Subchapter S Counsel for Community Banks

Yes. Since 1997, federal tax law has allowed banks and bank holding companies to elect Subchapter S status, which generally means the bank's income is taxed once, at the shareholder level, instead of at both the corporate and shareholder levels. A bank must meet the S corporation rules, including a limit of 100 shareholders (with family members counted as one), only eligible shareholders such as individuals, certain trusts, estates and some retirement accounts, and a single class of stock. Banks that used the reserve method for bad debts must change methods before electing. Many Texas community banks use the S election. Kennedy Sutherland LLP has helped banks and their owners with Subchapter S elections.

The main benefit of an S election for a community bank is a single level of federal income tax: earnings pass through to shareholders and are not taxed again when distributed. That can raise after-tax returns and help with owner succession. The drawbacks include limits on who can own shares and how many shareholders the bank can have, a single class of stock (which limits some capital-raising options), and the fact that shareholders owe tax on their share of income even if the bank keeps the earnings, so banks usually pay tax distributions. Converting may trigger built-in gains tax on gains that existed at conversion if they are recognized within five years. A tax and legal review should come before any decision.

Converting a bank from C corporation to S corporation status usually starts with a review of the shareholder list to confirm every owner is eligible and that the bank, or its holding company, will have no more than 100 shareholders under the family aggregation rules. Ineligible shareholders may need to be bought out or restructured, sometimes through a merger or reverse stock split. The bank must have one class of stock, may need to change its bad-debt accounting method, and must look at built-in gains and other tax effects with its CPA. All shareholders must consent, and the election is filed with the IRS on Form 2553 by the deadline for the tax year. A shareholder agreement should then protect the election going forward.

When S corporation bank shares are sold, gifted or inherited, the transfer must not go to an ineligible shareholder or push the total over 100 shareholders. A transfer to a corporation, a partnership, a nonresident alien, or a trust that does not qualify can end the S election. When a shareholder dies, the estate can hold the shares for a period, and certain trusts can hold them if the trustee makes the right election on time. Most S banks use a shareholder agreement that restricts transfers, requires consent, and gives the bank or other owners the right to buy shares that would otherwise go to an ineligible holder. Shareholders should coordinate their estate plans with the bank's agreement.