of S is disregarded andthe transaction is treated as if there is complete share-holder identity and proportionality of ownership in Tand S. Because there is complete shareholder identityand proportionality of ownership in T and S, underparagraph (l)(2)(i) of this section, the requirementsof sections 368(a)(1)(D) and 354(b)(1)(B) are treatedas satisfied notwithstanding the fact that no S stockis issued. Pursuant to paragraph (l)(2)(i) of this sec-tion, S will be deemed to issue a nominal share of Sstock to T in addition to the $100x of cash actuallyexchanged for the T assets, T will be deemed to dis-tribute all such consideration to A, B, and C, and thenominal S stock will be deemed transferred amongthe S shareholders to the extent necessary to reflecttheir actual ownership of S. The transaction qualifiesas 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 Tand S. D owns preferred stock in S described in sec-tion 1504(a)(4). For purposes of determining whetherthe 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 describedin section 1504(a)(4) is ignored and the transactionis treated as if there is complete shareholder iden-tity and proportionality of ownership in T and S. Be-cause there is complete shareholder identity and pro-portionality of ownership in T and S, under paragraph(l)(2)(i) of this section, the requirements of sections368(a)(1)(D) and 354(b)(1)(B) are treated as satis-fied notwithstanding the fact that no S stock is issued.Pursuant to paragraph (l)(2)(i) of this section, S willbe deemed to issue a nominal share of S stock to Tin addition to the $100x of cash actually exchangedfor the T assets, and T will be deemed to distributeall such consideration to A, B, and C. The transac-tion qualifies as a reorganization described in section368(a)(1)(D).

Example 6. A and B each own 50% of the stockof T. The T stock has a fair market value of $100x. Band C own 90% and 10%, respectively, of the stock ofS. T sells all of its assets to S in exchange for $100x ofcash and immediately liquidates. Because completeshareholder identity and proportionality of ownershipin T and S does not exist, paragraph (l)(2)(i) of thissection does not apply. The requirements of sections368(a)(1)(D) and 354(b)(1)(B) are not satisfied, andthe transaction does not qualify as a reorganizationdescribed in section 368(a)(1)(D).

(4) Effective date. (i) In general. Thissection applies to transactions occurringon or after March 19, 2007, except thatthey do not apply to any transaction occur-ring pursuant to a written agreement whichis binding before December 19, 2006, andat all times thereafter. A taxpayer mayapply the provisions of these temporaryregulations to transactions occurring be-fore March 19, 2007. However, the trans-feror corporation, the transferee corpora-tion, any direct or indirect transferee oftransferred basis property from either of

the foregoing, and any shareholder of thetransferor or transferee corporation maynot apply the provisions of these tempo-rary regulations unless all such taxpayersapply the provisions of the temporary reg-ulations.

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

Mark E. Matthews,Deputy Commissioner forServices 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 FederalRegister for December 19, 2006, 71 F.R. 75879)

Section 409.—Qualifi-cations for Tax CreditEmployee Stock Own-ership Plans26 CFR 1.409(p)–1: Prohibited allocation of securi-ties in an S corporation.

T.D. 9302

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Prohibited Allocations ofSecurities in an S Corporation

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations that provide guidanceconcerning requirements under section409(p) of the Internal Revenue Codefor employee stock ownership plans(ESOPs) holding stock of SubchapterS corporations. These final regulationsgenerally affect plan sponsors of, andparticipants in, ESOPs holding stock ofSubchapter S corporations.

DATES: Effective Date: These regulationsare effective December 20, 2006.

Applicability Dates: These regulationsare generally applicable with respect toplan years beginning on or after January 1,2006. See the Effective Date section of thepreamble for specific information.

FOR FURTHER INFORMATIONCONTACT: John T. Ricotta orVeronica A. Rouse at (202) 622–6090 (nota toll-free number).

SUPPLEMENTARY INFORMATION:

Background

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

Section 409(p)(1) requires an ESOPholding employer securities consisting ofstock in an S corporation to provide that,during an allocation year, no portion ofthe assets of the plan attributable to, orallocable in lieu of, the employer securi-ties may accrue (or be allocated directlyor indirectly under any plan of the em-ployer meeting the requirements of section401(a)) for the benefit of any disqualifiedperson. Section 409(p)(3)(A) providesthat a nonallocation year includes any planyear during which the ownership of theS corporation is so concentrated amongdisqualified persons that they own or aredeemed to own at least 50 percent of itsshares. Section 409(p)(4) provides, in gen-eral, that a disqualified person is any per-son whose deemed-owned ESOP shares(allocated ESOP shares and proportion ofsuspense account shares) are at least 10percent of the number of deemed-ownedshares of S corporation stock held by anESOP or for whom the aggregate num-ber of shares owned by such person andthe members of such person’s familyis at least 20 percent of deemed-ownedESOP shares. Under section 409(p)(5),the determination of whether a person isa disqualified person and whether a planyear is a nonallocation year is also madeseparately taking into account syntheticequity if such treatment results in treatingthe person as a disqualified person or theyear 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 FR42970). The text of those temporary regu-lations also served as the text of a notice ofproposed rulemaking (REG–129709–03,

2007–5 I.R.B. 382 January 29, 2007

2003–2 C.B. 506) published at 68 FR43058. The 2003 regulations providedguidance on identifying disqualified per-sons, determining whether an ESOP hasa nonallocation year, and defining syn-thetic equity under section 409(p)(5), andreserved some issues, including the def-inition of a prohibited allocation, the taxeffect of a prohibited allocation, and cer-tain issues relating to the definition ofsynthetic equity.

