The Sub S Bank Report – October 2010 (Volume 13, Issue 3)

Throughout the course of this economic downturn, three words continue to resonate among the financial services industry: “Capital. Is. King.” This simple axiom can often be heard echoing down the halls of Congress, and may as well be the battle cry for the federal agencies charged with quelling the recession. Indeed, the U.S. Treasury Department’s highly-touted solution to the financial crisis—allowing banks to offload their toxic assets with Treasury—was ultimately scrapped in favor of the TARP Capital Purchase Plan. This was undoubtedly because the latter directly infused much-needed capital into struggling institutions, while the former did not.

The veritas of this statement is no less applicable to the smallest rural community banks than it is to the largest, most complex financial conglomerates. In fact, it is often the case that smaller community banks have considerably less access to capital than do their giant publicly held counterparts. The most glaring example of this dichotomy can be seen with banks organized as Subchapter S corporations.

The Internal Revenue Code places a number of restrictions on the types and number of shareholders an S corporation may have, as well as on the types of securities an S corporation may issue. For example, S corporations may not have as shareholders corporations, partnerships, LLCs, non-resident aliens, most IRAs and certain trusts. And the number of permissible shareholders—which generally include individuals and certain trusts—cannot exceed 100 (after considering the family attribution rules). S corporations are also prohibited from having more than one class of stock. In other words, unlike their C corporation counterparts, S corporations may not issue any form of preferred stock. The reason for this is likely that Congress felt that the complexities of maintaining multiple classes of stock would be too difficult for mom-and-pop businesses to comprehend. However, as the allowable number of shareholders has grown over the years (from 10 in 1975 to well over 100 today (under the family attribution rules), the size and complexity of corporations electing to be taxed under Subchapter S has followed suit. Furthermore, the passage of the Minimum Wage Bill in 1996 that allowed financial institutions to elect S corporation status signaled a dramatic change in the traditional notion that S corporation owners could not understand the complexities of basic securities laws. Indeed, financial institutions with as much as $15 billion in assets have elected Subchapter S status. It is therefore imperative that the one-class-of-stock rules aimed at protecting Subchapter S shareholders from themselves be repealed, or at a minimum amended, to allow S corporations to issue preferred shares in the form of “qualified preferred stock.”

Qualified preferred stock would be analogous to ordinary preferred stock, except that holders would not be treated as shareholders of the S corporation. The benefit of this would be twofold: (1) it would allow otherwise ineligible shareholders (i.e. corporations, partnerships, LLCs, etc.) to own preferred stock in S corporations; and (2) it would also enable S corporations to raise additional capital without having to worry about tripping the 100 shareholder limit.

Qualified preferred stock itself would not be treated as a second class of stock, and would be defined as stock that (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; and (c) has redemption and liquidation rights which do not exceed the issue price of the stock (except for a reasonable redemption or liquidation premium). Qualified preferred stock would be convertible into other stock, and distributions made by the S corporation with respect to qualified preferred stock would be included as ordinary income for the holder and deductible to the corporation as an expense, similar in that regard to the “restricted bank director stock” now permissible for S corporation banks. Holders of qualified preferred stock would not be allocated any income, loss, deduction, credit or nonseparately computed income or loss with respect to such stock.

The addition of qualified preferred stock to the world of Subchapter S would be a relatively simple and straightforward task. Section 1361 of the Internal Revenue Code would be amended to add a new subsection (h) defining qualified preferred stock and describing its characteristics, along with a few additional minor conforming changes other sections.

The ability to issue qualified preferred stock would substantially increase banks’ and bank holding companies’ opportunities to raise capital without altering their ownership structures. Investors in qualified preferred stock would be attracted by their preferred status and, depending on the terms, senior position to the common shareholders. Qualified preferred stock should also be very attractive to bank regulators who, more than anyone, have championed the “capital is king” credo.

Under recent financial reform legislation, new issuances of trust preferred securities will generally no longer count as Tier 1 capital, further limiting financial institutions’ ability to raise funds and requiring that Subchapter S banks seek alternative avenues through which to increase capital in order to survive and compete in the current economic climate. Creating an exemption for qualified preferred stock would enhance the capability of Subchapter S banks to maintain a reservoir of capital to replace the trust preferred securities currently being phased out. Additionally, a qualified preferred stock issuance is not nearly as complex as a trust preferred securities offering and therefore results in reduced transaction costs to the issuer and potential end investor. 

