Independent Community Bankers of America
"S Corporation Reforms"
House Ways and Means Subcommittee on Select Revenue Measures
United States House of Representatives
June 19, 2003
C.R. (Rusty) Cloutier
MidSouth National Bank
Independent Community Bankers of America
Mr. Chairman, Ranking Member McNulty, and members of the Committee, my name is Rusty Cloutier. I am Chairman of the Independent Community Bankers of America ("ICBA")1 and President of MidSouth National Bank, a $400 million community bank located in Lafayette, Louisiana. I am pleased to appear today on behalf of the Independent Community Bankers of America to share with you our views on ways to reform and simplify subchapter S corporation rules. Allowing small businesses to operate as Subchapter S entities helps prevent the punitive double taxation of income, a key goal of sound tax policy.
The Independent Community Bankers of America greatly appreciates the opportunity to contribute several Code simplification suggestions for consideration that we believe will improve the viability of more small businesses and community-based banks. These simplifications measures have been adopted from a comprehensive ICBA/Grant Thornton LLP tax study and focus on simplification of restrictive S corporations rules.2 We are delighted that many of these simplification measures have been drafted into legislation pending in the 108th Congress. ICBA supports these important subchapter S reform bills, which include:
- The "Small Business and Financial Institutions Tax Relief Act of 2003," H.R. 714, introduced by Rep. Scott McInnis (R-CO) of the House Ways & Means Committee.
- The "Subchapter S Modernization Act of 2003," H.R. 1896, introduced by Rep. Claw Shaw (R-FL) and Rep. Bob Matsui (D-CA) of Ways and Means Committee.
- The "Small Business Opportunity and Growth Act of 2003," H.R. 1498, introduced by Rep. Jim Ramstad (R-MN).
We applaud these excellent legislative efforts to simplify the current onerous and restrictive subchapter S corporation rules so that small businesses can benefit from a more user-friendly tax code. The ICBA urges the Ways and Means Committee members to support these much-needed reform measures and to help ensure they are enacted in the current Congress.
In 1996, Congress passed the Small Business Job Protection Act of 1996 that allowed small banks to be eligible to elect S Corporation status for the first time starting in tax year 1997.3
Unfortunately, many community banks have been obstructed from converting to S corporations and benefiting from Congress's intended relief because of technical rules and community-bank specific regulations that could be addressed with tax simplification measures. This conclusion was further supported by a comprehensive General Accounting Office study in June, 2000.4
Notably, an additional 16 percent of all the small banks recently surveyed indicated that they were interested in making the S Corporation election pending resolutions of the various subchapters S glitches that prohibit using this tax status.5
Currently, before making the S Corporation election community banks must first overcome some difficult obstacles not faced by other corporate tax structures such as Limited Liability Partnerships (LLPs) or Limited Liability Corporations (LLCs) while attempting to avoid disrupting their operations or disenfranchising many of their existing shareholders.6 The obstacles most often outlined by community bankers include:
- Existing limitations on the types of shareholders,
- Existing limitations on the number of shareholders,
- Limitations on the options for raising capital (e.g., inability to issue preferred stock),
- Uncertainty regarding the possible application of the passive investment income tax, and
- Uncertainty regarding the treatment of director's shares.
The excellent subchapter S reform bills now pending in Congress would help reduce many of these ambiguities and obstacles in the current law and would enhance the ability of community banks to be able to utilize S Corporation status as intended by Congress.
ICBA Recommended Subchapter S Reforms
Allow IRAs as Eligible S Corporation Shareholders Current law severely restricts the types of individuals or entities that may own S Corporation stock.7 For tax years beginning after December 31, 1997, acceptable S Corporation shareholders generally include:
- Any individual, except for a nonresident alien;
- Certain trusts;
- Certain tax-exempt organizations; and
- Employee stock ownership plans (ESOPs).
Individual Retirement Accounts (IRAs) are not eligible S Corporation shareholders. Many community banks have been caught in an unintended trap because they had IRA shareholders prior to the 1996 law change that allowed banks to choose subchapter S status the first time in tax year 1997. Eliminating ineligible classes of stock and ineligible shareholders prior to the beginning of the first S Corporation tax year has been a significant barrier to community banks otherwise interested in making the S election. IRAs often hold significant portions of bank stock, thereby limiting banks' ability to elect S Corporation status. In many cases, banks find it virtually impossible to eliminate the significant amount of stock owned by IRAs due to capital constraints.
