Before you jump at the chance to turn your bank into an "S" corporation, make sure this newly granted tax strategy is right for your circumstances. Many critical questions still need to be answered by the Internal Revenue Service, the regulators, and the Administration.
The recently enacted Small Business Job Protection Act of 1996 (P.L. 104-188) is rich with tax provisions designed primarily to benefit small businesses. This law contains numerous reforms to Subchapter S of the Internal Revenue Code, including a provision that for the first time allows eligible small banks to become "small business corporations" or "S corporations," beginning after Jan. 1, 1997.
Absent any unforeseen regulatory impediments, well over 1,000 financial institutions may choose to elect S corporation status for the 1997 tax year.
S corporations enjoy the advantages of a corporate form of organization without being subject to its tax disadvantages. By eliminating the corporate level of tax, S corporation shareholders not only profit from significant tax savings, but realize a tremendous increase in the value of their shares.
Getting to that status won't be simple, however. It is crucial that banks interested in becoming an S corporation understand the rules governing eligibility, the election process, planning opportunities, and the potential impact of unresolved special issues peculiar to banks.
What is an S corporation?
Subchapter S of the Internal Revenue Code defines an S corporation as a domestic corporation which:
1. Does not have more than 75 shareholders.
2. Does not have shareholders other than individuals, estates, certain trusts, or certain exempt organizations, beginning after 1997.
3. Does not have a nonresident alien as a shareholder.
4. Does not have more than one class of stock.
There is also this caveat: Financial institutions using the reserve method of accounting for bad debts, and certain other corporations, are considered to be ineligible for S corporation status.
S corporations are exempt from federal taxation, with the exception of a possible corporate-level tax on built-in gains or excess passive investment income. For federal income tax purposes, S corporations are treated as partnerships. That is, all items of corporate income, deductions, losses, and credits are allocated to the shareholders on a pro rata basis. Personal exemptions, personal deductions, and net operating losses, however, are computed separately for purposes of shareholder allocations.
Is S for you?
Let's look at the eligibility requirements in more detail:
1. The 75 shareholders limit. The new law increased the maximum number of permissible S corporation shareholders from 35 to 75. Although evaluating shareholder limits may be a relatively easy process for the average community bank, some special rules should be considered in applying the shareholder limit.
For example, banks should be aware that a husband and wife (and their estates) are treated as one shareholder even if they own the stock individually or as co-owners. Additionally, qualified plans and tax-exempt entities are generally treated as one shareholder, but it is unclear at this time whether tax-exempt entities would be treated as more than one shareholder. Also, each beneficiary of the new category called "electing small business trusts" is counted as a separate shareholder. And people who are deemed owners of qualifying plan trusts are considered separate shareholders for purposes of counting the 75 shareholder limit.
Structuring the size of the shareholder base could present unique problems and costs. For example, banks with more than 75 shareholders may have trouble convincing shareholders to sell their stock in order to meet the 75-shareholder limit.
To the extent that buy-outs are necessary, banks should be sure that successor shareholder(s) are eligible and do not violate the 75-shareholder limit. For purposes of maintaining the prescribed 75-shareholder limit and in order to avoid the possibility of a future termination of "S" status, shareholder agreements are generally executed restricting the sale of stock. Otherwise, an institution already close to the limit could find that sales of shares by current holders to multiple buyers could put it over the federal limit.
2. Types of shareholders. Under the existing tax laws, an S election can be made only if all shareholders are individuals, estates, or certain trusts. Ineligible shareholders include corporations, partnerships, limited liability companies, individual retirement accounts, and nonresident aliens. The new law expands the types of eligible shareholders to include qualified plans (including employee stock ownership plans) and certain tax- exempt entities. Note that these provisions are effective for tax years beginning after Dec. 31, 1997.
There are also a few interesting developments in the new law that expand the types of permissible shareholders. For example, the new law allows certain subsidiaries, designated individually as a "qualified subchapter S subsidiary," or QSSS, to be wholly owned by an S corporation. The QSSS must be 100% owned by the S corporation and both the parent and the QSSS are treated as one entity.
Banks operating in a holding company structure will most likely elect S corporation status for the parent and the subsidiary bank or banks. In those situations, arrangements must be made to ensure that QSSS banks are 100% owned prior to making an election.
Another example of a new type of shareholder is a special trust called an "electing small business trust" or ESBT. ESBTs appear to provide more flexibility for estate and financial-planning purposes.
All required actions to remove ineligible shareholders, such as redemptions and corporate restructuring, must be made before the beginning of the first S corporation tax year.
3. No nonresident alien shareholders. Nonresident aliens are not eligible to be S corporation shareholders. This rule has remain unchanged since enactment of the subchapter S laws in 1958, and is intended to ensure that S corporation income that is exempt from corporate-level tax is subject to a U.S. individual graduated tax rate.
4. One-class-of-stock rule. The one-class-of-stock rule is intended to relieve any complication as a result of the apportionment of income and deductions among shareholders. Variances in voting rights will not disqualify a bank's subchapter S election so long as the outstanding shares of stock confer identical rights to distribution and liquidation proceeds.
