Many Iowa banks have become S corporations in recent years. The real advantage of S corporation status is the elimination of the double taxation of income faced by C corporations. C corporations are taxed at the Federal and state level on their earnings. Shareholders are then taxed again on the dividends from earnings and profits that are distributed by the company and reported to the shareholder on Form 1099-DIV. If the C corporation retains its earnings, they increase the value of the corporate stock; this increase is taxed as capital gain when the stock is sold.
C corporations pay their own tax on current operations. S corporation taxable income, loss or deduction items are reported pro-rata by the shareholders on their own tax returns.
Distributions of S corporation earnings are tax-free. The amount of S corporation earnings is measured using the corporation’s “Accumulated Adjustment Account,” or AAA. The AAA consists of retained taxable income earned while an S corporation, plus undistributed current year taxable income (after a few modifications). Distributions are considered to be made first from the AAA. If distributions exceed the AAA, the excess is usually a taxable C corporation dividend, if the financial institution formerly was a C corporation. Sometimes careful planning is needed to avoid accidentally triggering C corporation dividends.
A word of caution: if an S corporation bank normally distributes all of its taxable income, it should be very careful with fourth quarter distributions. At least some of the distribution should be delayed into the following year until taxable income has been computed. This can help keep banks from surprising their shareholders with unexpected taxable distributions. This is especially true for cash-basis banks because of the variability of accrued interest receivable and payable at year-end.
Any S corporation earnings retained by the bank increase the shareholder’s stock basis. This reduces the capital gain on any future sale of the bank.