To address this community bank IRA shareholder glitch that prevents the viable use of subchapter S, ICBA recommends allowing IRAs to hold S Corporation stock. Specifically, ICBA recommends grandfathering existing community bank IRA shareholders in place as of 1997 and not taxing IRA shareholders on the S Corporation earnings allocated to the IRA shareholders in a manner consistent with the treatment of S Corporation earnings allocated to ESOPs.
ICBA believes this reform will grant more community banks, now obstructed from making the S Corporation election, the added flexibility they need to have in dealing with IRA shareholders. Community banks interested in making the S Corporation election would no longer need to compel IRA shareholders to either sell their shares to the community bank or to third parties who are eligible S Corporation shareholders. In many cases, eliminating IRA shareholders proves an impossible task or in some cases, buyout costs puts a severe strain on community bank capital.
ICBA believes including IRA shareholders as eligible S Corporation shareholders by grandfathering existing bank IRA shares would provide significant relief to community banks and eliminate the high cost of eliminating bank stock held in IRAs.
Exempt Sale of Community Bank Stock by IRA to IRA Owner from Prohibited Transaction Treatment
Another alternative recommended reform to address the IRA shareholder problem that often prevents converting to subchapter S is to exempt the sale of community bank IRA-held stock from prohibitive transaction tax treatment. Under current law, the sale of IRA assets to a "disqualified party" is a prohibited transaction.8 Prohibited transactions are defined in Internal Revenue Code §4975.9
However, the owner of the IRA is a disqualified party and is prohibited from purchasing the community bank's stock from the IRA. The sale of plan assets to a disqualified party is prohibited no matter what price the owner is willing to pay the IRA for the stock. The penalty to an IRA for entering into a prohibited transaction is harsher than that applied to a prohibited transaction by a qualified plan. IRAs that participate in prohibited transactions taint the entire fund and the tax exemption is lost. The account ceases to be an IRA on the first day of the taxable year in which the prohibited transaction occurs.10
IRAs frequently hold community bank stock, resulting in a significant obstacle to banks that desire to make the S Corporation election. Only "qualified" plans, not IRAs, can be shareholders in an S Corporation. Accordingly, if a community bank decides to convert to S Corporation status, it must re-purchase the stock from the IRA. Often, the owner of the IRA does not want to give up the future benefit of stock ownership, and would like to purchase the stock from the IRA rather than having the community bank redeem the stock. The Department of Labor has granted exemptions, on a case-by-case basis, from the prohibited transaction rules when the IRA wanted to sell stock to a disqualified party.11 However, applications must be submitted for each individual case and are time consuming and expensive.
ICBA recommends allowing owners of IRAs holding the stock of a community bank making the S Corporation election to purchase the subject securities from the IRAs. This can be accomplished by amending IRC §4975 or IRC §408 to alleviate the penalty associated with an IRA selling one of its assets to its owner.
This reform would make it easier for community banks interested in making the S Corporation election to eliminate ineligible IRA shareholders. Community banks will not have to drain valuable resources to buy back stock held in IRAs. Therefore, more community banks will be able to make the S Corporation election and improve their competitive position by avoiding the double taxation of income that applies to C Corporation banks.
Allow Community Bank S Corporations to Issue Certain Preferred Stock
Current law only allows S Corporations to have one class of stock outstanding.12 C Corporations that want to make the S Corporation election must eliminate any second class of stock prior to the effective date of the S Corporation election. Issuing a second stock class by the S Corporation terminates its S Corporation status. Community banks must maintain certain minimum capital ratios to be considered a well-capitalized institution for regulatory purposes. As a community bank grows in size, its earnings alone may not provide sufficient capital to fund its growth. Banks needing more capital can raise additional capital by issuing common stock, preferred stock, or, in some cases, trust-preferred securities.
