S-Corps Come of Age
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.
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:
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.
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.