The Sub S Bank Report – April 2014 (Volume 17, Issue 1)

The Subchapter S Bank Association has released a letter sent to the three bank regulatory Agencies (The Federal Reserve System, OCC & FDIC) encouraging them to review their policy towards subchapter s bank dividends . In particular, the Association urges the Agencies to eliminate the unequal treatment between banks that elect S corp treatment in comparison to their C corp peers. Specifically, the Association encourages the Agencies to permit dividends for purposes of allowing shareholders to pay their federal income taxes.

The Association urges the regulatory agencies to support expanding the means for Subchapter S banks to access their capital by continuing to make the S election attractive through:
1.) Permitting dividends to pay taxes;
2.) Increasing the number of shareholders from 100 to 500;
3.) Permitting the issuance of preferred stock by S corporations

The Association urges Subchapter S banks to write to the Agencies to encourage a renewed focus on the value of the Subchapater S election to banks and their communities. The Association will be coordinating meetings with Subchapter S Banks and the regulatory Agencies in the near future and developing additional legislative strategies focused on increasing capital access for Subchapter S and smaller community banks.

The full text of the letter follows:

Dear Chair Yellen, Comptroller Curry and Chairman Greenberg:

We write to express our continued concern regarding the unequal treatment depository institutions and their holding companies that elect to be taxed under Subchapter S of the Internal Revenue Code (IRC) receive compared to their peers taxed under Subchapter C, especially when considered in the context of the capital conservation buffer rules presently contained in Basel III and regulatory dividend restriction policy.

While S corporations are not subject to tax at the entity level, shareholders of the S corporation must pay federal and, to the extent applicable, state income taxes on taxable income from their ownership in the S corporation – that income is attributable, of course, only if it is earned. The unequal treatment occurs because most S corporation shareholders rely on dividend distributions from the S corporation of at least a portion of that income to pay the taxes owed.

C corporations, on the other hand, pay income taxes at the entity level and shareholders are not subject to tax unless they receive a dividend distribution. Under Basel III and current supervisory policy, the S corporations may be prohibited from distributing this income in the form of dividends to their shareholders, thus limiting those shareholders ability to satisfy the income tax obligations arising from bank earnings. The issue was addressed in the final rule issued last
September as follows:

“The agencies recognize that S-corporation banking organizations structure their tax payments differently from C corporations. However, the agencies note that this distinction results from S-corporations’ pass-through taxation, in which profits are not subject to taxation at the corporate level, but rather at the shareholder level. The agencies are charged with evaluating the capital levels and safety and soundness of the banking organization. At the point where a decrease in the organization’s capital triggers dividend restrictions, the agencies believe that capital should stay within the banking organization. S-corporation shareholders may receive a benefit from pass-through taxation, but with that benefit comes the risk that the corporation has no obligation to make dividend distributions to help shareholders pay their tax liabilities. Therefore, the final rule does not exempt S-corporations from the capital conservation buffer…” 1This explanation seems to suggest that the Subchapter S election confers a benefit solely to the shareholders of the bank for which they assume the risk that dividend distributions may not be available to satisfy the resulting tax liability. This narrow view, however, ignores the significant benefit to the bank and to community banking as a whole. When Congress amended the Internal Revenue Code to permit banks, thrifts and their holding companies to elect subchapter s tax treatment in 1996, nearly a third of the banks in the United States ultimately elected S corporation tax treatment. The driving force for this change was the significant increase (approximately 65%) in net income to these banks and the elimination of double tax on earnings and dividends. The legislation resulted in an increase in bank capital and an increase in the attractiveness of community bank investments. While we are aware of no formal study, informally we know from dozens of conversations with controlling shareholder groups, that the subchapter S election “saved” many community banks. Many bank owners were able to “unlock” the value in their banking organizations and
avoided a forced sale of their banks to larger financial institutions.

Today nearly 2,300 banks, approximately one third of banks in this country, operate as Subchapter S banks. This is a highly efficient means of conducting business and is one of the attractive features of the election that allows community banks across the country to remain profitable and competitive with their larger, regional and national peers. Unfortunately, the current regulatory policy regarding dividend restrictions has resulted in a number of S corporation banks losing or being forced to terminate their S elections. The Association recently conducted a study of the 104 banks that terminated their S elections between 2009 and 2013. Approximately 25% of the group responded and 40% of those respondents (excluding terminated S elections due to merger or acquisition) cited regulatory restrictions on dividends resulting in an inability of shareholders to pay the income taxes owed as the main reason for termination of the election.

Based on anecdotal evidence and personal knowledge and discussions with several banks, many of these organizations had only temporary issues that led to termination of the S election. Pursuant to Subchapter S of the Internal Revenue Code, however, a corporation that terminates its S election must wait five years before being eligible to make a new election. Our study revealed that most of those banks that had been forced to terminate the election would like to re-elect and would support legislation reducing the current five year wait time. 

The issue of course for the Agencies as well as the Banks is capital maintenance. We believe that Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and Basel III have had a significant negative impact on a community bank’s ability to maintain and access new capital. The GAO Study that was completed in January 20122 as directed by section 172 of Dodd-Frank regarding “small bank” access to capital largely concluded that small banks, which it defined as banks with assets of $10 billion or less, essentially had no problems raising capital. Unfortunately, the study seemed to focus more on banks at the higher end of that scale, $1 billion and above, and had little focus on the approximately 6,000 financial institutions with less than $1 billion in assets. The study also did not analyze the special problems that S corporation banks face as a result of statutory limits on the number and types of permitted shareholders and classes of stock. In addition, the effective elimination of Trust Preferred Securities as a source of capital, despite the Collins Amendment exemption for banks under $500MM in total assets, has further exacerbated the capital raising faced by community banks. Curiously, the study concluded that the capital created by the issuance of trust preferred securities was significantly inferior to common equity. We categorically reject that conclusion when considering bank capital only.

