The Sub S Bank Report – December 2010 (Volume 13, Issue 4)

On December 17, 2010, the hotly-debated tax extender legislation cleared its final hurdle when President Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 into law. 

Although rigorously disputed on both sides of the aisle, Congress ultimately approved the bill by surprisingly-large bipartisan majorities, passing the bill 277-148 in the House and 81-19 in the Senate.  The law extends all Bush-era tax cuts for two years, thereby maintaining individual tax rates at 10, 15, 25, 28, 33 and 35 percent, respectively, through 2012.  While the continuation of these tax breaks is important to most Americans, the extensions are particularly critical for shareholders of Subchapter S corporations due to the fact that they are also taxed on the earnings of the S corporations in which they are shareholders.  If Congress had failed to pass the bill, individual tax rate brackets would have reverted to 15, 28, 31, 36 and 39.6 percent, a substantial increase from the current, and now newly-extended, tax rates.

The law also extends the 15 percent tax rate on long term capital gains and dividends through 2012.  Significantly, the extensions keep the tax rate on qualified dividends at 15 percent, preventing rates from jumping to a maximum level of 39.6 percent for earners in the highest tax bracket.  Such drastic increases undoubtedly would have a significant negative impact on many Subchapter S bankers and shareholders.  This extension is intended by many legislators to provide Congress the necessary time to formulate a more permanent solution to the many issues created under the current tax regime.

Also incorporated into the law are temporary relief provisions with respect to a number of other items.  The law provides for a maximum estate tax rate of 35 percent and a nontaxable threshold of $5 million ($10 million for married couples) for the estates of decedents dying on or after January 1, 2011 and on or before December 31, 2012.  Correspondingly, the law provides for a maximum tax rate of 35 percent and a $5 million dollar exclusion for gifts made through December 31, 2012.  Charitable incentives, such as tax-free distributions from IRAs when made for charitable purposes, are also extended through 2012.  The amount of Social Security tax levied on employees is reduced from 6.2 percent to 4.2 percent in calendar year 2011 for wages earned up to $106,800, creating potential tax savings of up to $2,136 per employee; however, both the employer’s share of Social Security taxes and Medicare tax rates remain unchanged by the law.  A two-year “patch” for the Alternative Minimum Tax (AMT) providing higher exemption amounts is also included in the law to reduce the burden of the AMT on middle-class taxpayers.    Finally, several important tax credit programs set for expiration after 2010 are temporarily extended through 2011, including the New Markets Tax Credit Program and the basis adjustment permitted to the stock of S corporations making contributions of property.

Although none of these provisions is permanent,  all are a welcome reprieve from the potential for tax increases in a still uncertain economy.  The Subchapter S Bank Association is committed to developing and promoting sound solutions to its members’ unique organizational tax implications, and as such, will diligently monitor these extensions over the course of the next two years.

Earlier this month, the Internal Revenue Service (IRS) issued an Action on Decision letter announcing that it was acquiescing to the Seventh Circuit Court of Appeals’ decision regarding the long-fought TEFRA disallowance appeal. 

In March of this year, the Seventh Circuit ruled in favor of the Vainisi Appellants—as well as the greater Subchapter S bank community—holding that the 20% TEFRA disallowance applies to Subchapter S and qualified Subchapter S subsidiary (QSub) financial institutions only for the first three taxable years after they elect Subchapter S tax status.

To recap, the TEFRA disallowance refers to a 20% reduction in the amount of a financial institution’s deductible interest expense attributable to its investments in qualified tax-exempt obligations. Financial institutions organized as C corporations are required to take the 20% TEFRA disallowance in every year in which they have any such interest expense. The Vainisi Appeal centered on whether the TEFRA disallowance should apply to S corporation financial institutions in the same manner. The IRS unsuccessfully argued that it did.

While the Court’s March decision was marked as a victory in the case, and many bank shareholders have already undergone the process of amending previous years’ returns, there has been some trepidation among banks outside of the jurisdiction of the Seventh Circuit that feared that the IRS might still interpret the TEFRA disallowance provisions according to the earlier U.S. Tax Court decision, though it was ultimately reversed by the Seventh Circuit. 

With the issuance of the letter, the IRS has opened the door for all shareholders of Subchapter S financial institutions to receive the 100% deduction for years beyond the initial three years following their institution’s S election. With the assistance of our friends at The Baker Group, we have determined that the cumulative impact of the TEFRA decision for 2010 will be approximately $16.8 million. Shareholders are advised to consult their tax professionals regarding refunds for previous tax years and in planning for 2010 tax returns.

The Subchapter S Bank Association was the driving force behind the TEFRA appeal, raising in excess of $100,000 to continue the fight to the Seventh Circuit. We are deeply grateful for all of the support we received from the Subchapter S bank community, industry professionals, the various state community banking associations, and most importantly Debra Koenig and her team at Godfrey & Kahn for all of the time and effort they put into arguing the appeal.

