The Sub S Bank Report – December 2014 (Volume 17, Issue 3)

Contracts are important, no question about it.  They define how we do business with another party, the responsibilities of each party and of course, the consequences for failure to comply with the terms.  Contracts set pricing, terms of payment and the general rights of the parties.  Your contract also determines the period of time that the parties have committed to the terms contained in the agreement.  On an intellectual level, we understand the importance of having good agreements in place, even with companies we’ve known and trusted for a very long time.

I’ve spent over 15 years on the technology side of the community banking industry.  During this time, the average term of agreements for major technologies has gone from a standard 3 years to about 10 years.  There isn’t a magic formula to determine the “best” length of agreement, but there is a point of diminishing return (and increasing risk).  I am concerned that, as an industry, we’ve crossed this line by more than a little bit.  Bear in mind that every community bank is different and there will be exceptions where a longer-than-average term makes good sense, but they are just that…  exceptions.  There are far too many technology agreements in place today that date back to pre-Internet days and the trend is moving in the wrong direction.

The goal of a longer-term contract depends on which side of the negotiating table you are on.  For the bank it’s a better price and/or terms.  For the vendor it’s the ability to spread discounts, implementation costs and other similar factors over a longer period of time.  Pretty simple, right?  But what happens when technology becomes obsolete (worthless)?  What if your customers no longer want what you’re committed to buy from your vendor?  Or what if your strategy changes and makes the product irrelevant?  What about new regulations or industry issues that cause you to need to have certain contractual protections in place?  Nothing stays the same and your agreements, whether we’re looking at price, terms or other conditions, shouldn’t either.

So, where is the balance?  How do you get a fair price without committing beyond a reasonable timeframe?  Each situation needs to be thoughtfully considered, but as a guideline, if you are looking to sign an agreement for more than 5 years, I’d encourage you to think very critically about your ability to see that far into the future. Most of us can’t really see beyond that point, particularly with the rate at which technology advances today.  If you’re not very sure, shorten the duration, even if it costs you a little more.  Paying that setup fee will look like a bargain compared to paying for another couple of years at above-market pricing or worse yet, for a product that no one wants or needs.

INTRODUCTION

The principal limitations on S corporations generally relate to the types of entities that can elect Subchapter S treatment and the number and types of shareholders that can own stock in such an entity. These limitations have evolved in a myriad of ways over the last twenty years to significantly expand the versatility of the S corporation as a choice of entity. This article will focus on the expansion of eligible shareholders to include charitable organizations, and the implications this change has on both shareholders who wish to make charitable contributions of S corporation stock and organizations that wish to accept such gifts. Importantly, shareholders seeking to contribute S corporation stock to a charity and organizations seeking to accept such contributions should be fully aware of the tax consequences to both parties that may result from such a gift.

HISTORY

Prior to 1998, Internal Revenue Code (“Code”) Section 1361 provided that only individuals, estates, and certain trusts could own stock in a Subchapter S corporation. A transfer of stock to an ineligible person (such as a non-U.S. resident) or entity would trigger a termination of the S election and tax treatment under general corporate income tax laws, including double taxation and other unfavorable provisions avoided via passthrough tax treatment. Depending on when such a transfer was discovered by the corporation or the Internal Revenue Service (“IRS”) the result could be substantial back taxes and penalties. At that time, S corporations were also limited to 35 shareholders and members of a family could not be treated as a single shareholder. In 1997, Congress enacted The Small Business Job Protection Act of 1996 (P.L. 104-88), a wide-ranging piece of legislation that contained a number of S corporation tax reforms. For example, the shareholder limit was increased to 75, the definition of trusts eligible to hold S corporation stock was expanded, and, importantly, banks were added to the list of organizations eligible to elect passthrough tax treatment under Subchapter S. In addition to these and other changes, however, the strict limitation on owners of S corporation stock was expanded to include an entirely new entity type – exempt organizations.

The Small Business Job Protection Act of 1996 amended Code Section 1361(b)(1)(B) to provide that an S corporation includes any eligible corporation which does not “have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual…” Further, Section 1361(c)(6) permits organizations which are “(A) described in section 401(a) or 501(c)(3), and (B) exempt from taxation under section 501(a)” to hold S corporation stock. The result of these provisions was to allow tax-exempt charities and tax-exempt retirement plans (including employee stock ownership plans “ESOPs” but not individual retirement accounts “IRAs”) to own S corporation stock. Beginning in 1998, S corporation shareholders could now make gifts of their S corporation stock to charitable organizations. Due to the nature of S corporations as closely-held businesses, S corporation stock may be, by far, the most valuable asset held by these potential donors – and the only means they have of making a substantial charitable donation. Conversely, charitable organizations now have access to a new, potentially large, source of giving – shares of closely-held, S corporation stock. While this increased flexibility with respect to S corporation stock and charitable giving may be welcome by both shareholders and charities, alike, there are important potential tax consequences from both the donor’s and charity’s perspective that must be fully appreciated.