Many community banks avoid issuing additional common stock to fund growth so that they can protect their status as an independent community bank and serve their local community lending needs. Instead, they frequently use preferred stock to fund growth and retain control. However, S Corporation banks are not allowed to issue preferred stock because preferred stock is considered a second class of stock. This prevents small community banks from having access to an important source of capital vital to the economic health and stability of the bank and the community it serves.
ICBA recommends exempting convertible or "plain vanilla" preferred stock from the "second class of stock" definition used for S Corporation purposes. This would help more community banks become eligible to make the S Corporation election as well as help those that currently have preferred stock outstanding would choose S Corporation status. Allowing bank S Corporations to issue preferred stock would allow them to reduce the burden of double taxation and, at the same time, fund future growth.
Reform the Treatment of Director Qualifying Stock for Purposes of the S Corporation and QSSS Elections
Because an S Corporation may have only one class of stock outstanding,13 in most cases, the S Corporation election is terminated if the bank issues a second class of stock. A director of a national bank is generally required to own stock in the bank to assure that the individual has a sufficient financial interest in the bank to be vigilant in protecting the bank's interests.14 A number of states have similar requirements for state chartered banks. In some cases, the state may require bank directors to hold bank subsidiary stock.
In some cases, stock issued by community banks or their holding companies to bank directors may not convey all of the economic interests conveyed to other shareholders. This type of director qualifying stock is issued solely to comply with the federal or state regulatory requirements. However, in this situation, the IRS may still determine that director qualifying stock is a second class of stock due to economic restrictions. Such an action by the IRS makes the bank ineligible to make the S Corporation election. Current rules are ambiguous as to whether director-qualifying stock, subject to substantial economic restrictions, held at the bank subsidiary level prevents the parent from making the Qualified Subchapter S Subsidiary (QSSS) election.15 Consequently, many banks with restricted director's stock have undoubtedly been weary of making the S Corporation election given the uncertainty surrounding the treatment of director qualifying stock. A number of banks are waiting for definitive IRS guidance on this issue. The results of a Grant Thornton's survey of community bank executives indicated that the uncertainty of the treatment of director qualifying stock is a significant obstacle for over 6 percent of the banks that are considering making the S Corporation election.16
ICBA recommends not treating director-qualifying stock, subject to substantial economic restrictions, when issued by bank S Corporations or by bank subsidiaries of an S Corporation bank holding company, as stock for S Corporation purposes. Additionally we recommend excluding bank director shares required by bank regulations from inclusion in the number of shareholders subject to the limitation under subchapter S rules. ICBA believes more banks will be able to make the S Corporation election when the uncertainty surrounding the treatment of director qualifying stock is eliminated.
Increase Maximum Number of S Corporation Shareholders to 150 and Count Family Members as One Shareholder.
When the S Corporation rules were first enacted, the maximum number of shareholders was 10.17 Throughout the period 1976-1982 Congress made a series of legislative changes to increase the number to 35. The Small Business Job Protection Act increased the maximum number of eligible S Corporation shareholders from 35 to 75 for tax years beginning after December 31, 1996.18
In many cases community banks have made a decision to assure that their institutions are widely owned, often by members of the communities they serve. The provision of the S Corporation rules limiting the number of shareholders to no more than 75 often forces community banks that wish to become an S corporation to disenfranchise shareholders, severely limit ownership and its ability to raise capital in the future. Additionally, other corporate structures such as a LLP or LLC do not have any limitation on the number of shareholders.
Unfortunately, community banks with more than 75 shareholders that decide that making the S Corporation election is beneficial must somehow force out some of their shareholders - even when they would prefer to be more broadly held. Efforts to force shareholders out through a reverse stock split or through the formation of a new holding company is generally a very thorny and expensive alternative.
ICBA recommends increasing the maximum number of allowable S Corporation shareholders to 150 and counting family members that are not more than three generations removed from a common ancestor as one shareholder for purposes of the shareholder limitation. ICBA believes that increasing the number of allowable shareholders will allow more community banks to make the S Corporation election and, at the same time, continue to be widely owned by members of their communities.