Subchapter S financial institutions today need shareholder agreements. Over the years, as the rules relating to S corporation ownership have evolved, so too has the complexity of ensuring compliance with the shareholder restrictions placed on S corporations. Such is particularly the case for Subchapter S banks and bank holding companies, whose shareholder compositions often consist of large family groups, complex trusts and the occasional IRA. One effective tool for managing all of this is the shareholder agreement.

A well-drafted shareholder agreement should clearly spell out what types of investors are permitted to own stock in the institution, and the restrictions on any share transfers. The agreement should generally prohibit any transfer of shares that would result in the inadvertent termination of the organization’s Subchapter S election. Likewise, it should contain a legend, which should also be printed on the back of each stock certificate, notifying potential acquirers of shares of the existence of the shareholder agreement and that any transfers are subject to federal and state securities laws and regulations.

A shareholder agreement, in its basic form, serves as a valid and enforceable contract between two or more parties governing some aspect of ownership in a corporation. In the case of S corporations, because they are limited in the number and types of permissible shareholders, it is important that the entire shareholder group be a party to the shareholder agreement because a single transfer can serve to invalidate the organization’s valuable Subchapter S election.

Understanding the advantages of shareholder agreements can allow Sub S institutions to specifically tailor a shareholder agreement to address the precise needs of the organization. Management should discuss with legal counsel and consider a number of factors prior to drafting an agreement or revising an existing one. The starting point for all shareholder agreement discussions should be focused on the organizational outlook and the philosophy of the controlling shareholder group.  For instance, if an organization consists primarily of passive investors, provisions within the shareholder agreement may be better structured to allow greater control by the majority interest holders. Conversely, if the organization is made up of shareholders who actively participate in the affairs of the organization, a different structuring of the agreement may be more appropriate. In any case, particular emphasis should be placed on maintaining the institution’s Subchapter S election and preventing its inadvertent termination.

Subchapter S Status & Tax Liability

At a minimum, shareholder agreements for Sub S financial institutions should include provisions clearly placing shareholders on notice of the intent of the organization to operate as an S corporation, the tax liabilities associated with S corporation ownership, the restrictions on permissible shareholders and share transfers, and any indemnification measures relating to a shareholder’s invalidation of the organization’s S election. Additional provisions should be included as necessary for the unique nature of the particular organization.

It is important that all shareholders, as well as potential acquirers of stock, have sufficient notice of an institution’s Subchapter S status and the shareholders’ resulting tax liabilities. A shareholder agreement should plainly state that the institution has elected Subchapter S status and that as an S corporation, its earnings (and losses) will be “passed through” or taxed to the shareholders on a pro rata basis at their individual federal tax rates. The agreement should further state that shareholders will be responsible for their individual tax liabilities stemming from the organization’s earnings regardless of whether any dividends or cash distributions are paid. While it is typical practice for Sub S institutions to make cash distributions to cover their shareholders’ tax liabilities, they cannot assure that such distributions will always be made. For example, state and federal bank regulatory agencies possess the authority to prohibit banks and bank holding companies from paying dividends, even if an institution has positive earnings. It is therefore critical that shareholders understand and acknowledge these obligations.

Share Ownership and Transfer Restrictions

Because S corporations are “pass-through” entities, they are restricted in the types and number of shareholders they may have. In general, only individuals, estates and certain trusts qualify to own S corporation stock. Additionally, S corporations may not have more than 100 shareholders; however, for purposes of determining the number of shareholders, all “members of a family” are treated as a single shareholder. The term “members of a family” is defined under Subchapter S of the Internal Revenue Code (IRC) to generally include all family members within six generations, as well as their spouses and ex-spouses. Failure to adhere to these requirements will cause an inadvertent termination in the entity’s S election. In the case where an existing shareholder proposes to transfer his/her shares, whether by gift, sale or otherwise, the agreement should require the shareholder to first notify the institution of the proposed transfer and all material terms. This will allow the institution to verify that the transferee qualifies as a shareholder under the terms of the shareholder agreement.

Company/Shareholder Purchase Rights

Often, a shareholder agreement will  contain repurchase provisions granting the institution a right of first refusal to repurchase any shares that are the subject of a proposed transfer. This can be beneficial to both the Sub S institution and the shareholders. It increases the marketability of shares that, due to the existence of the shareholder agreement and closely-held nature of the organization in general, otherwise may not exist. For instance, if a shareholder proposes to sell his/her shares to a non-qualifying individual or entity, the right of first refusal allows the organization to purchase those shares on the same terms as the proposed transfer. Additionally, closely-held organizations often want to maintain some control over who becomes a shareholder. A right of first refusal helps accomplish this objective. Another benefit is that when shares are repurchased by the institution, the remaining shareholders’ percentage of ownership increases.

