Subchapter S, One Year Later

By Baran, Mark | ABA Banking Journal, April 1998 | Go to article overview
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Subchapter S, One Year Later

Baran, Mark, ABA Banking Journal

Mark Baran, ABA senior tax counsel, wrote "Should you bank on Subchapter S?" in our December 1996 issue.

Almost 600 banks have made the switch to Sub S tax status, but many questions remain. Herewith, some answers

Community bankers across the nation are raving about the tax benefits Associated with electing Subchapter S status.

This option has been available since enactment of a provision in the Small Business Job Protection Act of 1996 allowing banks that don't use the reserve method of accounting for bad debts to become Subchapter S (or small business) corporations. By electing Subchapter S status, banks are treated as partnerships for federal income tax purposes, and can avoid paying a federal corporate-level tax. Almost 600 banks elected Sub S status in 1997. Many more institutions will likely follow suit this year.

Even seasoned tax professionals are instinctively cautious when it comes to advising bank clients on Subchapter S issues. This is because, for 40 years, the small business corporation tax laws, rules, regulations, and other technical pronouncements were developed for non-bank companies. While introducing banks into the Subchapter S tax world was a big plus for community banks, making the transition into this new status presents challenges-and traps.

In short, a continual process of education is necessary in order to preserve and protect the tax savings associated with electing S corp status.

Many technical tax, planning, and banking questions predictably arise both before and after a banking institution's S corporation election.

The following are some common Subchapter S questions and answers recently asked by community bankers..

Q. Are there new eligible shareholders for 1998?

A. Yes. The S rules for banks were implemented in two stages.

First, understand that as a general rule, all of a banking institution's shareholders must be individuals, estates, or certain kinds of trusts. The Small Business Job Protection Act of 1996 liberalized many of the traditional Subchapter S eligibility rules. For example, the number of permissible shareholders was raised from 35 to 75. Also, a new type of trust shareholder-- called an Electing Small Business Trust (ESBT)--that may accumulate income and have multiple beneficiaries is now a permissible S corporation shareholder. These rules were effective for the 1997 tax year.

For tax years beginning after 1997, employee stock ownership plans (ESOPs), pension plans, and certain charities are eligible shareholders. Individual retirement accounts, however, continue to be ineligible S corporation shareholders. These new shareholder rules could afford new opportunities for banking institutions interested in electing Subchapter S in the future without incurring the added costs associated with complex restructuring.

Q. How is it determined if a bank's passive investment income assets (i.e., securities portfolio) are subject to the applicable 25% limitation on passive investment income?

A. The tax laws impose a corporate-level "sting" tax on any amount of "passive investment income" that exceeds 25% of the gross receipts of the S corporation. "Passive investment income" is defined as gross receipts derived from royalties, rents, dividends, annuities, and sales or exchanges of stock or securities. If an S corporation exceeds this 25% limitation for three consecutive years, the Subchapter S election will be terminated.

This area of the law has proved to be one of the most troublesome for banks, especially for those experiencing low loan demand or who hold a considerable portion of passive investment assets for other sound banking reasons.

The Internal Revenue Service attempted to address these concerns in IRS Notice 97-5, which outlines the list of banking assets not subject to the passive investment tax rules. Except for the last catch-all paragraph, the assets not subject to the passive income rules in Notice 975 are fairly straight forward; they include real estate mortgage investment conduit (REMIC) interests, Federal Reserve Bank or Federal Home Loan Bank stock, and certain pledged assets.

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Subchapter S, One Year Later


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