Banking Taxation: Implications of Proposed Revisions Governing
S-Corporations on Community Banks (Letter Report, 06/23/2000,
GAO/GGD-00-159).
Pursuant to a legislative requirement, GAO: (1) analyzed possible
revisions to the tax rules governing S-corporations; and (2) determined
the potential impact such revisions might have, primarily on community
banks.
GAO noted that: (1) GAO studied five possible revisions to the tax rules
governing S-corporations; (2) the proposed provisions were written to
address perceived obstacles to becoming S-corporations cited by
representatives of the banking industry; (3) two of the five proposed
tax changes that GAO analyzed--increasing the number of shareholders and
allowing individual retirement accounts as shareholders--would affect
both non bank and bank corporations; (4) expanding the number of
eligible shareholders would allow more firms to choose to become
S-corporations; (5) increasing the shareholder limit, however, appears
to be more important to the banking industry than to other industries
because S-corporation banks have significantly more shareholders than
S-corporations from other industries; (6) the three remaining
provisions-- clarifying passive income rules, tax treatment of bank
director shares, and tax accounting of bad debts--specifically affect
individual banks' corporate strategies; (7) banks face certain obstacles
in becoming S-corporations that are situational to an individual bank's
history and business strategy; (8) the proposed tax provisions would
allow allow more and larger banks to benefit from not paying corporate
tax by electing S-corporation status, and the overall impact on
community banks would be determined by this expansion; (9) it is
difficult to project how many banks could be affected by the proposed
tax changes; (10) estimates ranged from about 300 to 5,700 banks and
thrifts; (11) the proposed provisions could help community banks become
more competitive relative to credit unions to the extent that converting
banks provide the same services offered by credit unions; (12) the
benefits of these proposed provisions for community banks relative to
larger banks would depend on the characteristics of the converting
banks; and (13) other potential impacts of the proposed provisions
include: (a) tax revenue losses estimated by the Joint Committee on
Taxation to be at least $748 million over a 5-year period; and (b)
behavioral changes--higher dividends and lower capital in S-corporation
banks, relative to comparable banks, that might have regulatory
implications.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-00-159
TITLE: Banking Taxation: Implications of Proposed Revisions
Governing S-Corporations on Community Banks
DATE: 06/23/2000
SUBJECT: Tax law
Lending institutions
Proposed legislation
Income taxes
Banking regulation
Tax exempt status
Corporations
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GAO/GGD-00-159
United States General Accounting Office
GAO
Report to Congressional Committees
June 2000
GAO/GGD-00-159
BANKING TAXATION
Implications of Proposed Revisions Governing S-
Corporations on Community Banks
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Contents
Page 261 GAO/GGD-00-159 S-Corporation Banks
Letter 1
Appendix I 30
History and Background
of S-Corporations
Banks Represent a Small Percentage of 30
All S-Corporations
Appendix II 37
Scope and Methodology
Analysis of Proposed Tax Revisions and 37
Potential Impacts
Agency Comments 41
Appendix III 42
Proposed Tax Provision
To Increase the Maximum
Number Of Shareholders
Proposed Tax Provision 42
Shareholder Limit Cited as an Obstacle 42
for Becoming an S-Corporation Bank
Appendix IV 47
Proposed Tax Provision
To Allow Individual
Retirement Accounts As
Shareholders
Proposed Tax Provision 47
Appendix V 50
Proposed Tax Provision
to Clarify Passive
Investment Income Rules
Proposed Tax Provision 50
Passive Income Regulations Predate 50
Banks' Eligibility to Become S-
Corporations
Appendix VI 54
Proposed Tax Provision
to Redefine Treatment of
Bank Director Shares
Proposed Tax Provision 54
Appendix VII 58
Proposed Tax Provisions
to Improve Bad Debt
Treatment
Proposed Tax Provision 58
Bad Debt Recapture Cited as Obstacle 59
to Subchapter S Election
Proposed Change Would Likely Lower 60
Banks' Tax Costs During Conversion to
Subchapter S Status
Appendix VIII 61
Comments from the
Department of the
Treasury
Appendix IX 63
Comments from the
Federal Deposit
Insurance Corporation
Appendix X 65
Comments From the Board
of Governors of the
Federal Reserve System
Appendix XI 66
GAO Contacts and Staff
Acknowledgments
Tables Table 1: Tax Revenue Loss Estimates 20
for 1999 Proposed Provisions
Figures Figure 1: Median Cash Dividend to Net 16
Income Ratios for S-Corporation Banks
and Comparison Banks From 1996 to
1999
Figure 2: Median Tier 1 Leverage 17
Capital Ratio for S-corporation Banks
and Comparison Banks From 1996 to
1999
Figure 3: Median Return on Assets 18
Ratios for S-corporation Banks and
Comparison Banks From 1996 to1999
Figure 4: Median Net Loans and Leases 19
to Assets Ratio for S-Corporation
Banks and Comparison Banks, 1996-1999
Figure I.1: Percentage of S- 30
Corporations by Industrial Sectors
Figure I.2: Dispersion of S- 31
corporation Banks by State
Figure III.1: Percentage Comparison 43
of the Number of Shareholders between
S-Corporations From all Industries
and S-Corporation Banks
Abbreviations
ABA American Bankers Association
CRA Community Reinvestment Act
ESOP employee stock ownership plan
FDIC Federal Deposit Insurance Corporation
ICBA Independent Community Bankers of
America
IRA individual retirement account
IRS Internal Revenue Service
NCUA National Credit Union Administration
OCC Office of the Comptroller of the
Currency
OTS Office of Thrift Supervision
REMIC Real Estate Mortgage Investment Conduit
SEC Securities and Exchange Commission
UBPR Uniform Bank Performance Report
QSSS Qualified Subchapter S Subsidiary
B-284651
Page 17 GAO/GGD-00-159 S-Corporation Banks
B-284651
June 23, 2000
Congressional Committees:
This report responds to a mandate in the Gramm-
Leach-Bliley Act of 1999 to study certain rules
that affect decisions by banks1 to elect S-
corporation status for federal tax purposes. Under
the Small Business Job Protection Act of 1996,
banks were permitted to elect S-corporation status
for the first time beginning in 1997. Banking
industry representatives have cited a number of
obstacles that banks face when converting to S-
corporation status. Possible revisions to the tax
rules included in our mandate were proposed to
address these obstacles and would generally expand
the banking and, in some cases, other industries'
eligibility to elect S-corporation status. Our
objectives were to (1) analyze possible revisions
to the rules governing S-corporations; and (2)
determine the potential impact such revisions
might have, primarily on community banks.2
As stated in the Gramm-Leach-Bliley Act, the
specific revisions we studied were (1) increasing
the permissible number of shareholders in S-
corporations; (2) permitting shares of S-
corporations to be held in individual retirement
accounts (IRAs); (3) clarifying that interest on
investments held for safety, soundness, and
liquidity purposes should not be considered
passive investment income;3 (4) discontinuing the
treatment of stock held by bank directors as a
disqualifying second class of stock for such
corporations; and (5) improving federal tax
treatment of bad debt for banks converting to S-
corporation tax status.
