The Sub S Bank Report – January 2013 (Volume 16, Issue 1)

Stock ownership in a Subchapter S corporation is largely limited to natural US persons; however, one notable exception is trusts and estates.  Section 1361(b) of the Internal Revenue Code of 1986, as amended (the “Code”) contains the shareholder eligibility provisions for a Sub S corporation. Some Subchapter S corporations intentionally prohibit Trusts from becoming shareholders largely because of the complexity and cost of monitoring and assuring compliance with the Code to safeguard against termination of the S corp election. Many S corporations undergo inadvertent termination of their election without knowing the election has been terminated, sometimes for years. Typically the termination is discovered only when an event causes a review of the trust shareholder’s status. Such an event typically occurs when due diligence in connection with a merger or acquisition is under way which can cause a significant delay or even derail the transaction entirely.

If a terminating event has occurred, the only way to avoid the dire consequences of such a termination is to seek a private letter ruling from the IRS. This is a costly and time consuming exercise which involves proving that the S corp was not aware of the facts or circumstances which led to the termination and as such that it was inadvertent. The current filing fees for such a letter ruling from the IRS are $18,000.00 not including attorneys fees for review of the termination circumstances and preparation of the ruling request.

There are four types of trusts that may qualify as a shareholder in an S corporation:     

(1) Revocable grantor trusts which are trusts created by an individual and are treated under the Code as owned by an individual;

(2) Testamentary trusts which are established under a last will and testament and may be a sub s shareholder for two years only;

(3) Qualified Subchapter S Trusts (QSST) which are trusts created for a single beneficiary and in which all the income is annually distributed to the beneficiary; and

(4) Electing Small Business Trusts (ESBT) which is a multi-beneficiary trusts which is taxed at the highest individual tax rate rather than at the tax rate of the beneficiary as is the case with most other trusts.

Some of the typical events that can cause termination of the S election include:

1) In the case of a grantor trust, the death of the shareholder followed by the failure of the trustee to make an arrangement for distribution of the shares to individual beneficiaries or election by the trust or a successor trust which would meet the requirement of a QSST or ESBT.

2) In the case of a shareholder that is a QSST (i.e. single beneficiary with all income required to be fully distributed annually), the failure by the Trustee to make annual distributions of all income timely.

3) In the case of a testamentary trust, the failure to timely distribute shares to individual beneficiaries or make an effective QSST or ESBT election.

4) In the case of an Estate owning S corp stock, the failure to transfer the S corp stock held by the estate to a qualifying shareholder within two years of the date of death.

These are clearly events that the typical S corp Bank management would not typically be monitoring nor have the technical knowledge to do so unless specifically trained. As such many unsuspecting S corp’s may already have suffered a termination of their S election which may have occurred years ago upon the happening of one of the above events and only upon review is it discovered.

Under these circumstances, the S corp shareholders and corporate directors should carefully consider their decision to permit trusts as shareholders and closely monitor any estate transfer activity. In addition, if such trust and estate shareholders are permitted, the S corp should consider adopting preventative measures within the Shareholder Transfer Restriction Agreement designed to safeguard the election in the event of one of the above circumstances occurs.

A more detailed description of the types of trusts is set forth below as well as some common examples of terminating events.

Revocable Grantor Trusts

Revocable grantor trusts (trusts that are treated under the Code as owned by an individual) are permitted Subchapter S shareholders, provided that the deemed owner is a citizen or resident of the United States. Revocable grantor trusts are fairly straightforward for the bank to monitor as a shareholder, since the granting shareholder continues to be responsible for the payment of all taxes stemming from distributions from the bank.

Although any asset contributed to a revocable grantor trust legally becomes the property of such trust, there is no distinction in tax treatment from that of the grantor. The individual establishing a revocable grantor trust is traditionally both the grantor of the assets contributed to the trust, as well as the beneficiary of such assets during his or her lifetime. Since there is no true division of ownership of such assets during the life of the grantor, revocable grantor trusts receive no favorable tax treatment at death. Throughout the life of the grantor, the assets of such trusts are deemed to remain part of the grantor’s gross income, even though legally owned by the trust; therefore, the grantor is obligated to report income stemming from all such assets on his or her personal return. Therefore, from the bank’s perspective, the only visible change will often only be a shift from issuing distribution checks to “John Doe” to “John Doe, as trustee to the John Doe Revocable Trust.”

