irs code 409
April 28, 2023

IRS Code 409: What Does it Mean on IRS Transcript?

Personal Taxes

IRS Code 409 refers to Section 409 of the IRC, which defines the requirements companies and their employees must meet to qualify for Employee Stock Ownership Plans (ESOP).

These benefit plans enable employees to own shares in the company they work for, which is why businesses often utilize them as a motivational tool for their employees.

Most employers offer ESOP as a part of the remuneration package to provide their employees with a way to earn more than their base salary.

We’ll cover critical aspects of IRS Code 409 to provide you with a better understanding of ESOP and its impact on your earnings.

Understanding IRC Section 409

Understanding IRC Section 409

Interpreting IRC Section 409 requires familiarity with other sections of the IRC. In particular, Section 409 references Section 401(a), which lays out the qualification requirements for trusts and the creation of profit-sharing, pension, and stock bonus plans.

Most taxpayers are familiar with Section 401(a) because 401(k) retirement plans are named after it. On the other hand, Section 409 lists the requirements an Employee Stock Ownership Plan must meet to retain the tax-qualified status.

Section 4957(e)(7) defines ESOP, while Section 409 only deals with the conditions under which a company can pass ownership to its employees.

This section of the IRC is particularly important for S corporations because it states that a disqualified person cannot receive a corporation’s accruals or allocations during a non-allocation year.

A disqualified person can be anyone who owns over 10% of ESOP shares, while a non-allocation year is a tax year in which disqualified persons own more than 50% of the company’s ESOP shares.

Even though this rule might seem difficult to comprehend, its practical implications are straightforward as it prevents S corporations from establishing ESOPs that favor highly compensated employees.

Mechanics of Employee Stock Ownership Plans

Although they’re slightly different from 401(k) and other types of retirement plans, ESOPs are still an attractive retirement investment option.

A company that wants to offer ESOP to its employees must establish a trust that allows employees to own company shares. Employees usually offer ESOPs as a part of salary packages to retain employees and increase their productivity.

The shares distributed to employees are relative to their pay, and the share percentage increases over time. However, it would be a mistake to assume all ESOPs are the same, which is why you must discuss the details of the plan with your employer before accepting it.

For instance, employees don’t have to contribute to most ESOPs, but some employers utilize plans that require employees to make salary or benefit concessions. Employees can sell their stock back to the company if they want to terminate their employment or retire.

These plans aren’t ideal for companies of all sizes as they’re generally recommended for businesses with over twenty employees. On the other hand, accepting ESOP in a company with a low stock value can limit how much you can earn per year.

Establishing an ESOP

Establishing an ESOP

Companies that want to offer stock to their employees must choose the right moment to establish ESOP. As noted earlier, ESOP is a trust that enables a company to allocate cash to buy shares from current owners or issue new shares if the owner doesn’t want to sell.

ESOPs can be an excellent option for companies with a history of profitability that except the value of their shares to keep growing.

In addition, the amount of debt compared with the business’s equity and the company’s relationship with the lander are essential factors companies must consider before establishing ESOP.

Conducting a feasibility study is the first step toward establishing ESOP. The study should determine if a company has sufficient funds to launch ESOP and create a plan for repurchasing shares from retiring employees.

Valuation of the business is the next step, as it is necessary to establish if the company’s value is too low or too high for ESOP. For instance, if the value of the company’s shares is too high, the company may be unable to repurchase them from its employees.

A business must prepare and submit its employee stock ownership plan to the IRS, although it can start contributing to the trust before the IRS approves the plan.

Afterward, a company must secure funding for the plan. Most businesses fund their ESOPs from the following sources:

  • Borrowing money from sellers or banks.
  • Allocating a portion of the company’s profits to ESOP.
  • Asking employees to make wage or benefit concessions.

Finally, a company must appoint a trustee to manage ESOP and establish an ESOP committee composed of senior management and non-managerial staff.

ESOP Qualification Requirements

ESOP Qualification Requirements

Aside from being an employee retention tool, ESOP is also a qualified retirement plan. As such, it is available to 70% of non-highly compensated employees.

You must meet the following conditions to qualify for ESOP:

  • In most cases, employees must be 21 to qualify for ESOP. Allowing younger employees to participate in the plan is at the employer’s discretion, but a company cannot increase the participation threshold over 21.
  • A company can allow employees to participate in the plan immediately or delay their ESOP eligibility for a year.

However, certain types of employees are excluded from ESOP participation. 

  • Independent contractors – Workers who report their income on Form W-2 or Form 1099-MISC cannot participate in ESOP.
  • Nonresident aliens – US companies cannot offer ESOP to foreign workers.
  • Union employees – Retirement benefits unions negotiate on behalf of employees can’t include ESOPs.
  • Leased employees – Employees working on a project or temporary basis don’t qualify for ESOP.
  • Employer’s relatives – Business owners cannot offer ESOP to their relatives.

Differences between ESOP and 401(k) Retirement Plans

401(k) and ESOP are some of the most popular retirement plans companies offer to their employers. 401(k) participants contribute to their plans, and in some cases, the employer can choose to match their contributions.

On the other hand, most ESOPs are funded through company stock and don’t require salary concessions. These plans are attractive for young or low-wage employees who don’t want to make payroll deferrals towards a 401(k) plan.

Moreover, ESOPs usually have higher return rates than 401(k) plans, although they’re sometimes volatile due to market oscillations.

All ESOP funds are tax-free until they’re distributed and can be transferred to a 401(k) or similar retirement plans. As a result, employees can avoid paying capital gain tax until retirement.

Employees leaving a company before retirement cannot keep the stocks acquired through ESOP. Instead, they must sell them to the employer for cash and then direct these funds toward a new retirement plan.

Frequently Asked Questions

What is the Difference Between Section 409 and Section 409(A) of the IRC?

Section 409(A) of the IRC covers inclusion in the gross income of deferred compensation under non-qualified deferred compensation plans, while Section 409 defines ESOP rules.

How Many Participants Can ESOP Have?

The IRS doesn’t limit the maximum number of ESOP participants, but in most cases, employees own approximately 10% of the company. 

What Is the Maximum Annual Compensation an Employee Can Earn Through ESOP?

Employees cannot earn over $100.000 through ESOP. 

Are ESOPs Risky?

Even though market fluctuations can affect the value of a company’s stock, employee stock ownership plans aren’t considered risky. Employees of ESOP companies usually profit from their stake in the business unless the company experiences financial difficulties. 

The Benefits of IRS Code 409 for Employees

Fully grasping the implications of Section 409 of the IRC is hard if you’re unfamiliar with employee stock ownership plans and sections of the IRC that deal with different aspects of ESOP.

Participating in this plan enables you to own shares in a company you’re working for and utilize the profits from these shares as your retirement plan.

Section 409 also stipulates that participants must keep their shares within the plan and determines the compensation they can receive for their stake in the company. Hence, familiarity with it can make accepting a job offer from an ESOP company easier.


Logan Allec, CPA

Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.

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