Corporations that elect Subchapter S status are
not subject to federal corporate income tax. The S-
corporation's income is "passed through" to S-
corporation shareholders, who are taxed on their
portion of the corporation's income, regardless of
whether they receive a cash distribution. At the
end of 1997, there were approximately 2.5 million
S-corporations in the United States, according to
Internal Revenue Service (IRS) data. S-
corporations operate in every industrial sector
and in every state. A corporation must meet a
number of eligibility requirements to become an S-
corporation, which we discuss more fully in
appendix I. If any of the criteria are no longer
met, a firm's tax status as an S-corporation would
be terminated automatically, and it subsequently
would be taxed as a C-corporation.
We conducted our work in Washington, D.C., and San
Antonio, TX, between December 1999 and May 2000,
in accordance with generally accepted government
auditing standards. Appendix II describes our
scope and methodology.
Results in Brief
We studied five possible revisions to the tax
rules governing S-corporations. The proposed
provisions were written to address perceived
obstacles to becoming S-corporations cited by
representatives of the banking industry. Two of
the five proposed tax changes that we
analyzed-increasing the number of shareholders and
allowing IRAs as shareholders-would affect both
nonbank and bank corporations. For example, the
first proposed provision would increase the
maximum number of shareholders in S-corporations
from 75 to 150. Expanding the number of eligible
shareholders would allow more firms to choose to
become S-corporations. Increasing the shareholder
limit, however, appears to be more important to
the banking industry than to other industries
because S-corporation banks have significantly
more shareholders than S-corporations from other
industries, according to IRS data.
The remaining three provisions-clarifying passive
income rules, tax treatment of bank director
shares, and tax accounting of bad
debts-specifically affect individual banks'
corporate strategies. Banks face certain obstacles
in becoming S-corporations that are situational to
an individual bank's history and business
strategy. For example, because the current tax
rules limit the amount of passive investment
income that S-corporation banks can earn, some
banks have found this rule to be a significant
obstacle to becoming an S-corporation, but others
have not. One provision we studied would clarify
that a bank's income from investment securities
usually held for liquidity purposes would not be
considered passive investment income under IRS tax
rules. The proposed change may be more consistent
with bank regulatory objectives-safety and
soundness-than with current tax treatment-taxing
similar types of income across industries in a
similar fashion. We discuss the specific proposed
tax provisions in appendixes III through VII.
The proposed tax provisions would allow more and
larger banks to benefit from not paying corporate
tax by electing S-corporation status, and the
overall impact on community banks would be
determined by this expansion. It is difficult to
project how many banks could be affected by the
proposed tax changes. Estimates ranged from about
300 to 5,700 banks and thrifts. The proposed
provisions could help community banks become more
competitive relative to credit unions to the
extent that converting banks provide the same
services offered by credit unions. The benefits of
these proposed provisions for community banks
relative to larger banks would depend on the
characteristics of the converting banks. Other
potential impacts of the proposed provisions
include
� tax revenue losses estimated by the Joint
Committee on Taxation to be at least $748 million
over a 5-year period; and
� behavioral changes-higher dividends and lower
capital in S-corporation banks, relative to
comparable banks, that might have regulatory
implications.
The Departments of Labor and Treasury, the Board
of Governors of the Federal Reserve System, the
Federal Deposit Insurance Corporation, and the
Office of Thrift Supervision provided comments on
a draft of this report, which are included near
the end of this letter.
Background
State banks are legally required to organize as
corporations in order to obtain insurance from the
Federal Deposit Insurance Corporation (FDIC).4
Also the Internal Revenue Code defines the term
"bank" to mean a bank or trust company that is
incorporated and doing business under the laws of
the United States.5 A corporation is a legal
business entity that generally raises money by
selling shares of stock to shareholders.
Corporations are generally subject to federal-
level corporate income taxation on earnings that
are either distributed to shareholders in the form
of dividend payments or reinvested in the
corporation in the form of retained earnings.
Shareholders in corporations are in turn subject
to the individual income tax on dividends received
and capital gains realized. In contrast,
corporations that elect Subchapter S status
generally are not subject to federal corporate-
level income tax. S-corporation tax status mainly
allows small, closely-held corporations meeting
certain requirements to elect to eliminate
corporate-level income taxation. S-corporation
shareholders are taxed on their portion of the
corporation's taxable income, regardless of
whether they receive a cash distribution.