Similar to a right of first refusal is a right of first offer. The right of first offer requires the selling shareholder to first solicit offers from the organization before seeking offers from third parties. If a shareholder elects to seek higher offers from third parties after first soliciting offers from the organization he/she may do so, but the shareholder may not sell the shares to a third party at a lower price or on other terms that are less favorable than those offered by the organization. If the terms offered by the third party are higher than the organization’s original offer, the organization has the opportunity to match the third party offer. The right of first offer is generally more preferential to selling shareholders because knowing that the organization will have the right to match a third party offer often discourages potential third party purchasers from exerting the effort to compute a competitive offer when to do so may be in vain.

A shareholder agreement can also be structured to include cross-purchase provisions, granting one or more shareholders the option to purchase shares from a selling shareholder or the estate of the deceased shareholder before the shareholder is allowed to pursue other buyers. Such a structure typically allows shareholders to purchase shares based on each shareholder’s pro rata ownership in the organization. This structure may be more appealing to an organization consisting of active shareholders or a large group of shareholders who may be capable of purchasing the shares when the opportunity arises.

Hybrid purchase provisions are also common in shareholder agreements for Sub S institutions.  Hybrid agreements derive their name from the fact that the agreement combines traditional repurchase provisions (right of first refusal or right of first offer) with cross-purchase provisions. Under such an agreement, the organization is given the option to purchase all or a portion of shares from the transferring shareholder, with the shareholder group granted the right to purchase the remainder of the shares after the organization has selected its course of action.  Drafting such an agreement can offer additional insulation to the institution’s Subchapter S election by granting another level of purchase rights in the event the organization is not in a financial position to repurchase its shares.

Repurchase, cross-purchase and hybrid provisions in shareholder agreements are not without certain risks. Minimum capital standards may render a bank or bank holding company unable to purchase shares at the moment the selling shareholder wishes to sell. Furthermore, problems may arise if the institution elects to purchase shares from one shareholder, but not others.  Another factor to consider is the method of determining the purchase price for shares that would otherwise be transferred for nominal or no consideration (e.g., by gift, bequest or in the event of a breach of the agreement (discussed below). Whether or not specific dates should be set for periodically valuing the shares, any deviations from GAAP and any discounts for minority and lack of liquidity should all be explained with specificity in the agreement.

The allowance for “permitted transfers” should also be taken into consideration when structuring repurchase provisions such as those described above. Permitted transfers generally allow shareholders to freely transfer shares to other shareholders within the organization or to other “members of a family” because such transfers would not jeopardize the organization’s Subchapter S status.

In the case of permitted transfers, or any other transfers that are ultimately approved by the Board of Directors, all transferees and their spouses should be required to become parties to the shareholder agreement. And if any shares are to be transferred to an individual claiming to be a “member of a family,” the institution should also require each such transferee to provide written documentation of his/her familial relationship(s). The latter requirement can be particularly useful in the event the institution is ever audited by the IRS.

Other Considerations

A typical shareholder agreement will also contain a number of other important provisions relating to the organization’s status as an S corporation. Shareholder agreements should include provisions addressing the voluntary termination of the organization’s Subchapter S election. The IRC requires a vote of the holders of at least a majority in interest to voluntarily terminate an S election; however, an organization may choose to require the approval of a greater majority if it so chooses.

Shareholder agreements should also contain indemnification provisions in the event a shareholder causes the inadvertent termination of the institution’s S election.   A shareholder can cause an inadvertent termination by transferring his/her shares (without approval from the organization) to a non-qualifying shareholder or to a number of individuals, thus causing the organization’s total number of shareholders to exceed 100. Often times when an organization’s Subchapter S election is inadvertently terminated, the organization does not learn of the termination until well after the occurrence of the event causing the termination. An inadvertent termination can give rise to additional, and potentially substantial, tax liabilities, including interest and penalties, for both the organization and the shareholders. A typical indemnification clause would require the shareholder causing the termination to indemnify the organization and the shareholders from any such liabilities.

Due to the potential pitfalls of Subchapter S status, all shareholder agreements should contain a provision nullifying any attempted transfer in violation of the agreement. Any such attempted transfers can also be treated as an offer by the offending shareholder triggering the organization’s and/or the shareholders’ purchase rights.

The incorporation of dispute-resolution procedures within a shareholder agreement is an invaluable method of decreasing risk and increasing organizational efficiency. Non-traditional dispute resolution processes such as binding arbitration provide a private and confidential forum for resolving disputes arising out of or in connection with the agreement. There is a strong policy in favor of the arbitration of disputes when it can be shown that the parties freely entered into the agreement to arbitrate. This policy is to such an extent that an agreement to arbitrate can be enforceable even when the underlying contract (shareholder agreement) in which it is located is invalidated.