The Association and many other interested parties are continuing to work to encourage Congress to loosen the restrictions on the number and types of permitted shareholders, as well as to make alternative types of capital instruments available to Subchapter S banks. Such alternative capital instruments include preferred stock that would not count as a shareholder for Subchapter S limitation purposes.

In addition to revisiting the dividend restriction rule contained in the Basel III Capital Conservation Buffer provisions, we encourage the Agencies to support efforts to expand access to capital for Subchapter S banks by supporting an increase of the shareholder limit from 100 to 500 and permitting entities other than natural persons and trusts to hold shares of an S corporation. Finally, we encourage the Agencies to support expansion of capital instruments for Subchapter S banks to include preferred stock.

These issues are of critical importance to one-third of the banks in the United States, 90% of which are under $1 billion in assets and serve as the essential credit back bone of smaller communities and their local businesses throughout the country.

All too often Washington completely forgets about Subchapter S banks and their special needs and circumstances. Examples include the original TARP and SBLF programs, whose initial structures simply did not work for Subchapter S banks. That initial oversight was corrected only after 9 months of negotiations with the Treasury Department to redesign the TARP program to allow Subchapter S banks to participate. Changes were made to the SBLF approximately one month prior to the expiration of the program, effectively denying Subchapter S banks any opportunity to participate.

Recently, the Agencies issued a proposed amendment to the Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure. This proposal neglects to address the unique situation of Subchapter S holding companies. We strongly urge the Agencies to embrace the Subchapter S bank community and undertake a concerted effort to promote their health and ability to raise capital and function as freely as possible in the best interest of their
shareholders and communities.

This can only be achievedthrough discussion and policy-making that includes the

needs and interests of Subchapter S banks at the outset of the process rather than as a mere afterthought. The Subchapter S Bank Association was formed in 1997 primarily as an educational organization servicing the unique needs of the Subchapter S banks and their directors, officers and shareholders. We appreciate the Agencies attention to these issues and would welcome the opportunity to explore these issues in a personal meeting which would include some of our bank members.

1. “REGULATORY CAPITAL, IMPLEMENTATION OF BASEL III, CAPITAL ADEQUACY, TRANSITION PROVISIONS, PROMPT CORRECTIVE ACTION, STANDARDIZED APPROACH FOR RISK-WEIGHTED ASSETS, MARKET DISCIPLINE AND DISCLOSURE REQUIREMENTS, ADVANCED APPROACHES RISKBASED CAPITAL RULE AND MARKET RISK CAPITAL RULE,” 78 FED. REG. 55339, 55354-55355 (Sept. 10, 2013).
2. U.S. GOV’T ACCOUNTABILITY OFFICE, REP. NO. GAO-12-237, DODD-FRANK ACT: HYBRID CAPITAL INSTRUMENTS AND SMALL INSTITUTION ACCESS TO CAPITAL (2012).

Passed as part of the Health Care and Education Reconciliation Act of 2010 and codified as Internal Revenue Code (“Code”) section 1411, the NIIT imposes a 3.8% tax on net investment income of individuals, trusts, and estates for tax years beginning on or after January 1, 2013. Proposed regulations were issued in late 2012 and after a review of numerous comments from the legal community and interested parties the IRS issued final and new proposed regulations implementing the NIIT in late 2013. This article discusses which taxpayers are subject to the tax, how the tax is calculated and which types of income will be taxed in the context of S corporation banks.

Calculation of the Tax

The threshold questions in calculating the tax are whether a taxpayer has sufficient income to be subjected to the tax,and whether the taxpayer has net investment income. 

Individual Taxpayers

Taxpayers are only subject to the NIIT to the extent income exceeds the statutory threshold amount. For individual taxpayers, Code section 1411(a)(1) provides that the tax is imposed on the lesser of (i) net investment income for the taxable year, or (ii) the excess of modified adjusted gross income (“MAGI”) over the threshold amount provided in the statute. For purposes of this calculation, the “threshold amount” is equal to $250,000 for married taxpayers filing a joint return or $200,000 for single filers.1 MAGI is equal to adjusted gross income increased by any foreign earned income exclusions taken under Code section 911. 2 Taxpayers with no foreign earned income will simply use their adjusted gross income to calculate whether and to what extent they are subject to the NIIT. In the case of an individual taxpayer, married and filing a joint return, if MAGI does not exceed $250,000, no tax is imposed. If, however, MAGI is $280,000 and the taxpayer has net investment income of $50,000, $30,000of the $50,000 will be subject to the tax (the lesser of $50K or $280K – $250K).

Trust and Estates

Trusts and estates are subject to a similar, albeit much lower, threshold test under Code section 1411(a)(2). In the case of a trust or estate, the tax is imposed on the lesser of undistributed net investment income for the tax year or the excess of adjusted gross income over the statutory amount.3 The statutory amount for trusts and estates is tied to the dollar amount at which the highest tax bracket begins under Code section 1(e). This presents two important differences from the NIIT as imposed on individuals at a relatively high threshold amount that is fixed by statute. The threshold income amount for trusts and estates is much lower than for individuals ($11,950 for tax year 2013 and $12,150 for tax year 2014).4 Additionally, because it is tied to the tax brackets (revised by the Service each year), the income threshold for trusts and estates is indexed for inflation annually. Another important feature of the NIIT as imposed on trusts is that it only applies to net investment income that is not distributed to beneficiaries of the trust by the end of the tax year. Therefore, it may be possible to avoid the tax by distributing net investment income to the beneficiaries who may not meet the much higher income threshold for individuals. For example, a trust with a single beneficiary and $50,000 of adjusted gross income in 2013 (all of which is undistributed net investment income) will be subject to the tax on $38,050 of that income ($50,000-$11,950). Alternatively, rather than accumulating the income in 2013, the trust could have distributed it to the sole beneficiary, a married individual with MAGI of $180,000. In this case, the trust now has no undistributed income and is not subject to the tax. Additionally, the beneficiary, whose MAGI does not exceed the $250K threshold will also not be subject to the NIIT on that income.