The history of S-corporation legislation reflects
congressional intent to provide a tax election to
benefit small business corporations. Beginning in
1997, financial institutions that meet certain
requirements were permitted to elect Subchapter S
status. We discuss the history of S-corporations
and the eligibility requirements for becoming S-
corporations more fully in appendix I. Generally,
to qualify for S-corporation status, a business
must meet the following requirements: 6
� The business must be a domestic corporation.
� The business must have only one class of
stock.
� There must be no more than 75 shareholders.
� The shareholders must be only individuals;
estates (including estates of individuals in
bankruptcy); certain trusts; and for tax years
beginning in 1997, certain tax-exempt
organizations. 7 Nonresident aliens, partnerships,
limited liability companies, and individual
retirement accounts are not qualifying
shareholders.
� The business cannot be a financial
institution that uses the reserve method of
accounting for bad debts for tax purposes. Certain
other types of corporations8 also do not qualify.
� All shareholders must agree to the business'
decision to be an S-corporation.
Banks meeting the eligibility requirements for S-
corporations generally can avoid corporate income
tax obligations. According to FDIC data, as of
year-end 1999, slightly over 1,300 banks and
thrifts were S-corporations (about 13 percent of
total banks and thrifts) with average bank assets
of about $100 million. Asset levels of S-
corporation banks ranged from $4.7 million to $5.5
billion. However, most banks have continued their
status as C-corporations. Reasons why banks may
not choose to elect S-corporation status include
(1) failure to meet the eligibility requirements,
(2) conversion costs associated with meeting the
requirements, and (3) expected rapid growth that
requires a larger shareholder base to attract
sufficient capital to support such growth.
Some S-corporation requirements, such as the
shareholder and passive income restrictions, can
affect bank management strategies related to a
bank's capital structure. Capital provides banks
long-term funding that cushions the banks against
unexpected losses. Banks can raise capital by
selling shares of stock to shareholders and by
retaining earnings.
Under national banking law, directors of national
banks that are regulated by the Office of the
Comptroller of the Currency are required to hold
shares of bank stock. Banks also are required to
hold capital that is commensurate with the risks
associated with their assets, liabilities, and
ongoing banking activities. Credit risk faced by a
community bank is closely tied to economic
conditions in the specific community in which the
bank provides banking services.
The Gramm-Leach-Bliley Act of 1999 expanded bank
powers. It facilitated affiliation among banks,
securities firms, and insurance companies. As a
result, the competitive landscape faced by
community banks could change, with or without
changes to rules governing S-corporations.
Likewise, the services provided by community banks
could change.
Analysis
Our analysis addresses (1) the implications of
individual proposed provisions; and (2) the
overall impact of the provisions, if passed,
primarily on community banks.
Two Provisions Affect S-Corporations in All
Industries
The first two provisions we studied-increasing the
number of shareholders and permitting individual
retirement accounts (IRAs) as shareholders-affect
S-corporations in all industries, not only the
banking industry. The other three provisions we
studied-clarifying passive income rules, tax
treatment of bank director shares, and tax
accounting of bad debts-were specific to the
banking industry.
Increasing the Number of Eligible Shareholders
Appears More Important to the Banking Industry
than to Other Industries Wishing to Become S-
Corporations
According to discussions with industry
representatives and our analysis, the shareholder
limit appears to be more of a constraint for banks
wishing to elect Subchapter S tax status than for
firms in most industries. Across all industries,
roughly 2.5 million corporations have elected to
be S-corporations as of the end of December 1997.
Of these 2.5 million S-corporations from all
industries, 91 percent had 3 or fewer
shareholders, and less than 1 percent had more
than 31 shareholders, according to IRS data. Since
1997, 1,318 banks, or about 13 percent of banks in
the industry, have converted to S-corporation
status, according to FDIC data as of the end
December 1999. About 40 percent of these S-
corporation banks had 3 or fewer shareholders, and
about 11 percent had 31 or more shareholders,
according to IRS data.
Bankers, banking industry representatives, and
legal and accounting experts we interviewed cited
the 75-shareholder limit as a major obstacle for
banks wishing to elect Subchapter S tax status.
Bankers told us that the current shareholder limit
forced them to eliminate (i.e., "buy-out")
minority shareholders and limited their ability to
pass shares on to family generations for estate
planning purposes.
Bank regulators did not express any safety and
soundness concerns with increasing the number of
eligible shareholders. If the shareholder limit
were increased to 150, bank regulators noted that
it would be easier for banks to raise additional
capital, which could be important in the event of
an economic downturn. On the other hand, some
legal experts told us that the requirement to
obtain 100 percent shareholder consent to elect
Subchapter S status may become even harder if the
shareholder limit were increased. Treasury
officials expressed the concern that increasing
the number of shareholders further distances S-
corporations from the simplified business
model-one of the main justifications for their
corporation income tax exemption. We discuss this
proposed provision more fully in app. III.
IRA Shareholders Must Be Eliminated During
Conversion Process
Individual retirement accounts (IRAs) are
ineligible shareholders for S-corporations.
Although C-corporation banks are permitted to have
IRA shareholders, if they wish to become S-
corporations they must eliminate the IRA
shareholders. Banks have found ways to eliminate
their IRA shareholders. For example, some bankers
and legal and accounting experts told us that
banks repurchased stock held in IRAs, but this
added to the cost of conversion. Others told us
that individuals owning the IRA shares have
applied to the Department of Labor for permission
to buy back the bank shares,9 which added to the
time that it took to convert to an S-corporation.
