The Sub S Bank Report – December 2013 (Volume 16, Issue 4)

On May 10, 2013, the IRS issued final regulations under IRC Section 336(e) allowing sellers of certain domestic corporations, including subchapter S corporations, to make an irrevocable unilateral election to treat the sale of the corporation’s stock as a deemed sale of the corporation’s underlying assets, assuming certain requirements are met. Previously, this asset sale treatment was only available under the provisions of IRC Section 338(h)(10), which not only required the formal consent of both parties to the sales transaction (the buyer and the seller), but also restricted noncorporate purchasers and certain corporate purchasers from taking advantage of this potentially favorable tax treatment. Because the buyer has no role in making the 336(e) election, it is imperative that the purchase agreement reflect the intentions of both parties with respect to the election.

The Section 338(h)(10) Election
Assume that the target corporation is a subchapter S corporation. In circumstances where a buyer is paying a premium for the stock of the S-Corp, the buyer generally prefers to treat the transaction as a purchase of the underlying assets of the S-Corp. This allows the buyer to allocate the premium to the tax basis of the acquired assets on an asset-by-asset basis (similar to the book purchase accounting treatment that is typically applied) and might also result in a Section 197 intangible asset for which the buyer can take a tax deduction via amortization on a straight-line basis over 15 years. In addition, the S-Corp shareholders generally are indifferent to this asset sale treatment, as any potential net gain from the deemed sale of the assets, which would be reported on the shareholders’ Schedules K-1, would also increase those shareholders’ tax basis in the S-Corp stock – thus eliminating any double taxation from the asset sale.

IRC Section 338(h)(10) allows the buyer and seller to make a joint election to treat the sale of S-Corp stock as a sale of the underlying assets of the S-Corp. However, the election is only available if the buyer is a corporation and only in situations where a single buyer acquires at least 80 percent of both the value and vote of the S-Corp stock within a 12-month period, referred to as a “qualified stock purchase” or QSP. Thus, the Section 338(h)(10) election is not available to noncorporate purchasers or in situations where multiple corporations acquire stock that would otherwise meet the requirements of a QSP.

The Section 336(e) Election
The Section 336(e) regulations eliminate these restrictions by allowing an S-Corp and its shareholders to make a unilateral election to treat the disposition of at least 80 percent of both the value and vote of S-Corp stock within a 12-month period, referred to as a “qualified stock disposition” or QSD, as a sale of the underlying assets of an S-Corp. The Section 336(e) election also is available for QSDs involving noncorporate purchasers, including individuals,
private-equity funds, and partnerships, as well as a QSD involving multiple purchasers.

The tax consequences of a Section 336(e) election are similar to that of a Section 338(h)(10) election. If the buyer (or buyers) is paying a premium for the stock of an S-Corp, this premium is allocated to the tax basis of the underlying assets of the S-Corp on an asset-by-asset basis and might also result in a Section 197 intangible asset, providing a tax benefit to the buyer over a 15-year period. The S-Corp shareholders would also report any net gain from the deemed sale of the assets on their personal tax returns (as reported on the S-Corp’s Schedules K-1) and would increase their tax basis in the S-Corp stock accordingly. Also note that in the case of both a Section 338(h)(10) election
and a Section 336(e) election, an S-Corp is deemed to liquidate immediately after the deemed asset sale, thus resulting in capital gain or loss to the S-Corp shareholders on their disposition of the S-Corp stock.

In situations where a transaction qualifies as both a QSP and a QSD, the rules of IRC Section 338 take precedence. In other words, a corporate buyer and S-Corp would have to make a joint Section 338(h)(10) election in order to secure the deemed asset sale treatment; the Section 336(e) election would not be available.

Making the Election
The Section 336(e) election can be made for any QSD occurring on or after May 15, 2013. An S-Corp and all of its shareholders must enter into a written binding agreement in order to make the election, and an election statement must be attached to a timely filed S-Corp return for the year in which the QSD occurs. In addition, if at least 80 percent but less than 100 percent of an S-Corp’s stock is being sold, all of its shareholders must still make the election, regardless of whether they are selling their stock, for the election to be effective. The final regulations provide that the Section 336(e) election statement must be titled, “This is an election under Section 336(e) to treat the disposition of the stock of [insert name and employer identification number of Corp] as a deemed sale of such corporation’s assets.”

