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ARTICLE ON BANKS, IRAs, AND S CORPORATIONS

January 11, 2006

We have an article in the current issue of the Iowa Bankers Association "Exchange" magazine. It is reproduced in the expanded entry below (if you don't see it, click "read more").

Bank S corporations: Where we stand in 2006.

By Joe Kristan

The S corporation has become the preferred tax structure for community banks. Recent law changes open the door for more banks to become S corporations. Nine years have passed since the first bank S corporation elections took effect – long enough to show that this format isn’t a passing fad.

The Ten-year Itch.

2006 is the tenth year this format has been available for community banks. Ten years isn’t just a round-numbered anniversary for S corporations. The “built-in gain” tax also goes away after a corporation has been an S corporation for ten years.

S corporations generally don’t pay their own federal income tax. Their income is instead taxed on their shareholders’ 1040s. But during the ten-year built-in gain period, S corporations must pay a corporate income tax -- the "built-in gains tax" -- if it cashes out any gains that were economically accrued at the time of the S corporation election. The biggest such built-in gain is normally “intangible” value – blue sky, core deposits and goodwill. These are normally cashed out only when a bank is sold in an asset sale.

The first bank S corporations will complete their built-in gain period at the end of 2006. Such banks will be able to sell their assets without a corporate-level tax. Buyers are generally willing to pay more for bank assets than bank stock because they can deduct the intangible value over 15 years, and because they don’t inherit the legal and tax troubles of the seller. But the second layer of tax on sales of C corporation assets, or assets subject to built-in gain tax, can make asset deals too expensive for sellers. By waiting for the built-in gain period to expire, sellers have the best of both worlds – the higher price of an asset sale without a corporate-level federal tax.

IRAs now can own S corporation bank holding companies – but they might not want to for long.

The 2004 American Jobs Creation Act made Individual Retirement accounts eligible to own stock of S corporation “bank” stock. Unfortunately, Congress was rather literal about this. Only stand-alone S corporation banks qualified for IRA ownership; bank holding company (BHC) structures were left out.

Legislation passed in December 2005 corrected this error, allowing IRAs to hold S corporation stock. As a practical matter, many bankers will find that the new rules work best as a way to gracefully remove holding company stock from IRAs as part of an S corporation election.

The legislation only allows IRAs that owned bank or BHC stock on October 22, 2004 to join an S corporation election. IRAs owning bank stock will have to pay “Unrelated Business Income Tax (UBIT) on their S corporation earnings. UBIT is a tax imposed on tax-exempt entities, like charities, to discourage them from competing with taxable entities.

The UBIT will mean that bank income passing through traditional IRAs will be taxed twice – first as UBIT, and again as IRA distributions when IRA funds are withdrawn for retirement. This makes IRAs an inefficient way to hold S corporation stock.
Many IRAs are expected to use a one-time escape hatch in the new law to transfer their bank holding company stock to the IRA beneficiaries. 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." When that happens, the IRA is considered terminated and fully taxable to the beneficiary; worse still, a 100% excise tax applies to the stock purchase. The new rules allow IRA beneficiaries a one-time chance to get the bank and BHC stock out of the IRA without these dire consequences if all of the following conditions are met:

· The stock must have been held by the IRA as of October 22, 2004.

· The sale must be made pursuant to an S election by the bank.

· 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.

· The IRA cannot pay any commissions, costs, or other expenses in connection with the sale.

· 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 following these rules may seem like a lot of trouble, many IRA owners are likely to find it trouble worth taking. Traditional IRAs are just not a tax-efficient way to hold bank holding company stock.

TEFRA rules: will IRS attack 3-year roll-off?

One bonus of electing S corporation status is that after three S corporation years, the 20% “TEFRA” interest deduction disallowance goes away. One IRS agent has caused concern by saying that the 20% TEFRA disallowance does not, in fact, go away. As the agent is arguing that the tax code itself is wrong, we think his argument is unlikely to prevail.

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