An S “election” represents a change in a bank’s tax status. When a bank “elects” S corporation status, it opts to become taxed under Subchapter S of the U.S. Tax Code, instead of Subchapter C of the Code. When taxed as a C corporation, the bank pays federal income taxes on its taxable income. By making the S election, the bank no longer pays federal income tax itself. The tax liability does not disappear altogether, though. Instead, the tax liability “passes through” to the shareholders. This means that the bank’s tax liability becomes the obligation of the bank’s shareholders. While no guarantees generally exist, the bank will ordinarily intend to distribute enough cash to the shareholders to enable them to satisfy the tax liability.
The following table shows what happens when a bank makes an S election. In the table, the bank no longer incurs any federal tax liability following the S election. However, the $350 tax obligation simply “passes through” to the shareholders.
In the preceding table, the bank’s pre-tax income generated a $350 tax obligation, regardless of whether the bank was taxed as a C or S corporation. In the C corporation scenario, the bank directly paid the tax obligation to the government; in the S corporation alternative, the shareholders paid the taxes due on the bank’s earnings. Since the taxes due remain constant at $350 regardless of whether the bank elects
S corporation status or not, what incentive exists for banks to elect S corporation status?
The S election creates two primary tax advantages relative to C corporations:
The best way to illustrate tax advantage #1 is with an example.
In the C corporation scenario, the bank pays $200 of dividends to shareholders. After the shareholders pay taxes on these dividends (at a 15% tax rate on dividends), the shareholders will have after-tax cash flow of $170 from their investment. Assume, instead, that the bank elects S corporation status. In this case, the shareholders owe taxes of $350 (35% of the bank’s $1,000 pre-tax income), but the bank makes distributions of $550. This leaves the shareholders with $200 of after-tax cash flow. No further taxes are owed on the $200. In fact, for any amount of distributions between zero and $1,000 (the bank’s pre-tax earnings), the shareholders will generally face tax liability of $350. By electing S corporation status, therefore, shareholders increase their after-tax cash flow from $170 to $200, an 18% increase.
Given the aforementioned tax benefits, why would every bank not elect S corporation status? Several potential disadvantages of the election exist:
To minimize these risks, the board of directors and management may adopt a more conservative management style for the S corporation bank than the C corporation bank. For instance, higher capital ratios may be desirable. In addition, the bank may adopt more strict underwriting requirements or maintain a lower loan/deposit ratio to reduce the risk of losses.
S corporation elections may be an attractive alternative for banks, but a careful examination of the advantages and disadvantages is necessary. Banks with relatively low balance sheet growth and high profitability often make the best candidates for S elections, because these banks have the capacity to distribute a large portion of their earnings. On the other hand, an S election would be less beneficial for other types of banks. For instance, banks that intend to pursue acquisitions or that have potentially volatile earnings may be better served by remaining C corporations.
If your bank does elect to make an S election, it is typically more complicated than simply “checking a box” on a tax filing. Instead, a number of professionals may need to be involved to ensure the bank’s goals are achieved:
Reprinted from Mercer Capital’s Value Matters™ 2008-08, published August 31, 2008