A public hearing on the 2003 regula-tions was held on November 17, 2003.New temporary regulations under section409(p) (T.D. 9164, 2005–1 C.B. 320) werepublished in the Federal Register on De-cember 17, 2004, (69 FR 75455). Thenew temporary regulations (2004 tempo-rary regulations) addressed certain issuesraised in the comments, as well as address-ing the topics reserved in the 2003 tem-porary regulations. The text of the 2004temporary regulations also served as thetext for a notice of proposed rulemaking(REG–129709–03, 2005–1 C.B. 351) pub-lished at 69 FR 75492.

A public hearing on the 2004 proposedregulations was held on April 20, 2005.After consideration of the comments re-ceived, these final regulations adopt theprovisions of the proposed regulationswith certain modifications discussed inthis preamble.

Explanation of Provisions

Definition of Prohibited Allocation

These regulations retain the rule ofthe 2004 temporary regulations concern-ing prohibited allocations under whichthere is an impermissible accrual to theextent employer securities consisting ofstock in an S corporation are held underthe ESOP for the benefit of a disquali-fied person during a nonallocation year.Thus, in the event of a nonallocation year,S corporation shares held in a disquali-fied person’s account and all other ESOPassets attributable to S corporation stock,including distributions, sales proceeds,and earnings, are treated as an imper-missible accrual whether attributable tocontributions in the current year or a prioryear. A commentator questioned whetherthe definition of prohibited allocation inthe 2004 temporary regulations shouldinclude account balances of disqualified

persons from prior years. The rule ofthe 2004 temporary regulations has beenretained because it is consistent with theintent of the statute, and the IRS and Trea-sury Department believe it is necessaryto prevent the concentration of ownershipinterests that section 409(p) was intendedto prevent.

A commentator also questioned thetreatment of proceeds from the sale ofstock previously allocated to a disqual-ified person’s account under the 2004temporary regulations. The commenta-tor expressed concern that treating thesales proceeds as an impermissible accrualwhen the original allocation of stock isalready a prohibited allocation is a dou-ble penalty. The final regulations do notchange this rule in the 2004 temporaryregulations. An allocation of sales pro-ceeds from stock held for the benefit of adisqualified person back into the accountof the disqualified person is as valuablean accrual for the disqualified person asan investment in employer stock. Thistreatment is also consistent with the pro-hibition in section 409(p)(1) with respectto amounts that are “allocable in lieu of”employer stock.

Effect of a Prohibited Allocation

These regulations retain the rule of the2004 regulations that if there is a prohib-ited allocation during a nonallocation year,the ESOP fails to satisfy the requirementsof section 4975(e)(7) and ceases to be anESOP. As a result, the exemption fromthe excise tax on prohibited transactionsfor loans to leveraged ESOPs contained insection 4975(d)(3) would cease to apply toany loan (with the result that the employerwould owe an excise tax with respect to thepreviously exempt loan). These regula-tions clarify that an additional result wouldbe the plan’s failure to satisfy the qualifica-tion requirements under section 401(a) fornot operating the plan in accordance withits terms to reflect section 409(p). Otherconsequences include imposition of an ex-cise tax on the S corporation under sec-tion 4979A. An example has been addedto these final regulations to illustrate theimpact of these rules on an S corporationESOP.

These regulations include the rule fromthe 2004 regulations under which a pro-hibited allocation is a deemed distribution

that is not an eligible rollover distribution.These regulations also add that same ruleto the list of distributions that are not el-igible rollover distributions in the regula-tions under section 402(c) (at §1.402(c)–2of the Treasury Regulations). As a result,under recently proposed regulations relat-ing to designated Roth contributions undersection 402A, a deemed distribution as aresult of a section 409(p) prohibited alloca-tion with respect to a designated Roth ac-count would not constitute a qualified dis-tribution for purposes of section 402A. Seeproposed §1.402A–1, A–11, at 71 FR 4320(January 26, 2006).

Prevention of Nonallocation Year

The preamble to the 2004 regulationsdescribed methods that a plan might useto prevent the occurrence of a nonalloca-tion year, including (1) a reduction of syn-thetic equity (for example, through can-cellation or distribution), (2) a sale of theS corporation securities held in the partic-ipant’s ESOP account before a nonalloca-tion year occurs so that the account is notinvested in S corporation stock, or (3) atransfer of the S corporation securities heldfor the participant under the ESOP into aseparate portion of the plan that is not anESOP or to another qualified plan of theemployer that is not an ESOP.

