Broadening the Base for Sub-S

Let’s start by defining an S-corporation.

One very clean definition of an S-corporation is a domestic corporation, not deemed an ineligible, that has no more than 100 shareholders and has only one class of stock.

What is the primary benefit of converting to the S-corp status, and who typically elects to do so?

The tax savings is undoubtedly the primary, if not the only, reason a bank would consider making an S-corp election. Under Subchapter-S, the bank’s earnings are no longer subject to a double corporate tax [one for the corporation and one for the shareholders] so you are wiping out a 34% rate on the first level of earnings that the corporation would pay. In effect, the corporation is treated as a partnership for tax purposes, so the earnings flow passes through to the individual shareholders who report it on their personal tax returns. When you run the numbers, it’s quite a significant motivation for many banks. More than 25% of the banking industry has made the election so far.

The tax laws surrounding Subchapter-S have specific requirements on what types of shareholders a company may have, the number of shareholders, and a few other nuances. A smaller, closely held, or family-owned bank would most likely fit those requirements.

That sounds great. What’s the other side of the equation?

There are a couple of reasons why banks that are qualified don’t elect to go Sub-S. In many cases, it’s because there isn’t enough understanding on how these corporations work. This election has to do with tax lawsu00e2u20ac”which are not perfect and are even draconian, in my opinion. Also, it can be very expensive to make the election because you may have to rearrange the ownership structure and makeup of the bank. And in some cases, the bank might wish to sell itself in the near future, which could impact whether it would be worthwhile to go to the work and expense of converting the bank to an S-corp if it won’t be an S-corp for very long.

There are many factors, but the point is, every bank is different and has a unique story to tell, and therefore has different reasons why it should or should not elect to convert to an S-corp. You can’t take a cookie-cutter approach. So when you sit down with a board, which I often do, and talk with the directors and learn what they are all about, you may find it is not worthwhile for them to go Subchapter-S. Having said that, while I wouldn’t automatically advise the election, directors must understand that they have a fiduciary duty to explore this option and determine if it is feasible.

What do they need to demonstrate in their investigation?

They have a duty to the shareholders to maximize their return. Therefore, if converting to an S-corp is a possibility for the bank, they should explore it. That doesn’t mean they have to do it. For instance, some banks may have a shareholder who refuses to consentu00e2u20ac”and you need 100% consensus to convert. In other cases, some boards may be reluctant to buy out shareholders when they find they have too many to qualify under the rules. Other times, they may have the wrong types of shareholdersu00e2u20ac”generally only individuals, estates, certain trusts, charities, qualified plans, and certain IRAs may own stocku00e2u20ac”that’s it. Furthermore, of those who are eligible shareholders, some may be subject to a different type of tax. So there are many variables involved in the decision.

How do you help banks work through this decision?

If I go to a bank board, I sit down and ask a series of questions regarding who and what the stockholders are. I then develop a plan on how to deal with each of these shareholders so they will fit into the S-corp rules. This takes up a significant amount of time for existing banks. De novo banks, on the other hand, can start off as a Subchapter-S, so they are way ahead of the pack because they don’t have what I call “conversion issues.”

Given the logical benefit of the tax savings, what are some of the reasons shareholders of a qualified company might not consent?

Sometimes shareholders understand it will save the corporation money but they still don’t want the additional tax on their returns. That’s a common question for directors, by the way: Where does the tax liability go? The answer is the shareholders’ taxes are going to go up because the income flows through to them. Banks usually issue a minimum amount of dividend or a distribution to cover the shareholders’ taxes. But sometimes shareholders still aren’t comfortable with that, so it may cause one or two of them to refuse to make the election. I’ve even seen shareholders of dubious character use the consent requirement to negotiate a higher buyout price for their stock. Remember, closely held stock is not readily tradeable, so all of a sudden these shareholders may see an opportunity to make money, and they take advantage of it.

How should a board respond such a situation?

My recommendation is always educate, educate, educate, so everybody is on the same page which makes the process much easier. If someone feels left out, it quickly turns personal.

Do you have any advice for how boards should approach buyout negotiations?

It falls under the umbrella of a shareholder reduction strategy and tender offer, similar to a going-private transaction. Today, many companies are looking at buyouts to escape Sarbanes-Oxley Act requirements. [To fall below the radar for Sarbanes-Oxley, you must have fewer than 300 shareholders.] In some cases, the buyout is structured as a tender offer where the bank sets the price. Other times it’s considered an involuntary cash-out, in which the minority shareholders have no choice. If that is the approach taken, a qualified appraisal is made to determine the fair value of the stock, which becomes the buyout amount. At that point the shareholders really have no choiceu00e2u20ac”they will receive fair value for their stock.

Sometimes it’s a strain on a bank’s capital to reduce shareholders, so boards must consider whether it’s worth the cost. I always ask banks to go through a cost/benefit analysis. I put a line down the middle of a chalkboard and say, “Here’s what you need to do, here’s what it’s going to cost, and here are the benefits. Do the benefits outweigh the cost?” Nine times out of 10, they do.

What recent regulatory changes have made an impact on banks’ decisions to consider a S-corp strategy?

The American Jobs Creation Act last year made a number of changesu00e2u20ac”three of which I have earmarked as important for banks. The first concerns raising the number of allowable shareholders from a ceiling of 75 to 100, which qualifies many more banks for Sub-S. It also allows current Sub-S banks to add more shareholders, should they choose to do so. More important, there’s a provision that allows family members to be treated as one shareholder within that 100-shareholder limitation. This determination even includes ex-spouses and goes up to six generations. This is the most significant benefit, in my estimation.

What do you need to prove those connections? A DNA sample?

Rightu00e2u20ac”how do you prove it? For now, the Internal Revenue Service is going to trust you. Interestingly, I have seen a bank that had, on paper, 350 shareholders, but under this new provision, they now officially have 75. So I think this election is going to be used a lot because of that provision alone.

Have there been any other changes?

Yes, one that was meant to be a relief provision and expansion of Sub-S, but in fact, is a disappointment. Banks used to be prevented from making the election if they had stock held by IRAs. The new provision expands that restriction; however, it excludes any bank that has a holding company. Enough fingers got on the actual language so that now it has an extremely limited application. This is going to keep a lot of banks that have a tremendous amount of stock in an IRA from making the election. This means their only option is to buy out their stock, which means paying penalties and taxes. If it’s only a small amount, that’s possible, but banks that have built up quite a bit within IRAs are not in a position to buy out that stock. And even if you don’t have a holding company, it looks as though there could be two or three levels of taxes on the same earnings. I’m hopeful Congress may eventually fix this with some type of technical correction or guidance.