Last year Congress voted to allow Individual Retirement Accounts to own stock of bank S corporations (but not other S corporations). They proceeded to utterly botch the job. The legislation passed last year only allowed banks without holding companies to qualify for S corporation status with IRS owners. That allowed approximately one bank to take advantage of this provision.
Congress took a big step towards fixing the job when it passed legislation allowing bank holding companies with IRA owners to elect S corporation status. This fix was included in H.R. 4440, the "Gulf Opportunity Zone Act of 2005. The President is expected to sign the bill.
WHAT IT MEANS
The bill only applies to IRAs that owned bank stock on October 22, 2004, and only to the extent they owned the stock on that day. Bank holding companies wanting to make an S election now have until March 15, 2006 to become S corporations for the 2006 calendar year.
Traditional IRAs will still not be ideal S corporation shareholders. Bank income will presumably be "Unrelated Business Taxable Income" to the IRA, making it taxable at corporate tax rates. When the traditional IRA makes a distribution to its owner, that distribution will also be taxable. This means there will still be two taxes on traditional IRAs owning bank holding company stock.
GET THE STOCK OUT OF THE IRA?
Absent special rules, this double tax on future earnings would be unavoidable. Under normal circumstances a purchase of stock out of an IRA by an IRA beneficiary leads to tax catastrophe in the form of a "prohibited transaction." The IRA would be considered terminated and fully taxable to the beneficiary and a 100% excise tax would apply to the stock purchase.
The tax law allows IRA beneficiaries a one-time chance to avoid this double tax on future bank earnings. The IRA beneficiary can safely buy bank or bank holding company stock out of an IRA if ALL of these conditions are met:
(1) The stock must have been held by the IRA as of October 22, 2004.
(2) The sale must be made pursuant to an S election by the bank.
(3) The sale must be for fair market value at the time of sale, as established by an independent appraiser, and the terms of the sale must be at least as favorable to the IRA as the terms would have been on a sale to an unrelated party.
(4) The IRA cannot pay any commissions, costs, or other expenses in connection with the sale.
(5) The stock must be sold in a single transaction for cash no later than 120 days after the S election is made.
These requirements are not to be trifled with. A violation of the prohibited transaction rules -- even a seemingly trivial one -- is an unmitigated tax disaster. But while these rules may seem like a lot of trouble, it's likely worth it for traditional IRA owners. Traditional IRAs are just not a tax efficient way to hold bank holding company stock.
Unfortunately, the IRA may have to pay "unrelated business income tax" on part of the bank sale price. It's still likely to be a better deal in the long run than paying UBIT on bank earnings.
The TaxProf Blog roundup of H.R. 4440 links.
American Bankers Association press release praising IRA fix in original Senate bill.
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
Joe Kristan writes the Tax Update items, and any opinions expressed or implied are not necessarily shared by anyone else at Roth & Company, P.C. Address questions or comments on Tax Updates to