Finally, the NIIT is not imposed on grantor trusts, as income of the trust is deemed to be income of the grantor or other individual deemed to be the owner of the trust.5 This income to the owner of the trust, however, will be included in the calculation of NIIT for that individual.6 

Definition Of Net Investment Income 

The purpose of the NIIT is to tax passive income not associated with the business activities of the taxpayer. To properly define the types of income to which the tax applies, Code section 1411(c)(2) defines the trade or business activities to which the tax applies and Code section 1411(c)(1) defines the three general categories of income associated with those activities. The interaction between these two provisions and the regulations implementing them are complex, but central to properly determining a taxpayer’s net investment income.

Income Categories
Under Code section 1411(c)(2) the tax applies to certain income from a trade or business that is either a passive activity or trading in financial instruments or commodities.7 The definition of “net investment income” then includes the following categories of income:
• (i) income from interest, dividends, annuities, royalties, and rents (“Portfolio Income”), other than income derived in the ordinary course of a trade or business that is not passive activity or trading in financial instruments;
• (ii) other gross income derived from a passive activity or trading in financial instruments (“Other Income”); and
• (iii) the net gain on the disposition of property other than property held in a trade or business that is not a passive activity or trading in financial instruments (“Disposition Income”).8 The sum of those categories is then reduced by any allowable deductions.9

Whether income allocated to the shareholders of an S corporation is subject to the tax depends on the category of the income and the nature of the activity through which it was earned.

Covered Businesses
Generally, income in each of the above categories will be included in net investment income if it was derived in a trade or business that is (A) a passive activity with respect to the taxpayer or (B) trading in financial instruments or commodities.10 Because the income is passed through the S corporation to its shareholders, it must first be determined whether the activity at the entity level (the S corporation or a lower-tier subsidiary) is a trade or business that is a passive activity or financial trading.11 If the activity conducted by the S corporation or lowertier subsidiary is derived from a trade or business that is not a passive activity or financial trading,12 that activity must also not be passive with respect to the individual shareholder to whom the income is allocated (the taxpayer).13 The NIIT generally relies on section 469 and the regulations thereunder (the passive activity loss rules) to determine whether a trade or business is considered passive, and thus, included in net investment income. Alternatively, a determination whether income is derived from trading in financial instruments or commodities will be made at the entity level, based on the activity of the S corporation or its subsidiary earning the income.14

Portfolio Income: interest, dividends, annuities, royalties, rents unless derived in the ordinary course of a trade or business that is not a passive activity or trading in financial instruments or commodities.

As with the other categories of income, Portfolio Income will be excluded from net investment income iff it is not derived from a trade or business that is a passive activity or financial trading. Due to the inherently passive nature of Portfolio Income, however, an additional requirement is imposed on its exclusion from net investment income. Exclusion of Portfolio Income requires that it be derived not only in a qualifying trade or business, but that it be derived “in the ordinary course” of that trade or business that is not a passive activity or trading in financial instruments or commodities. In the case of an S corporation bank, interest derived from the bank’s loan portfolio, for example, is properly excluded from net investment income. The bank’s lending activities are a trade or business and interest on those loans is derived in the ordinary course of that trade or business. For purposes of determining whether Portfolio Income is derived “in the ordinary course” of a trade or business the regulations also make clear that income from the investment of working capital will be treated as not derived in the ordinary course of a trade or business.15

Other Income: unless derived from a trade or business that is not a passive activity or trading in financial
instruments.

Under the second category of net investment income, Other Income includes income that is not Portfolio Income or Disposition Income that is derived from a trade or business that is passive or financial trading.16 Examples of such other income that would be included in net investment income are income earned from the trade or business of an S corporation (that is not Portfolio Income), which is considered passive to a particular shareholder. Note that the income is not required to be earned “in the ordinary course” of a trade or business to be excluded under this category of income. Income can be earned from any trade or business activity. The income allocated to the taxpayer/shareholder, however, must not be passive.

Disposition Income: the net gain on the disposition of property other than property held in a trade or business that is not a passive activity or trading in financial instruments The third category, net gain on the disposition of property is potentially the broadest of the three categories of income included in net investment income. The term “disposition” as defined in the regulations extends beyond traditional sales to include “a sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition (including a deemed disposition, for example, under section 877A).”

The third category, net gain on the disposition of property is potentially the broadest of the three categories of income included in net investment income. The term “disposition” as defined in the regulations extends beyond traditional sales to include “a sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition (including a deemed disposition, for example, under section 877A).”17 This broadly defined term would include option payments received upon expiration of an option as well as S corporation shareholder distributions in excess of basis (treated as a deemed sale). Dispositions would also include casualty or other losses attributable to theft or abandonment. The net gain, however, cannot be reduced below zero to result in a net loss for NIIT purposes.18 Like the Other Income category, the net gain is not required tobe earned in the “ordinary course” of a trade or business to be excluded from net investment income. The property disposed of must only be held in a trade or business that is not a passive activity or financial trading. Additionally, special rules will apply in the disposition of partnership interests or S corporation stock.19

Passive Trade or Business and Traders Trading in Financial Instruments

As discussed above, once the proper category of income is determined, the relevant inquiry is whether:
(1) that income is attributable to a trade or business of the S corporation;
(2) whether that trade or business is trading in financial instruments or commodities; and if not,
(3) whether that trade or business is passive to an individual shareholder (the ultimate owner of the income and taxpayer).

