Investment Soul Mates
Pickering, C. J., McBride, Brian, Independent Banker
S Corporations and municipal bonds-a match made in heaven
or financial institutions that are Subchapter "S" Corporations, tax-free municipal bonds offer tax equivalent yields that dwarf taxable yields. As a result, most S Corporations should own as many municipal bonds as possible given their liquidity, asset/liability, distribution and income constraints.
Because of attractive yields that S Corporations realize on tax-free municipal bonds and because the basis step up applies to tax-free income, most S Corporations benefit from maximizing tax-free income. S Corporations planning to distribute all income annually should not own tax-free securities because distributions of taxfree income are generally taxable to the shareholders.
However, an S Corporation that plans to distribute annually only part of its income should manage taxfree income so that net taxable income is sufficient to pay any planned distributions. For example, an S Corporation that has net income of $1 million and intends to distribute $600,000 per year in net taxable income to shareholders could (and perhaps should) reserve the remaining $400,000 per year as tax-free income.
Tax-free municipals are even more attractive to S Corporations than C Corporations for two reasons:
The tax rate used in calculating the tax equivalent yield is likely higher (39.6 percent versus 34.0 percent); and,
The 20 percent TEFRA disallowance disappears after three years as an S Corporation.
CALCULATING TAX-EQUIVALENT YIELDS
In calculating the tax equivalent yield for S Corporations, the most relevant yield is the tax equivalent yield to maturity (or call date, if applicable). …