DONOR ISSUES

Three of the major issues associated with making a donation of S corporation stock to a charity are: (1) whether the stock is subject to any transfer restrictions; (2) whether the donor or S corporation are comfortable with giving a charitable organization legal rights in the S corporation; and (3) whether the donor will be able to deduct the full, appreciated value of the stock for income tax purposes.

Transfer Restrictions

An important component of the organization and management of an S corporation is the shareholder agreement. Because of the closely-held nature of S corporations, many shareholder agreements impose restrictions on the transfer of stock among individuals. For example, transfers of stock may require notice to and approval by the board of directors of the S corporation or independent legal opinions that the transfer will not cause an inadvertent termination of the corporation’s S election. These transfer restrictions are utilized both to protect the S corporation from a termination and the associated tax liability and to guide the trajectory and management of the corporation. In fact, some shareholder agreements impose an outright prohibition on ownership of stock by 501(c)(3) organizations. Comprehensive shareholder agreements and transfer restrictions are especially important in the case of Subchapter S banks, which tend to have larger and more diverse shareholder groups. Finally, transfer restrictions could also prevent the charity from selling the stock after the gift has been made. Before deciding to gift S corporation stock to a charity, a donor must ensure that such a transfer is permissible under the S corporation’s shareholder agreement and that any preconditions to transfer, such as notice and approval by the board are strictly followed.

Legal Rights

Once a review of the shareholder agreement has confirmed no legal restrictions on a gift of stock to a charity, a donor must determine whether he or she is willing to grant the charitable organizations legal rights in the S corporation that are associated with being a shareholder. While this may not be a serious issue for an S corporation with a large shareholder group, any gift of stock to a charity will confer ownership rights (albeit minority ownership rights) to that charity. In the case of an individual who owns all or substantially all of the stock of an S corporation, they will be ceding some control of that entity to the charitable organization and should appreciate that before making such a gift. Additionally, depending on the transfer restrictions set forth in the shareholder agreement, a donor must be comfortable with a potential sale of the stock by the charity to a third party.

Charitable Deduction

A donor of S corporation stock must also be aware of the rules regarding charitable deductions. First, under Code Section 170(f)(8), gifts in excess of $250 require proof of the donation in the form of a “contemporaneous written acknowledgement” from the charity. This acknowledgement must list the amount of any cash and description of any property contributed, state whether the charity provided any goods or services in consideration for the property received, and provide an estimate of the value of such goods or property provided to the donor. Second, to the extent the value of the stock exceeds $5,000 the donor must complete all or a part of IRS Form 8283 and file with his or her income tax return in the year of the gift. If the value of the stock exceeds $10,000 the donor is required to obtain a “qualified appraisal” from a “qualified appraiser” that includes specific information required by the Code and Treasury Regulations. An appraisal summary and Form 8283 signed by both the donor and appraisal must be included with the donor’s tax return. Finally, a donor must be aware that the income tax deduction associated with the gift of the stock will often be less than the appraised value of the stock.

Contributions of appreciated stock are generally a favorable vehicle for making large charitable contributions. Such a contribution produces tax benefits for both the donor and the donee. Not only will the donor receive a tax deduction for the full appraised value of the stock, but the donor also avoids recognizing any gain related to the appreciation of the stock. The charity will also not be subject to tax on the dividends or passive income realized from holding the stock as an investment, nor will it be taxed on the gain on sale of the stock. The rules change, however, in the case of an S corporation.

For purposes of calculating the corresponding charitable tax deduction, a gift of S corporation stock is treated like a gift of a partnership interest. Code Section 170(e)(1), which sets forth the rules governing charitable deductions for contributions of ordinary income and capital gain property states in part that:

“For purposes of applying this paragraph in the case of a charitable contribution of stock in an S corporation, rules similar to the rules of section 751 shall apply in determining whether gain on such stock would have been long-term capital gain if such stock were sold by the taxpayer.”

Under these rules, the charitable deduction allowed is equal to the appraised value of the stock less the proportionate share of ordinary income the donor would have recognized upon liquidation of the S corporation. Essentially, a hypothetical liquidation of the S corporation takes place and all proceeds are distributed to its shareholders. To the extent the shareholders proportionate share of the distribution would produce ordinary income (e.g. inventory or depreciation recapture) versus a capital gain, the donor’s charitable deduction would be reduced by that amount. As such, donors may lose some of the value that would be associated with a gift of appreciated stock of a C corporation. Donors relying on the charitable deduction from a gift of S corporation stock to reduce tax liability must take care to calculate the appropriate amount of the deduction.