Also note that Portfolio Income is required to be derived in the ordinary course of a trade or business to escape inclusion in net investment income. Example 4 to Regulation Section 1.1411-4(b) illustrates this analysis in the context of an S corporation bank. In the case of an S corporation bank, interest income from the entity’s loan portfolio will qualify as derived in the ordinary course of a trade or business under Reg. Section 1.469-2T(c)(3)(ii)(A), which excludes from the definition of portfolio income interest on loans and investments made in the business of lending money. Whether the income is included in net investment income, therefore, depends on whether the bank is engaged in trading financial instruments or commodities, and whether that income is considered passive to an individual shareholder.

Trading in Financial Instruments and Commodities

Regardless of shareholder involvement in the activities of the S corporation, income allocated to the shareholders will be included in their net investment income to theextent it is derived from the trade or business of “a trader trading in financial instruments. . .or commodities. . .”20 The regulations go on to define financial instruments to include: stocks and other equity interests, evidences of indebtedness, options, forwards or futures contracts, notional principal contracts, any other derivatives, or any evidence of an interest in any of the items aforementioned items including short positions.21 While loans made to customers of a bank are financial instruments under this definition, the regulations imply that such business activities engaged in by a bank would not be considered “trading in financial instruments” for purposes of the NIIT. 22

There is some concern, however, that the term “trader” is not clearly defined in the regulations. Some taxpayers have indicated that without clear guidance, it is ambiguous whether some activities engaged in by S corporation banks might be considered trading in financial instruments, subjecting shareholders to additional NIIT on that income. On October 29, 2013, the American Bankers Association (“ABA”) wrote a letter to the Service requesting additional guidance regarding the definition of “a trade or business of trading in financial instruments or commodities” under Section 1411(c)(2).23 The ABA raises the concern of its members that certain banking activities such as the
origination of loans including residential mortgages, small business loans and other activities engaged in by S
corporation community banks where those loans are then sold to other institutions could fall within the definition of trading in financial instruments. This concern does not extend to loans and other financial instruments held by the
banks, but only those instruments that are sold to other institutions.

The ABA reasons that the Service likely did not intend for such treatment, based on the example to the regulations stating that an S corporation engaged in the banking business is not in a trade or business of trading in financial instruments. They also note the fundamental difference between a bank’s relationship with its customers for
whom it is originating loans and the activities of a “trader” seeking profit from “short-term market swings.” While it is likely the Service did not intend for the business of banking to be subsumed within the definition of trading in financial instruments, without clear guidance to that effect, there is some inherent risk in taking that position with respect to an S corporation bank’s calculation of its net investment income. The Service has yet to issue guidance regarding application of Section 1411(c)(2) to the business of banking.

Passive Activity and Material Participation
Having classified the activity of the S corporation bank as other than trading in financial assets, the final inquiry is the participation of the shareholder (taxpayer) in the trade or business. Income derived from a trade or business that is not “trading in financial instruments” must not be passive with respect to the taxpayer to be excluded from net investment income.24 This requirement focuses on the individual shareholder to whom the income is allocated. Section 1411(c)(2)(A) and the regulations reference Section 469 for determining whether a trade or business is passive with respect to a taxpayer. Section 469 and the regulations thereunder (known as the passive activity loss rules) restrict the ability of taxpayers to artificially generate passive income from certain types of passive activities. Therefore, the NIIT generally relies on these passive activity rules already in place for determining whether a trade or business is passive to a taxpayer. The regulations, however, are careful to note that Section 469 passive activity is broader in scope than passive activity for NIIT purposes under Section 1411(c)(2)(A). Therefore, not all of the Section 469 rules are applicable
to the NIIT – only those specifically referenced in the final regulations, including the rules for recharacterization of passive income and regrouping discussed herein

The key underpinning to the Section 469 rules is “material participation.” Section 469 defines a passive activity as any Section 469 trade or business activity in which the taxpayer does not materially participate, including most rental activities.25 These rules also allow a taxpayer to combine multiple activities together (grouping) to assess material participation. Therefore, before examining the taxpayer’s participation with respect to a business activity, it is necessary to ascertain whether it is beneficial to group multiple activities together to treat as a single activity to meet the “material participation” threshold.

Under Reg. Section 1.469-4, a taxpayer may group together certain activities to treat trade or business activities together or on an individual basis for determining whether they are passive. These grouping rules allow taxpayers to aggregate their participation across several related trades or businesses for purposes of meeting the material participation threshold. The final regulations also allow for a regrouping of activities on a taxpayer’s amended return in the case of certain changed circumstances. The regulations, however, did not go so far as to allow regrouping at the entity level. Partnerships and S corporations are not allowed to regroup on the theory that the owners of the entities, rather than the entities themselves, are subject to the NIIT. Therefore, allowing entities to regroup would extend this benefit to other entities whose owners are not subject to the NIIT. Further, a grouping of activities made by a pass through entity such as an S corporation cannot be treated as separate activities by the shareholders of that S corporation. 26 The shareholder can, however, group that activity with one or more separate activities conducted by the taxpayer either directly or indirectly through other entities.