Department of Labor officials told us that
processing the exemption takes a minimum of four
months.
Bank regulators we met with did not identify any
safety or soundness concerns with allowing S-
corporation bank shares to be held in IRAs,
because banks are permitted to do so as C-
corporations. However, Treasury officials
generally opposed this proposal because permitting
IRAs to hold shares in S-corporation banks would
create untaxed income for a potentially long
period of time. If this provision were passed,
they supported an alternative proposal that would
tax the IRAs under the Unrelated Business Income
Tax, which parallels similar tax treatment of
other pension funds. We discuss this proposed
provision more fully in appendix IV.
Three Proposed Provisions Affect S-Corporation
Banks' Operations
Three of the proposed provisions we
studied-clarifying passive income rules, tax
treatment of bank director shares, and tax
accounting of bad debts-may affect banks'
management strategies but do not directly affect S-
corporations in other industries.
Clarifying Current Tax Treatment of Passive
Investment Income Could Improve Converting Banks'
Liquidity
If a bank's passive investment income10
exceeds 25 percent of gross receipts for 3 years,
it may lose its S-corporation eligibility. Bank
accounting experts we interviewed stated that the
present IRS rules for passive investment income
relating to Subchapter S corporations and
potential terminations of Subchapter S status are
not clear. They said that at a minimum, IRS needs
to provide clearer guidance on what constitutes
passive investment income for banks. These experts
proposed that a bank's income from investment
securities not be considered passive income for
tax purposes. IRS and Treasury officials stated
that the current rules give tax examiners
sufficient flexibility in dealing with different
tax situations for banks and did not believe
further clarification was needed.
IRS guidance lists banking assets that are
not subject to passive investment income
limitations.11 The IRS guidance also includes a
"catch-all" paragraph that excepts from passive
investment income assets that are held by the bank
to satisfy "reasonable liquidity needs." However,
Treasury securities are not listed explicitly in
IRS' current guidance. Some bankers are concerned
that if the banks were audited, IRS examiners
would consider their U.S. Treasury securities as
"passive" investment income rather than actively
held for "reasonable liquidity purposes." Bankers
and legal and accounting experts emphasized that
banks in rural and low-growth areas experiencing
either cyclical or low loan demand may not be able
to comply with current passive investment income
rules. These banks typically hold large portfolios
of Treasury securities to offset the cyclical cash
flows and low loan demand in their communities.
Some bankers and accounting experts whom we
spoke with were concerned that IRS may treat
banks' investment income as passive investment
income in some situations, which may deter banks
from holding prudentially adequate levels of
liquidity. Federal Reserve officials told us that
although they understood IRS' position on passive
investment income, they were concerned that strict
interpretation of tax rules could limit the
liquidity a S-corporation bank would keep. They
felt the limit would cause banks to change the
types of assets they kept in their portfolios,
lowering banks' overall liquidity.
We observed that accountants' interpretations
of passive income rules varied, which could result
in inconsistent treatment for tax purposes. Legal
and accounting experts we interviewed told us that
some banks are shifting investments to meet
perceived passive investment income restrictions.
For example, one banker told us that his bank had
begun shifting the bank's Treasury securities into
riskier investments to avoid losing its S-
corporation tax status. Our analysis also
suggested that S-corporation banks had slightly
higher loan to asset ratios (had become slightly
less liquid) relative to comparison groups of C-
corporation banks (discussed below). We discuss
the proposed provision on passive income more
fully in appendix V.
Share Agreements of National Bank Directors May
Need to be Rewritten to Qualify for S-Corporation
Status
To become eligible to be an S-corporation, a firm
is allowed to have only one class of stock. Under
national banking law, bank directors are required
to hold a minimum of $1,000 par value of stock in
their bank.12 The stock can be held in the form of
common stock; but as a matter of practice, some
bank directors hold preferred stock,13 which
constitutes another class of stock. Therefore, the
way banks write their shareholder agreements for
bank director shares can create a second class of
stock (which would disqualify a bank from becoming
an S-corporation), unless the agreements are
rewritten during the conversion process so that
the bank has only one class of stock.
Another requirement under national banking law
that can affect an S-corporation bank is that
national banks must have a minimum of five bank
directors. These shareholder requirements for
national bank directors increase the number of
shareholders for banks electing S-corporation
status. Some bankers have told us that these
requirements limit their ability to manage the
number of shareholders of the banks, and they
cited them as an obstacle to the Subchapter S
election.
The proposed provision would not consider bank
director shares as a second class of stock or
count bank director shares as shareholders for S-
corporation purposes. IRS officials have not
changed their regulations to address the bankers'
concerns and stated that to do so would require
legislative changes. We discuss this proposed
provision more fully in appendix VI.
Technical Change in Banks' Tax Accounting for Bad
Debts Lowers Cost for Converting to S-Corporation
Bank tax accounting experts we interviewed have
cited the current tax treatment for banks'
accounting for bad debt as an obstacle to the
Subchapter S election. The proposed provision
would change the tax deductions for certain losses
embedded in the loan portfolio at conversion from
a C-corporation bank to an S-corporation.