CHARITABLE RECIPIENT ISSUES

A charitable donation of S corporation stock can also present tax challenges for the charitable organization receiving the gift. As previously mentioned a gift of C corporation stock to a charitable organization generally does not result in any tax liability to the charity either while the charity holds the investment and receives dividends on the stock or when the charity later disposes of the stock. Conversely, in the hands of a tax-exempt organization, S corporation stock would subject the entity to unrelated business income tax (“UBIT”) on both distributions made  to the charity while it held the stock, as well as on the gain on sale of the S corporation stock. UBIT seeks to prevent the shifting of business assets from a taxable corporation to tax-exempt entities. In furtherance of this purpose, Code section 512(e) imposes UBIT on 501(c)(3) charitable organizations, and 401(a) qualified plans such as 401Ks that hold S corporation stock.  Such entities are subject to UBIT on all items of income, loss, or deduction that flow through to the entity as an owner of S corporation stock and also on any gain or loss from the disposition of that S corporation stock. Depending on the organizational structure of the entity (e.g. corporation or trust) the UBIT rate is equal to the top tax rate for that entity.

Careful planning on the part of the exempt organization is crucial to ensure that distributions from the S corporation are sufficient to cover any UBIT liability during the time period that the organization plans to hold the stock. This may include reviewing the S corporation’s distribution policies and financial projections and specifically addressing the issue of distributions to cover taxes with the S corporation prior to accepting any gifts of stock. This issue may be of particular concern to charities reviewing a potential gift of stock of an S corporation bank – where federal banking agency regulations may limit or prohibit shareholder distributions based on bank capital requirements. Tax-exempt organizations must also be aware of the donor’s basis in the stock. When the stock is transferred to the charity, the charity assumes the donor’s basis. Upon disposition, the charity will be liable for UBIT on the difference between the sale price of the stock and the basis transferred from the donor. Charities that receive gifts of stock with a very low basis will be subject to a larger tax liability when they later dispose of the stock. Whether a charity plans to hold the S corporation stock for a long time, or dispose of it quickly, they must factor in the ability to satisfy this tax liability.

CONCLUSION

The ability for tax exempt charitable organizations to own S corporation stock opened up an avenue for charitable giving to individuals who own closely-held S corporations and whose largest asset is often the stock in that corporation. It also gave these charities access to a new form of corporate giving. Charitable donations of S corporation stock, however, require detailed review and analysis of both the practical and economic consequences of the gift as well as the tax consequences to both the donor and the charity. By gifting appreciated S corporation stock, donors potentially risk a part of their charitable deduction depending on the amount of ordinary income they would be deemed to receive in a hypothetical liquidation of the S corporation. From a charity’s perspective, assurance of sufficient distributions is essential to ensure the tax-exempt organization has cash to cover UBIT liability associated with income earned on the S corporation stock. The charity also must know the basis in the stock to calculate the tax liability on its eventual disposition and be able to properly value the charitable contribution. Both parties should carefully determine whether the responsibilities and restrictions associated with holding S corporation stock make a charitable donation of that stock a worthwhile endeavor for each party.

One of the most important aspects of managing an S corporation shareholder group is knowing when and how the family attribution rules apply to treat multiple shareholders within the same family as a single shareholder for purposes of the 100 shareholder limit. Due to apparently conflicting provisions in the Internal Revenue Code (the “Code”) and Treasury Regulations (the “Regulations”) there is often confusion regarding how to treat a married couple that later divorces. Originally, the Code and Regulations treated spouses as a single shareholder and upon divorce, as separate shareholders. The enactment of the family attribution rules in 2004, however, changed this rule so that both spouses and former spouses would always be treated as a single shareholder. While seemingly a minor distinction, noting this rule may be important for S corporations that are approaching the 100 shareholder limit.

The general rule applying to married couples and family is found in Code Section 1361(c)(1)(A):

For purposes of subsection (b)(1)(A) [referring to the shareholder limit], there shall be treated as one shareholder –
(i) a husband and wife (and their estates), and
(ii) all members of a family (and their estates).

The Regulations go on to state that this treatment “will cease upon dissolution of the marriage for any reason other than death.”  Reading these two provisions alone, it appears clear that spouses are treated as a single shareholder, but on divorce they are treated as separate shareholders. The later enacted provisions describing the family attribution rules, however, contradict this clear cut rule.

Code Section 1361(c)(1)(B)(i) provides that for purposes of the family attribution rules “the term ‘members of a family’ means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant.” (emphasis added). The Regulations go on to reiterate this family attribution rule that both a spouse and a former spouse will continue to be treated as a member of the family. The result is a contradiction between Regulation Section 1.1361-1(e)(2) and Regulation Section 1.1361-1(e)(3), stating first that upon divorce spouses are treated as separate shareholders and later that spouses and former spouses are treated as members of a family, and thus, as a single shareholder.

This contradiction resulted from a drafting error when the family attribution rules were enacted in 2004. Congress should have repealed earlier-enacted provision dealing solely with a husband and wife, which were later subsumed within the broader family attribution rules. This was likely not done because the Code sections merely reveal a redundancy between Code subsections (c)(1)(A)(i) and (c)(1)(A)(ii) and the contradictory provision appears in the Regulations enacted thereunder.

In summary, spouses and former spouses (whether by divorce, death, or otherwise) should always be treated as a single shareholder due to the “family attribution rules.” In discussing this issue with a colleague, I discovered a useful analogy: “The family attribution rules are like the mob. Once you’re in the family, you’re always in the family.”