Allowing S corporations to issue qualified preferred stock would provide the nearly 2,500 Subchapter S banks throughout the country with the necessary tools to effectively combat cyclical downturns such as the one banks are struggling with today. This, in turn, would encourage increased lending and investment by these financial institutions, which is critical to this nation’s recovery. It is therefore of the utmost importance that the “one class of stock” restrictions in Subchapter S be eased to permit S corporations to issue qualified preferred stock. 

If you are interested in learning more about qualified preferred stock, or would like to become involved in the effort to bring about these reforms, please contact the Subchapter S Bank Association at (210) 228-9961 or by email at btoppin@subsbanks.org.

Mr. Toppin is a partner with the law firm of Kennedy, Toppin & Sutherland, LLP in San Antonio, Texas and is the executive director of the Subchapter S Bank Association. He can be reached at (210) 228-4414 or by email at btoppin@ktsllp.com. 

As leaves begin to turn color, for many it signals the start of football season and the World Series, and for many others . . . it signals the onset of tax planning season.  Although tax planning strategies are analyzed and implemented on a year-round basis, the fourth quarter is an essential time for organizations to focus their attention on implementing tax planning strategies to assure that their shareholders realize the most tax-efficient return on their investment.  S corporation banks face newly legislated tax provisions in 2010 when planning and implementing their year-end tax planning strategies, as well some expiring tax provisions, to provide ample opportunities for tax planning this year.

New Legislation: Health Care Reform
Earlier in 2010, Congress passed the massive health care reform legislation, which included a large amount of tax provisions to provide both tax relief to small businesses in relation to their health care costs, as well as to raise revenue offsets for the cost of the new health care provisions. The tax provisions in this legislation are initially effective for varying dates stretching out all the way to 2018. One provision in particular that some S corporation banks are interested in is the Small Employer Health Insurance Credit, which is immediately effective in 2010.  This credit is available to “small employers,” defined as an employer that offers its employees qualified health insurance coverage, and has less than 25 full-time equivalent employees (FTE’s) during the year that receive an average annual wage of less than $50,000.  There are many intricacies involved in computing eligibility for this credit, and the credit amount itself, such as the stipulation that 2% or greater shareholders are not included when calculating FTE’s and average wages.  It is important that S corporation banks work with their advisors in calculating the potential 2010 credit and communicate to their shareholders that they (the shareholders) may implement this credit when conducting their own tax planning.

New Legislation: Small Business Jobs Act of 2010
The recently-passed Small Business Jobs Act of 2010 provided many opportunities for 2010 tax planning that weren’t available before.  Highlights of this legislation important to keep in mind for year-end tax planning include:

• For any tax year beginning in 2011, the legislation shortens the holding period of assets subject to the built-in gains tax to five years if the fifth taxable year in the recognition period precedes the taxable year beginning in 2011.  For 2010 asset sales, prior legislation had shortened the built-in gains tax recognition period to seven years, provided the seventh year of the S corporation election preceded the 2010 taxable year.

• Section 179 expensing of eligible fixed asset purchases is now increased to $500,000 for 2010.  If an S corporation bank places into service $2,000,000 or greater of eligible fixed assets during 2010, the $500,000 expensing limitation will be gradually phased-out dollar-for-dollar for the amount of assets that exceed $2,000,000.

• For 2010 & 2011, certain types of real property are eligible for the Section 179 expensing provision.  Qualified leasehold improvements, qualified retail improvement property and qualified restaurant property is now eligible for expensing under this provision, where prior to this legislation a taxpayer could not elect Section 179 expensing for real property.

• 50% federal bonus depreciation on qualified new fixed assets is extended through 2010.

• First-year depreciation on luxury automobiles increased by $8,000 (to $11,060).

• Excess business credits incurred in 2010 can be carried back five years.

• Not necessarily of direct import for S corporations, but for 2010, self-employed individuals are allowed to deduct the cost of their self-employed health insurance premiums when computing their income that is subject to self-employment taxes for 2010.

Expiring Provisions:  Bush Tax Cuts
It is important to remember when considering the timing of income and deductions at year-end for 2010 the scheduled expirations of several favorable tax provisions put in place early on during the Bush Administration.  These provisions expire after 2010, so for 2011, tax planners need to take into consideration the anticipated higher marginal tax brackets in the immediately following tax year. 