Revocable grantor trusts pose significant threats to the institution’s S election when not properly supervised. Pursuant to Section 1362(c)(2) of the Code, upon the death of a shareholder that has held shares of S corporation stock in a revocable grantor trust during his or her lifetime, such shares may only remain within the trust for a two-year period commencing on the day of the shareholder’s death. In the event the shares are not timely transferred out of the trust, the bank’s S election automatically terminates.

Testamentary trusts

Testamentary trusts are common vehicles utilized to pass wealth to subsequent generations, especially for individuals with sophisticated estate plans. Testamentary trusts are created by a decedent’s last will and testament. Unlike revocable grantor trusts, testamentary trusts do not become operative until the death of the grantor. As such transfer vehicles are found in many estate plans, the Code permits testamentary trusts to hold stock within an S corporation for a period not to exceed two years from the date the stock is transferred into the trust. It is important to note that while revocable grantor trusts and testamentary trusts are each permitted to hold stock for a two-year period, the commencement date of such period varies dependent on the type of trust. Since the shares of S corporation stock are held within the trust prior to the grantor-shareholder’s death, when considering a revocable grantor trust, the two-year period begins on the date the grantor-shareholde’s death. Due to the nature of the transfer, when it is the last will and testament of the shareholder that provides for the transfer, the shares of S corporation stock may be legally part of the probate estate for a reasonable period prior to the ultimate transfer into the testamentary trust. For this reason, the two-year holding period does not begin to accrue until the shares are transferred from the shareholder’s estate into the testamentary trust.

A significant problem created by testamentary trusts is the institution’s complacency with the transfer from the estate to the testamentary trust. Oftentimes, an additional step is required following the initial transfer of the shares into the testamentary trust. It is key that bank management remember that the concessions relating to trusts granted under Section 1361(c)(2) of the Code are intended to be temporary in nature. In essence, when a testamentary trust is involved, two transfers of the shares must occur to avoid jeopardizing the institution’s Subchapter S election. First, the shares of the S corporation are passed from the decedent shareholder’s estate into the testamentary trust upon the conclusion of the probate proceedings. Second, the shares of the S corporation must be transferred to a qualifying trust or a timely election must be filed to permit the present trust vehicle to be capable of continuing to hold the shares. Subchapter S banks often confuse the initial transfer from the estate to the testamentary trust with the transfer required to be made from the testamentary trust to a qualified shareholder (which still could be another trust), Similar to revocable grantor trusts, if the shares are not transferred out of a testamentary trust within the two-year compliance period, the S bank will automatically lose its status as an S corporation.

Qualified Subchapter S Trusts (QSSTs)

Section 1361(d) sets forth a special rule permitting trusts meeting the definition of a “qualified Subchapter S trust” to be shareholders of an S corporation. Qualified Subchapter S Trusts (QSSTs) are trusts that provide for only one income beneficiary and require that any corpus distributed during the life of such income beneficiary be distributed only to said beneficiary. To qualify as a QSST, all income derived from the trust must be distributed to the income beneficiary each year and upon the death of the income beneficiary, the terms of the trust must require that all of the trust’s assets be distributed to such beneficiary.

Unlike revocable grantor trusts and testamentary trusts, a QSST may only be a shareholder of an S corporation upon the affirmative election of the current income beneficiary. Once shares of an S corporation have been transferred into a trust that otherwise qualifies as a QSST, the current income beneficiary has only two months and fifteen days to file the QSST election. Failure to timely file a QSST election will result in an inadvertent termination of the institution’s Subchapter S election.

Electing Small Business Trusts (ESBTs)

Similarly, untimely elections for Qualified Subchapter S Trusts often occur as a result of unchecked transfers to legally distinct trust instruments. Estate plans oftentimes provide for the decedent’s assets to be placed in separate trusts to take full advantage of favorable tax provisions at death. Consider the following example:

Scenario

Ben establishes a revocable grantor trust which meets the requirements of a qualified subpart E trust (the “Trust”). Pursuant to the terms of the Trust, Ben is the sole income beneficiary and retains the power to revoke the Trust during his lifetime. However, upon Ben’s death, the Trust corpus is to be divided between a Credit Shelter Trust and a Marital Trust. The Credit Shelter Trust is to be funded with an amount not to exceed that which can pass tax free under estate taxation laws. The Marital Trust is to be funded with all the remaining assets of the Trust, specifically including all of Ben’s stock in Bank C, a Subchapter S bank. Ben’s wife, Donna, is to be the sole income beneficiary of both the Credit Shelter Trust and the Marital Trust, but has no power to invade the corpus of either trust.

