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Subchapter S Eligibility for Community Banks:
The American Jobs Creation Act of 2004
Jeffrey E. Smith
Bricker & Eckler LLP
June 2006
While opinions may differ as to their success, one of the oft-cited worthy goals of Congress and the banking agencies in recent federal legislative and regulatory initiatives has been to provide generally for increased flexibility for community banks. Those initiatives have included making it easier for community banks to qualify for the pass-through federal income tax advantages of Internal Revenue Code Subchapter S treatment.
However, qualifying for Sub S treatment comes with some significant baggage. Among other things, Sub S requirements include strict limitations on the number and characteristics of qualifying shareholders and the requirement that Sub S organizations have only one class of stock (except that it can have both voting and nonvoting stock), both of which impact the viability and use of Sub S treatment for institutions.
Following years of prohibition, the way was cleared for eligible banks to qualify for Sub S treatment by the Small Business Job Protection Act of 1996. Since then, a number of community banks have taken advantage of the ability to qualify for Sub S status. The recent American Jobs Creation Act of 2004 (the “Act”) expands opportunities for existing, as well as de novo, community banks to take advantage of Sub S treatment.
Under the Act:
the number of eligible Sub S shareholders has been increased from 75 to 100,
the type of eligible Sub S shareholder has been expanded to include multiple generations of family as one shareholder,
the type of eligible Sub S bank shareholder has been expanded to include qualifying IRA accounts, and
qualifying Sub S banks (as well as bank and financial holding companies) have expanded opportunities to receive interest and dividends on certain designated assets without violating the “passive investment” rules otherwise applicable to Sub S organizations.
Interestingly, the Act does not authorize IRA’s to hold bank holding company stock, a distinction which may not have been intended and which hopefully may be addressed in technical correction legislation. If not, the distinction represents a serious impediment to the ability of financial institutions to take advantage of the expanded authority contained in the Act.
Banks may elect to convert to Sub S status, or may be formed de novo as Sub S institutions. Either way, eligible banks are able to push qualifying income down to shareholders without the interim imposition of federal income taxes on the institution, thus providing enhanced shareholder returns.
The primary downside of Sub S status involves the need to monitor and police shareholders so as to avoid disqualifying events which could adversely impact Sub S status, and related issues with respect to reduced capital flexibility. While some Sub S banks utilize “trust preferred” stock for additional capital needs, trust preferred issuances can be complex and costly, and there are limitations on the eligibility of trust preferred securities for core capital. The expanded number, and type, of authorized shareholders for Sub S banks will enable banks to raise additional capital and to avoid certain problems related to multi-generational share distribution in family holdings, thus providing important additional planning flexibility. In a conversion, expanded shareholder eligibility also reduces the cost of shareholder buyouts by enabling the converted institution to retain more eligible shareholders.
The expanded “passive income” provision of the Act also provides important investment flexibility to eligible Sub S institutions in periods of reduced loan demand.
As a related aside, significant strides have also been made in enabling state-chartered banks to qualify for formation as “limited liability companies” (or “LLC’s” as they are called) under state law, including the FDIC’s final rule on LLC eligibility for insured institutions issued in February, 2003. This method of formation, like Sub S eligibility, generally enables qualifying LLC’s to avoid federal taxation at the company level while pushing down earnings to the “members” (ie shareholders). The good news is that (i) LLC’s are generally significantly more flexible and liberal in terms of governance issues (including lack of restrictions on number and type of members), and (ii) in addition to the FDIC’s actions, many states have taken action to permit state banks to choose an LLC organizational structure. However, and most importantly, the bad news is that IRS regulations do not yet recognize pass-through treatment for bank earnings like other non-bank Sub S organizations, and therefore despite the FDIC’s efforts and those of various state banking agencies to enable banks to form and operate as LLC’s, there is unfortunately no federal income tax advantage at the present time for utilizing that organizational form.
Therefore, while important issues remain the Act helps to take the industry in the right direction. It has further opened the door for existing community banks to consider conversion to Sub S status, and for de novo community banks to consider formation as Sub S organizations. Sub S qualification is not a panacea, however, and may or may not be appropriate depending on the plans and needs of a particular institution. As with any important decision, boards must carefully consider all of the implications of Sub S organization on the institution and appropriate constituencies before proceeding. Hopefully the ongoing movement toward enhanced incentives and operational flexibility for community banks will encourage Congress, the IRS, state tax authorities, and state and federal banking agencies, to continue to find opportunities to help community banks retain their viability, and competitiveness, as key participants in the financial services industry sector.
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