New Law Makes It Time to Weigh Tax Payoff of S Corporation Status
Pluth, Robert R., Jr., American Banker
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. …