In each case, multiple trade or business activities may only be grouped as a single activity if the activities constitute an “appropriate economic unit.” 27 This appropriate economic unit test is based on the relevant facts and circumstances of a given situation and includes factors such as:
• similarities and differences in types of trades or businesses;
• (ii) the extent of common control;
• (iii) the extent of common ownership;
• (iv) geographic location; and
• (v) interdependencies among the activities.28

Once an appropriate grouping is determined by the taxpayer, the “material participation” requirements are applied to determine whether the activity is passive with respect to the taxpayer. 

The “material participation” for a given tax year can be satisfied in a number of ways including:
• a total of 500 hours of participation in the activity;
• (ii) participation constitutes substantially all of the participation by all individuals;
• (iii) participation for at least 100 hours and no other individual participates more;
• (iv) participation for at least 100 hours in a significant participation activity and participation in all significant participation activities totals 500 hours;
• (v) material participation in the activity for any tax years; or

• (vi) for personal service activities – material participation for any three tax years preceding the current tax year.

These various tests provide wide latitude (especially when combined with the grouping rules) for taxpayers to qualify for material participation and prevent income from inclusion in net investment income. Finally, significant planning opportunities may exist with respect to disposition of a business activity or property that otherwise might be deemed a passive activity under the regulations. If a taxpayer can meet the “material participation” requirements with respect to the activity in the year of disposition, NIIT may be avoided on potentially large net gains.

Returning to the example of the S corporation engaged in the trade or business of banking, the final step is determining whether the interest income from the bank’s loan portfolio is included in a shareholder’s net investment income depends on whether that shareholder’s involvement in the business satisfies any of the tests for “material participation” set forth above. For example, officers of the bank that own stock would no doubt meet the 500 hour rule. Additionally, directors of the bank who hold stock may also be able to exclude their allocation of income under the material participation rules based on the extent of their involvement in the activities of the bank. If the shareholder in question meets any of the abovedescribed tests, income allocated to the shareholder will not be included in net investment income and not subject to the tax.

As should be abundantly evident, the NIIT rules are quite complex and care is required to navigate them without inadvertently triggering a potential large tax burden on net investment income. With mindful planning, however, taxpayers may be able to effectively manage exposure to the NIIT. In subsequent issues, we will address other issues related to the NIIT including the new Proposed Regulations relating to distributions of S corporation stock and special issues when dealing with electing small business trusts (ESBTs) and qualified subchapter S trusts (QSSTs).

1 I.R.C. § 1411(b) (the threshold amount for married taxpayers filing separate returns is one half the joint filing amount).

2 I.R.C. § 1411(d) (includes adjusted gross income increased by the excess of (1) the amount excluded from gross income under section 911(a)(1), over (2) the amount of any deductions or exclusions disallowed under section 911(d)(6) with respect to the section 911(a)(1) amount).

3 I.R.C. § 1411(a)(2).

4 I.R.C. § 1(e); Rev. Proc. 2013-35.

5 Treas. Reg. § 1.1411-3(b)(1)(v).

6 Id.

7 I.R.C. § 1411(c)(2).

8 I.R.C. § 1411(c)(1)(A).

9 I.R.C. § 1411(c)(1)(B).

10 I.R.C. § 1411(c)(2).

11 See Treas. Reg. § 1.1411-4(b)(3) Ex. 1,2 & 3 (evaluating the trade or business activity at the entity level).

12 Whether the activity is considered a trade or business will be determined in accordance with Code section 162.

13 Treas. Reg. § 1.1411-4(b)(2)(i).

14 Treas. Reg. § 1.1411-4(b)(2)(ii).

15 Treas. Reg. § 1.1411-6(a).

16 Treas. Reg. § 1.1411-4(c).

17 Treas. Reg. § 1.1411-4(d)(1).

18 Treas. Reg. § 1.1411-4(c)(2).

19 Prop. Reg. § 1.1411-7.

20 Treas. Reg. § 1.1411-5(a)(2).

21 Treas. Reg. § 1.1411-5(c)(1).

22 Treas. Reg. § 1.1411-4(b)(3) Ex. 4 (stating that an S corporation engaged in a banking trade or business is not a trade or business of trading in financial instruments or commodities under Reg. Sec.1.1411-5(a)(2)).

23 Guidance Regarding Application of the Net Investment Income Tax to Certain Activities of an S Corporation Bank, American Bankers Association, October 29, 2013 (http://www.aba.com/Tools/Function/Acct/Documents/ABAlettertoIRS(SCorpNIITGuidance).pdf.

24 I.R.C. § 1411(c)(2)(A).

25 I.R.C. § 469(c).

26 Treas. Reg. § 1.469-4(d)(5).

27 Treas. Reg. § 1.469-4(c)(1).

28 Treas. Reg. § 1.469-4(c)(2).

Purpose of a Shareholder Agreement
A shareholder agreement is a contract between and among the shareholders of a corporation and potentially the company as well. Shareholder agreements can do all of the following:
• Create limitations on the number and type of shareholders that may own a company’s stock;
• Create the mechanisms to allow existing shareholders or the company the option to acquire any shares prior to their being sold or transferred to a new shareholder;
• Ensure that certain administrative functions and securities laws are complied with throughout future transfers of the stock;
• Create unilateral or mutual obligations and duties on the part of shareholders or the company;
• Outline the methods and process for determining fair market value of the company’s stock and any related disputes; and
• Establish programs for shareholder liquidity.

All of these considerations and related provisions may impact the value of a company’s stock and the ability to ever realize that value. Taking the time to understand the shareholder agreement is of critical importance for all shareholders. Taking the time to periodically review the shareholder agreement and ensure its ability to achieve
its intended purpose and provide the greatest benefit to the company and shareholders is the job of the board of
directors.