An S-Corp and buyer also must report certain information to the IRS related to the deemed sale of the S-Corp’s assets. The IRS intends to modify Form 8883, “Asset Allocation Statement Under Section 338,” or create a new form for the election. However, until Form 8883 is modified or a new form is created, an S-Corp and buyer should file Form 8883 and make the necessary adjustments to the form to properly reflect the transaction. Additionally, because the Section 336(e) election is a unilateral election included with a timely filed S-Corp return, it is imperative that a buyer confirm that the purchase agreement includes language either specifically requiring the S-Corp to make the election with its return or specifically prohibiting it from making the election.

Conclusion
While S-Corp acquisitions typically are structured in a way that generally would be eligible for a Section 338(h)(10) election – although exceptions can always apply – there might be situations in which this may not be the case. For example, due to the financial crisis in recent years, private equity groups have been more active buyers of financial institution stock, and they might want to structure their acquisitions using LLCs or other entity types that are not eligible purchasers in the context of a QSP. There might also be situations where an individual or group of individuals wants to
directly purchase the S-Corp stock but also desire to treat the stock purchase as an acquisition of assets. In these situations, the availability of the Section 336(e) election will provide more flexibility to gain the desired tax treatment for both buyer and seller.

Contact Information
Kevin Powers is a partner with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or kevin.powers@crowehorwath.com.

1 T.D. 9619
2 Though the final regulations provide for this unilateral
election not only in the case of sales of the stock of a domestic
corporation but with respect to distributions of the stock
to shareholders of a domestic corporation as well as certain
other exchange transactions, this article reviews the application
of the final regulations only in the context of stock sales.

The 17th Annual Subchapter S Bank Association’s Annual Conference is being held on October 23- 24th, 2014 at The HiltonPalacios 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.

The Subchapter S Bank Association engaged a statistics and mathematics graduate student at Georgetown University, Washington, DC to review some performance measures and other statistics of interest on S Banks. The following brief report reflects some interesting comparisons between the profitability and dividend practices of S corp banks versus C corp banks. In addition, S corp bank conversions from S corp back to C corp tax status was also tracked over the past 4 years. While not statistically significant, total conversions from S to C were 123 banks.

When looking at ROA (Return On Assets) and ROE (Return on Equity) for the 2nd quarter of 2013, the institutions were divided by asset size: (i) 100-250 million; (ii) 250-500 million; (iii) 500 million to 1 billion: and (iv) over 1 billion. Within each asset bracket are sub-categories for S corp, C corp, and all banks.

The average ROA and ROE by asset size are as follows:
100-250 million:
In this category there were 831 S corp banks with an average ROA of 1.248 and average ROE of 11.504, 1,421 C corp banks with an average ROA of 0.8 and average ROE of 5.441, and in total 2,252 banks with an average ROA of 0.968 and average ROE of 7.678.

250-500 million:
In this category there were 329 S corp banks with an average ROA of 1.3 and average ROE of 11.959, 892 C corp banks with an average ROA of 0.776 and average ROE of 6.886, and in total 1,221 banks with an average ROA of 0.917 and average ROE of 8.253.

500 million-1billion
In this category there were 124 S corp banks with an average ROA of 1.482 and average ROE of 14.507, 549 C corp banks with an average ROA of 0.755 and average ROE of 7.089, and in total 673 banks with an average ROA of 0.888 and average ROE of 8.456.

1 billion +:
In this category there were 70 S corp banks with an average ROA of 1.742 and average ROE of 15.891, 583 C corp banks with an average ROA of 1.029 and average ROE of 9.118, and in total 653 banks with an average ROA of 1.105 and average ROE of 9.843.

When looking at dividends declared to net income (total cash dividends declared as a percent of net income) for the 2nd quarter of 2013, the institutions were divided into S corp, C corp, and all banks categories. For all banks, the average dividend paid was 22.338%, this resulted from the combination of banks that did not pay a dividend (0%) and 47.454% for banks that did pay a dividend. For S corp banks, the average dividend paid was 41.564%, resulting from the combination of banks that did not pay a dividend (0%) and 56.279% for banks that did pay a dividend. For C corp banks, the average dividend paid was 14.22%, again, resulting from the combination of banks that did not pay dividend (0%) and 39.76% for those that pay any dividend. 

In addition to the averages, we created a frequency distribution (histogram) based on dividends declared as a percentage of net income of S corp and C corp instutions paying any positive dividend greater than 0% and up to 100%.