Any methods of preventing a nonallo-cation year must satisfy applicable legaland qualification requirements, includingthe nondiscrimination requirements ofsection 401(a)(4) (including the rules at§1.401(a)(4)–4 relating to benefits, rightsand features), and implementation of thesemethods must be completed before a non-allocation year occurs. These regulationsretain the special rule provided in the2004 regulations for applying the nondis-crimination requirements under section401(a)(4) for a plan that uses the transfermethod. Thus, these regulations providethat, if a transfer is made from an ESOP toa separate portion of the plan (or to anotherqualified plan of the employer) that is notan ESOP in order to prevent a nonalloca-tion year, then both the ESOP and the planthat is not an ESOP will not fail to satisfythe requirements of §1.401(a)(4)–4 merelybecause of the transfer. Similarly, theseregulations provide that, subsequent to thetransfer, the plan will not fail to satisfy therequirements of §1.401(a)(4)–4 merely be-

January 29, 2007 383 2007–5 I.R.B.

cause of the benefits, rights, and featureswith respect to the transferred benefits ifthose benefits, rights, and features wouldsatisfy the requirements of §1.401(a)(4)–4if the mandatory disaggregation rule forESOPs at §1.410(b)–7(c)(2) did not ap-ply. These regulations clarify that anysuch transfers must be effectuated by anaffirmative action taken no later than thedate of the transfer, and all subsequent ac-tions (including benefit statements) mustbe consistent with the transfer having oc-curred on that date. Further, in order touse the transfer method to prevent a non-allocation year, the plan must provide forthe transfer of the stock to the non-ESOPportion of the plan.

A commentator described anothermethod of preventing a nonallocationyear under which stock of a participant isexchanged for cash or other assets, whichare already in the accounts of other partici-pants in order to change the stock holdingsamong participants before a nonallocationyear occurs, but which does not changethe overall stock holding of the ESOPtrust. This method has been referred to asreshuffling. The commentator requestedthat relief from the nondiscriminatoryavailability requirements be extended tothis method.

Absent a special rule for applyingthe nondiscrimination requirements ofsection 401(a)(4), it will be difficult fora plan to prevent a nonallocation yearthrough reshuffling without violatingsection 401(a)(4). The right of each par-ticipant to have or not have a particularinvestment in his or her account (either asa participant-directed investment or as atrustee-directed investment) is a plan rightor feature that is subject to the currentand effective availability requirements of§1.401(a)(4)–4. Accordingly, if assets inthe accounts of one or more non-highlycompensated employees (NHCEs) aremandatorily exchanged, then, in the ab-sence of other relevant factors, the planwould generally be expected to fail tosatisfy the nondiscriminatory availabilityrequirements of §1.401(a)(4)–4.

The IRS and Treasury Department donot believe that it would be appropriate toprovide a special rule that would materi-ally weaken the standard for nondiscrim-inatory availability of participant rightsto a particular investment under the plan.By contrast, the special nondiscrimina-

tion rules for stock transferred out of theESOP do not change the rights of NHCEsto any particular investment in the planas a whole, but simply allow the transferand allow the rights of participants whosestock is transferred out of the ESOP to betaken into account in determining whetherthe rights of participants whose stockremains in the ESOP satisfy the nondis-criminatory availability requirements of§1.401(a)(4)–4.

An S corporation may be able toachieve the same result as reshufflingby reducing contributions for HCEs whoare or may become disqualified persons,by providing additional benefits to NHCEswho are not disqualified persons, by ex-panding coverage to include all employ-ees, or by diversifying out of employerstock for HCEs who are or may becomedisqualified persons and who are qualifiedparticipants within the meaning of section401(a)(28)(B)(iii) (that is, by mandatingdiversification using one of the diver-sification options that are offered to allqualified participants, for which there isan existing special nondiscrimination ruleat §1.401(a)(4)–4(d)(6)). Thus, in addi-tion to plan transfers, any of these actionsmay help prevent the concentration ofdeemed-owned ESOP shares that section409(p) prohibits, without the nondiscrimi-nation problems otherwise associated withreshuffling. Of course, any transfer orother method used to ensure compliancewith section 409(p) must also satisfy anyother legal requirements that may apply,including section 407(b)(2) of the Em-ployee Retirement Income Security Act of1974 (ERISA) (88 Stat. 829) Public Law93–406 (which, in relevant part, generallyprohibits a plan from investing more than10 percent of elective deferral accountsin employer stock, unless the plan is anESOP, the investment is at the directionof the participant, or another exceptionapplies).

Treatment of Family Members asDisqualified Persons

The 2004 regulations included a num-ber of attribution rules, which these regu-lations retain, including the application ofthe section 318 attribution rules to own-ership of synthetic equity in determiningwho is a disqualified person. Section409(p) contains references to the sec-

tion 318 rules in certain cases, such asin determining a nonallocation year, butcommentators pointed out that the section318 rules did not apply for purposes ofthe disqualified person definition, whichwas not reflected in an example. Anothercommentator pointed out that the rulesfor determining whether family membersare disqualified persons varies accord-ing to the individual being tested. Forexample, the technical language of sec-tion 409(p)(4)(D) treats parents-in-law asmembers of a married child’s family whentesting whether a child is a disqualifiedperson, but not as members of the samefamily as the child’s parents when testingwhether the child’s parents are disquali-fied persons. In response to comments, theregulations have been modified to clarifythese rules, including revisions in the ex-amples to illustrate the application of therules to specific factual patterns.

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

These regulations retain the rules fromboth the 2003 and the 2004 regulationsregarding calculation of the number ofshares of synthetic equity that are not de-termined by reference to shares of stockof the S corporation. These regulationsprovide that the person who is entitledto the synthetic equity is treated as own-ing a number of shares of stock in theS corporation equal to the present valueof the synthetic equity (with such valuedetermined without regard to any lapserestriction as defined under the section83 regulations) divided by the fair marketvalue of a share of the S corporation’sstock as of the same date. These regula-tions also retain the special rule under the2004 regulations that permits the ESOPto provide, on a reasonable and consistentbasis for all persons, for the number ofsynthetic equity shares treated as ownedon a determination date to remain constantfor up to a 3-year period from that date(triennial method). This rule addressesconcerns raised in comments to the 2003regulations regarding the volatility of thenumber of shares of synthetic equity wherethat calculation is based on the value of anS corporation share.

