With the signing of the American Taxpayer Relief Act of 2012 (H.R. 8) S corp Banks and their owners now have some certainty about taxes, at least for the foreseeable future. In addition to tax rate preservation (for some), Congress also enacted a number of other “business tax” extensions that were specific to S corps.
We all knew tax rates were going to go up, but many were able to dodge a bullet with the permanent extension of current tax rates for those earning less than $400,000 if filing individually, $425,000 if filing as head of the household or $450,000 if filing jointly. For those who earn more than the thresholds mentioned, the top tax bracket has been raised to 39.6%. Capital gains and dividend rates have been increased to 20% from 15% for the same top tax bracket. More specifically, capital gains and dividend rates remain at 15% for taxpayers in the 25-35% brackets and zero for taxpayers in the 10-15% brackets. Capital gains and dividends are also subject to the 3.8% Net Investment Income Tax (NIIT) described below.
H.R. 8 also increased the social security tax from 4.2% to 6.2% on earnings up to $113,000. In addition, there is a Medicare tax surcharge of .9% on earned income above $250,000 (joint) and $200,000 (single) on top of the current 2.9% tax.
A very relevant S corp provision of H.R. 8 is the extension of the five year built-in gains recognition (holding) period, rather than a return to the ten year recognition period. This provision has been extended for an additional 2 years.
The special basis adjustment rules for S corp’s charitable contributions has also been extended, which allows an S corp shareholder to use the adjusted basis of the contributed property rather than the fair market value.
Net Investment Income Tax and the Health Care Act
It is time for the impact of the Health Care and Education Reconciliation Act of 2010 (Health Care Act) to be felt. Pursuant to section 1411 of the Internal Revenue Code, the new 3.8% NIIT is set to begin January 1, 2013 on taxpayers making more than $250,000 (joint) or $200,000 (single). When it comes to the NIIT the devil is in the details, so much so that the IRS just issued 42 pages in the Federal Register of proposed regulations governing the implementation of the NIIT. A quick review of these will reveal an extraordinarily complicated proposal that will require significant study and further interpretation by tax professionals and the IRS about whether and when the tax will be imposed. Big picture for the typical S corp Bank is:
• The tax will be imposed on certain S corp bank earnings if the taxpayer is passive with respect to the income. In general, if you “materially participate in the business,” you may not be subject to the tax.
• Treasury Reg 1.469-5T(a) provides a list of tests to determine who would be considered to be materially participating. An example might be a director who spends 500 hours or more on bank business attending meetings, promoting the bank, etc.
• With respect to a shareholder who materially participates, net investment income does not include loan or investment income since that income is “derived in the ordinary course of a trade or business” for a bank.
• Estates and Trusts will be subject to the NIIT if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount is $11,650).
Trust Specific Matters
The NIIT proposed rulemaking contains special rules for Qualifying Subchapter S and Electing Small Business Trusts, as well as S corps in general, in connection with the calculation and recognition of net investment income, expense and gain.
Certain trusts will not be subject to the NIIT:
• Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (e.g. charitable trusts and qualified retirement plan trusts exempt from tax under IRC section 501, and Charitable Remainder Trusts exempt from tax under IRC section 664).
• Trusts that are classified as “grantor trusts”.
• Trusts that are not classified as “trusts” for federal income tax purposes such as Real Estate Investment Trusts and Common Trust Funds.
S Corp Banks Still Viable
While most S corp shareholders will pay more tax and there will be more pressure on Bank’s to distribute more cash to cover those higher taxes, S corp bank structure benefits still are very much intact and the principal advantages of an S corp still remain. Cash distributions to shareholders of S corps will not be subject to tax and retained earnings will increase basis, thereby, reducing the capital gains tax upon sale. There is a case to be made that there is more value in owning an S corp bank than a C corp bank as a result of these features, especially over the long term. In addition, the S corp structure provides certain opportunities to create a tax advantage for a buyer that can be obtained upon a properly structured sale of the bank, which can add significant value to the franchise. These fundamentals all remain intact after H.R. 8.
Mr. Kennedy and Mr. Sutherland are partners in the law firm of Kennedy Sutherland LLP, a firm headquartered in San Antonio, Texas with a comprehensive practice in financial institutions law. Mr. Kennedy is President and founder of the Subchapter S Bank Association. Mr. Sutherland serves as the Association’s Executive Director.