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IRAs AS S CORPORATION BANK OWNERS: A LEGISLATIVE MESS

November 12, 2004

It's been said that watching lawmaking is as gut-turning as watching sausage-making. While that may be true, there is a significant difference: sausage is always useful at the end of the process.

The recently enacted "American Jobs Creation Act" has at least one provision so poorly drafted as to be useless. The provision enabling Banks with IRA owners to make S corporation elections is a mess.

The provision appears to be designed to enable C corporation banks with IRA-owned stock an opportunity to make an S corporation election. As drafted, however, it applies to almost nobody, and even where it might apply, it might be expensive to the IRA beneficiary.

S CORPORATION ELIGIBILITY

S corporations, as regular readers know, generally pay no taxes on their income; the income is instead taxed on the persona returns of their owners. Only individuals, estates and some trusts are permitted to own S corporation stock. IRAs are not permitted shareholders.

Banks were first allowed to become S corporations as a result of 1996 legislation. Some banks have been unable to make their S corporation elections because IRAs own bank stock. Severe "prohibited transaction" penalties often make it impossible for the IRA owner or the bank to buy the stock out of the IRAs.

THE NEW LAW: ELIGIBILITY

The AJCA allows "banks" with stock held by an IRA on October 22, 2004 to make S corporation elections. Thus the first problem with the new law - the rule is restricted to "banks." Almost all banks are owned in holding companies, which are not mentioned in the new rules. It appears that by its terms, the new rule only applies to the very small minority of banks that are not owned by holding companies.

NEW LAW: TWO TAXES?

If an IRA-owned bank qualifies to make an S election, the IRA S corporation income will often be taxed more harshly than non-IRA shares.

The tax law says the IRA will pay "unrelated business income tax" (UBIT) on their share of S corporation income. They will also pay a second round of UBIT on "any gain on the disposition of stock in the S corporation." UBIT is computed at corporate rates, which can be as high as 35%.

S corporation shareholders increase the basis of their shares by the S corporation income they pay tax on; they reduce their basis by cash distributions made by the S corporation to help owners pay their tax. This basis adjustment usually ensures that S corporation income is only taxed when it is earned; if the income is passed to shareholders through distributions, or recovered by a sale of the shares, the previously-taxed earnings aren't taxed again because they have increased basis.

The basis adjustment doesn't shelter built-in gain in the stock that exists when the S corporation election takes effect.

TRADITIONAL IRA: ANOTHER TAX

With traditional IRAs, however, there is a second tax. When the IRA beneficiary withdraws the earnings, they are taxable under the normal IRA rules. Distributions by Roth IRAs will be tax-free.

CHECKING OUT OF THE ROACH MOTEL

IRAs can be like Roach Motels for bank stock - it can check in, but not out. The "prohibited transaction" rules often make it impossible for owners of closely-held corporations to redeem stock out of an IRA, and they almost always prevent an individual from buying stock out of the IRA. Prohibited transactions are catastrophic, triggering a 100% tax. Until now, the only way to get stock out of an IRA has been the Department of Labor exemption letter process, an expensive and uncertain mechanism.

The new law gives IRAs a 120-day window following the S election to sell IRA stock without causing a prohibited transaction. It isn't clear whether this window opens on the date the S election is filed, or on the effective date of the election. The sale apparently would result in UBIT, but there would be no prohibited transaction.

SUMMARY

For now, the Bank-IRA-S corporation provisions of the new law are nearly useless because of they don't seem to encompass holding companies. Even if this hurdle is crossed, the provisions may be most useful for getting bank stock out of the IRA to enable the S election; the double tax on S corporation income in traditional IRAs makes them uneconomical vessels to hold S corporation stock. Roth IRAs, by contrast, may be perfectly content to pay UBIT, if the bank pays significant dividends.

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