In addition to the average percentages paid, the number of institutions that pay dividends as a percentage of 2nd quarter 2013 net income were broken into the following ranges: 0%, 0%-40%, 40%-70%, and 70%-100%. Looking at all banks, 3,382 paid a 0% dividend, 1,269 paid between a 0% and 40% dividend, 1,055 paid between a 40% and 70% dividend, and 684 paid between a 70% and 100% dividend. For S corp banks, 496 paid a 0% dividend, 372 paid between a 0% and 40% dividend, 591 paid between a 40% and 70% dividend, and 438 paid between a 70% and 100% dividend. And for C corp banks, 2,886 paid a 0% dividend, 897 paid between a 0% and 40% dividend, 464 paid between a 40% and 70% dividend, and 246 paid between a 70% and 100% dividend.

Finally, the number of institutions that converted from S corp to C corp banks between the period of Q2-2009 and Q2 2013 was calculated. Between the 2nd quarters of 2012 and 2013, 18 banks converted from S corp to C corp. In other words, of the 2,293 S corp banks in the 2nd quarter of 2012 still operating under the same FDIC certificate number, only .78 of 1% chose to convert back to C corp status by the 2nd quarter of2013.

Between the 2nd quarters of 2011 and 2013, 37 banks converted back to C corp status. Between the 2nd quarters of 2010 and 2013, 73 banks converted back to C corp status, and finally, between the 2nd quarters of 2009 and 2013, 104 banks have converted back to C corp status. 

The year-over-year conversion (S corp banks that converted to C corp status the next year) are as follows. Between the 2nd quarters of 2012 and 2013, 18 banks converted back to C corp status (from above), between the 2nd quarters of 2011 and 2012, 22 banks converted back C corp status, between the 2nd quarters of 2010 and 2011, 40 banks converted back C corp status, and between the 2nd quarters of 2009 and 2010, 43 banks converted back to C corp status. This shows that the conversion rate from S corp to C corp status has steadily been declining since 2009. More generally, the number of banks converting for 2012 and 2013 is about half of that for 2010 and 2011.

The following graph shows the number of S corp institutions that chose to convert to C corp in the 2nd quarter year-over-year. The results show approximately a 50% reduction in the number of S corp to C corp converstions the last two years from the two years before.

The Association plans to develop more research regarding these banks and the reasons for their conversion back to C status. The Association expresses its appreciation to Mr. Andrew Craig for his work in developing this report.

Review Raw Data

The Sub S Bank Association held its 16th Annual Conference on October 24-25, 2013 in San Antonio, Texas. A distinguished group of industry experts created another great conference which covered a broad range of bank-specific Subchapter S topics. From the ever-popular investment strategies and trends panel to detailed discussions of new laws and regulations in the new federal income tax scheme adopted in 2012 resulted in excellent feedback. One of the presenters, Kevin Powers of the firm of Crowe Horwath LLP graciously expanded a portion of his presentation into an article that headlines this issue of the Sub S Bank Report. In addition, the following is a brief summary of some of the highlights of these talented and fully engaged subchapter S Bank professionals. Should you desire to access any of the presenter’s materials or the entire 1 ½ day conference, you may do so by contacting: Amy Trevino at atrevino@kslawllp.com or 210-228-9500.

The Capital Markets and Sub S Banks’ Panel nailed it and set the tone for the first day of our conference. Tom Mecredy of Vining Sparks gave an overview of the M&A market and focused on Seller motivations and considerations. Rick Foggia of Commerce Street Capital focused on buyer considerations and structuring of transactions. Robert Reilly, founder of Williamette Management Associates, discussed specific valuation theories and M&A trends involving Sub S
Banks. A lively discussion between the panel and audience occurred regarding “The Sub S Bank premium” (of 15-18%) and precisely what it is attributed to and how successful sellers are at realizing that premium.

Our Investment Portfolio Management & Issues Panel received high remarks from our attendees. Randy Rouse of Broadway Bank, a valued annual contributor gave a firsthand look of investments his bank currently is exploring and shared his wisdom on weathering the capital impact of the inevitable shift in interest rates. Ryan Hayhurst of The Baker
Group provided data on each attendees investment portfolio and how it compared to the other Subchapter S Bank attendees. He also summarized some of the key regulatory guidance on analyzing and managing interest rate risks and provided the audience with several ideas for mitigating portfolio depreciation using MBS and munis.” Terry Robertson of Raymond James, covered range of portfolio management strategies and observations regarding the use of the HTM in the portfolio. Greg Roll of Vining Sparks provided an overview of a number of investment alternatives and focused significant attention on the opportunities with Hybrid ARM’s and other mortgage related investment strategies.