Synopsis

Since no Bank C stock is to be transferred into the Credit Shelter Trust, the effect of such trust is irrelevant for present purposes. However, upon Ben’s death, Ben’s stock in Bank C is to be transferred from the revocable grantor trust to the Marital Trust. Pursuant to Section 1361(c)(2)(A)(ii), the Trust may continue to hold the stock of Bank C for a period not to exceed two (2) years from the date of Ben’s death. Since the Marital Trust is irrevocable, it will not satisfy the requirements for a qualified subpart E trust; therefore, Donna will be required to make a QSST election within the 2-month, 16-day period beginning on the date the stock of Bank C is legally transferred into the Marital Trust. Failure to make a timely QSST election will result in an inadvertent termination of Bank C’s Subchapter S election.

There are numerous variations of the above examples. Each bank has unique shareholder issues, especially when it comes to trust matters. However, it is important that senior bank management undertake a “trust check-up” of the institution. The trustee of each trust that is a registered shareholder of the bank should be contacted for purposes of reviewing the governing documents of the trust. Items for review should include: (a) type of trust; (b) status of QSST/ESBT election, if applicable; (c) potential for the creation of successor trusts; and (d) eligibility of potential trust beneficiaries to qualify as Subchapter S shareholders. Additionally, the bank should engage its individual shareholders to make such shareholders aware of the negative implications that may stem from estate plans that do not properly consider Subchapter S compliance. The bank will be in a better position to manage shareholder succession issues if it is aware of such matters before they arise. Shareholder succession is an issue that all Subchapter S banks will inevitably confront at some point. Trusts play a large role in these succession matters. Understanding the institution’s trust shareholders permits bank management to be proactive when handling such issues and, in turn, reduces the institution’s operational risk.

*Patrick J. Kennedy, Jr. is founding partner of Kennedy Sutherland LLP specializes in assisting community banks with a wide range of corporate, banking, regulatory and securities matters. The firm represents and provides substantive educational content to the Subchapter S Bank Association.

Subchapter S of the Internal Revenue Code of 1986, as amended (the “Code”), permits corporations making an election under Section 1362 to eliminate the imposition of the corporate tax on the entity’s income and pass all earnings through to the institution’s shareholders. At the shareholder level, earnings are taxed once, as ordinary income. In 1997, Subchapter S of the Code was amended to grant banks the ability to elect Subchapter S tax treatment and to permit S corporations to own qualified Subchapter S subsidiaries. Since 1997, over 2,500 banks and bank holding companies have made Subchapter S elections. Providing financial institutions the ability to be taxed under Subchapter S has been noted as one of the most significant developments affecting community banks in recent history.¹

Beneficial Attributes of Subchapter S Taxation Come at a Cost

Subchapter S fosters local and family ownership by permitting the value of the institution to be passed directly to investors. Institutional value is accessed by virtue of the ability of such banks to make substantial distributions of earnings which have not been subject to double tax. Traditional C corporations may only mirror such value by accumulating after-tax earnings within the corporation in anticipation of a subsequent sale. Pass-through tax treatment promotes a more flexible business planning structure for bank shareholders and generally increases net income for the institution by sixty-five percent (65%). However, entities electing Subchapter S treatment are limited to one hundred (100) qualifying shareholders. Furthermore, with limited exceptions, S corporations may only have natural persons as shareholders. The most burdensome component of operating under Subchapter S, however, is that S corporations are prohibited from issuing more than one class of stock.

Focus on Regulatory Capital 

Subchapter S financial institutions are subject to regulatory oversight by the prudential bank regulatory agencies. Banks and bank holding companies are required to maintain certain capital levels under federal and state laws and regulations. Stemming from the recent economic downturn and the governmental bailouts of major financial institutions, bank regulators have reaffirmed the importance of capital within the banking sector. Section 171 of The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), addressed some capital concerns by downgrading the regulatory treatment of trust preferred securities to Tier 2 capital and incrementally phasing out existing trust preferred securities from inclusion as a component of Tier 1 capital over a three-year period ².  Financial institutions subject to The Small Bank Holding Company Policy Statement of the Federal Reserve as of May 19, 2010 are statutorily exempt from Section 171 and may continue to utilize trust preferred securities as a source of Tier 1 capital; however, these trust preferred securities vehicles have largely disappeared from the market and, unless privately placed, are no longer a ready source of capital for financial institutions³.  Basel III⁴  seeks to heighten capital standards and will likely affect banks and bank holding companies of all asset sizes once implemented by the various regulatory agencies, especially considering its emphasis on common equity.