Current S-corporation eligibility restrictions
require that for tax purposes, financial
institutions must use the specific charge-off
method for bad debt expense (i.e., firms can take
a tax deduction against income or "write-off" an
asset in the tax year that it is deemed
worthless). Small C-corporation banks are
permitted to use the reserve method of accounting
for their bad debts for tax purposes (i.e., the
bank can take a deduction against its income for
additions to its bad debt reserves in an amount
that will make the reserve balance large enough to
absorb anticipated future bad debts). If a small
bank that uses the reserve method wishes to become
an S-corporation, it must change its accounting
methods for bad debts from the reserve method to
the specific charge-off method. Banks are then
required to "recapture" their reserve (the value
of estimated losses) as income, which is taxed at
the corporate rate as "built-in" gain, income
created by recapturing the reserve.14 For some
banks, this can be a costly part of conversion to
an S-corporation. The built-in gain from the
reserve is recaptured into taxable income over a 4-
year period.15 Currently, after conversion a bank
can deduct its built-in losses only for the first
year, and it can deduct these losses only up to
the value of their built-in gains. Any remaining
"built in" losses cannot be carried over or used
against other income to lower taxes. The ability
to deduct built-in losses from bad loans may
become more important in the event of an economic
downturn. When the economy is strong and a bank is
experiencing relatively few loan losses, the
ability to deduct the built-in losses is less
important. Conversely, as loan losses increase, so
does the importance of a bank's ability to deduct
built-in losses.
The proposed change would allow built-in losses to
be matched against built-in gains over the 4-year
recapture period. Treasury officials indicated a
willingness to address the issue, but they also
said the change would complicate tax rules at a
time when they are attempting to simplify these
rules. We discuss this proposed provision more
fully in appendix VII.
Obstacles that Banks Face in Electing Subchapter S
Status Are Situational
Representatives from the banking industry cited a
number of perceived obstacles in converting to
Subchapter S status. However, the obstacles cited
by bankers, industry representatives, and legal
and accounting experts were situational and
specific to a bank's history and business
strategy. We found that obstacles cited by one
bank were not necessarily important to another
bank, depending on the nature of the bank's
business. For example, some banks were very
concerned about the IRS rules for passive
investment income; other banks had little concern
about their levels of passive investment income.
The American Bankers Association (ABA) and the
Independent Community Bankers of America (ICBA),
banking industry associations, surveyed their
membership about obstacles in electing Subchapter
S status. The major obstacles cited in these two
studies included the 75-shareholder limit, the
restriction on IRAs as shareholders, tax treatment
of passive investment income as it relates to
banks, inclusion of bank director shares in the 75-
shareholder limit, and accounting problems with
the way bad debts are treated for tax purposes. In
our interviews with bankers and legal and
accounting experts, bankers cited other obstacles,
including the (1) requirement to have 100 percent
shareholder consent to elect Subchapter S status
and (2) inability to pass shares to family
generations because of S-corporation shareholder
rules that count each family member as a single
shareholder.16 The proposed provisions that we
studied were written to address many of these
obstacles.
Impact on Community Banks
The proposed tax provisions would allow more
and larger banks to benefit from S-corporation tax
status, and the overall impact on community banks
would be determined by this expansion. To the
extent that the proposed revisions would lead to
Subchapter S conversions concentrated among
smaller community banks, the major impact would be
to improve the competitiveness of community banks
in relation to credit unions. Alternatively, the
proposed revisions could lead to Subchapter S
conversions among larger banks not sharing the
characteristics normally associated with community
banks, which would increase competitive pressures
for community banks. It is difficult to project
how many banks would convert, and estimates varied
on how many banks would likely convert due to
these provisions. The impact of the proposed tax
changes on community banks will ultimately depend
on the characteristics of those banks that choose
to convert to Subchapter S tax status.
In addition to the competitive impacts of the
proposed provisions, banking regulators expressed
a concern about the increased incentive for S-
corporation banks to pay higher dividends relative
to other banks in the event of an economic
downturn. Our analysis supported this concern. Tax
revenue losses could be associated with the
proposed tax provisions, if passed.
Competitive Impact on Community Banks Depends on
the Characteristics of Banks That Choose to
Convert to S-Corporation Status
The impact of the proposed tax changes on
community banks depends on the characteristics of
those banks that choose to convert to Subchapter S
tax status. By lowering the tax burdens on
community banks that would convert to S-
corporation status, the proposed provisions could
help community banks become more competitive with
credit unions, which are exempt from federal
income taxes. In addition to an increase in the
number of Subchapter S tax conversions, existing S-
corporation community banks could become more
competitive by virtue of the potential cost
savings introduced by the proposed provisions,
such as clarification of passive investment income
rules.
Difficult to Project Potential Universe of
Eligible Banks
We found it difficult to project a potential
universe of those banks likely to be affected by
expansion of the eligibility for becoming S-
corporation banks. Three factors made it difficult
to project the potential universe. First, there is
no commonly accepted definition of community
banks. Second, bank regulators do not track S-
corporations differently from other banks. Third,
shareholder data are not easily obtainable on
nonpublicly traded firms.
Although we found no commonly accepted
definition of a community bank, a number of
characteristics are associated with community
banks. Most often, a bank that limits itself to
banking services in a local community, with board
members and management who reside in the local
community, is considered a community bank. In
addition, banks can be classified as a community
bank on the basis of asset size. For example, two
commonly used asset size categories used to
classify a community bank are assets of less than
$500 million and assets of less than $1 billion.
Other characteristics that have been used to
classify a bank as a community bank include the
provision of banking services that (1) use
personal, relationship-based banking; (2) are
limited to traditional banking services for
individual and business customers, especially
small business customers; and (3) are limited to
rural communities.
Bank regulators do not track S-corporation
banks differently from non-S-corporation banks,
and they do not maintain data on the number of
shareholders for banks. We asked regulators, tax
experts, and banking industry representatives to
provide their best estimates of the number of
banks that would likely be affected by the
provisions. Their estimates of how many banks
would convert to S-corporation status varied and
ranged from 300 to 5,662 banks and thrifts. We
discuss these estimates more fully in appendix
III.
