By Curtis Carpenter, Sheshunoff Management Services

In any business, it’s not what’s happening now, but what’s coming next that gets people talking.

In 1997, Congress granted banks the right to form as S-corporations, or convert from C-corp status to S-corp status. Since an entity could have no more than 100 shareholders to be eligible, meaning the largest banks were not affected by this change, and the change was a tax issue that had no impact on operations, the minimal fanfare attending this event quickly died down without further discussion.

Almost 600 banks converted in that first year, less than a tenth of all banks at the time. Today, about 2,200 banks - more than one-fourth - are chartered as S-corps. Approximately 25 bank holding companies and banks headquartered in California, Oregon and Washington are currently S-corps.

Next year those original 600 will mark their 10-year anniversaries as S-corps. With that milestone they will shed the last vestiges of conversion from C-corp tax treatment. While these banks and their shareholders have enjoyed the income tax advantages of an S-corp from the time of the conversion, once a converted bank marks its 10-year anniversary the tax advantages in the event of a sale kick in, and that’s what’s starting to get the attention of buyers and sellers now.

What to Expect
Until now, prices paid for C-corp banks and S-corp banks have been comparable. Only one west coast S-corp sold in the past two years, which was South Coast Bancorp, Inc. in Irvine, Calif., for 2.2 times book and 17 times earnings. However, once S-corp banks cross the 10-year threshold, this will likely change.

With full S-corp status, the sale of the bank (structured as an asset sale) will no longer trigger a built-in gains (BIG) tax. In addition, this structure allows the premium paid above the actual value of the assets to be deducted for tax purposes by the buyer over 15 years. The buyer and seller have to agree to account for the sale as an asset sale for tax purposes in what is known as a Section 388 (h)(10) election.

Even with the 10-year anniversary approaching, there are several reasons why we do not anticipate a mad rush to buy and sell those groundbreaking 600 S-corps next year. For example:

1. While the eventual sale of the bank may have been a consideration in the decision to convert to an S-corp, there were other short-term advantages motivating the bank to convert in most cases and it’s unlikely that a majority of these banks will be ready to sell come 2007.
2. Strategic buyers will remain more focused on acquiring banks that further their plans to compete in a specific market or line of business, and the tax advantages of an S-corp purchase will be secondary to finding a target with the right business fit.
3. Under normal circumstances it will take nine months to effect the sale of a bank. Since deals closing after January of 2007 will be the first S-corp banks to be sold free of BIG taxes, expect management and their advisors to delay starting the process until later in 2006.

Whether or not we suddenly see an increase in the number of deals involving S-corp banks, there is no question that these banks will sell for a premium. In a sale of a traditional C-corp bank, it has been common for the price of the sale to be greater than the market value of the bank’s actual assets. The difference, or “goodwill”, has been a cost to the buyer. As an S-corp, this difference between the book value of the assets and the sale price is considered a premium that can be amortized for tax purposes by the buyer over a 15-year period.

For example, if an S-corp has a book value of $20 million and is sold for $50 million, the buyer can write off $2 million a year for 15 years.

This tax advantage makes the payment of the premium more affordable for the buyer, allowing for a higher premium than if there were no tax advantages. This tax advantage is unique to S-corp banks because of the single level of taxation.

For example, if a bank has $1 million basis in its assets and sells for $10 million, as a traditional C-corp, the bank would pay $3.1 million of tax on the $9 million gain, and the shareholders would pay tax again when the net $5.9 million is passed through.

With an S-corp sale, the entire $10 million gain flows through to shareholders who pay capital gains on $9 million, thereby avoiding this double taxation.

Be Prepared
Selling an S-corp sounds so much simpler, and the reasons for buying or selling one so clear, some bankers may be lulled into believing there is nothing here but opportunity. Not so. As with any financial transaction, there will be pitfalls and hidden dangers.

Since this is new territory for banks, many bank advisors will be learning the ropes right along side their clients. A savvy few will draw on the legal and tax experience of experts who have worked with non-bank S-corps for many years and have facilitated hundreds of transactions.

Valuation of bank stock will take on a new dimension, making depth of experience with many types of institutions in many markets more critical. Failure to clarify certain points about a sale or ask the right questions can lead to costly mistakes by either the buyer or the seller. And details like accounting for assets sold before the 10-year waiting period, must be handled right the first time around.

Plus, some banks that are attractive to a buyer now but have a few years to go before reaching the 10-year milestone are still candidates as some of the S-corp benefits are still viable. Knowing how to parse those can significantly change the numbers.

S-corps Benefits Remain
With all the talk about the 10-year anniversary, eligible C-corp banks may feel they’ve missed the opportunity. Not so. The immediate benefits to shareholders make S-corp conversion worth investigating at any time. Plus, as the sale of S-corps without BIG moves from an event to the norm over time, the advantages to both sides will become a routine part of the decision to convert.

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