Day 2 started with a special video presentation on the story behind the successful move to get Congress to pass Sub S for Banks and the history of the Association. You can watch the video at (http://www.youtube.com/watchv=DdmWkTcK1Ns&feature=youtu.be). Pat Kennedy, President of the Association thanked all who participated in making the video possible, including Al Jones and George Hawn of American Bank, Marty Madden and John Madden of First National Bank of La Grange, Illinois, Guy and Ray Collado of Commerce National Bank and Trust and Joe Press, President of Fortner, Bayens, Levkulich & Garrison, P.C. At the conclusion of the video Pat reminded all present that the achievement (of Sub S for Banks) was largely a “grassroots” effort which came from the industry participants and not bank association agendas. He encouraged activism on the part of bankers in the current environment, in particular community bank regulatory relief. It was a perfect segway to introduce the next panel.

The Legislative and Regulatory Panel was power packed with great information,led by John Hand, ICBA’s Congressional legislative specialist who covered the latest in the Washington landscape. Kevin Powers of Crowe Horwath LLP provided an excellent presentation on M&A structuring strategy including the 338(h)(10) election and the new regs on section 336 e, which makes asset purchase treatment much easier. Finally Paul Sirek of Eide Bailly discussed the newly finalized Basel III NPR and its significant impact on community banks. His presentation was comprehensive and well received. He acknowledged the success the Association had in its efforts to limit some of Basel III negative impact on community banks and sub s banks in particular. The challenge remains to obtain equal treatment in dividend paying capacity for tax payments. The group discussed some of the initiatives taking place and invited participation from more banks on this important topic.

Tax and Accounting Panel began with an excellent review of Sub S bank capital accounting and strategies for managing distributions, basis and ordering rules by David Silagi of Crowe Horwath LLP. Lance Davis of BKD, provided excellent materials on the new federal income tax rules and specifically covered the new tangible property rules, and key IRS exam issues of interest to Banks. Tim Malecha of Clifton-LarsonAllen provided an indepth discussion of the New Net Investment income tax and its impact on sub s bank shareholders who participate at different levels in the organization.

Thomas L. Danielson, CPA of the firm CliftonLarsonAllen demonstrated a software program that easily evaluates an acquisition target. With their program banks can easily identify suitable targets, look at the financial health of a target and prepare financial models of targets quickly.

Shareholder Management Panel was conducted by Joe Press of Fortner, Bayens, Levkulich & Garrison, P.C. who discussed, Pat Kennedy and Dub Sutherland of Kennedy Sutherland LLP who discussed unique capital and strategic challenges and opportunities for Sub S Banks and the importance of having the right shareholder agreement in place and other important shareholder related issues and opportunities.

Executive Compensation Strategies for Board, Shareholders and Executives Panel was covered by Trey Deupree of Equias Alliance specifically in regards to the use of bank owned life insurance while Dub Sutherland discussed other equity based compensation strategies to conclude the successful Conference. We extend our sincere thanks to the incredible group of talented professionals who participated on panels and in the audience to make this arguably the best ever Conference the Association has sponsored. Significant positive feedback was also received by many who attended the Association’s preconference special program: Community Banking in a New World (http://events.r20.constantcontact.com/register/event?llr=iorf5wjab&oeidk=a07e7x7lgnnb474e11a). As a result we plan to make this an annual event.

Conference Feedback
Thank you for your feedback! We like the way you think! Several of you left invaluable feedback for us that we look to incorporate into next year’s seminar:
1.) What topics do you want to hear more of: Multishare shareholders; Basel III; F/S Issues & Disclosures; K-1 reporting issues; Regulatory & Legislative Issues; Merger & Acquisition Trends/Ideas; Tax Changes; Investment Strategies.
We are exploring incorporating all of these topics into our 2014 program. If there is something else you would like to see let us know!
2.) Consider starting the program on Thursday morning early and ending on Friday at lunch.You spoke and we listened! Our 2014 conference will kick off early on Thursday, October 23rd, 2014 and end by 1:30 pm on Friday, October 24th.