A careful review of the articles of incorporation, bylaws, state law, and other relevant agreements will be necessary in order to ensure compliance with this rule. Under current regulations, certain commercial agreements (i.e. employment agreements) and buy-sell agreements or redemption plans are generally not taken into account for purposes of the one-class-of-stock rule unless the principle purpose of the agreement appears to be to circumvent the rule.
5. Discontinue reserve method of accounting for bad debts. To qualify for S corporation status, banks must account for bad debts using the specific charge-off method. That method permits a tax deduction only for actual charge-offs as loans become worthless. As a result of the Tax Reform Act of 1986, only banks with assets greater than $500 million are required to use this method. Small banks have the option to account for bad debts using the experience reserve method (which is calculated using a six-year moving average of actual losses) or the specific charge-off method.
The benefits of S corporation status seem to significantly outweigh the advantages of using the reserve method. Banks currently using the reserve method must change their method of accounting and assess the value of bad debt reserves, particularly those with high reserves beginning before 1988, prior to electing S corporation status.
Electing S corporation status
Any eligible small business corporation wishing to elect S corporation status must file IRS Form 2553, Election By a Small Business Corporation. The election is valid only if all shareholders consent by the fifteenth day of the third month of the year of election (or no later than March 17, 1997, for an S corporation election for the 1997 tax year).
Ensuring shareholder consent requires planning and may prove to be an onerous task. In certain cases, special consent rules may apply for minors, estates, and spousal shareholders in community property states. Additionally, consent is required from any shareholders who acquired stock on or after Jan. 1, 1997.
To expand on a point noted earlier, an S corporation is not subject to corporate income tax. S corporations are also not subject to the accumulated earnings tax, the corporate alternative minimum tax, and the personal holding company tax. All income is taxed to the shareholders, whether or not the income is distributed.
Additionally, the basis of an S corporation shareholder's stock is increased upon the taxation of undistributed income, and decreased when the previously taxed income is distributed. Therefore, cash distributions from S corporation earnings are generally not taxed, allowing undistributed earnings to provide the advantage of an increased stock value.
Aside from special tax attributes, an S corporation remains a corporation in many other important respects. For example, corporate redemptions, reorganizations, and liquidations are still subject to the corporate tax rules and the corporate entity continues to retain its limited liability feature.
The S election will remain effective until it is voluntarily, statutorily, or inadvertently terminated. Terminations occur upon revocation of or disqualification from S status, or from an excessive amount of passive investment income.
Once a termination occurs, a corporation immediately ceases to be treated as an S corporation for tax purposes and the corporation may not make another election for five years, unless the U.S Department of Treasury consents.
Special bank concerns
There are several tax issues under the new S corporation legislation that particularly relate to banks and could affect a bank's decision about S corporation election. The following is a summary:
1. Passive investment income. An S corporation will automatically terminate if, for three consecutive years, 25% or more of the gross receipts of the S corporation consists of passive investment income. Further, an S corporation may be subject to a special tax on "excess passive investment income" at the highest corporate rate, presently 35%. For these rules to apply, the S corporation must have subchapter C (ordinary corporation) earnings and profits from prior years.
While there are limited exceptions, the gross receipts derived from rents, royalties, dividends, interest, annuities, and sales or exchanges of stock or securities are considered passive investment income. Most banks that would otherwise qualify for S corporation status might face tax on excess passive investment income--or termination of the S election altogether.
Under existing law, interest received from loan portfolios consisting of loans not originated by the holder, and from investment assets (including tax-exempt interest) could be in violation of the passive investment income limitations even though the assets generating the passive income are held in order to meet bank regulatory liquidity requirements. Banks with a high loan-to-deposit ratio are especially at risk of violating the passive investment income limitation.
The IRS regulations appear to provide some relief, but unfortunately do not provide important clarification concerning interest earned on investment assets and non-originated loans. For example, IRS regulations provide that gross receipts that are "directly derived" in the "ordinary course of a trade or business of lending or financing" are not passive income, but interest earned from the "investment of idle funds" is passive. Under the tax regulations, passive income also does not include income derived in the ordinary course of a trade or business.
ABA believes that IRS regulations should reflect that, notwithstanding its source, interest income should be considered an "active" part of the banking business. IRS has been informed of this potentially dangerous issue and the ABA, along with other groups, requested that clarification be provided to the banking community. The matter is pending.
2. Built-in gains tax. As noted earlier, S corporation built-in gains are not exempt from a corporate-level tax. The built-in gains tax is designed to prevent the use of S corporations to avoid tax on appreciated assets and certain income items attributable to "pre-election" or C (ordinary) corporation appreciation. This tax is imposed at the highest corporate rate and applies to unrealized C corporation gains over a ten-year period after the conversion to an S corporation.
Built-in losses or deductions attributable to C corporation years may be used to offset built-in gains during the same year, and net operating losses, capital losses, and credits can be used to offset any built-in gains tax liability.