A commentator questioned whether thetriennial method of the 2004 regulationsshould be expanded to permit a more flex-

2007–5 I.R.B. 384 January 29, 2007

ible triennial period that allows for the ac-celeration or delay of the triennial determi-nation date. The commentator argued that,since the triennial method’s purpose is toeliminate the risk attributable to volatilityof the present value of the nonqualified de-ferred compensation stock and the risk at-tributable to the fair market value of com-pany stock, the inability to delay or ac-celerate the date, automatically and dailyif necessary, weakens the purpose of themethod.

These regulations include changes inthe triennial methodology to permit theability, during the 3-year period, to accel-erate a determination date prospectivelyin the event of a change in the plan yearor any merger, consolidation, or trans-fer of ESOP assets under section 414(l).However, a determination date may notbe changed retroactively and the changemust be effectuated by a plan amendmentadopted before the new determinationdate.1

A commentator also requested clar-ification regarding how shares of syn-thetic equity are calculated with respectto nonqualified deferred compensation.Specifically, the commentator wanted toknow what discount rate should be usedto calculate the present value of nonqual-ified deferred compensation, and how todetermine the number of equivalent sharesfor a split-dollar life insurance arrange-ment. These regulations do not mandatea specific discount rate for calculatingthe present value of nonqualified deferredcompensation or a specific method for de-termining the equivalent number of sharesfor a split dollar arrangement. However,any assumptions used for such purposesmust be reasonable.

Finally, a commentator asked whetheran individual S corporation share-holder’s right of first refusal to acquireS corporation stock from an ESOP forits fair market value is considered syn-thetic equity. The regulations have beenrevised to clarify that the right of first re-fusal to acquire stock held by an ESOP isnot treated as a right to acquire stock of anS corporation under these regulations if theright to acquire stock would not be takeninto account under §1.1361–1(l)(2)(iii)(A)in determining whether an S corporation

has a second class of stock and the priceat which the stock is acquired under theright of first refusal is not less than theprice determined for purposes of the putright required by section 409(h). See§54.4975–11(d)(5) of the Excise Tax Reg-ulations. Of course, any right of firstrefusal must comply with the require-ments of §54.4975–7(b)(9) of the ExciseTax Regulations. In addition, these regula-tions give the Commissioner the authorityto treat a right of first refusal as syntheticequity if the Commissioner determines,based on the facts and circumstances,that the right to acquire stock held by theESOP constitutes an avoidance or evasionof section 409(p).

Effective Dates

These regulations generally are appli-cable for plan years beginning on or afterJanuary 1, 2006. However, these regula-tions retain, by cross reference, the 2004regulations for plan years beginning beforeJanuary 1, 2006.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Or-der 12866. Therefore, a regulatory assess-ment is not required. It also has been de-termined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations,and because the regulation does not im-pose a collection of information require-ment upon small entities, the RegulatoryFlexibility Act (5 U.S.C. chapter 6) doesnot apply. Pursuant to section 7805(f)of the Internal Revenue Code, the tem-porary and proposed regulations preced-ing these final regulations were submittedto the Chief Counsel for Advocacy of theSmall Business Administration for com-ment on its impact on small business.

Drafting Information

The principal authors of theseregulations are John T. Ricotta andVeronica A. Rouse of the Office of the Di-vision Counsel/Associate Chief Counsel(Tax Exempt and Government Entities);

however, other personnel from the IRSand Treasury participated in their devel-opment.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding an entry toread, 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 readas follows:

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

* * * * *A–4. * * *(g) Prohibited allocations that are

treated as deemed distributions pursuantto section 409(p). * * *

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

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

(a) Organization of this section and def-inition—(1) Organization of this section.Section 409(p) applies if a nonallocationyear occurs in an ESOP that holds sharesof stock of an S corporation that are em-ployer securities. Paragraph (b) of this sec-tion sets forth the general rule under sec-tion 409(p)(1) and (2) prohibiting any ac-crual or allocation to a disqualified per-son in a nonallocation year. Paragraph (c)of this section sets forth rules under sec-tion 409(p)(3), (5), and (7) for determiningwhether a year is a nonallocation year, gen-erally based on whether disqualified per-sons own at least 50 percent of the sharesof the S corporation, either taking into ac-count only the outstanding shares of theS corporation (including shares held by the

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 applyif 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.

ESOP) or taking into account both the out-standing shares and synthetic equity of theS corporation. Paragraphs (d), (e), and (f)of this section contain definitions of dis-qualified person under section 409(p)(4)and (5), deemed-owned ESOP shares un-der section 409(p)(4)(C), and synthetic eq-uity under section 409(p)(6)(C). Paragraph(g) of this section contains a standard fordetermining when the principal purpose ofthe ownership structure of an S corporationconstitutes an avoidance or evasion of sec-tion 409(p).

(2) Definitions. The following defini-tions apply for purposes of section 409(p)and this section, as well as for purposes ofsection 4979A, which imposes an excisetax on certain events.

(i) Deemed-owned ESOP shares has themeaning set forth in paragraph (e) of thissection.

(ii) Disqualified person has the mean-ing set forth in paragraph (d) of this sec-tion.

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

(iv) Employer securities means em-ployer securities within the meaning ofsection 409(l).