The top individual tax brackets are scheduled to increase from 33% and 35% up to 36% and 39.6%, respectively. It has been widely reported that President Obama’s budget proposal calls for these top two brackets to increase after the 2010 tax year.  If no legislation is passed to extend the application of these tax brackets, individuals of all income levels will be negatively impacted by expiring tax brackets.

The tax rate on long-term capital gains for individuals above the 15% marginal ordinary tax bracket increases from 15% to 20% after 2010, which will be important for S corporation shareholders planning sales of stock or assets in the coming months.  Timing will obviously be crucial, especially when considering entering into an installment sale in 2010.  Electing out of installment sale treatment and paying tax on the entire gain in 2010 could be an optimal strategy in some cases when the 5% tax rate increase on long-term capital gains is considered.

Also very important is the expiring provision for the favorable long-term capital gains tax rate being applied to qualified corporate dividend income of individuals.  Since this provision was passed, many corporate shareholders have enjoyed a 15% federal tax rate on taxable corporate dividend income.  Should this provision be allowed to expire after 2010, corporate dividends would be taxed at the much higher ordinary income rates, which would likely also increase (as discussed above).  S corporation banks with a very thin Accumulated Adjustments Account (AAA) balance that also have a corporate Earnings & Profits (E&P) balance retained from their C corporation years should consider whether it would be advisable to pay distributions at the end of 2010 out of E&P (rather than from AAA) to “peel out” the E&P balance.  The result would be that shareholders would be taxed on dividends paid out of E&P, but only at the current 15% federal tax rate, rather than what could conceivably be at 39.6% in 2011 and beyond.  S corporation banks could also consider making a special election to treat the distributions paid during 2010 as taxable E&P dividends in order to potentially eliminate taxation at much higher rates in the future.  However, if an S corporation bank has ample AAA and/or very limited capacity to pay distributions to its shareholders currently and in the coming years, it may not be the best strategy to accelerate tax on the bank’s E&P balance.  It is vital that S corporation banks work with their advisors on this issue to ascertain that the most beneficial strategy is in place.

Long-Term Considerations: Is the S Election Still Optimal?
An important long-term consideration during tax planning this year for many S corporation banks may be whether the S corporation election is still the most optimal structure for the organization going forward.  Several factors, such as the inability to pay tax distributions because of regulatory constraints, or the difficulty in raising capital due to shareholder restrictions, may make maintaining an S election difficult. 

Also needing consideration when discussing this topic is the increasing individual tax rates discussed earlier in this article, while C corporation tax rates are remaining static.  One should remember, however, that these scheduled individual rate increases are reverting back to the same levels as in 1997, when banks were first allowed to make S corporation elections.  Many banks analyzed the tax benefits at that time (when corporate dividends were also taxed at ordinary tax rates) and determined that the S corporation election was the preferable tax structure.

When considering the impact of increasing individual tax rates in the future, S corporation banks should remember that beginning in 2013, a special 3.8% surtax (the Medicare tax) will apply to the pass-through earnings of “passive” shareholders (discussed in greater detail below) that have $250,000 or greater of adjusted gross income.  This provision may make an S election more expensive for banks with a large base of passive shareholders once it becomes effective in 2013.

Other Year-End Planning Items
The following checklist includes other important items to consider when formulating tax planning strategies for 2010:

• Repairs & maintenance costs – Review fixed asset accounts to determine whether repairs that have been capitalized on the bank’s books may be deductible for income tax purposes.  Repairs that merely keep an asset in operating condition and do not prolong the life of the property are generally deductible for income tax purposes.
• Loss on disposed fixed assets – Review tax depreciation schedules for junked assets that may have remaining tax basis that could be taken for a loss.  Also, if considering whether to trade or sell a vehicle, consider if there may be a tax loss built into the vehicle and whether taking that loss during 2010 would provide a good planning opportunity.

• If the S corporation bank is in a significant loss position for 2010, remember that the “old” net operating loss carryback rules are back in place. Individual shareholders can carry back net operating losses two years, and as always, carry them forward for 20 years.  This could impact tax planning strategies where the timing of income and deductions are flexible.

