President Clinton recently signed the Small Business Job Protection Act of 1996 which, for the first time, allows certain financial institutions to elect S corporation status, effective Jan. 1, 1997.
Significantly, S corporations now may own directly or indirectly all the shares of one or more qualified subsidiaries. Thus, certain bank holding companies can remain intact and make S corporation elections.
Two principal benefits are available from S corporation status: avoiding double taxation and decreasing the taxable gain on any sale of shares in the institution. As illustrated below, those benefits can be both immediate and continuing.
If an S election is made, the financial institution's profits are taxed only once, at the shareholder level.
Currently, two levels of taxation apply to financial institution earnings that are distributed to shareholders as dividends. Assume that ABC Bank has profits of $1 million. The bank pays $340,000 of federal income tax and has $660,000 of remaining profits to distribute to its shareholders. Since the current maximum marginal rate for individuals is 39.6%, shareholders would pay federal income tax of $261,360 if the remaining profits were paid to them as dividends.
Thus, shareholders would only keep $398,640 of ABC's total profits.
An S corporation, however, generally does not pay federal income tax on its profits. Instead, tax is paid by the shareholders. Thus, ABC's shareholders pay federal tax of $396,000 on the bank's profits. This leaves $604,000 to be distributed, tax-free, to shareholders. ABC's shareholders are able to keep an additional $205,360 of profits after federal income taxes.
Alternatively, assume that ABC distributes only one-half ($500,000) of its profits to shareholders. This represents a $104,000 economic dividend to the shareholders after they pay their federal taxes on the bank's profits due to the S election. The $500,000 of undistributed profits increases shareholders' tax basis in their bank stock. This happens each year profits are retained.
Thus, if their bank stock is sold for cash several years after the election is made, shareholders would incur significantly less capital gains tax because of the annual basis increases. No such increases apply to shareholders in financial institutions that do not make an S election.
The new law also significantly eases eligibility for any business to elect S status. For example, the number of shareholders an S corporation is permitted to have has been raised from 35 to 75, and it now is easier for S corporations to raise capital. The law also expanded the class of eligible shareholders to include qualified plans, certain multiple-beneficiary trusts commonly used for estate planning, and employee stock ownership plans.
In addition to the normal qualification rules, the only additional restriction upon financial institutions that wish to elect S status is that they may not use the reserve method of accounting for bad debts.
Significant additional restrictions remain, however. For example, an S corporation cannot have more than one class of shares (although voting and nonvoting common shares are allowed). Therefore, if one intends to make an election effective Jan. 1, 1997, certain steps may be required before yearend, for example, redemption of ineligible shareholders, converting preferred shares to common shares, and ending use of the reserve method.
Other issues must be addressed before making an S election. The institution must protect against an inadvertent termination of its S status, and arrangements must be made to determine the additional tax liabilities of shareholders.
Shareholder agreements should be prepared (or modified, if agreements already are in place) for the benefit both of the electing parent financial institution and its shareholders. The parent institution must be protected against transfers of shares to ineligible shareholders or to more than 75 shareholders, either of which would terminate the S election. This could occur, for example, upon the death of a shareholder whose estate is directed to distribute shares to five heirs, if the bank already is at the 75 shareholder limit. At a minimum, the financial institution and-or its other shareholders must be given right of first refusal.
In addition, shareholders need assurances that they will get dividend distributions in amounts at least equal to their increased personal tax liabilities due to the transfer of the institution's tax liability to them.
Unresolved tax issues remain concerning the conversion of a consolidated group of corporations to S status. In addition, switching from the reserve method to the specific chargeoff method may trigger immediate income recognition.
Finally, entering into shareholder agreements that oblige the institution to make prescribed dividend distributions may require regulatory approval. Closely held bank holding companies and other financial institutions should consult immediately with their tax and regulatory advisers to determine whether the benefits of converting to S status make the move worthwhile.
Mr. Pluth heads the tax practice of the Chicago law firm Schiff Hardin & Waite.