(v) ESOP means an employee stockownership plan within the meaning ofsection 4975(e)(7).

(vi) Prohibited allocation has the mean-ing set forth in paragraph (b)(2) of this sec-tion.

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

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

(b) Prohibited allocation in a nonallo-cation year—(1) General rule. Section409(p)(1) provides that an ESOP holdingemployer securities consisting of stock inan S corporation must provide that no por-tion of the assets of the plan attributable to(or allocable in lieu of) such employer se-curities may, during a nonallocation year,accrue under the ESOP, or be allocated di-rectly or indirectly under any plan of theemployer (including the ESOP) meetingthe requirements of section 401(a), for thebenefit of any disqualified person.

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

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

(ii) Impermissible accrual. There is animpermissible accrual to the extent thatemployer securities consisting of stockin an S corporation owned by the ESOPand any assets attributable thereto are heldunder the ESOP for the benefit of a dis-qualified person during a nonallocationyear. For this purpose, assets attributableto stock in an S corporation owned by anESOP include any distributions, withinthe meaning of section 1368, made onS corporation stock held in a disqualifiedperson’s account in the ESOP (includingearnings thereon), plus any proceeds fromthe sale of S corporation securities heldfor a disqualified person’s account in theESOP (including any earnings thereon).Thus, in the event of a nonallocation year,all S corporation shares and all other ESOPassets attributable to S corporation stock,including distributions, sales proceeds,and earnings on either distributions orproceeds, held for the account of such dis-qualified person in the ESOP during thatyear are an impermissible accrual for thebenefit of that person, whether attributableto contributions in the current year or inprior years.

(iii) Impermissible allocation. An im-permissible allocation occurs during anonallocation year to the extent that a con-tribution or other annual addition (withinthe meaning of section 415(c)(2)) is madewith respect to the account of a disqual-ified person, or the disqualified personotherwise accrues additional benefits, di-rectly or indirectly under the ESOP or anyother plan of the employer qualified undersection 401(a) (including a release and al-location of assets from a suspense account,as described at §54.4975–11(c) and (d) ofthis chapter) that, for the nonallocationyear, would have been added to the ac-count of the disqualified person under theESOP and invested in employer securitiesconsisting of stock in an S corporationowned by the ESOP but for a provision inthe ESOP that precludes such addition tothe account of the disqualified person, and

investment in employer securities duringa nonallocation year.

(iv) Effects of prohibited alloca-tion—(A) Deemed distribution. If a planyear is a nonallocation year, the amountof any prohibited allocation in the accountof a disqualified person as of the first dayof the plan year, as determined under thisparagraph (b)(2), is treated as distributedfrom the ESOP (or other plan of the em-ployer) to the disqualified person on thefirst day of the plan year. In the case ofan impermissible accrual or impermissibleallocation that is not in the account of thedisqualified person as of the first day ofthe plan year, the amount of the prohibitedallocation, as determined under this para-graph (b)(2), is treated as distributed onthe date of the prohibited allocation. Thus,the fair market value of assets in the dis-qualified person’s account that constitutesan impermissible accrual or allocation isincluded in gross income (to the extent inexcess of any investment in the contractallocable to such amount) and is subjectto any additional income tax that appliesunder section 72(t). A deemed distributionunder this paragraph (b)(2)(iv)(A) is not anactual distribution from the ESOP. Thus,the amount of the prohibited allocation isnot an eligible rollover distribution undersection 402(c). However, for purposes ofapplying sections 72 and 402 with respectto any subsequent distribution from theESOP, the amount that the disqualifiedperson previously took into account as in-come as a result of the deemed distributionis treated as investment in the contract.

(B) Other effects. If there is a prohib-ited allocation, then the plan fails to satisfythe requirements of section 4975(e)(7) andceases to be an ESOP. In such a case, theexemption from the excise tax on prohib-ited transactions for loans to leveragedESOPs contained in section 4975(d)(3)would cease to apply to any loan (withthe result that the employer would owe anexcise tax with respect to the previouslyexempt loan). As a result of these failures,the plan would lose the prohibited trans-action exemption for loans to an ESOPunder section 4975(d)(3) of the Code andsection 408(b)(3) of Title I of the Em-ployee Retirement Income Security Actof 1974, as amended (ERISA). Finally, aplan that does not operate in accordancewith its terms to reflect section 409(p) failsto satisfy the qualification requirements

2007–5 I.R.B. 386 January 29, 2007

of section 401(a), which would cause thecorporation’s S election to terminate undersection 1362. See also section 4979A(a)which imposes an excise tax in certainevents, including a prohibited allocationunder section 409(p).

(C) Example. The rules of this para-graph (b)(2)(iv) are illustrated by the fol-lowing example:

Example. (i) Facts. Corporation M, anS corporation under section 1361, establishes Plan Pas an ESOP in 2006, with a calendar plan year. PlanP is a qualified plan that includes terms providingthat a prohibited allocation will not occur during anonallocation year in accordance with section 409(p).On December 31, 2006, all of the 1,000 outstandingshares of stock of Corporation M, with a fair marketvalue of $30 per share, are contributed to Plan P andallocated among accounts established within Plan Pfor the benefit of Corporation M’s three employees,individuals A, B, and C, based on their compensa-tion 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 ofthe shares ($4,200); and participant C’s accountincludes the remaining 60 shares ($1,800). The planyear 2006 is a nonallocation year, participants A andB are disqualified persons on December 31, 2006,and a prohibited allocation occurs for A and B onDecember 31, 2006.

