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The AJCA aids financial institutions seeking S status.

S corporation status first became available to financial institutions in 1997; ever since, over 2,000 banks and thrifts-almost 25% of all financial institutions--have converted from C to S status. Many others have considered it, but the various limits and restrictions have undoubtedly discouraged them. Although the American Jobs Creation Act of 2004 (AJCA) does not address all of the issues encountered by banks considering an S election, it does ease some of the more problematic requirements. Its new provisions for shareholders, IRKs and passive income may allow more banks to take advantage of the benefits S status offers.

Number of Shareholders

Prior to the AJCA, S corporations could not have more than 75 shareholders, although a husband and wife were counted as only one shareholder. Under Sec. 1361(b)(1)(A), as amended by AJCA Section 232(a), that number has increased to 100, effective for tax years beginning after 2004.

Perhaps most significant, an entire family--not just a husband and wife-can now elect to be treated as a single shareholder; see Sec. 1361(c)(1)(A), as amended by AJCA Section 231(a). For this purpose, a "family" includes a common ancestor, lineal descendants of that ancestor and the spouses (or former spouses) of the lineal descendants or common ancestor, for up to six generations; see Sec. 1361(c)(1)(B). Further, this applies whether the individual owns stock directly, or indirectly as a beneficiary of an electing small business trust or qualified subchapter S trust; see Sec. 1361 (c) (2) (B).As an added convenience, the election is made on a family (versus individual) basis under Sec. 1361(c)(1)(D), thus simplifying the process.

These changes are not only more flexible as to the total number of shareholders, which benefits banks considering S status, they are also more flexible as to the movement of shares between family members, which benefits shareholders directly.

Historically, S bank shareholders have been severely limited in their ability to bequeath, gift or sell shares to family members, for fear of inadvertently terminating the S election by creating new shareholders and exceeding the maximum allowable number. The new family election alleviates this concern; regardless of the number of individuals comprising a "family" its status as a single shareholder does not change.


S shareholders are not only limited in number, but also in type. Historically, the only eligible shareholders under Sec. 1361(b) were U.S. citizens or resident aliens, employee stock ownership plans and certain tax-exempt organizations and types of mists. Other kinds of entities and individuals, including non-resident aliens, partnerships, corporations and IRAs, could not own S stock. However, after the AJCA, certain IRAs (regular and Roth) are now eligible S bank shareholders, albeit subject to very specific limits.

According to Sec. 1361(c)(2)(B)(vi), as amended by AJCA Section 233(b), the IRA beneficiary has to be an eligible shareholder, and the IRA shareholder had to have been in existence as of Oct. 22, 2004. IRAs that became shareholders afterward are ineligible.

Only IRAs that own bank stock qualify; IRAs that own bank holding company stock do not; see Secs. 1361(c)(2)(B)(vi) and 581. This distinction appears to be an oversight; on July 22, 2005, Congress introduced tax technical correction legislation (HR 3376, S 1447) to include bank holding companies, retroactive to the AJCA's effective date. However until the legislation is enacted, the exception remains limited to banks.

UBI rules: While the IRA exception can be positive for banks considering an S election, it is not necessarily positive for IRAs. IRAs are tax-exempt entities, but are subject to tax on unrelated business income (UBI), which includes S income; see Sec. 512(e)(1), as amended by AJCA Section 233(d). Thus, some beneficiaries may prefer removing bank stock from an IRA portfolio. In the past, IRAs could not sell stock directly to a beneficiary; the sale was a prohibited transaction that caused loss of exempt status.

The AJCA provides a very limited exemption. Under Sec. 4975(d)(16), as amended by AJCA Section 233(c), only bank stock held by the IRA as of Oct. 22, 2004 is eligible. The sale can only be made pursuant to an S election by the bank. It must be negotiated as an arm's-length transaction at fair market value, as established by an independent appraiser, and the IRA cannot incur any selling costs or related expenses. Finally, the stock must be sold in a single transaction for cash no later than 120 days after the entity makes the S election.

Although the prohibited transaction exception provides a new planning opportunity for banks considering S status, eligible IRAs and their beneficiaries may not necessarily want to take advantage of it. The cost of the appraisal, the value of the stock or the cash and timing requirements could discourage a beneficiary from purchasing stock from an IRA.

Passive Income

S corporations that were previously C corporations are limited by Sec. 1362 in the amount of passive income they can earn each year. Historically, bank investment income has been included in the definition of passive income. If an S bank's gross receipts from investment income exceed 25% of its overall gross receipts, it has to pay a corporate-level tax on its net investment income. Further, if this occurs for three consecutive years, the S election will automatically terminate, and the bank will revert to C status.

For banks with large investment portfolios, the passive income rules are first a deterrent to electing S status, and then an obstacle in retaining it. However, effective for tax years beginning after 2004, Sec. 1362(d)(3)(F), as amended by AJCA Section 237(a), modifies the definition of passive income to exclude interest income earned by banks and bank holding companies, as well as dividend income earned from assets required, for regulatory purposes, to be held by banks or their holding companies (including stock in the Federal Home Loan Bank, Federal Reserve Bank and Federal Agricultural Mortgage Bank, or participation certificates issued by a Federal Intermediate Credit Bank) . Although other forms of dividends, as well as gains on sales of stock and other securities, are still passive income, excluding investment interest income greatly reduces the potential threat of the passive income rules.


Despite the various limits and restrictions that often close the door to a successful S election, the AJCA makes it possible for banks to consider or reconsider the possibility of becoming an S corporation.

Why Do S Elections Appeal to Financial Institutions?

S corporation status is often viewed as more desirable than C corporation status, for many reasons. First (and possibly foremost), S banks incur only one level of tax at the shareholder level, while a C corporation is taxed twice on its income--at the corporate level and then at the shareholder level. By eliminating the second level of tax, shareholders increase the overall return on their investment.

An S election can also give shareholders an advantage if they sell their investment, as it is more flexible than C status. C bank shareholders will typically sell only stock, rather than assets, to eliminate the corporate-level tax. On the other hand, S banks incur tax only at the shareholder level, regardless of whether they sell either stock or assets.

Buyers prefer asset sales, because they can step up their basis in the purchased assets to fair market value and deduct the purchase premium over 15 years. In the case of a stock sale, the sellers' basis in the assets carries over to the buyers, and the purchase premium is permanently capitalized. Thus, buyers are usually willing to pay more for assets than stock, but not necessarily enough to offset a C bank's additional tax liability. Consequently, S banks may he more attractive to buyers and have a better bargaining position than their C counterparts.

From Lisa Brooks, CPA, Nashville, TN
COPYRIGHT 2005 American Institute of CPA's
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Title Annotation:American Jobs Creation Act of 2004
Author:Brooks, Lisa
Publication:The Tax Adviser
Date:Sep 1, 2005
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