As you probably know, H.R. 1591 was vetoed on May 1st by the President because a portion of the bill attempted to structure a timetable for troop removals from Iraq. Fortunately, the minimum wage increase bill, including the Subchapter S provisions, was included in the latest supplemental war spending bill, H.R. 2206, which was signed by the President on May 25th. The text of these Subchapter S reforms is included as Appendix A at the end of this Report. Each section is summarized below:
Capital Gain of S Corporation not Treated as Passive Investment Income
Presently, S corp. banks are subject to a corporate level tax at the highest corporate tax rate on excess net passive income if a corporation has: 1) accumulated earnings and profits in that taxable year, and 2) gross receipts of more than 25% of which are passive investment income. If an S corp. bank meets or exceeds these limits for three consecutive taxable years, the bank’s S election is automatically terminated. The new regulations, which will become effective for taxable years beginning after the date of enactment, eliminate any gains attributable to sales or exchanges of stocks or securities as an item of passive investment income.
Treatment of Bank Director Shares
On January 24, 2002, the IRS issued Private Letter Ruling # 200217048, which held that restricted bank director stock agreements created a second class of stock. For Sub S banks, this ruling was problematic since banks electing Subchapter S may have only one outstanding class of stock. This new regulation eliminates this problem because restricted bank director stock will no longer be treated as a second class of stock. This provision will apply retroactively to December 31, 2006, so all Sub S banks that have previously issued bank director stock will be covered by the amendment.
Additionally, directors holding only bank director stock will not be counted as shareholders for Sub S purposes and it will not be treated as outstanding for purposes of determining whether an S corp. holds 100% of a Q Sub. Such stock will also now be disregarded in allocating items of income and loss among shareholders, and distributions paid to directors will now be tax deductible by the bank or bank holding company. The effective date of these amendments will apply to taxable years beginning after December 31, 2006.
Special Rule for Bank Required to Change from the Reserve Method of Accounting on Becoming an S Corporation
This provision allows banks making an S election to recognize built-in gains in the last year of existing as a C corp., rather than in their first year as an S corp. This amendment is meant to allow the corporation, rather than the shareholders, to shoulder the burden of paying this initial built-in gains tax. This amendment too will apply to taxable years beginning after December 31, 2006.
Treatment of the Sale of Interest in a Qualified Subchapter S Subsidiary
According to the Internal Revenue Code, Q Subs must be 100% owned by their parent corporations. And any Q Sub that ceases to be wholly owned by the parent is effectively treated as a “new corporation” immediately before cessation from the parent. Presently, if the parent corporation sells more than 20% of the Q Sub, the parent does not qualify for nonrecognition treatment under section 351 of the Code, and the entire transfer is treated as a taxable sale. Under the new law effective for taxable years beginning after December 31, 2006, Sub S bank holding companies will be permitted to sell any portion of a Q Sub and recognize a gain or loss on the sale equal only to the percentage of the interest sold. In effect, the transaction would be treated as a sale of an undivided interest in the assets of the Q Sub, followed by a deemed transfer to the Q Sub, in which nonrecognition under section 351 would apply.
Elimination of all Earnings and Profits Attributable to pre-1983 Years for Certain Corporations
Currently, banks and bank holding companies making S elections are forced to transfer all of their accumulated earnings and profits (AE&P) when converting to Subchapter S. Under the new law, banks and bank holding companies making S elections after the law is enacted will be permitted to reduce their AE&P by the amount of AE&P that accumulated in any taxable year beginning before January 1, 1983.
Deductibility of Interest Expense on Indebtedness Incurred by an Electing Small Business Trust to Acquire S Corporation Stock
ESBTs, are typically a preferred method of structuring stock ownership in banks making S elections for non-qualifying owners such as corporations, partnerships, and the like. Historically, interest paid by an ESBT to purchase S corp. stock has not been a deductible administrative expense for purposes of determining taxable income of the S portion of the ESBT. Items that may be taken into consideration include: items of income, loss or deduction allocated to the ESBT as a shareholder of an S corp. under subchapter S of the Code; gains or losses from sales of S corp. stock; and, to the extent provided in regulations, state or local income taxes or administrative expenses allocable to the S corp. stock portion of the ESBT. For taxable years beginning after December 31, 2006, this list will be expanded to include interest expense paid or accrued on indebtedness incurred to acquire S corp. stock. As a result, deductions for interest expense may now also be taken into consideration when computing taxable income of the S portion of an ESBT.