(ii) Conclusion. On December 31, 2006, par-ticipants A and B each have a deemed distributionas a result of the prohibited allocation, resulting inincome of $24,000 for participant A and $4,200 forparticipant B. Corporation M owes an excise taxunder section 4979A, based on an amount involvedof $28,200. Plan P ceases to be an ESOP on the dateof the prohibited allocation (December 31, 2006) andalso fails to satisfy the qualification requirements ofsection 401(a) on that date due to the failure to com-ply with the provisions requiring compliance withsection 409(p). As a result of having an ineligibleshareholder under section 1361(b)(1)(B), Corpora-tion M ceases to be an S corporation under section1361 on December 31, 2006.

(v) Prevention of prohibited allo-cation—(A) Transfer of account tonon-ESOP. An ESOP may prevent a non-allocation year or a prohibited allocationduring a nonallocation year by providingfor assets (including S corporation secu-rities) allocated to the account of a dis-qualified person (or a person reasonablyexpected to become a disqualified personabsent a transfer described in this para-graph (b)(2)(v)(A)) to be transferred intoa separate portion of the plan that is not anESOP, as described in §54.4975–11(a)(5)of this chapter, or to another plan of theemployer that satisfies the requirementsof section 401(a) and that is not an ESOP.Any such transfer must be effectuated byan affirmative action taken no later thanthe date of the transfer, and all subsequent

actions (including benefit statements) gen-erally must be consistent with the transferhaving occurred on that date. In the eventof such a transfer involving S corporationsecurities, the recipient plan is subject totax on unrelated business taxable incomeunder section 512.

(B) Relief from nondiscrimination re-quirement. Pursuant to this paragraph(b)(2)(v)(B), if a transfer described inparagraph (b)(2)(v)(A) of this section ismade from an ESOP to a separate portionof the plan or to another qualified plan ofthe employer that is not an ESOP, thenboth the ESOP and the plan or portion ofa plan that is not an ESOP do not fail tosatisfy the requirements of §1.401(a)(4)–4merely because of the transfer. Further,subsequent to the transfer, that plan willnot fail to satisfy the requirements of§1.401(a)(4)–4 merely because of thebenefits, rights, and features with respectto the transferred benefits if those ben-efits, rights, and features would satisfythe requirements of §1.401(a)(4)–4 if themandatory disaggregation rule for ESOPsat §1.410(b)–7(c)(2) did not apply.

(c) Nonallocation year. A year is a non-allocation year if it is described in the gen-eral definition in paragraph (c)(1) of thissection or if the special rule of paragraph(c)(3) of this section applies.

(1) General definition. For purposes ofsection 409(p) and this section, a nonallo-cation year means a plan year of an ESOPduring which, at any time, the ESOP holdsany employer securities that are shares ofan S corporation and either—

(i) Disqualified persons own at least50 percent of the number of outstandingshares of stock in the S corporation (in-cluding deemed-owned ESOP shares); or

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

(A) The outstanding shares ofstock in the S corporation (includingdeemed-owned ESOP shares); and

(B) The shares of synthetic equity inthe S corporation owned by disqualifiedpersons.

(2) Attribution rules. For purposes ofthis paragraph (c), the rules of section318(a) apply to determine ownership ofshares in the S corporation (includingdeemed-owned ESOP shares) and syn-thetic equity. However, for this purpose,section 318(a)(4) (relating to options toacquire stock) is disregarded and, in ap-

plying section 318(a)(1), the members ofan individual’s family include membersof the individual’s family under paragraph(d)(2) of this section. In addition, an indi-vidual is treated as owning deemed-ownedESOP shares of that individual notwith-standing the employee trust exception insection 318(a)(2)(B)(i). If the attributionrules in paragraph (f)(1) of this sectionapply, then the rules of paragraph (f)(1)of this section are applied before (and inaddition to) the rules of this paragraph(c)(2).

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

(ii) Pursuant to section 409(p)(7)(B),the Commissioner, in revenue rulings,notices, and other guidance publishedin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter), mayprovide that a nonallocation year occursin any case in which the principal pur-pose of the ownership structure of anS corporation constitutes an avoidance orevasion of section 409(p). For any yearthat is a nonallocation year under this para-graph (c)(3), the Commissioner may treatany person as a disqualified person. Seeparagraph (g) of this section for guidanceregarding when the principal purpose ofan ownership structure of an S corporationinvolving synthetic equity constitutes anavoidance or evasion of section 409(p).

(4) Special rule for certain stock rights.(i) For purposes of paragraph (c)(1) ofthis section, a person is treated as own-ing stock if the person has an exercisableright to acquire the stock, the stock is bothissued and outstanding, and the stock isheld by persons other than the ESOP, theS corporation, or a related entity (as de-fined in paragraph (f)(3) of this section).

(ii) This paragraph (c)(4) appliesonly if treating persons as owning theshares described in paragraph (c)(4)(i)of this section results in a nonalloca-tion year. This paragraph (c)(4) does notapply to a right to acquire stock of anS corporation held by a shareholder that issubject to Federal income tax that, under

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 deter-mining if an S corporation has a secondclass of stock, provided that a principalpurpose of the right is not the avoidanceor evasion of section 409(p). Under thelast sentence of paragraph (f)(2)(i) of thissection, this paragraph (c)(4)(ii) does notapply for purposes of determining own-ership of deemed-owned ESOP shares orwhether an interest constitutes syntheticequity.