S Corp Shareholder Agreements
Shareholder agreements serve an obvious purpose in the context of S corporation bank holding companies,protecting the S election. A sturdy shareholder agreement dedicated to that end is important given the value the S election creates for shareholders and the drastic consequences that can result from a termination of the S election. However, many shareholder agreements fail to do just that. In addition, these same shareholder agreements fail to capitalize on the opportunity they provide to establish, protect and realize shareholder value by serving as a relationship management tool. The shareholder agreement serves as a tool to manage the relationships between each shareholder in relation to one another as well as the relationship between each shareholder and the holding company. When initially drafted, the shareholder agreement probably served its purpose well enough given the desire to make the election to convert or form as an S corp and other common goals of the shareholders at that time. Over time, however, the shareholder base and the nature of these relationships have likely changed. Therefore, as a relationship management tool, the shareholder agreement must be periodically revisited to ensure it properly reflects the existing relationship status among shareholders.

Preparation
Protecting the S election and accretion of shareholder value throughout the holding company’s lifecycle requires a long-term, holistic approach to drafting a shareholder agreement. Within this article I operate under an assumption that an S corp holding company already has a shareholder agreement in place, but that it has not been refreshed or redrafted in some time. What do I mean by long-term? 20-30 years. What do I mean by holistic? First, the holding company board must look at the bank’s or banks’ history including: asset growth; loan and deposit mix; economic development, stagnation, or decline in its markets; and employee productivity, retention, and satisfaction. Second, the board must review the current state of affairs including: current performance compared to budget and outlook for the balance of the year; three year budget and strategic plan, with special focus on the capital plan; and succession plan or lack thereof. Third, the board must take all of the factors discussed in the first and second point and project those over the long-term time horizon. Fourth, the board must review the historic and present dividend policy or practice of the holding company, now benefited by an informed view of the historic, present and future considerations of the bank, allowing the board to balance the needs of the holding company with those of the bank. Last, the board should review the shareholder history of the holding company and where it stands as of today. This discussion should include the likelihood of near-term transfers and expected transfers that may be to a large group or involve complicated estate planning techniques. While it is never fun to discuss the possibility of the death of a shareholder, especially when they are in the room, it is a necessary conversation to have if the board is serious about maximizing the value of the shareholder agreement refresh. With this thorough cataloging of the situation, the board should be well positioned to tailor the provisions of the shareholder agreement to (i) strengthen protection of the S election, (ii) create accountability for those who threaten the S election, and (iii) accrete value to the holding company through improved relationship management.

A corresponding review of the bylaws and shareholder certificate should be conducted when reviewing the shareholder agreement to ensure consistency and compliance.

Strategic Planning Commentary
The process described above, while onerous, provides a tremendous opportunity to discuss opinions, biases, projections, and prophecies that were true or false, and why. In doing so, lays a predicate for challenging or
accepting the same as they relate to the future.

Protecting the S Election
The range of tools to protect the S election (read, restrict transfers of holding company stock) is quite broad. This
article does not attempt to provide the reader with a series of matching provisions given a certain situation; rather,
it provides an outline of options to consider given a holding company’s desire to be more or less restrictive in relation to management of shareholder numbers and the possibility for inadvertent terminations of an S election if shareholders themselves are not managed.

IMPORTANT NOTE: The provisions discussed below only work to the extent they are enforced. Many inadvertent
terminations are caused not by the lack of certain provisions in a shareholder agreement, but rather by the failure to enforce the provisions.

Preemptive Rights: The articles of incorporation (certificate of formation) should specifically allow or deny preemptive rights. If a holding company permits preemptive rights, all shareholders have the ability to purchase the necessary number of shares issued with any future issuance of common stock, and, therefore, avoid being diluted.

Notice of Proposed Transfer: The decision of whether or not to include a notice of proposed transfer provision can have more of an impact than many might realize. If the provision is not included in a shareholder agreement or is limited, the presumption will be that any transfer by a shareholder abides by the shareholder agreement and any transferred stock will only be evidenced upon the books of the holding company at the time it is brought to the holding company’s attention, assuming the transfer was a permitted transfer. Leaving this provision out of a shareholder agreement and allowing the burden of qualifying the transferee as an eligible S corp shareholder on the transferor may provide the holding company with a good faith argument that it was unaware of the ineligible status or terminating event, when dealing with an inadvertent termination situation. We recommend a proactive approach including a notice provision for any transfers, including permitted transfers.

If the board does decide to include a notice of proposed transfer in the shareholder agreement, the board must
decide when and to what degree the notice will apply. The notice may apply to all transfers, permitted or otherwise,
or only those that are non- permitted transfers. If the notice of proposed transfer is expansive enough to include
prior notice for all transfers, the board will have the opportunity to review any proposed transfers for compliance
with the S corp and shareholder agreement requirements. The board’s obligation in a transfer situation will be to
timely review, evaluate for compliance with S corp and shareholder agreement requirements, and respond to the
shareholder with a decision. Including this provision in the shareholder agreement creates an affirmative duty on
the board which will require that they have the ability to appropriately determine whether or not a shareholder
qualifies as an S corp shareholder. If the board was to approve a transfer that caused the termination of the
S election, it would be difficult to argue that the termination of the S election was inadvertent and should be
reinstated without a penalty. Therefore, we recommend that this provision include a clause that allows the board
to obtain the opinion of an attorney with the cost to be borne by the transferring shareholder. As noted above, this
provision only works if it is consistently enforced by the holding company.

Prohibited Transfers: A prohibited transfers provision should prevent transfers to any party that would
terminate the holding company’s S election or violate the terms of the shareholder agreement. This provision may
also be expanded to include additional detail about specific types of prohibited transfers and a reiteration that any
decision making shall be conducted by the board in its sole discretion.