For banks, built-in gains may include, but are not limited to:
(a) Gains attributable to assets held on the first day of the S corporation election.
(b) Negative adjustments made under Internal Revenue Code Section 481 resulting from a change in the overall accounting method from accrual to a cash method.
(c) Intangibles such core deposits and excess servicing rights.
(d) Unrealized gains in the securities portfolio.
(e) The recapture of the bad debt reserve upon the change from the reserve method of accounting for bad debts to the specific charge-off method.
For purposes of the built-in gains tax, an independent appraisal of the assets of the C corporation or the bank holding company stock prior to an S corporation election is recommended.
WARNING: Banks should be aware of a provision in the Clinton Administration's 1996 budget proposal that sought to impose immediate gain recognition on both the corporation (with respect to appreciated assets) and its shareholders (with respect to their stock) upon the conversion to S corporation status. Depending on the outcome of the November election, this provision may reappear and perhaps become a costly obstacle to banks wishing to convert to S corporation status.
3. Director's qualifying shares. The banking laws governing national banks require a director to own at least $1,000 in stock in their bank or its holding company. Banks usually enter into buy-sell agreements with directors that require a resigning director to sell the qualifying stock (typically nonvoting common shares) to the bank or another shareholder at a fixed price. Even though buy-sell agreements are generally not counted as a second class of stock, ABA has nevertheless asked IRS to clarify the point.
4. Federal banking regulators. In October, ABA met with staff from the Federal Reserve, the Comptroller's Office, FDIC, and the Office of Thrift Supervision to informally discuss unique S corporation issues for banks. Some of the issues discussed were potential safety and soundness concerns under an S corporation structure, capital requirements, and additional filing procedures.
A bonus to the banking industry is the ability of banking regulators to understand the unique nature of bank investments and operations, particularly with respect to enforcing liquidity and capital standards. Such an understanding, however, does not necessarily prevent the banking regulators from becoming an obstacle. ABA urged the regulators to consider the positive effect that S corporation banks will have on the value of a bank charter, the ability to raise new private capital, and the ability to preserve existing capital.
ABA suggested to the agencies that no special filing procedures should be required. At an absolute maximum, the association suggested, a notification of an S election should be sufficient.
In response, on Oct. 29, the interagency Federal Financial Institutions Examination Council released Financial Institution Letter 91-96. The announcement stated that special notification will not be required for conversion to Subchapter S status, though the announcement noted that numerous ordinary requirements that could be related to the transaction--such as filing under the Change in Bank Control Act--would still be necessary. The Exam Council also noted that distributions by an S corporation to shareholders would be considered dividends subject to the prompt corrective action statute.
5. Requests for accounting method changes. In order to accomplish a change in accounting method for bad debts, IRS requires that the taxpayer file a request for permission to change to the specific charge-off accounting method. No accounting-methods changes can be made until consent is received from the IRS Commissioner. Generally, a "Section 481 adjustment," as these are termed, requires that excess reserves be taken into income over six years.
IRS has been informed of the anticipated volume of requests and has been asked to implement an automatic procedure. This would alleviate an important and significant obstacle to banks seeking to elect S corporation status, effective Jan. 1, 1997.
The rules governing 481 adjustments also apply to requests for a change in a bank's overall method of accounting. Because C corporations planning to convert to an S corporation are required to change to a calendar year, potential delays may result for banks currently operating on a fiscal taxable year-end.
6. Application of special bank tax rules. The Subchapter S tax laws state that the taxable income of an S corporation shall be computed in the same manner as in the case of an individual. The drafters did not foresee potential conflicts in the tax law concerning items of income and deductions that are treated differently for banks and individuals.
For example, Sections 265 (a) and (b) of the tax code outline the tax-exempt- interest disallowance rules for nonbanks and banks, respectively. Without further clarification, application of the disallowance rules at the bank and shareholder level could result in the application of Section 265 twice.
The new law also contains a conflict concerning the character of income on the sale of investment securities by the bank. Under current tax laws, the bank would treat income from the sale of securities as ordinary gain or loss. Individuals, on the other hand, would treat the income from the sale of investment securities as a capital gain or loss, unless they are dealers in securities. Along these same lines, banks can take an ordinary bad-debt deduction from income taxes, while individuals incur a capital loss in the year a debt is written off.
More changes to come?
The above conflicts highlight only some of the potential issues inherent in making a S corporation election for banks. The manner in which this legislation was included in the small business tax bill was indeed abrupt and did not thoughtfully consider the issues and inherent difficulty in applying the subchapter S rules to financial institutions.
It is unknown at this time whether the banking agencies and IRS will issue much-needed guidance or clarification by the end of 1996. In the meantime, interested banks should consult their tax advisors to determine eligibility and the appropriateness of an S corporation election.
Additionally, there are important unresolved state bank-franchise tax issues that have yet to be addressed by state legislatures.
ABA anticipates that the special bank issues will be resolved in favor of the banking industry, thereby allowing the thousands of bank shareholders who may benefit from the new S corporation legislation the opportunity to experience a long-awaited and well-deserved tax break.
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