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

(6) Effect of nonallocation year. Seeparagraph (b) of this section for a pro-hibition applicable during a nonallocationyear. See also section 4979A for an ex-cise tax applicable in certain cases, includ-ing section 4979A(a)(3) and (4) which ap-plies during a nonallocation year (whetheror not there is a prohibited allocation dur-ing the year).

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

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

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

(ii) The aggregate number of suchperson’s deemed-owned ESOP shares andsynthetic equity shares of the S corporationis at least 10 percent of the sum of—

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

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

(iii) The aggregate number of theS corporation’s deemed-owned ESOPshares of such person and of the mem-bers of such person’s family is at least 20percent of the number of deemed-ownedESOP shares of the S corporation; or

(iv) The aggregate number of theS corporation’s deemed-owned ESOPshares and synthetic equity shares of suchperson and of the members of such per-son’s family is at least 20 percent of thesum of—

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

(B) The synthetic equity shares of theS corporation owned by such person andthe members of such person’s family.

(2) Treatment of family members; defi-nition—(i) Rule. Each member of the fam-ily of any person who is a disqualified per-son under paragraph (d)(1)(iii) or (iv) ofthis section and who owns any deemed-owned ESOP shares or synthetic equityshares is a disqualified person.

(ii) General definition. For purposes ofsection 409(p) and this section, memberof the family means, with respect to anindividual—

(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 linealdescendant of the brother or sister; and

(D) The spouse of any individual de-scribed in paragraph (d)(2)(ii)(B) or (C) ofthis section.

(iii) Spouse. A spouse of an individualwho is legally separated from such individ-ual under a decree of divorce or separatemaintenance is not treated as such individ-ual’s spouse under paragraph (d)(2)(ii) ofthis section.

(3) Special rule for certain nonalloca-tion years. See paragraph (c)(3) of thissection (relating to avoidance or evasionof section 409(p)) for special rules underwhich certain persons are treated as dis-qualified persons.

(4) Example. The rules of this para-graph (d) are illustrated by the followingexamples:

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

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

of the shares owned by the ESOP (200 is 28.6% of700). During 2006, neither P, Q, nor R is a disquali-fied 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 ofP, Q, and R is a disqualified person under paragraph(d)(1)(iii) of this section because P and members ofP’s family own at least 20% of the deemed-ownedESOP shares (144 (the sum of 65, 65 and 14) is 20.6%of 700). As a result, disqualified persons own at least50% of the outstanding shares of the S corporationduring 2006 (O’s 100 directly owned shares, O’s 200deemed-owned shares, P’s 65 deemed-owned shares,Q’s 65 deemed-owned shares, and R’s 14 deemed-owned shares are 55.5% of 800).

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

(ii) Conclusion. In this example, individual U is adisqualified person under paragraph (d)(1) of this sec-tion (because U’s family consists of S, T, U, V, W, andX, and, in the aggregate, those persons own more than20% of the deemed-owned ESOP shares) and individ-ual X is also a disqualified person under paragraph(d)(1) of this section (because X’s family consists ofS, T, U, V, W, and X, and, in the aggregate, thosepersons own more than 20% of the deemed-ownedESOP shares). Further, individuals T and V are eacha disqualified person under paragraph (d)(2) of thissection because each is a member of a family that in-cludes one or more disqualified persons and each hasdeemed-owned ESOP shares. However, individualsS, W, and Y are not disqualified persons under thisparagraph (d). For example, S does not own morethan 10% of the deemed-owned ESOP shares, andS’s family, which consists of S, T, U, and X, owns, inthe aggregate, only 13% of the deemed-owned ESOPshares (X’s parents are not members of S’s family be-cause the family members of a person do not includethe parents-in-law of the person’s descendants). Fur-ther, note that, for purposes of determining whetherthe ESOP has a nonallocation year under paragraph(c) of this section, the shares directly owned by Sand Y would be taken into account as shares ownedby disqualified persons under the attribution rules inparagraph (c)(2) of this section.

(e) Deemed-owned ESOP shares. Forpurposes of section 409(p) and this section,a person is treated as owning his or herdeemed-owned ESOP shares. Deemed-owned ESOP shares owned by a personmean, with respect to any person—

(1) Any shares of stock in theS corporation constituting employer secu-rities that are allocated to such person’saccount under the ESOP; and

2007–5 I.R.B. 388 January 29, 2007

(2) Such person’s share of the stock inthe S corporation that is held by the ESOPbut is not allocated to the account of anyparticipant or beneficiary (with such per-son’s share to be determined in the sameproportion as the shares released and al-located from a suspense account, as de-scribed at §54.4975–11(c) and (d) of theExcise Tax Regulations, under the ESOPfor the most recently ended plan year forwhich there were shares released and allo-cated from a suspense account, or if therehas been no such prior release and alloca-tion from a suspense account, then deter-mined in proportion to a reasonable esti-mate of the shares that would be releasedand allocated in the first year of a loan re-payment).

(f) Synthetic equity and rights to ac-quire stock of the S corporation—(1) Own-ership of synthetic equity. For purposes ofsection 409(p) and this section, syntheticequity means the rights described in para-graph (f)(2) of this section. Synthetic eq-uity is treated as owned by the person thathas any of the rights specified in paragraph(f)(2) of the section. In addition, the attri-bution rules as set forth in paragraph (c)(2)of this section apply for purposes of at-tributing ownership of synthetic equity.