Permitted Transfers: The permitted transfers provision (potentially used as both a sword and shield) of a
shareholder agreement is one of the areas that requires the most discussion among the board. If you are too
restrictive in provisioning for permitted transfers, you are going to deal with the ire of frustrated shareholders; if
permitted transfers are too broad, you risk having your shares widely held by estate planning mechanisms such as
trusts, exposing you to increased risk of an inadvertent termination. To navigate these waters, the board will need
to balance the holding company’s desire for future capital with shareholder numbers and the needs and desires
of the shareholder base for estate planning flexibility. There is no right or wrong list of permitted transfers, and
the board will have to engage in detailed discussions among themselves and their attorney to work through all of
the possible pros and cons of each addition or deletion from the list. What should result from these discussions
is a list of permitted transfers that optimize the holding company’s shareholder base over time without creating
unnecessary risk of an inadvertent termination.

In addition to the examples of permitted transfer provisions provided below, the board can also require shareholders
to be actively involved (as further defined by the board) with the holding company or the bank in order to be a
shareholder. An active involvement clause in the permitted transfers provision has the potential to frustrate many
shareholders and, especially, devisees of shareholders who may not live in the markets served by the holding
company or bank. The board can, however, make a finding that it is in the best interest of the bank to have holding
company shareholders who can contribute in meaningful ways, as opposed to absentee shareholders who simply
collect dividends.

The bottom line is that determining the list of permitted transfers can create a lot of disagreement between the
board members due to varying opinions on the bank’s future and individual concerns about estate planning. The
key here is to remind the board that their duty is to do what is best for the holding company and its shareholders
with all of the information currently available.

Right of First Refusal: This is one of the most common provisions in an S corp shareholder agreement. This
provision can be a standalone section of the shareholder agreement or contained in the “purchase right” provision
that is tied to any transfers which do not fall under the permitted transfers provision. Typically, anyone designated
in the shareholder agreement as having the right of first refusal (a “right holder”) is entitled to purchase the shares
of any shareholder who undertakes to sell or transfer their shares to a party not included as a permitted transferee.
The typical right holders are the holding company and any shareholder of the holding company at the time of the
proposed sale or transfer.

Rights of first refusal can be structured in a number of ways related to both who is a right holder and when it is applied.
Some examples include: company only; shareholder only; company and shareholder; applied to all transfers;
applied to non-permitted transfers; applied to transfers for nominal value or gifts; and applied upon the death of
shareholder.

Once a shareholder receives an offer to have his or her shares purchased or decides to make a transfer to a nonpermitted transferee (the shares to be sold or transferred are referred to as “offered shares”), the selling shareholder is required to provide written notice of the bona fide offer (an offer for value at or around fair market value) or proposed transfer to the holding company; the holding company will make a determination as to whether or not to purchase the shares. The determination by the board to exercise its right to purchase the offered shares (some or all) must be completed within a timeline identified in the shareholder agreement. When a selling shareholder desires to sell their shares pursuant to a bona fide offer, the right holder or holders purchase the offered shares at the same price as in the offer. If the proposed transaction involves a transfer of shares not for value (not a bona fide offer), the shareholder agreement must address how to determine the purchase price to be paid by the holding company or non-selling shareholders. The determination of fair market value in such a situation is worth discussing in detail. Most controversies regarding the price of the stock can be dealt with in the shareholder agreement if sufficient time is dedicated to creating the mechanisms for establishing the fair market value or resolving any dispute related to fair market value. If the holding company decides not to exercise its right, the remaining offered shares are offered to any other right holders including non-selling shareholders. Exercise by the non-selling shareholders may be done on a pro rata basis in rounds until all offered shares have been purchased or by simply making the offered shares available to the non-selling shareholders on a first come, first served basis. This process is also guided by a timeline set forth in the shareholder agreement.

The shareholder agreement can also dictate whether to allow a transfer of shares for anything other than value, and therefore, limit the transfer of shares by a shareholder only to permitted transferees or a bona fide
purchaser.

Assuming that a right of first refusal is desired, it must be structured to anticipate and accommodate a wide range of situations. Further, the right of first refusal is only effective at limiting the transfer of shares if the holding company or non-selling shareholders are able to step-up and exercise the right.

Death of a Shareholder: Procedures for the death of a shareholder and documentation of such an event is critical to utilizing the shareholder agreement as a “shield.” What do you do upon the death of a shareholder? Simple answer, do not transfer the shares on the books of the holding company until you have written evidence from an experienced attorney stating that the transfer is to a permitted S corp shareholder (this assumes completion of all necessary elections and filings). In order to protect the holding company from the risk of an inadvertent termination, it is critical that the board understands the estate plans of a shareholder at death. Our recommendation of best practices includes creating an affirmative obligation on the part of a shareholder to provide estate planning documents to the holding company and a requirement that each shareholder annually certify whether a transfer has taken place. These administrative processes are one of the burdens that accompany the substantial benefit of being an S corp bank.

Within the context of permitted transfers and rights of first refusal, a shareholder agreement may contain a provision specifically dealing with the limitations imposed on the transfer of shares upon the death of a shareholder. Specifically, a shareholder agreement may provide that the right of first refusal is triggered if the shareholder’s estate does not provide evidence of a qualifying transfer within some specified time period of the death of the shareholder, we would recommend no later than 18 months. Further, a shareholder agreement can limit the transfer of shares to a certain
number of shareholders, regardless of whether they are considered a “family member” under section 1361 of the Code. This is often times part of a broader “slotting” arrangement outlined in the shareholder agreement, which is used to limit the overall number of shareholders and, typically, maintain some arbitrary number of shareholders established by the board years ago. Many shareholder agreements were drafted prior to 2004, when the number of permitted S corp shareholders was increased from 75 to 100 and the definition of “family member” was added to section 1361 of the Code.

