Subchapter S refers to a chapter in the Internal Revenue Code (the “Code”) enacted in 1954 covering the taxation of S corporations. According to Subchapter S, an S corporation is a “small business corporation” for which a valid election under Subchapter S of the Code is in effect. Generally, S corporations are not subject to the “double taxation” normally associated with C corporations; rather, the earnings of an S corporation are taxed only once—at the shareholder level. For many years, banks and thrifts had been prohibited from electing to be taxed as S corporations. But in August 1996, Congress enacted the Minimum Wage Bill, amending the Code to allow banks and thrifts to elect Subchapter S taxation as of January 1, 1997. Presently, there are nearly 2,500 financial institutions throughout the United States that have elected to be taxed under Subchapter S.
I. WHAT IS SUBCHAPTER S?
As stated above, Subchapter S refers to a chapter of the Code governing the taxation of small business corporations, including banks and thrifts. The effect of a Subchapter S election is that the entity is no longer subject to corporate level taxes.
In general, the earnings of C corporations are taxed first at the corporate level; then once again at the shareholder level as dividends are paid on those earnings. The earnings of S corporations, on the other hand, “flow through” to the shareholders, who then include those earnings on their individual tax returns. Because S corporation shareholders report the corporation’s earnings on their individual tax returns, the amount of tax each shareholder owes with respect to those earnings is based on the shareholder’s individual marginal tax rate.
The earnings of an S corporation are allocated among its shareholders based upon each shareholder’s pro rata ownership in the corporation. For example, if a shareholder owns 50% of an S corporation, that shareholder will be responsible for paying taxes on 50% of the corporation’s earnings in any given year.
An S corporation calculates its earnings in essentially the same manner as a C corporation. For example, interest and business expense deductions will offset the corporation’s earnings and reduce taxable income to the shareholders.
The following illustration shows the income tax benefits of an S corporation as compared to a C corporation:
While shareholders of S corporations have the added benefit of only one level of taxation, they also retain the limited liability protection from creditors enjoyed by C corporation shareholders.
Another benefit of an S corporation is the capital gains tax consequence of a sale of the corporation. In the case of C corporations, a shareholder’s basis in his/her stock is essentially the purchase price of the stock, which remains unchanged for the duration of the period the shareholder owns the stock. Conversely, an S corporation shareholder’s basis is adjusted by the corporation’s retained earnings. In other words, undistributed earnings of an S corporation will not be subject to capital gains tax if a shareholder later sells his/her stock. The result is a favorable climate for capital accumulation in the bank.
The below illustration compares the capital gains effect between a C corporation and an S corporation shareholder, assuming both purchase their stock at $50 and sell one year later at book value of $200/share.
In connection with a corporation’s Subchapter S election, if the corporation has one or more wholly-owned subsidiaries, it can elect for those subsidiaries to be treated as “qualified Subchapter S subsidiaries” or “QSubs.” For example, for a banking organization with a bank holding company structure, the parent bank holding company would make a Subchapter S election (on a Form 2553) and make a QSub election for each of its subsidiary banks (on Forms 8869).
For purposes of Subchapter S, a QSub is treated as a disregarded entity, meaning that in general all assets, liabilities, items of income, deduction and credit of the QSub are treated as the assets, liabilities, and items of income, deduction and credit of the parent S corporation.
II. SHAREHOLDER ELIGIBILITY
Because of the significant tax advantages afforded to S corporations, there are a number of limitations and restrictions are placed on the corporation itself and/or its individual shareholders. One significant restriction is that only certain types of shareholders may qualify to own stock in an S corporation. Those include:
- Individuals (and their estates);
- Grantor trusts, electing small business trusts and qualified Subchapter S trusts;
- Not-for-profit corporations and ESOPs; and
- IRAs and Roth IRAs (but only to the extent the stock was owned prior to 10/22/04).
Ineligible shareholders of an S corporation include:
- Non-resident aliens;
- Limited liability companies; and
- IRAs and Roth IRAs (under circumstances not described above).
In addition, an S corporation is not permitted to have more than 100 shareholders. However, for purposes of considering the number of shareholders of an S corporation, all “members of a family” are treated as a single shareholder. The term “members of a family” is defined in Subchapter S of the Code and was added in 2004 to enable S corporations to expand their actual numbers of shareholders without exceeding the 100 shareholder limit discussed above. Subchapter S of the Code defines members of a family include all shareholders and spouses (and former spouses) of shareholders, who are up to six generations removed from a “common ancestor.” For purposes of
calculating which shareholders are considered members of a family, neither the common ancestor nor any of the common ancestor’s lineal descendants actually need to be (or have been) shareholders of the corporation.
Because of the above-referenced restrictions on the number and types of shareholders eligible to own stock in S corporations, it is critical that the company enter into a shareholder agreement upon electing Subchapter S. The primary purpose of a shareholder agreement is to protect the institution’s Subchapter S election from an inadvertent termination caused by having an ineligible shareholder or too many shareholders. To be effective, all shareholders must be a party to the shareholder agreement. Typically, the types of restrictions contained in a shareholder agreement include:
- Prior board approval of all or certain types of transfers;
- Prohibition on transfers to non-qualified individuals or entities; and
- Limitation on the number of allowable shareholders.
In addition to protecting against an inadvertent termination of the corporation’s Subchapter S election, a shareholder agreement also creates a number of other benefits. Most shareholder agreements grant the S corporation a right of first refusal to repurchase stock, which provides for the orderly distribution of shares and creates an avenue for shareholders to sell their stock in an otherwise limited market. Shareholder agreements also create significant estate tax discounts due to their share transfer restrictions.