(2) Synthetic equity—(i) Rights to ac-quire stock of the S corporation—(A) Gen-eral rule. Synthetic equity includes anystock option, warrant, restricted stock, de-ferred issuance stock right, stock appre-ciation right payable in stock, or similarinterest or right that gives the holder theright to acquire or receive stock of theS corporation in the future. Rights to ac-quire stock in an S corporation with respectto stock that is, at all times during the pe-riod when such rights are effective, bothissued and outstanding, and held by a per-son other than the ESOP, the S corporation,or a related entity are not synthetic equitybut only if that person is subject to federalincome taxes. (See also paragraph (c)(4)of this section.)

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

is not less than the price determined un-der section 409(h). See §54.4975–11(d)(5)of the Excise Tax Regulations. The rightof first refusal must also comply with therequirements of §54.4975–7(b)(9) of theExcise Tax Regulations. This paragraph(f)(2)(i)(B) does not apply if, based onthe facts and circumstances, the Commis-sioner finds that the right to acquire stockheld by the ESOP constitutes an avoidanceor an evasion of section 409(p). See alsosection 408(d) of ERISA, under which theexemption provided by section 408(e) ofERISA (and the related exemption at sec-tion 4975(d)(13) of the Code) does not ap-ply to an owner-employee, including anemployee or officer of an S corporationwho is a 5 percent owner.

(ii) Special rule for certain stock rights.Synthetic equity also includes a rightto a future payment (payable in cash orany other form other than stock of theS corporation) from an S corporation thatis based on the value of the stock of theS corporation, such as appreciation in suchvalue. Thus, for example, synthetic equityincludes a stock appreciation right withrespect to stock of an S corporation thatis payable in cash or a phantom stock unitwith respect to stock of an S corporationthat 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 acquirestock or other similar interests in a relatedentity to the extent of the S corporation’sownership. Synthetic equity also includesa right to acquire assets of an S corporationor a related entity other than either rightsto acquire goods, services, or property atfair market value in the ordinary course ofbusiness or fringe benefits excluded fromgross income under section 132.

(iv) Special rule for nonqualified de-ferred compensation. (A) Synthetic equityalso includes any of the following with re-spect to an S corporation or a related en-tity: any remuneration to which section404(a)(5) applies; remuneration for whicha deduction would be permitted under sec-tion 404(a)(5) if separate accounts weremaintained; any right to receive property,as defined in §1.83–3(e) of the IncomeTax Regulations (including a payment toa trust described in section 402(b) or toan annuity described in section 403(c))in a future year for the performance ofservices; any transfer of property in con-

nection with the performance of servicesto which section 83 applies to the extentthat the property is not substantially vestedwithin the meaning of §1.83–3(i) by theend of the plan year in which transferred;and a split-dollar life insurance arrange-ment under §1.61–22(b) entered into inconnection with the performance of ser-vices (other than one under which, at alltimes, the only economic benefit that willbe provided under the arrangement is cur-rent life insurance protection as describedin §1.61–22(d)(3)). Synthetic equity alsoincludes any other remuneration for ser-vices under a plan, method, or arrangementdeferring the receipt of compensation to adate that is after the 15th day of the 3rd cal-endar month after the end of the entity’staxable year in which the related servicesare rendered. However, synthetic equitydoes not include benefits under a plan thatis an eligible retirement plan within themeaning of section 402(c)(8)(B).

(B) For purposes of applying paragraph(f)(2)(iv)(A) of this section with respect toan ESOP, synthetic equity does not includeany interest described in such paragraph(f)(2)(iv)(A) of this section to the extentthat—

(1) The interest is nonqualified deferredcompensation (within the meaning of sec-tion 3121(v)(2)) that was outstanding onDecember 17, 2004;

(2) The interest is an amount that wastaken into account (within the meaning of§31.3121(v)(2)–1(d) of this chapter) priorto January 1, 2005, for purposes of taxationunder chapter 21 of the Internal RevenueCode (or income attributable thereto); and

(3) The interest was held before the firstdate on which the ESOP acquires any em-ployer securities.

(v) No overlap among shares ofdeemed-owned ESOP shares or syntheticequity. Synthetic equity under this para-graph (f)(2) does not include shares thatare deemed-owned ESOP shares (or anyrights with respect to deemed-ownedESOP shares to the extent such rightsare specifically provided under section409(h)). In addition, synthetic equityunder a specific subparagraph of this para-graph (f)(2) does not include anything thatis synthetic equity under a preceding pro-vision of paragraph (f)(2)(i), (ii), (iii), or(iv) of this section.

(3) Related entity. For purposes of thisparagraph (f), related entity means any en-

January 29, 2007 389 2007–5 I.R.B.

tity in which the S corporation holds an in-terest and which is a partnership, a trust,an eligible entity that is disregarded as anentity that is separate from its owner un-der §301.7701–3 of this chapter, or a qual-ified subchapter S subsidiary under section1361(b)(3).

(4) Number of synthetic shares—(i)Synthetic equity determined by referenceto S corporation shares. In the caseof synthetic equity that is determinedby reference to shares of stock of theS corporation, the person who is entitledto the synthetic equity is treated as owningthe number of shares of stock deliverablepursuant to such synthetic equity. In thecase of synthetic equity that is determinedby reference to shares of stock of theS corporation, but for which payment ismade in cash or other property (besidesstock of the S corporation), the num