S-Corporation Status Could Allow Community Banks
To Be More Competitive With Credit Unions
S-corporation status could allow community banks
to be more competitive with credit unions.
However, credit unions may react by seeking
additional relief from restrictions on their
activities. As stated earlier, credit unions are
financial institutions that are not subject to the
federal corporate income tax. A credit union is
owned by its members, which are the credit union's
customers, and does not issue stock. Credit unions
generally have limited business powers in relation
to banks. Officials from the American Bankers
Association told us that their initiatives to
expand S-corporation opportunities for banks were
motivated by continued federal income tax
exemption for credit unions. Officials from the
National Credit Union Administration (NCUA) told
us that if Subchapter S eligibility for banks were
expanded, NCUA would ask for more leeway in
membership. According to NCUA officials, because
credit unions are structured as cooperatives,17
they do not have the same profit motive as banks
or the same incentive to pay out dividends to
their membership. As tax-exempt institutions,
credit unions can accumulate retained earnings tax-
free, and such retention can be a major source of
capital for credit unions. In addition, a credit
union's earnings are not passed through to its
membership as taxable income in the same way that
S-corporation bank shareholders must pay personal
income tax on their portion of taxable income from
the S-corporation bank. Therefore, the potential
impacts of the proposed provisions on community
banks could differ from the historical impacts of
federal tax exemption on credit unions.
Competitive Pressures for Community Banks Could
Increase if Larger Banks Become S-Corporations
The proposed provisions, especially the
expansion in the maximum number of shareholders,
could also affect the competitive playing field
between community banks and large financial
institutions.18 Although the largest current S-
corporation bank has about $5.5 billion in assets,
most current S-corporation banks are relatively
small community banks. The average asset size of S-
corporation banks was almost $99 million as of
year-end 1999, according to FDIC data. However, as
stated earlier, the proposed expansion to a
maximum of 150 shareholders has the potential to
motivate larger banks to take actions to convert
to Subchapter S status. In addition, due to
insufficient data on the number of shareholders
for privately held C-corporation banks with under
500 shareholders, it is difficult to project how
many more banks would likely become S-
corporations, as stated earlier.
To the extent that the proposed revisions
would lead to Subchapter S conversions
concentrated among smaller community banks, the
major impact would be to improve the
competitiveness of community banks in relation to
credit unions. Alternatively, the proposed
revisions could lead to Subchapter S conversions
among larger banks not sharing the characteristics
normally associated with community banks. With
this scenario, the benefits associated with the
proposed revision for community banks relative to
credit unions would be offset by greater
competitive pressures from larger banks that are
able to convert to Subchapter S status.
Regulators Concerned About the Incentive for S-
Corporation Banks to Pay Dividends in the Event of
an Economic Downturn
Although the banking regulators expressed few
specific concerns about individual proposed
provisions, they were concerned about the
supervisory implications of possible behavioral
differences between S-corporation banks and other
banks in the event of an economic downturn. They
stated that the tax incentive for S-corporation
banks to pay out dividends rather than retain
earnings, compared to C-corporation banks, could
mean that S-corporation banks build up less
capital in good economic times. Moreover, in the
event of an economic downturn, when other banks
would likely lower dividends, the incentives for S-
corporations to pay out dividends would likely
continue so that individual shareholders could pay
taxes. Potentially, this could precipitate bank
capital falling below supervisory thresholds, thus
increasing the risk of failure. This pressure to
pay dividends, combined with the shareholder
restrictions on S-corporation banks, could also
affect the ability to raise capital compared to C-
corporations that do not have the same shareholder
restrictions.
The regulators noted that this concern could be
mitigated because all banks are subject to the
prompt corrective action statute and its
implementing regulations.19 As a result, an insured
bank is prohibited from paying dividends if, after
such a capital distribution, the bank would be
undercapitalized as defined in section 38 of the
Federal Deposit Insurance Act. The federal banking
agencies also have noted that they have the
authority to restrict, or in some cases entirely
prohibit, payment of dividends in other
situations, e.g., due to capital concerns arising
from an institution's risk profile.
Key Performance Measures Differ between S-
Corporation Banks and Other Banks
Our analysis of 520 S-corporation banks that
converted to S-corporation status in the first
quarter of 1997 showed differences in certain
performance measures, relative to comparable
banks. Our analysis of key performance indicators
supports the regulators' views that S-corporation
banks have an incentive to pay out dividends and
that such behavior could raise supervisory concern
in the event of an economic downturn.
To compare the financial performance of S-
corporation banks that converted to S-corporation
status in 1997 with comparable C-corporation
banks,20 we studied 1996-1999 quarterly data on the
following indicators:
� dividend to net income (dividend payout)
ratios,
� capital-to-asset (Tier-one leverage capital)
ratios,
� return on asset ratios, and
� net loans and leases to total assets ratios
(higher ratios represent lower liquidity).
We found statistically significant differences for
the S-corporation banks in some of these
indicators. Their median cash dividend payout
ratios increased, but ratios for those C-
corporation banks in the comparison group did not.
The difference in the trends of cash dividend
payouts between S-corporation banks and comparable
banks were statistically significant. The higher
dividend payouts in turn may have contributed to
somewhat lower capital-to-asset ratios among S-
corporation banks. Because of the importance of
these indicators for maintaining bank solvency,
regulators may need to pay special attention to
the capital strength of S-corporation banks to
avoid problems in these banks in the event of an
economic downturn.
