Qualified Preferred Stock
S corporations are currently prohibited from issuing more than one class of stock. Under Internal Revenue Code (“IRC”) Section 1361(b)(1)(D) and Treasury Regulations (“Regulation”) Section 1.1361-1(l)(1), a corporation that has more than one class of stock will not qualify as a small business corporation, and thus, cannot be an S corporation. This prohibition precludes S corporation banks from participating in a major source of capital – issuance of preferred stock. The proposed legislation offers an alternative to this outright prohibition of “qualified preferred stock” in the case of S corporation depository institutions and their holding companies.
The holders of qualified preferred stock would not be treated as shareholders of the S corporation. The resulting benefits would be two-fold: it would (i) allow otherwise ineligible shareholders (e.g. corporations, partnerships, LLCs, and foreign persons) to invest in S corporations and (ii) enable S corporations to raise capital resources without having to terminate their S election (preserving their pass-through status).
Qualified preferred stock would not be treated as a second class of stock and would be specifically defined as stock that (i) is not entitled to vote; (ii) is limited and preferred as to dividends and does not participate in corporate growth; and (iii) has redemption and liquidation rights that do not exceed the price of the stock (except for a reasonable redemption or liquidation premium). Qualified preferred stock would be convertible into common stock of the corporation, and distributions made by the S corporation with respect to the qualified preferred stock would be taxed as ordinary income to the holder and deductible to the corporation as an expense – similar to “restricted bank director stock” that S corporation banks may now issue. Holders of qualified preferred stock would not be allocated any income, loss, deduction, credit or non-separately computed income or loss with respect to such stock. Further, purchasers of qualified preferred stock would be attracted by their preferred status and senior position to holders of common stock.
Under IRC Section 1361(b)(1)(B), a Subchapter S corporation may not have more than 100 shareholders. The proposed legislative initiative would increase that limit to 500 shareholders for S corporation banks. This is the number that has historically been the threshold for non-public companies prior to the Jobs Act of 2012, which permitted shareholder numbers to grow to 2,000 before a company is required to register and be subject to the reporting requirements of the Securities Exchange Act of 1934. It is also the maximum number of allowable partners/members before a limited partnership or LLC becomes subject to SEC reporting obligations.
When Subchapter S of the Internal Revenue Code first came into existence in 1958, an S corporation was limited to 10 shareholders. This limit was first increased to 25 in 1976 and has grown progressively larger over the years, as advances in technology have reduced the cost and increased the ease with which these larger shareholder groups could be managed. The limit was most recently raised to 100 as a result of the American Jobs Creation Act of 2004. With shareholder management software and digital technology advances, managing 500 shareholders and generating 500 K-1s no longer presents a significant burden on many S corporations, including many banks that are already managing shareholder groups near the current 100-shareholder limit.
As shareholder groups have changed and increased in size over time, capital needs have also increased as banks grow and seek the ability to meet ever-evolving challenges. Many Subchapter S banks have reached or are close to approaching the current 100 shareholder limit. Both concerns about shareholder group size and access to capital can be met by an increase in the maximum number of shareholders to 500. The historical, progressive expansion of the shareholder limit demonstrates that its primary purpose is one of administrative convenience. As the sophistication of S corporation banks continues to grow, so should their capacity to take on and manage additional shareholders. Finally, this 500 shareholder limit is still far below the level at which corporations are subject to the reporting requirements of the SEC.
The ability to issue qualified preferred stock and expand a Subchapter S bank’s shareholder base would substantially increase opportunities to raise capital at an important time. Both measures should also be attractive to the regulatory agencies, which are closely monitoring bank capital. The strengthening of capital adequacy requirements under the Dodd-Frank Act and Basel III have created an environment in which community banks require additional avenues through which to raise capital so as to continue to thrive in today’s challenging economy.