III. ELECTION PROCEDURE AND TIMING
An election to be taxed under Subchapter S of the Code must comply with the various provisions prescribed under the Code. A corporation and its shareholders must meet the above-referenced requirements on the first day of the taxable year if an election is to be effective as of the beginning of that taxable year. Otherwise, an election may be effective at a later date, but a separate short year return will be necessary for the portion of the year that the corporation operates as a C corporation. The election itself requires the written consent of 100% of the institution’s shareholders.
IV. CORPORATE RESTRUCTURINGS
In order to ensure that 100% of the corporation’s shareholders consent to the Subchapter S election, an organization may enter into a corporate restructuring that will, in effect, guarantee 100% shareholder approval. Additionally, under circumstances where the corporation does not qualify to elect Subchapter S because it has more than 100 shareholders (after consideration of all members of a family), or it has shareholders that do not qualify to own stock in an S corporation (e.g. corporations, partnerships, LLCs, non-resident aliens), a corporate restructuring can be utilized to eliminate those barriers to qualifying to elect Subchapter S status.
There are a number of different types of corporate restructurings that can enable a corporation to qualify to be taxed as an S corporation. The following are some common examples:
1) Redemption offer
- Corporation offers to redeem shares from shareholders
- Can be utilized to buy out shareholders who do not qualify to own stock in an S corporation, will not consent to the S election, will not execute the shareholder agreement, or to reduce shareholder numbers under
2) Reverse stock split
- Reduces outstanding stock by a fraction (i.e. 1 for 100 split)
- Utilized to reduce shareholder numbers under 100 by buying out shareholders who will be left with fractional shares
3) Merger (cash-out merger)
- Corporation merges with newly-formed interim corporation
- Terms require that shareholders qualify to own stock in an S corporation, consent to S election and execute shareholder agreement
- If necessary to reduce shareholder numbers, can also stipulate that shareholders must own minimum number of shares in order to remain shareholder in resulting corporation
Most corporate restructuring will require some degree of approval from state and/or federal agencies. In many cases, an independent valuation of the corporation’s stock is necessary to determine the price to be paid to those shareholders who receive cash for their shares, either voluntarily or involuntarily. Additionally, depending on the type of restructuring employed, prior shareholder approval may be necessary.
An election to be taxed under Subchapter S can be very advantageous for a community bank. First and foremost is the advantage of eliminating the double taxation normally associated with C corporations. Other advantages of electing S corporation status include:
- Reduction in capital gains recognized upon sale of stock
- Opportunities to reduce market value of stock for gift/estate purposes
There are also certain potential disadvantages associated with electing S corporation status. These generally include:
- Only one class of stock is permissible (i.e. no preferred stock)
- Shareholders subject to pro rata share of tax on earnings of the corporation regardless of whether dividends are paid
- Limitations on types and number of shareholders
- Potential built-in gains tax consequences (discussed below)
- Limits on passive investment income (discussed below)
- Potentially greater exposure to Medicare tax (discussed below)
- Less tax benefit if significant portion of earnings attributable to tax-exempt income
In general, a corporation that elects Subchapter S may be subject to a built-in gains tax on the sale of assets within a specified amount of time after its S election. Built-in gains refer to the unrecognized appreciated value of an S corporation’s assets as of the date of its Subchapter S election. If the corporation sells any appreciated assets within 10 years of its S election date (referred to as a ten year recognition period), the corporation may owe a tax of 35% on those built-in gains. However, built-in gains can be offset by built-in losses when computing the amount of any built-in gains tax due. Recent legislation has temporarily reduced the built-in gains tax recognition period to seven years, but absent legislation making this change permanent, the recognition period will return to 10 years after 2010.
S corporations may also be subject to an additional tax on passive investment income. For any year in which an S corporation has undistributed earnings and profits from pre-S corporation years, it will be subject to an additional corporate tax on any income which is considered passive investment income and which exceeds 25% or more of gross receipts. Also, a corporation’s S election may be involuntarily terminated if its passive investment income exceeds 25% of gross receipts for three consecutive years and the Company has undistributed earnings and profits from pre-S corporation years. Recent legislation provides that, in the case of a bank, a bank holding company or a financial holding company, interest income and dividends on assets required to be held by these institutions (i.e. stock in the Federal Reserve Bank, Federal Home Loan Bank, etc.) are not treated as passive investment income for purposes of the S corporation passive investment income rules.
Recently, Congress passed the Heath Care and Education Affordability Reconciliation Act of 2010 which, among other things, imposes a “Medicare tax” of 3.8% on the lesser of an individual’s investment income or the excess of the individual’s modified adjusted gross income above $200,000 ($250,000 for joint filers). The flow through nature of an S corporation’s earnings will therefore have additional tax consequences for shareholders. Whether a shareholder is considered an active shareholder or a passive shareholder will also have an impact. Income earned by the S corporation bank in the ordinary course of business will be treated as ordinary income for active shareholders, and thus, will not be subject to the 3.8% Medicare tax. Investment income earned by the S corporation bank will be treated as investment income to the active shareholder, and will be subject to the Medicare tax. Conversely, all of the S corporation bank’s income (whether ordinary or investment) will be subject to the Medicare tax for passive shareholders. The Medicare tax will become effective for taxable years beginning on or after January 1, 2013.
Bruce Toppin is a partner with the law firm of Kennedy, Toppin & Sutherland, LLP and the executive director of the Subchapter S Bank Association. Mr. Toppin can be contacted by phone at (210) 228-4414 or by e-mail at firstname.lastname@example.org.