The Sub S Bank Report – June 2014 (Volume 17, Issue 2)

This past February, Ways & Means Committee Chair Dave Camp released a proposed version of the Tax Reform Act of 2014, containing several provisions that would provide considerable change to our current income tax system. One provision of particular interest to S corporation community banks is Section 3301 of this Act, which would limit the availability of the cash method of accounting for tax purposes (“cash method”) for taxpayers.

Currently, any S corporation bank is allowed to use the cash method. In order for an accrual basis S corporation to automatically change to the cash method, currently the corporation has to have average annual gross receipts of less than $50,000,000 for the prior three years. An automatic change generally means there is no user fee to be paid with the application to change methods, and the change does not have to be approved by the IRS prior to making the change. Thus, in the past, the cash method has been accessible for all S corporation banks, particularly those with less than $50,000,000 of annual gross receipts.

What is so attractive about the cash method? All community banks generally keep their books/financial statements on the full accrual basis of accounting, but for tax reporting purposes only, many S corporation community banks have been using the “cash method” of accounting in calculating the taxable income from the bank. Here is how an S corporation bank benefits from the cash method:

In Year #1 of the accounting method change, the bank does not have to realize taxable income on the end-of-year balance of uncollected interest receivable, nor does the bank get to deduct accrued interest on deposits not paid and other accrued expenses. There is often a large gap between the receivables and payables at year-end (but not always). For example, if at the end of Year #1of making the change to the cash method, a bank has $1,000,000 of accrued interest receivable and $200,000 of accrued interest payable and accrued expenses, the bank would defer the net $800,000 of taxable income to the next year, when the interest income is actually collected and the interest and others expenses are actually paid (so, taxable income in Year #1 of the cash method is less than book income by this $800,000 deferral). Then, at the end of Year #2, the gap between receivables/payables measured at that date is deferred into the next year, and so on. Essentially, there is typically a large benefit in the first year of the change to the cash method, and that deferral keeps rolling forward until ultimately the bank sells its assets and realizes that deferral into taxable income, or until the bank is no longer permitted to use the cash method of accounting (i.e., it reverts back to a C corporation and has above $5 million gross average annual gross receipts, which is the size limit for C corporations to use the cash method).

So, if the proposed provision limiting the use of the cash method only to banks with less than $10 million average annual gross receipts is ultimately passed into law, many S corporation banks would be impacted…..that rolling deferral of taxable income in the example above would ultimately get recaptured into taxable income over a four-year spread, beginning in 2019 according to the proposal. That means taxable income would be higher than book income, which could cause some capital issues for S corporation banks…..tax distributions required by shareholders to pay the tax on the cash method deferral
recapture would be a larger proportion of book earnings and could cause a potential drop in capital ratios. With Basel III on the horizon, this could be a definite cause for concern for many S corporation banks.

Paul Sirek is a Partner with Eide Bailly. He has more than 17 years public accounting experience with a focus on the financial institutions industry where he provides management consulting, tax planning and tax compliance services to financial institutions ranging in size from less than $20 million to more than $1.6 billion.  He can be reached at psirek@eidebailly.com  or 612-253-6500

Editors note: While we commend steps to to simplify the tax code and enact comprehensive tax reform, we urge all S Corp banks to keep a keen eye out for this issue. The Subchapter S Bank Association has joined with American Institute of CPAs and seven other groups in monitoring and opposing converting from the cash method to accrual basis as we believe it would create a significant burden to S Corp banks.Most significantly, we believe that switching from cash method would lead to significant cash-flow problems as it would require banks to recognize revenue in advance of getting paid.

Luckily, this section of Chairman Camp’s tax reform bill has yet to gain any traction; however, we promise to continue to monitor it and work to get as many members and senators on record against it to help   “erase” it from any future drafts of Tax Reform.

A special note and recent development regarding the applicability of the net investment income tax rules and their applicability to directors and shareholders of S corp banks.

Prior guidance and interpretation, largely, concluded that unless an S corp shareholder or director put in at least 500 hours into the bank activity per year, they would be considered as “passive” for tax purposes and their K-1 income would be subject to the 3.8% net investment income tax.

The Association has been advised by one of our professional advisors that their firm has held internal discussions and is aware of similar discussions with other accounting firms that  a little known provision in the Sec. 469 passive activity regulations stipulates that if an individual puts at least 100 hours into an activity, then that individual needs to recharacterize the income from that 100+ hour activity to passive income and not deduct passive losses against it.

We are advised that this recharacterization also would apply to the Sec. 1411 regs dealing with the 3.8% tax.  Thus, if a bank director were able to accumulate at least 100 hours during the year (rather than 500), he or she should be able to treat their K-1 income from the S corporation as “active” and thus not be subjected to the 3.8% tax.