Exclude Bank Income from Passive Investment Income Tax
S Corporations with accumulated C Corporation earnings and profits are subject to a 35 percent tax on "passive investment income" exceeding 25 percent of gross receipts for any year.19 Additionally, a company's S Corporation status is terminated if the 25 percent limit is exceeded for three consecutive years.20 Passive investment income generally includes:
- Annuities, and
- Gains on sales of stock and securities.21
Passive investment income does not include gross receipts directly derived from the active and regular conduct of a lending or finance business.22 Gross receipts directly derived in the ordinary course of a trade or business of lending or financing include gains (as well as interest income) from loans originated in a lending business. Interest earned from the investment of idle funds in short-term securities, however, does not constitute gross receipts directly derived in the ordinary course of business.23 IRS Notice 97-5 generally provides that gross receipts directly derived in the ordinary course of a banking business are not passive investment income for purposes of the passive investment income tax. Income from the following assets are considered part of the active and regular conduct of a banking business:
- Loan, participations, or REMIC regular interests;24
- Equity investments needed to conduct business (FHLB stock etc.);25
- Assets pledged to a 3rd party to secure deposits or business;26 and
- Investment assets needed for liquidity or loan demand.27
As a result, income and gain from these assets will not be considered subject to the passive investment income limitation applicable to S Corporations.
Treasury and the IRS believe that the special provisions of the Internal Revenue Code that apply to banks should apply only to the specific state-law entity that qualifies as a bank under IRC §581. They believe that the special bank treatment of items should not apply to nonbanks, even if the nonbank is affiliated with a bank and the parent makes the Qualified Subchapter S Subsidiary (QSSS) election with respect to all of its subsidiaries.28
The amount of investment assets needed for liquidity or loan demand can be very subjective, with most banks not wanting to gamble that an IRS agent may disagree with their estimates. Banks find this uncertainty regarding the possible application of the passive investment income tax (and possible S Corporation termination) to be problematic and many have delayed or discarded their decision to make the S Corporation election.
ICBA recommends excluding bank income from the passive investment income tax imposed by IRC §1375, effective for tax years beginning after December 31, 1996. Bank income would be defined as as all income from any corporate entities that qualify as a bank under IRC §581 and from any 100 percent owned subsidiaries of a bank.
ICBA believes that reforming the onerous passive income rules will eliminate the uncertainty of the unintended application of the passive investment income tax (and possible S Corporation termination). Banks no longer will have the potentially significant and uncertain treatment of passive investment income hanging over their decision-making process. By treating all bank income as earned from the active and regular conduct of a banking business, banks will no longer face the conundrum of evaluating investment decisions based on tax considerations rather than on more important safety and economic soundness issues.
Tax code simplification in the S corporation area would go a long way in allowing community-based banks to convert to S corporation status as Congress intended in 1996. Many community banks and small businesses find that current technical barriers to making the conversion from a C Corporation to an S Corporation are too great to overcome. Current restrictions and complicated rules for S Corporation status make the conversion from C Corporation status unattainable for many community banks, thwarting Congress's intended relief from punitive double taxation. ICBA believes reforming and simplifying onerous subchapter S corporation rules will create a tax code that is small-business friendly and improve community banks' ability to meet the lending needs in their local communities.
Restrictions on S Corporation stock ownership and the shareholder limit are, in general, some of the most difficult hurdles for community banks to overcome. These S corporation restrictions do not apply to other corporate forms of business. The limit on the number of S Corporation shareholders continues to pose a significant barrier to many community banks. Often, community bank ownership has passed from generation to generation, expanding with each generation. It does not take many generations of family growth for community banks to exceed the S Corporation stockholder limit.
The ICBA recommends several subchapter S Corporation rule changes that would greatly simplify the ability for community banks to elect Subchapter S status as Congress intended. These include, grandfathering bank IRA shareholders as eligible S corporation shareholders, allowing community bank S corporations to issue preferred stock, reforming onerous director's share rules, increasing the allowable number of S Corporation shareholders to 150, treating family members as one shareholder, and reforming the application of passive income rules.
The ICBA is delighted to see the Ways and Means Committee examining the reform options presented in the solid subchapter S reform bills now pending in the 108th Congress. We enthusiastically support the bipartisan subchapter S reform bills: H.R. 714, H.R. 1896, and H.R. 1498. Each of these bill would help community banks better utilize subchapter S tax status and improve their ability to provide needed capital and credit in their local communities.
