How Subchapter S Issues Could Snag a Sale

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acquisitions-5-2-19.pngNearly 2,000 banks in the U.S. have elected Subchapter S tax treatment as a way of enhancing shareholder value since 1997, the first year they were permitted to make the election. Consequently, many banks have more than 20 years of operating history as an S corporation.

However, this history is presenting increasingly frequent challenges during acquisition due diligence. Acquirers of S corporations are placing greater emphasis on due diligence to ensure that the target made a valid initial Subchapter S election and continuously maintained eligibility since the election. Common issues arising during due diligence typically fall into two categories:

  • Failure to maintain stock transfer and shareholder records with sufficient specificity to demonstrate continuous eligibility as an S corporation.
  • Failure by certain trust shareholders to timely make required Qualified Subchapter S Trust (QSST) or Electing Small Business Trust (ESBT) elections.

A target’s inability to affirmatively demonstrate its initial or continuing eligibility as an S corporation creates a risk for the acquirer. The target’s S election could be disregarded after the deal closes, subjecting the acquirer to corporate-level tax liability with respect to the target for all prior periods that are within the statute of limitations. This risk assessment may impact the purchase price or the willingness of the buyer to proceed with the transaction. In addition, the target could become exposed to corporate tax liability, depending on the extent of the compliance issues revealed during due diligence, unless remediated.

Accordingly, it is important for S corporation banks to ensure that their elections are continuously maintained and that they retain appropriate documentation to demonstrate compliance. An S corporation bank should retain all records associated with the initial election, including all shareholder consents and IRS election forms. S corporation banks should also maintain detailed stock transfer records to enable the substantiation of continuous shareholder eligibility.

Prior to registering a stock transfer to a trust, S corporation banks should request and retain copies of all governing trust instruments, as well as any required IRS elections.

It is also advisable to have the bank’s legal counsel review these trust instruments to confirm eligibility status and any required elections. Banks that are relying on the family aggregation rules to stay below the 100 shareholder limitation should also keep records supporting the family aggregation analysis.

While S corporation banks have realized significant economic benefits through the elimination of double taxation of corporate earnings, maintaining strong recordkeeping practices is a critical element in protecting and maximizing franchise value, especially during an acquisition. Any S corporation bank that is contemplating selling in the foreseeable future should consider conducting a preemptive review of its Subchapter S compliance and take any steps necessary to remediate adverse findings or secure missing documentation prior to exploring a sale.

Policing Your S Corporation Status: Six Simple Steps

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s-corporation-12-30-15.pngS corporations have an obligation to police their shareholder base to see that all shareholders remain eligible. A common problem S corporations face is making sure that after the subchapter S election is made, it stays effective. When a bank is gearing up to make its S election, attorneys and accountants are typically reviewing shareholder documentation to confirm eligibility. But, after the S election is effective, most banks do not regularly review their shareholders’ list to confirm eligibility. Actions beyond the bankers’ control, such as the death or divorce of a shareholder, can result in an inadvertent termination of the S election. The tax consequences for the company and its shareholders can be disastrous.

Here is a common scenario.  A bank has a shareholder who passes away. The executor, who is much more concerned with administering the estate than protecting the bank’s S election, either transfers the bank shares to an ineligible shareholder, such as a corporation, or does nothing and leaves the shares in the estate. While an estate is an eligible shareholder, an estate does terminate for tax purposes at some point, so as a general rule, shares cannot be held in an estate indefinitely. The executor fails to notify the bank that the shareholder has passed away for several years. Dividend checks continue to be cashed in the name of the deceased shareholder. All the while, the bank is not aware of what has happened

Then, sometimes years later, something raises the issue. For example, the executor may finally contact the bank to effect the transfer of the shares, or a new review of the bank’s shareholder list may raise questions about why an estate is still a shareholder. Only then does the bank realize that the shareholder’s will transferred the shares to a corporation or that the shares have been sitting in the estate for many years. As a result, the S election has been compromised.

The good news is that the IRS has a program in place for S corporations to request relief for inadvertent terminations. However, consent of 100 percent of the S corporation shareholders is required, along with a filing to the IRS and a substantial filing fee.

It can be time consuming to obtain the requested relief from the IRS, but going through the process is essential if there has been an inadvertent termination. However, through the suggestions below, bankers may be able to avoid the inadvertent termination in the first place, which is obviously preferable:

  1. Review shareholders’ list: The bank should conduct a detailed review of the list of shareholders at least annually to confirm all shareholders are eligible. In addition, every two years, the bank’s accountants or attorneys should conduct a detailed review of the list.
  2. Review the shareholders’ agreement: Most S corporations have a shareholders’ agreement in place to protect the S election. If the shareholders’ agreement was drafted several years ago, an attorney should review it to confirm that the agreement is up to date with current law. In addition, the agreement should contain protections in the event the S election is inadvertently terminated, such as shareholder indemnification of the expenses incurred in connection with obtaining relief for the inadvertent termination and a covenant by the shareholders to take all steps necessary to remedy the inadvertent termination. There are other provisions that are useful as well.
  3. Shareholder communication: On an annual basis, banks should send a certification to each shareholder to confirm the shareholder still qualifies as an eligible shareholder. This annual certification requirement can be built into the shareholders’ agreement or something that the bank just sends out on its own each year.
  4. Remind shareholders of estate planning issues: Either in conjunction with the annual certification or separately, remind shareholders about the consequences upon the shareholder’s death. For example, a shareholder should talk with the attorney who drafted his or her will to confirm that the shares pass to an eligible shareholder.
  5. Train the bank’s corporate secretary: The corporate secretary should be mindful of S corporation qualifications and eligibility issues as well as common issues that could impact the S election. The corporate secretary can possibly help avoid an inadvertent termination by being proactive and asking the right questions.
  6. Road map memos: Banks should consider requiring shareholders, for example, as part of the shareholders’ agreement, to have their estate planning attorneys provide the bankers with a letter or memorandum detailing what happens to the shares upon the death of a shareholder, especially if the shares are already held in a trust.

By taking the steps above, a potential inadvertent termination of a bank’s subchapter S election can be avoided. An ounce of prevention is worth a pound of cure.

Tax Conundrum: How to Handle the Purchase of an “S” Corporation

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treasure-chest.jpgApproximately one-third of all banks in the United States are organized as subchapter S corporations. Since a potential buyer is likely to encounter a seller that is a subchapter S bank, it is important to understand the unique tax consequences to the selling corporation and its shareholders. For example, the selling shareholders may seek concessions, in the form of additional consideration, to reimburse them for any additional tax liability they might incur based upon the chosen structure. Board members, whether representing the seller or buyer, will need to consider these tax issues in order to properly evaluate a proposed acquisition structure and obtain the desired results.

Any buyer purchasing a corporation at a premium typically prefers to structure the transaction in a way that allows the buyer to receive a “stepped-up basis” in purchased assets. In other words, the buyer wants to directly allocate the amount paid for the corporation’s stock to the acquired assets for tax and accounting purposes. While this treatment may be required under U.S. generally accepted accounting principles, it does not automatically apply for federal income tax purposes. In fact, a buyer acquiring the stock of a corporation generally will take a carryover tax basis in purchased assets, as opposed to a stepped-up tax basis, thus potentially leaving tax dollars on the table. While a buyer can purchase assets directly without purchasing stock in order to receive this stepped-up tax basis, it might not always be practical (or permissible) to structure a transaction this way. So what’s a buyer to do?

Internal Revenue Code Section 338(h)(10) provides a special election for “qualified stock purchases,” which are defined as any transactions, or series of transactions, in which at least 80 percent of the stock of one corporation (the target corporation) is purchased by another corporation (the acquiring corporation) during a 12-month period. If the election is made, a purchase of target corporation stock is treated as though the acquiring corporation directly purchases the assets of the target corporation. In other words, the purchase of the stock is disregarded for tax purposes—and for tax purposes only.

There are two situations in which a Section 338(h)(10) election can be made:

  1. The target corporation is a subsidiary in a consolidated group; or
  2. The target corporation is a subchapter S corporation.

It is the latter of these two situations that is more common among bank holding company acquisitions.

It should be noted that a Section 338(h)(10) election can be made only if all parties involved in the transaction agree to the election. If the target is a subchapter S corporation, the approval of every shareholder of the S corporation must be obtained—no exceptions. A single dissenting shareholder can disrupt the entire process (although there are some strategies to avoid that). It should also be noted that the acquiring corporation assumes all liabilities of the target corporation, including tax liabilities.

Now that we have set the table as to why, and under what circumstances, a Section 338(h)(10) election can be made, let’s take a look at the tax consequences for the parties involved, assuming the target corporation is an S corporation bank holding company with a single 100 percent-owned qualified subchapter S bank subsidiary.

For the target corporation:

  • All holding company and bank assets are sold in a taxable transaction.
  • All holding company and bank liabilities are assumed by the acquiring corporation.
  • Corporate-level S corporation built-in gains tax could apply.
  • Corporate-level state income tax applies to net gains from taxable sale of assets (presuming the relevant states follow the federal Section 338(h)(10) treatment).
  • Holding company is liquidated.

For the selling shareholders:

  • Gains (and losses) from the sale of assets pass through to shareholders and are reported on the shareholders’ personal income tax returns; the tax basis in the S corporation stock is increased or decreased accordingly.
  • Shareholders recognize the gain or loss upon liquidation of holding company shares.

For the acquiring corporation:

  • Tax basis of purchased assets, including intangible assets, is stepped up (or stepped down).
  • Premium paid above fair market value of hard assets generally is converted into a tax-deductible intangible asset that can be deducted on a straight-line basis over 15 years.
  • No tax attributes of the target corporation carry over, which would commonly occur in the context of a stock purchase without a Section 338(h)(10) election.

As discussed earlier, subchapter S corporations make up about one-third of all banks in the United States. Because potential buyers are likely to encounter a selling S corporation, it is important to understand the unique tax consequences affecting the parties involved, including the target corporation, its shareholders, and the acquiring corporation. The Section 338(h)(10) tax rules are detailed, and there might be exceptions to the general rules described here. Taxpayers should review their specific fact patterns before deciding on a course of action.