This  could be significant for some director/shareholders of S corporation banks, as that 3.8% surtax stung quite a few people in 2013.  100 hours is a LOT easier for a director to reach than 500 hours. The Subchapter S Bank Associations encourages S corporation bank shareholders and directors to reach out to their tax advisors regarding this 100-hour provision. We  also would appreciate hearing from others on whether they are taking similar positions.

Patrick J. Kennedy, Jr. is founder of the Subchapter S Bank Association and Kennedy Sutherland LLP, which provides comprehensive legal services to banks, bank holding companies, and directors, officers and shareholders. He can be reached at pkennedy@kslawllp.com or 210-228-4431.

One of the defining characteristics of the S corporation is the limit on the total number of allowable shareholders. When Subchapter S of the Internal Revenue Code first came into existence in 1958, an S corporation was limited to 10 shareholders. This limit was first increased to 25 in 1976 and has grown progressively larger over the years. It was most recently raised to 100 as a result of the American Jobs Creation Act of 2004. This most recent increase in the shareholder limit, however, was accompanied by another provision that arguably had a greater impact on the number of individuals who could own S corporation stock. The family shareholder rules allowed for all members of a family to be treated as a single S corporation shareholder for purposes of the shareholder limit. 

The family shareholder rules are found in Internal Revenue Code Section 1361(c) and Treasury Regulation 1.1361-1(e)(3) and provide that stock owned by members of a family is treated as owned by one shareholder, but only for purposes of the maximum shareholder limit. Members of a family are defined to include a common ancestor and all lineal descendants, including spouses and former spouses of such descendants. In addition, all legally adopted children, children who have been placed with an individual for legal adoption, and any eligible foster children will be treated as blood-related to such individuals. Finally, estates of deceased individuals, grantor trusts, and beneficiaries of other eligible trusts (such as QSSTs, ESBTs and voting trusts), provided those beneficiaries are members of the family, will qualify for treatment as a single shareholder.

As originally enacted, treatment of a family as a single shareholder required an election by at least one of the members of the family. This election regime, however, was discarded in 2005 by the Gulf Opportunity Zone Act and all family groups holding S corporation stock will automatically qualify for treatment as a single shareholder.

The only additional requirement is that on the applicable date, the common ancestor cannot be more than six generations removed from the youngest generation of shareholders. This “applicable date” is the latest of: (1) the date the Subchapter S election was made; (2) the earliest date that a member of the family held stock in the S corporation; or (3) October 22, 2004 (the effective date of the American Jobs Creation Act). Note that this test only applies for purposes of finding a common ancestor and effectively limits how far back in time one can go to identify a common ancestor. Once this common ancestor has been identified under the “six-generation test,” lineal descendants (and their spouses) more than six generations removed from the common ancestor who later acquire stock in the corporation will also be treated as members of the family.

The result of the family shareholder rules is the potential for a greatly expended shareholder group (well in excess of the statutory 100 shareholder limit). The rules are especially impactful for wealth transfer and estate planning purposes and allow older generations to transfer stock in S corporations to younger generations at an earlier stage without worrying about bumping up against the shareholder limit.

The expansive definition of “members of a family,” however, also creates some complexity for the S corporation in terms of tracking the number of shareholders. It becomes increasingly important to keep detailed records of stock ownership and transfers, especially for S corporations that are approaching the 100 shareholder limit or that have multiple large family groups as shareholders. We highly recommend that S corporations review their stock ownership and transfer records to ensure that family groups are being tracked appropriately. For example, the creation of a family tree for each family group that holds stock in an S corporation can assist with tracking transfers among family members and can avoid an inadvertent increase in shareholders beyond the limit.

Patrick J. Kennedy, III is an associate at Kennedy Sutherland LLP. His practice focuses on Tax and Business Law with an emphasis on corporate transactions and securties law. He can be reached at 210-585-2187 or pjkennedy3@kslawllp.com

On June 6th, House Majority Leader Eric Cantor, R-Va., laid out a busy legislative agenda for the remainder of June in a memo to House Republicans. In the memo, Cantor stated that as they return from their summer stretch into the swampy heat of Washington D.C., they will continue to work on an agenda that builds upon their work from the beginning of the year, including everything they accomplished in May.

Cantor noted that during the first part of the year, Chairman Dave Camp put forth a bold tax reform proposal, the Tax Reform Act of 2014, which aimed to address a broken tax code that penalized hard work and innovation, stifles American competiveness, and economic growth. As the Committee continues to receive feedback on the draft, Cantor scheduled floor consideration, for the week of June 9th, on three targeted tax extender bills. Of the three scheduled, two of the bills that were addressed were HR 4453 (permanent S Corporation Built in Gains Recognition Period Act of 2014) and HR 4454 (Permanent S Corporation Charitable Contributions Act of 2014).

As mentioned in our previous email alert, HR 4453, authored by Representative Dave Reichert, would make permanent currently expired provisions that reduces for businesses who are organized as S Corps the built-in gains tax holding period from 10 to 5 years. The Subchapter S Bank Association has long believed that this change will allow banks easier access to their capital to grow and create new jobs. HR 4454, which also is authored by Reichert, would make permanent temporary tax provisions regarding the basis adjustment rules for charitable giving by S Corps.