Thank you Mr. Chairman for the opportunity to appear before you today. ICBA looks forward to working with you and the committee to ensure the enactment of beneficial S corporation reforms.
1 ICBA is the primary voice for the nation's community banks, representing some 4,600 institutions with 17,000 locations nationwide. Community banks are independently owned and operated and are characterized by attention to customer service, lower fees and small business, agricultural and consumer lending. ICBA's members hold more than $526 billion in insured deposits, $643 billion in assets and more than $402 billion in loans for consumers, small businesses and farms. For more information visit www.icba.org.
2 "Community Bank Tax Relief and Simplification Options," A study prepared for the Independent Community Bankers of America by Grant Thornton LLP, 2003.
3 Public Law 104-188.
4 U. S. General Accounting Office, "Banking Taxation, Implications of Proposed Revisions Governing S-Corporations on Community Banks," June 2000. (GAO/GGD-00-159).
5 Grant Thornton LLP, Ninth Annual Survey of Community Bank Executives.
7 Internal Revenue Code §1361(b)(1).
8 Internal Revenue Code §4975(c)(1)(A)
9 Internal Revenue Code §408 (e)(2)(A)
10 Internal Revenue Code §408(e)(2)
11 (PTE 98-59) 63 FR 69326, 12/16/98 (25 BPR 2673, 11/16/98).
12 Internal Revenue Code §1361(b)(1)(D).
13 Internal Revenue Code §1361(b)(1)(D).
14 12 U.S.C. section 72.
15 The Small Business Job Proection Act added IRC §1361(b)(3) that allows an S corporation to own a qualified subchapter S subsidiary (QSSS). A subsidiary qualifies as a QSSS if:
- the subsidiary would be eligible to elect subchapter S status if its stock were owned directly by the shareholders of its S corporation parent;
- the S corporation parent owns 100 percent of the subsidiary's stock; and
- the parent elects to treat the subsidiary as a QSSS.
If the QSSS election is made, the subsidiary is not treated as a separate taxable entity, and all the assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as the assets, liabilities, and items of income, deduction, and credit of the parent S corporation.
16 "Community Banks: A Competitive Force," Sixth Annual Survey of Community Bank Executives, Grant Thornton LLP
17 See former Internal Revenue Code §1371(a)(1), as in effect for taxable years starting before January 1, 1977.
18 Internal Revenue Code §136(b)(1)(A).
19 Internal Revenue Code §1375(a).
20 Internal Revenue Code §1362(d)(3)(A).
21 Internal Revenue Code §1362(d)(3)(C)(i)
22 Internal Revenue Code§1362(d)(3)(C)(iii)
23 Treas. Reg. §1.1362-2(c)(5)(iii)(B)(2)
24 All loans and REMIC regular interests owned, or considered to be owned, by the bank regardless of whether the loan originated in the bank's business. For these purposes, securities described in section 165(g)(2)(C) are not considered loans.
25 Assets required to be held to conduct a banking business (such as Federal Reserve Bank, Federal Home Loan Bank, or Federal Agricultural Mortgage Bank stock or participation certificates issued by a Federal Intermediate Credit Bank which represent nonvoting stock in the bank).
26 Assets pledged to a third party to secure deposits or business for the bank (such as assets pledged to qualify as a depository for federal taxes or state funds).
27 Investment assets (other than assets specified in the preceding paragraphs) that are held by the bank to satisfy reasonable liquidity needs (including funds needed to meet anticipated loan demands).
28 The Small Business Job Protection Act added IRC §1361(b)(3) permitting an S Corporation to own a qualified subchapter S Subsidiary (QSSS). A subsidiary qualifies as a QSSS if (1) the subsidiary would be eligible to elect subchapter S status if its stock were owned directly by the shareholders of its S Corporation parent; (2) the S Corporation parent owns 100 percent of the subsidiary's stock; and (3) the parent elects to treat the subsidiary as a QSSS. If the QSSS election is made, the subsidiary is not treated as a separate corporation for tax purposes, and all the assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as the assets, liabilities, and items of income, deduction, and credit of the parent S Corporation.