Corporation Law Change Could Mean Tax Bonanza

The owners of hundreds and probably thousands of small, closely held banks could save millions in taxes by taking advantage of a soon-to-be available corporate structure, according to banking lawers and tax specialists.

By becoming S corporations, closely held banks may be able to ward off acquirers and attract more long-term investment.

"We've been working toward this day for six years," said Al Jones, chief executive of American Bank in Corpus Christi, Tex. "This could be a huge incentive to invest in community banks."

Patrick Kennedy Jr., a San Antonio lawyer who for years has championed such limited-liability forms of ownership for small banks, said the new law's "benefits are enormous."

The change is "quite a far-reaching and welcome thing for community banks," he said.

Owners in Texas, which has hundreds of small, closely held community banks, are expected to take quick advantage of the change.

The S corporation change is part of the Small Business Job Protection Act of 1996, commonly known for its provisions increasing the minimum wage. The legislation, awaiting the signature of President Clinton, allows banks and thrifts to use S corporation structures for the first time and liberalizes the definition of S corporations.

The S corporation structure was designed for small businesses with few shareholders as a way to shield owners personally from certain liabilities associated with running a business while keeping their individual tax status.

But depository institutions were always barred from using the ownership structure because they could, in theory, use the bad-debt-reserve accounting method. But bank proponents said the reserve method is never used - even for accounting for bad debts.

The new law will change that, as well as increase the maximimum number of shareholders allowable for an S corporation to 75 from 35.

"This legislation permits for the first time S corporations to have subsidiaries," Mr. Kennedy added. "So bank holding companies would also be eligible."

The American Bankers Association supported the bill, which was designed to create incentives to start small businesses.

"There's something in this law for everyone," said Donna Fisher, the ABA's director of tax and accounting issues. "For large banks, small banks, for bank customers, for bank owners. It's going to be very positive."

The biggest goody is the ability of banks to avoid "double taxation" inherent in regular corporations, where both the company's earnings and its shareholders' dividends are taxed.

Banks that become S corporations would not have to pay corporate income taxes, but their shareholders will pay the personal tax rate for whatever earnings the bank makes. Any after-tax income is kept by the shareholders or used as retained earnings.

For instance, shareholders of a bank that makes $1 million in before-tax income would end up with $400,000 in cash from dividends after corporate and personal taxes are subtracted. Assuming the bank passes all of its after-tax income to shareholders in the form of dividends, shareholders would end up with $605,000 because the corporate tax is never paid.

Mr. Jones said he reconfigured his shareholder setup to accommodate an S corporation-like structure years ago, and plans to switch as soon as he's legally able: the 1997 tax year. He feels it could be a big shot in the arm to independent-minded bank owners, making community banks a better long- term investment.

"There's one less reason to have an exit strategy," he said, referring to the mergers sweeping the industry. "This form of ownership could finally stabilize independent banking in many communities."

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