After conversion, the median cash dividend to net
income ratio (the dividend pay-out ratio) for S-
corporation banks increased relative to the C-
corporation bank comparison group. This increase
could be associated, in part, with the additional
incentive for S-corporation banks to pay out
dividends to shareholders (to cover their
additional tax liability) relative to the
incentive for C-corporation banks to retain
earnings. In addition, the median capital-to-asset
ratio21 for S-corporation banks declined slightly
relative to our comparison group of C-corporation
banks. There were no significant post-conversion
differences in liquidity between the trends of
these two groups. The following indicators that we
analyzed demonstrate some differences between S-
corporation banks and the comparison group of
banks.
Dividends Increasing
The median cash dividend payout ratios22 for S-
corporation banks (which had been higher than for
our comparison group, even before conversion)
increased from 1996 through 1999; the comparison
group did not change significantly during this
time. Our analysis of the median cash dividend
payout ratios showed an increasing gap between S-
corporation and non-S-corporation ratios that was
statistically significant. The increasing dividend
payout ratios for S-corporation banks are not
surprising because the shareholders now pay
personal income tax on bank income, whether or not
it is distributed as dividends (see fig. 1).
Figure 1: Median Cash Dividend to Net Income
Ratios for S-Corporation Banks and Comparison
Banks From 1996 to 1999
Source: GAO analysis of FDIC data.
Slight Decline in Capital-to-Asset Ratios
Bank capital performs several very important
functions. It absorbs losses, promotes public
confidence, restricts excessive asset growth, and
provides protection to depositors. Bank regulators
have traditionally placed a great deal of
attention in their examination and supervisory
programs on institutions' capital positions. Banks
are subject to several capital-based regulations.
One of these regulations establishes a minimum
leverage capital standard. In general, the prompt
corrective action statutes, which we referred to
earlier, are triggered when the Tier 1 leverage
ratio23 is less than 4 percent, the Tier 1 risk-
based capital ratio is less than 4 percent, or the
total risk-based capital ratio falls below 8
percent.24 Our analysis of the median Tier 1
leverage capital ratios showed that both groups of
banks were well above the minimum regulatory
requirement.
Consistent with the increasing cash dividend
payout ratios, the median Tier 1 leverage capital
ratios of S-corporation banks were lower than for
the non-S-corporation comparison group in absolute
terms and declined further from 1996 to 1999 than
did non-S-corporation banks' Tier 1 leverage
capital ratios across that same time period. From
1996 through 1999, in a comparison of the movement
of the Tier 1 leverage capital ratios of S-
corporation banks and the comparison group, the
widening of the gap between the two groups was
statistically significant-the S-corporation banks
fell further below the comparison group (see fig.
2). Although the widening of this gap was
statistically significant, the gap increased less
than one half of a percentage point. Because our
analysis spans only 4 years, these trends could
change in either direction over a longer period of
time and under different economic conditions.
Figure 2: Median Tier 1 Leverage Capital Ratio
for S-corporation Banks and Comparison Banks From
1996 to 1999
Source: GAO analysis of FDIC data.
Higher Return on Assets
The continued viability of a bank depends on its
ability to earn an appropriate return on its
assets and capital. Good earnings performance
enables a bank to fund its expansion, to remain
competitive in the market, and/or replenish its
capital funds. Probably one of the most widely
used measures of bank earnings is the return on
assets ratio. Our analysis of the return on assets
ratios25 showed that both groups of banks were
considered profitable by industry standards.
For the return on asset ratios (which were higher
for S-corporation banks in every quarter), the
median values for S-corporation banks declined
somewhat less from 1996 to 1999 than the values
for non-S-corporation banks across that same time
period.26 That is, both groups have seen a decline
in this performance measure; but on average, the S-
corporation ratio has fallen at a slower rate. The
gap between S-corporation banks and the comparison
group also widened slightly over this 4-year
period (see fig. 3). This may indicate a number of
things, including that the S-corporation banks (1)
were more profitable; (2) had been more efficient
in using their assets; or (3) became comparatively
more risky relative to the comparison group,
because higher returns on assets tend to be
associated with higher risk. As stated before,
this trend could change over a longer period of
time and under different economic conditions.
Figure 3: Median Return on Assets Ratios for S-
corporation Banks and Comparison Banks From 1996
to1999
Source: GAO analysis of FDIC data.
Slightly Lower Liquidity
S-corporation banks' median ratios of net loans
and leases to total assets were higher
(representing lower liquidity levels) than the
comparison group for all quarters except one. In
comparing the median net loans and leases to
assets ratio of S-corporation banks to the same
ratio in its peer group, we found that although
both S-corporation and comparison group banks show
a slight trend towards decreasing liquidity levels
over the 1996 through 1999 period, there was no
statistical difference between the trends of the
two groups. The liquidity measure we analyzed-net
loans and leases to asset ratio-increases as the
bank becomes less liquid (i.e., as the bank's
loans increase relative to its total assets).
Figure 4: Median Net Loans and Leases to Assets
Ratio for S-Corporation Banks and Comparison
Banks, 1996-1999
Source: GAO analysis of FDIC data.
Estimated Tax Revenue Loss for Proposed Provisions
Tax revenue losses would be likely if the five
proposed provisions that we studied were passed.
According to the proposals written for the 1999
tax reform act, the tax revenue losses were
estimated to be at least $748 million over 5 years
and about $1.9 billion over a 10-year period. If
passed, the most costly provision-increasing the
maximum number of shareholders to 150-would affect
all industries. The revenue loss from the three
provisions that would affect only the banking
industry would not be as costly and was estimated
to be $168 million over 5 years. The following
table presents the revenue estimates for four of
the proposed provisions that we studied.