• Remember the Vainisi decision from March 17, 2010, in which the 7th Circuit Court of Appeals reversed the earlier decision of the Tax Court, and ruled that the TEFRA interest expense disallowance does not apply to S corporation banks (including Q-Subs) after they have not been a C corporation for three years or more.

• Passive loss rules – If in a loss position, consider whether the shareholder base is largely “passive” or not.  “Passive” has a complex definition with many different qualifications, the most general being that if an individual spends less than 500 hours a year on the activity, they are considered passive and can only offset pass-through losses with other passive income.  Excess passive losses are carried forward indefinitely until eventually offset by passive income, or the passive activity is fully disposed of by the individual shareholder.

• As in every year, review the loan portfolio to confirm that all bad debts are properly charged-off in order to protect tax deductibility in 2010.

• If not yet a cash basis bank, consider whether changing the bank’s tax accounting method to the cash basis would be beneficial for 2010.  Banks with average gross receipts of less than $50 million can make this change under automatic consent provisions, meaning they would not have to file appropriate IRS documents to affect the change until the due date of the S corporation tax return.

• Consider paying prepaid expenses if the initial benefit of the prepaid lasts less than 12 months and is thus eligible for accelerated tax deduction.

• Evaluate the bank’s level of tax-exempt municipal bonds and loans, and whether it is appropriate when considering the bank’s distribution strategy to its shareholders, since tax-exempt interest does not increase the S corporation’s AAA (and correspondingly, its ability to pay tax-free shareholder distributions).

• Payment of bonuses and compensation to employees – Consider the impact if the employee is also a shareholder of the bank.  Accrued compensation to S corporation shareholders often cannot be deducted until paid.

• Consider timing of profit sharing contributions to assure 2010 tax deduction.

• Consider bond swaps (for a profit or a loss, depending on earnings position of the bank) prior to year-end.

• Evaluate meals & entertainment to assure only 50% deductible items are booked to that account (Christmas parties, employee summer picnic, etc. are 100% deductible).

Although the above checklist of general tax planning items is not going to be all-inclusive for all S corporation banks, it will hopefully provide for a starting point in formulating 2010 year-end tax planning strategies.  Balancing tax planning with bank profitability and capital levels can be somewhat of a juggling act at year-end, but finding the correct balance and implementing proper strategies (including newly available ones) can provide an S corporation bank’s shareholders the optimal return on their investment.

Paul Sirek, CPA, MBT and Linda Koerselman, CPA are Partners with the accounting firm Eide Bailly, LLP. 

When the clock strikes midnight on December 31 officially bringing 2010 to a close, the cheers of revelers may be drowned out by the groans of taxpayers as a new (or rather old) framework for taxation goes into effect.  Barring action by Congress, the tax cuts enacted in 2001 and 2003 are set to expire at year’s end, and the Democrats and Republicans have thus far been unable to agree on what, if any, tax regime should replace the current system.  While Republicans have been steadfast in their opposition to any proposal that does not extend the 2001 and 2003 cuts in their totality, Democrats are split as to whether they favor a permanent, two-year or limited extension of the current law.  Faced with contentious November elections that could change the leadership in one or both of the House and Senate, Congress has postponed any vote on the tax cuts until the lame-duck session.  While significant uncertainty exists as to the ultimate outcome, this article briefly examines the proposals currently under discussion.     

Impact of Expiration of Tax Cuts
The first possibility is that Congress will be unable to agree on legislation and the cuts will simply expire.  As the previous article discussed, an expiration of the current tax structure will result in a reversion back to the 2001 levels of taxation.  The specific provisions created in 2001 that would cease to be in effect include the rate reductions of the top four brackets (from 39.6 percent to 35 percent for the highest bracket), the creation of the 10 percent bracket for a portion of the income previously taxed at 15 percent and marriage penalty relief.  The 2001 act also included more targeted measures such as increases in child-related credits, incentives for savings for retirement and education, phase-out of the estate tax and modifications to the gift tax.

The 2003 provisions set to expire include cuts with respect to capital gains, qualified dividend income and certain business expenses.  For those in higher tax brackets, the capital gains rate will increase from 15 percent to 20 percent, returning to its level prior to the implementation of the cuts.  Additionally, the cut with respect to corporate dividends is at risk, with the potential result of an increase from the rate of 15 percent under current law to the applicable individual income tax level.  In the case of those in the highest bracket,