Traditional Financial Institutions Permitted to Issue Preferred Stock

State member banks and bank holding companies organized as traditional C corporations are permitted to issue preferred stock and are otherwise not limited to offering only a single class of security. To qualify for Tier 1 capital treatment, such securities must fall within the definition of “qualifying noncumulative perpetual preferred stock.⁵  Bank holding companies may issue cumulative preferred stock that will qualify as Tier 1 capital; however, capital regulations restrict Tier 1 treatment to an aggregate cap of twenty-five percent (25%) of the sum of all Tier 1 capital components, including all other restricted core capital.⁶  The only form of preferred stock that state member banks may include in Tier 1 capital is noncumulative perpetual preferred stock.

The Communities First Act (H. R. 1697)

Subchapter S financial institutions can only issue one class of stock and, as such, are prohibited from issuing preferred stock.⁷  Subchapter S banks may only raise capital by issuing additional common stock. In many instances, the 100-shareholder cap applicable to S corporations forces Subchapter S banks to dilute shareholder value in order to meet capital adequacy guidelines. The Communities First Act (H.R. 1697) seeks to address the foregoing situation. The Communities First Act proposes to amend Section 1361 of the Code by adding a new subsection. The incorporation of the proposed subsection would permit Subchapter S banks and bank holding companies to issue a type of preferred stock identified as “qualified preferred stock.⁸  Qualified preferred stock would meet the requirements of subparagraphs (A), (B) and (C) of Section 1504(a)(4) of the Code⁹  and, therefore, would not be treated as second class of stock for the issuing institution. Qualified preferred stock would be preferred to dividends, but would not participate in corporate growth,nor confer voting rights on the holder. Redemption and liquidation rights would not exceed the issue price of the security, but the instrument would be capable of possessing conversion features. From a regulatory standpoint, permitting Subchapter S financial institutions to issue qualified preferred stock is beneficial to both the safety and soundness of the institution and the Deposit Insurance Fund. Allowing Subchapter S banks to issue preferred stock would provide an additional capital raising avenue without diluting current common stockholders ownership interests, which can be an important concern for a shareholder group—particularly in a period of lower valuations as the industry has been and anticipates experiencing for the foreseeable future. Enabling Subchapter S bank holding companies to issue qualified preferred stock would allow these parent organi zations to downstream the proceeds of such issuances directly to the bank and thereby increase capital reserves at the bank level. It is important that all available means be provided to institutions to source additional capital, particularly in an environment when available capital is a challenge to attract.  Qualified preferred stock would open the doors of Subchapter S banks and bank holding companies to a wider pool of prospective investors and could significantly contribute to relieving the pressure on such institutions to maintain heightened capital levels. Qualified preferred stock would also foster institutional growth by permitting Subchapter S banks to utilize additional capital-raising tools to fund such growth.

Subchapter S banks play a key role in communities across the United States. With nearly 2,500 such institutions presently in operation, Subchapter S banks constitute approximately one-third (1/3) of the banking industry. “S corporations represent the most common corporate entity in the [United States].”¹⁰  “Over 3.6 million small business corporations in this country have elected to be treated as S corporations for federal income tax purposes.”¹¹  Subchapter S is a viable business model for any corporation, but is especially beneficial to community bankers and the communities they serve. Small businesses and community banks are key buttresses of the national economy. Permitting Subchapter S banks to access capital through qualified preferred stock fosters growth not only for the institution, but also for the small businesses that rely on such institutions for critical business financing. 