At a minimum, any S corp shareholder agreement should contain a provision requiring proof of the eligibility of proposed new shareholders upon a shareholder’s death, and allow the holding company’s attorney to review the estate transfer documents to ensure this fact.

Slotting: As mentioned above, “slotting” was commonly used when the shareholder limit was 75 and the family members were not treated as a single shareholder. Slotting controlled the number of shareholders, while providing an equitable structure to provide larger shareholders with some ability to transfer shares. Slotting was particularly 6 generations of one family to be treated as one S corp shareholder because it was a balanced way to recognize a shareholder’s ability to transfer shares based on the amount of shares held. For example, a 20% shareholder might be given 5 slots while a 5% shareholder might only have one. Many of the slotting arrangements that were in early S corp shareholder agreements are still in place now.

The expansion of the S corp shareholder limit to 100 and collapse of “family members” into a single shareholder make a slotting arrangement unnecessary today, and even cause conflict with these new shareholder provisions. If a shareholder agreement contains a slotting arrangement, we recommend redrafting the shareholder agreement to incorporate other concepts discussed in this article that can accomplish the same result without being unduly restrictive.

Joinder Agreement: A joinder agreement provision and exhibit is crucial to any shareholder agreement. A properly drafted joinder agreement provision will notify the existing shareholders that their attempts to transfer their shares will not be valid unless, among other things, the new shareholder executes the joinder agreement. The joinder provision is usually incorporated into a broader provision regarding a transfer on the books of the holding company as the
only “true” evidence of a transfer.

The joinder agreement should recite that the new shareholder has read the shareholder agreement and agrees to have himself/herself/itself bound by the shareholder agreement and contain a provision that affirms that he/she/it is a valid S corp shareholder and will not terminate the S election of the holding company.

Shareholder Liability for Taxes: A simple but important provision of the shareholder agreement is one requiring the shareholders to agree and acknowledge that they are responsible and liable for all federal, state, and local taxes owed due to their ownership in the holding company, regardless of its ability to pay a dividend for such amount. This provides an opportunity to include a provision or section outlining the holding company’s dividend policy. Some of these provisions only contemplate a dividend for payment of estimated tax liability based on the federal, state, and local taxes imposed on a resident in the same location as the holding company while others discuss dividends as a certain percentage of net income, assuming the maintenance of certain capital ratios. These are case specific considerations
that are outside the scope of this article. And while dividend provisions are certainly recommended, they would not supersede a regulatory-imposed limitation on dividends, an increasingly important issue post-Basel III.

Liability for Expenses Related to an Inadvertent Termination: As the shares of many S corp holding companies have become widely held, the risk of an inadvertent termination has greatly increased. Many shareholder agreements fail to
include a provision that provides for direct liability for or requires reimbursement from a shareholder who
terminates the S election. In the event that the holding company’s S election is terminated, the cost of filing a private letter ruling with the Internal Revenue Service is $18,000 – excluding investigation of the facts and circumstances surrounding the terminating event and attorney’s fees.

Best practice is to play offense with your shareholder agreement by requiring annual certifications of transfers and attorney review of any transfers to ensure S corp shareholder eligibility. As an added protection to the holding company, however, the shareholder agreement should contain a provision requiring shareholders who trigger an inadvertent termination to pay all expenses incurred on behalf of the holding company and any other shareholders.

Conclusion
The S corp shareholder agreement should function in such a way as to avoid uncertainty and disagreement in
dealings among individual shareholders and between shareholders and the holding company. As such, it is critical to review shareholder agreements periodically to ensure they remain relevant and effective related to their intended purpose. Further, as years pass, and a company evolves, the shareholder agreement must be reviewed and refreshed to take into account the changes that the bank, holding company, and shareholders have encountered. While this article illustrates several provisions that can increase the effectiveness of a shareholder agreement as a relationship management tool, by no means have we presented an exhaustive list of the provisions vital to an effective shareholder agreement. A number of other provisions can impact shareholder value and increase or mitigate risk, specifically control and liquidity provisions. If you have any questions regarding the provisions referenced in this article or other shareholder agreement provisions, please do not hesitate to contact us.

The genesis of the Subchapter S Bank Association came from the desire to drive value for community banks and
their shareholders. During the last 17 years the Association has continued to work to protect that value and identify
other ways in which Sub S banks can maximize their returns.

The Association now looks forward to providing its members with new and exciting ways to improve their sources of revenue and reduce expenses. The first such rapidly emerging trend and opportunity we see is in the mobile banking sector. See Wall Street Journal article entitled “Lenders Place Their Bets on Mobile Banking,“ which was run on April 9th, 2014 (http://tinyurl.com/luatw4u). We ask that you respond to the Mobile Banking Survey that was linked in the email you received to download the newsletter or by visiting (http://tinyurl.com/lyhsxts) to help us better identify the opportunity. What you can count on from the Association is that we will ensure our members have the best available information
in our Sub S Bank Reports with a focus on the highest standards from a regulatory and best practices point of
view.

The 17th Annual Subchapter S Bank Association’s Annual Conference is being held on October 23-24th, 2014 at The Hilton Palacios Del Rio in San Antonio, Texas. We also will be hosting the 2nd Annual Community Banking in a New World Conference the day before on October 22nd at The Hilton Palacios Del Rio. Both are great conferences to attend packed with useful information and networking opportunities with others in the industry. To register for the conference visit www.subsbanks.org.