Closely-held bank holding companies may choose to incorporate their bylaws directly into the shareholder agreement. This helps eliminate potentially conflicting terms between the company’s bylaws and its shareholder agreement. And, unlike a corporation’s bylaws, a shareholder agreement is executed by each individual shareholder, thereby providing increased organizational transparency. Similarly, a shareholder agreement may also set forth voting requirements necessary to act on both planned events and unforeseen or special events, similar to what would be contained in a voting agreement.

The above discussion addresses only a portion of the numerous provisions that should be considered when drafting or revising a shareholder agreement. A well-crafted agreement should comprehensively address the myriad of considerations relating to ownership of S corporation stock. And as a whole, a shareholder agreement should endeavor to facilitate a banking organization’s overall objectives with respect to its shareholder group.

Mr. Toppin is a partner with the law firm of Kennedy, Toppin & Sutherland, LLP in San Antonio, Texas and serves as the executive director of the Subchapter S Bank Association. His practice focuses on the representation of financial institutions throughout the United States on a variety of corporate, banking, securities and regulatory matters. He can be reached at (210) 228-4414 or by email at btoppin@ktsllp.com.

As we approach the New Year, there is a degree of uncertainty as to how the municipal market will adapt to the loss of several tax provisions that are scheduled to expire on December 31st, 2010.  The most widely talked about provision, the Build America Bond (BAB) program, had a profound impact in the muni sector, generating $179 billion in new issuance since inception.  While there has been significant interest in extending BABs beyond its slated 2010 expiration, with focus in Washington on extending tax cuts, unfortunately most of the muni tax provisions were left out of the recently-passed $858 billion Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act.  The most notable expiring provisions include:

• The small issuer exception for bank qualified bonds which increased the issuance limit from $10 million per year to $30 billion for 2009 and 2010 issues.

• The 2% “safe harbor” exemption which allowed financial institutions to treat the purchase of non-bank qualified bonds issued in 2009 and 2010 (excluding refunding issues) in the same manner as BQ issues with respect to avoiding the TEFRA disallowance (limited to 2% of the institution’s average adjusted total assets).

• The non-AMT provision that allowed for 2009 and 2010 non-refunding issues to be exempt from the calculation of the institution’s alternative minimum tax liability.

Indeed, these provisions had a remarkable impact on new issuance volume since the American Recovery and Reinvestment Act was signed into law in early 2009.  According to the Bloomberg’s Fixed Rate New Issuance Index, taxable volume alone surged to a near 900% increase from 2008.

BQ limit of $10 million was initially established in 1986 as part of the TEFRA bill.  Today this limit hardly reflects the same buying power as it did in 1986.  While the $30 million limit satisfies an inflation adjusted limit, it is still relatively low considering the current breadth of the muni market.  Regardless, the supply of BQ paper will be suppressed given that Congress decided to ignore attempts to extend the limit.  

While the ultimate fate of theses tax provisions is bleak, recent headlines related to doomsday scenarios of widespread defaults in the muni sector are overblown.  That is not to say that analyzing the creditworthiness of a municipality is unimportant.  The erosion of tax revenues will impact municipal balance sheets.  Historically the lag between declines in property assessed values to actual property tax collections during economic recessions is about two years.  Given the duration of the credit crisis that began almost three years ago, property tax revenues may not reach a trough until late 2011 or into 2012.  According to data compiled by the Rockefeller Institute and the Census Bureau, the year-over-year change in property tax revenues continued to increase throughout 2009.  Halfway through 2010, the rate of this increase started to wane while income and sales taxes began to show signs of returning to positive growth.  Most local general obligation bond issues are secured by property taxes.  It is critically important for investors to identify the level of property tax collections that would be insufficient to meet the debt service obligations on all outstanding GO debt pledged to those collections.  This, in addition to debt to assessed ratios, per capita debt, overlapping debt, coverage ratios, debt limit capacity, and fund balance or net asset changes are key steps in the credit analysis process.

We expect the municipal sector to experience continued price volatility in the near term as we move into 2011.  The price behavior will be mostly attributed to the supply shortage and headline risk.  Over the long term, demand for tax exempt income is expected to increase given the likely prospect for higher tax rates.  Due diligence is a necessity with respect to analyzing the muni portfolio’s credit risk.  This is also necessary before a purchase decision has been made.  Unlike the corporate sector, the transparency of the aforementioned credit metrics requires substantial research. While the information can be obtained within the bond’s official statement and financial statements, The Baker Group provides to current and prospective clients a Municipal Credit Profile Sheet for all bond offerings that highlight those metrics, among other data sets that will help investors begin the credit analysis process.  This information is also made available to clients using our Advanced Portfolio Monitor for further evaluation of the portfolio.