On June 12th, the House adopted the reforms by a count of 263 to 155. The provisions received strong bipartisan support, with all but two Republicans supporting the measure and forty-two Democrats parted with their leadership and the Administration and voted yes as well. Ways and Means Committee Chairman Dave Camp kicked off the day by offering these remarks on the House floor:

“The bill we have before us today is the right step forward to level the playing field between the small businesses on Main Street and big businesses. If a small business chooses to operate as an S corporation for tax purposes, we should ensure that they have the ability to access certain capital without tax penalties.

…This is a bipartisan, commonsense bill that will give
small businesses some much needed relief from the
burdens of the tax code, and allow them to make new investments and create new jobs.”

Washington State Congressman Dave Reichert had this to say:

“The BIG tax is a double tax on S corporations who want to sell their assets after converting from C corporation status.

…As we’ve heard from Jim Redpath…who testified before one of our Ways and Means hearings…the BIG tax causes S corporations to hold onto unproductive or old assets that should be replaced. He gave the example of a road contractor which is holding onto old equipment that is sitting in the junkyard…because if he sold them, they would be subject to the BIG, double tax.
Instead of selling the assets and using the proceeds to hire new workers or invest in new equipment, the business owners sit on the sidelines. This is a perfect example of the tax code influencing business decisions and needs to stop.”

The measures now will be sent to the  Senate side, where new Finance Committee Chair Ron Wyden (D-OR) and Majority Leader Harry Reid (D-NV) will work on how to move the extenders package forward, which includes two year extensions of these to S corporation provisions. Most likely, we will have to wait on the outcome of the November election before we see movement on these bills. However, the passage in the House is a big step and we will continue to press and move the issue forward as it is taken up on the Senate side.

Amy E. Trevino is membership coordinator for the Subchapter S Bank Association and business development coordinator for Kennedy Sutherland. She can be reach at 210-802-4285 or atrevino@kslawllp.com

As the title suggests, the banking industry has seen the number and pricing of 2014 mergers and acquisitions increasing again in 2014.

Has that anticipated surge occurred?  Not yet.  And more industry experts have conceded they don’t expect a surge any time soon if at all in the near future.  Why not?  Primarily a couple of factors: a continuing price gap between buyers and sellers, some lingering asset quality problems, and a change in buyers’ valuation of branches.

That said, increased activity and pricing has been driven by a narrowing price gap, improved asset quality, and better delivery of banking products and services.   Other contributing factors are the opportunity to partner with another bank to scale increased regulatory and other operating costs, improve loan volume, and leverage new products.  Another key driver has been the run-up in bank stocks over the last couple years.  Four banking indexes: SNL Bank and Thrift, S&P Bank, NASDAQ Bank, and KBW Bank all outperformed the Dow and S&P 500 in 2012 and 2013.  This provided a number of regionals and local publicly traded banks with stronger currency to pay higher prices.

We, at Commerce Street Capital, are speaking with community banks daily.  Many of them are Sub S Corporations (see the charts below).  Please note that these charts represent privately held institutions.  Total FDIC insured institutions as of March 31, 2014 were 6,730.  So Sub S banks make up roughly a third of the total population.

In addition, the table above indicates over 96% of those Sub S banks have assets <$1 billion – local community banks.

Our daily discussions suggest certain anecdotal evidence as well to the increased M&A activity and pricing.  A number of board and management teams are aging.  They either neglected to implement a clear succession plan or have difficulty finding qualified professionals to fill key positions.  The smaller institutions indicate a lack of well-rounded banking generalists.  An unintended consequence of bank consolidation increased banking specialists to help improve efficiencies yet depleted the generalist role.  Needless to say, the smaller the bank the broader the responsibilities, especially for the senior executives.  A challenge that will continue to grow.

Another driver we’ve heard is the loss of retail banking to the larger banks.  This began years ago, but many community banks are carrying smaller branches which result in a drag on profitability and capital allocation.  In smaller rural locations, they can’t exit the market as it is difficult to find interested buyers.  However, selling or merging with a partner may either help absorb the cost or provide an opportunity to consolidate and eliminate costs altogether.

As we proceed through 2014, we anticipate activity and pricing trends to continue.  Look for markets in the Southeast and West that were devastated by the recent recession to continue recovering with resulting bank M&A activity picking up.  As for the rest of the country, expect more of the same with volume and pricing to continue their steady rise.

Richard D. Foggia is Managing Director in the Financial Institutions Group of Commerce Street Capital, LLC. He is focused on mergers and acquisitions, capital raising and strategic planning advisory for financial institutions primarily in the Great Lakes and Midwest Region. He can be reached at 763-657-7624 or rfoggia@cstreetcap.com