***

1 See HAMID MEHRAN & MICHAEL SUHER, FEDERAL RESERVE BANK OF NEW YORK, FEDERAL RESERVE BANK OF NEW YORK STAFF REPORTS: THE IMPACT OF TAX LAW CHANGES ON BANK DIVIDEND POLICY, SELL-OFFS, ORGANIZATIONAL FORM, AND INDUSTRY STRUCTURE, 1 (2009) (“Perhaps no law or regulation in recent times has had as great an effect on the operation of small banks in the U.S. as the Small Business Job Protection Act of 1996.”).
2  See Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. § 5371(b)(4) (2011) (setting forth the effective dates and phase-in periods imposed under Dodd-Frank).
3See UNITED STATES GOVERNMENT ACCOUNTABILITY OFFICE, DODD-FRANK ACT: HYBRID CAPITAL INSTRUMENTS AND SMALL INSTITUTION ACCESS TO CAPITAL, 9 (2012) (“[P]rovisions in the Dodd-Frank Act require banking regulators to establish rules that will effectively subject bank and thrift holding companies to regulatory capital requirements that are at least as stringent as those applicable to insured depository institutions, thereby effectively eliminating hybrid capital instruments from Tier 1 capital.”).
4The Basel Committee on Banking Supervision (BCBS) is a committee composed of members from twenty-seven (27) nations which serves as a forum for discussion and cooperation of supervisory matters pertaining to the banking industry worldwide. Basel III was proposed by the BCBS to improve the resiliency of the banking sector by strengthening global capital and liquidity requirements and improving the banking industry’s ability to absorb loss during periods of economic stress. Notable proposals under Basel III attempt to place an increased emphasis on common equity, raise minimum capital ratios and impose capital buffers.
5See 12 C.F.R. pt. 225, App. A (2011) (setting forth the capital adequacy guidelines for bank holding companies). Pursuant to the Capital Adequacy Guidelines for Bank Holding Companies: Risk-Based Measure, “[t]he elements qualifying for inclusion in the tier 1 component of a banking organization’s qualifying total capital are (i) qualifying common stockholders’ equity; (ii) qualifying noncumulative perpetual preferred stock, including related surplus, and senior perpetual preferred stock issued by the United States Department of the Treasury (Treasury) under the Troubled Asset Relief Program (TARP) . . . (iii) minority interest related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class A minority interest); and (iv) restricted core capital elements.”
6Id. (“The aggregate amount of restricted core capital elements that may be included in the tier 1 capital of a banking organization must not exceed 25 percent of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Stated differently, the aggregate amount of restricted core capital elements is limited to one-third of the sum of core capital elements, excluding restricted core capital elements, net of goodwill less any associated deferred tax liability.”).7    See 12 U.S.C. 1361(b) (2010) (“The term ‘S corporation’ means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect for such year.”). To qualify as a “small business corporation,” an entity must not (i) have more than 100 shareholders; (ii) have any shareholders who are not natural persons (subject to certain exceptions); (iii) have any nonresident aliens as shareholders; (iv) have more than one class of stock.

8Community Banks Serving Their Communities First Act, H.R. 1697, 112th Cong. § 502 (2001). As proposed, Section 502 appears as follows:

“(a) IN GENERAL.—Section 1361 (defining S corporation) is amended by adding at the end the following new subsection:
“(h)TREATMENT OF QUALIFIED PREFERRED STOCK.—
(1) IN GENERAL.—For purposes of this subchapter—
(A) qualified preferred stock shall not be treated as a second class of stock, and
(B) no person shall be treated as a shareholder of the corporation by reason of holding qualified preferred stock.
(2) QUALIFIED PREFERRED STOCK DEFINED.—For purposes of this subsection, the term ‘qualified preferred stock’ means stock which meets the requirements of subparagraphs (A), (B), and (C) of section 1504(a)(4). Stock shall not fail to be treated as qualified preferred stock merely because it is convertible into other stock.
(3)DISTRIBUTIONS.—A distribution (not in part or full payment in exchange for stock) made by the corporation with respect to qualified preferred stock shall be includible as ordinary income of the holder and deductible to the corporation as an expense in computing taxable income under section 1363(b) in the year such distribution is received.”

9See 12 U.S.C. 1504(a)(4) (2010) (“For purposes of this subsection, the term ‘stock’ does not include any stock which—(A) is not entitled to vote, (B) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, (C) has redemption and liquidation rights which do not exceed the issue price of such stock (except for a reasonable redemption or liquidation premium), and (D) is not convertible into another class of stock.”).
10S Corps: Recommended Reforms That Promote Parity, Growth and Development for Small Businesses: Hearing Before the H. Subcomm. on Finance and Tax of the H. Comm. on Small Business, 110th Cong. 3 (2008) (statement of Cynthia Blankenship, Chairman, Independent Community Bankers of America).
11S Corps: Recommended Reforms That Promote Parity, Growth and Development for Small Businesses: Hearing Before the H. Subcomm. on Finance and Tax of the H. Comm. on Small Business, 110th Cong. 3 (2008) (statement of the U.S. Chamber of Commerce).