"S" Corporations - The Road to Eligibility

Prior to 1997, financial institutions were not allowed to elect S corporation status. This changed with the Small Business Jobs Protection Act of 1996 (The 1996 Act). The 1996 Act allowed financial institutions to elect S corporation status if they opted out of using the reserve method for computing their bad debt deduction. The 1996 Act also increased the number of shareholders an S corporation could have from 35 to 75. It also allowed certain trusts that held holding company shares to become eligible S corporation shareholders. While the 1996 act revisions allowed many financial institutions to become S corporations, tax law obstacles remain for others. The principal remaining obstacles to S corporation status include:

S corporations cannot have preferred stock.
IRAs normally cannot own S corporation shares.
Corporations and partnerships cannot own S corporation shares.
All shareholders must consent to an S corporation election.
S corporations cannot have more than 100 shareholders.
A holding company must own 100% of a bank for the holding company S corporation election to apply to the bank.

Legislation has been introduced to address most of these issues, but no changes appear imminent.

There are some “self-help” measures to help get around these obstacles. For example, a reverse stock split can sometimes enable a holding company to acquire 100% of the stock of a subsidiary bank, or to reduce the number of holding company shareholders below 75. Such strategies sometimes create non-tax problems when shareholders are forced out.

A financial institution elects S corporation status by filing Form 2553 no later than 2 1/2 months after the start of its first S corporation year. If there is a holding company structure, the holding company files Form 2553 and the 100% subsidiaries file Form 8869 to become “qualified subchapter S subsidiaries,” or “QSUBs.”