Table 1: Tax Revenue Loss Estimates for 1999
Proposed Provisions
Provision 5-year estimate (2000- 10-year estimate (2000-
2004) 2009)
1. Affecting all
industries
(A) Increase shareholders $580 million revenue loss $1,544 million revenue
to 150 loss
(B) Include IRAs as No estimatea No estimatea
eligible shareholders
Subtotal #1 $580 million revenue loss $1,544 million revenue
loss
2. Affecting only banking
industry
(C) Exclude investment $10 million revenue loss $23 million revenue loss
securities income from
passive income tax
treatment
(D) Treatment of $26 million revenue loss $100 million revenue loss
qualifying director
shares
(E) Improve bad debt tax $132 million revenue loss $201 million revenue loss
treatment
Subtotal #2 $168 million revenue loss $324 million revenue loss
Total revenue impact $748 million revenue loss $1,868 million revenue
loss
aAt the time these estimates were prepared,
several proposals were being considered that would
affect the estimates. Therefore, the Joint
Committee on Taxation did not prepare estimates
for this provision.
Source: Estimates prepared by the Joint Committee
on Taxation based on provisions presented for the
1999 tax reform bill.
IMPACT OF S-CORP TAX TREATM
Impact on Community Banks Depends on
Agency Comments and Our Evaluation
We requested comments from the Departments of
Labor and the Treasury, the Board of Governors of
the Federal Reserve System, the Federal Deposit
Insurance Corporation, and the Offices of the
Comptroller of the Currency and Thrift
Supervision. Treasury, FDIC, and the Federal
Reserve provided written comments that are
included in appendixes VIII, IX, and X
respectively. The Director of Exemption
Determinations, Pension and Welfare Benefits
Administration, Department of Labor and the
Director, Internal Review, Office of Thrift
Supervision provided technical comments on a draft
of this report, which we incorporated where
appropriate. The Office of the Comptroller of the
Currency did not have any comments on our report.
The Department of the Treasury stated that
"the report presents an informative and balanced
discussion of the issues involved and, in
particular, the potential impact of the proposal
on community banks." In addition, Treasury had
five general comments. First, Treasury stated that
S-corporation status was originally intended for
small, simple entities and that this form of
corporate organization should not be available to
large entities with complicated capital
structures. Second, Treasury stated that most of
the proposals address transition issues and are
intended to address problems arising during
conversion from C-corporation to S-corporation
status. Third, Treasury stated that the impact of
the proposals on community banks is not
unambiguously favorable, because the proposed
revisions might encourage large, noncommunity
banks to convert to S-corporation status, thus
subjecting community banks to greater competition.
Fourth, Treasury stated that certain performance
measures might not be comparable for S-
corporations and C-corporations. For example,
comparing pre-tax dividend-to-earnings ratios,
(i.e., payout ratios) or return on assets ratios
could indicate differences between C-corporations
and S-corporations, even in cases where there is
no difference in economic substance. Fifth,
Treasury stated that S-corporations should not
have greater difficulty retaining earnings.
The report states that the history of S-
corporation legislation reflects congressional
intent to provide a tax election to benefit small
business corporations. The report states in
relevant sections that most of the proposals are
intended to address obstacles banks face in
converting from C-corporation to S-corporation
status. However, we do not think these obstacles
represent transitory issues in the sense that they
will dissipate or disappear over a short period of
time. For example, C-corporations wishing to
convert to S-corporation status in the distant
future could face the obstacle created by the
maximum number of allowable shareholders.
In response to Treasury's comment that
certain performance measures may not be comparable
for S-corporations and C-corporations, we added
statements to clarify statistical adjustments that
were made to improve comparability. The
performance data we obtained from bank regulators
contained statistical adjustments of dividend
payout and return on asset variables for S-
corporation banks to facilitate comparative
analysis of the performance of S-corporation and
comparison group C-corporation banks. The
adjustments were made to after-tax measures of
earnings and dividends. We note, however, that
although these adjustments improve comparability,
they do not provide exact comparisons. In response
to Treasury's comment that S-corporations should
not have greater difficulty retaining earnings, we
note that discussion in the report focuses on
incentives for S-corporation banks to make larger
dividend payouts and reduce the use of retained
earnings as a source of capital. The report does
not contain a discussion of the difficulties S-
corporation banks have in retaining earnings.
FDIC stated that there are four items in the
report for which further clarification or comment
may be needed. For the first two items, which are
related, FDIC stated that the report is
inconsistent in its discussion of proposed changes
to the passive investment income rules; and the
discussion in the findings section regarding
passive investment income focuses exclusively on
holding of U.S. Treasury securities. FDIC
discussed distinctions between investment in
Treasury securities; investments held for safety,
soundness, and liquidity purposes, and investment
securities.
FDIC addressed two additional items. First,
FDIC stated that it is important to note that
safety and soundness concerns associated with high
dividend payout rates are mitigated by the fact
that all dividend distributions to shareholders
are subject to the prompt corrective action
statute and its implementing regulations. In
particular, FDIC cited the authority of federal
banking agencies to restrict dividends if, after
such a distribution, the bank would be
undercapitalized. Second, FDIC stated that it is
unclear what our basis is for the statement that S-
corporation status can allow banks to be more
competitive with credit unions. FDIC added that
credit unions do not have the same incentive as S-
corporation banks to pay dividends to their
membership to satisfy personal income tax
obligations.
The proposed revision in the passive
investment income rules we studied was clarifying
that interest on investments held for safety,
soundness, and liquidity purposes should not be
considered passive income. In discussing the
revision, we make reference to investment
securities that are usually held for liquidity
purposes. We also discuss specific investment
securities, such as Treasury securities, as an
example of a major area where clarification may be
warranted. Our discussion of securities in general
or specific securities does not represent an
inconsistency. In response to FDIC's comment, we
added clarifying language in the report.
In response to FDIC's comment on dividend
payout rates, we added statements indicating that
federal bank regulators have prompt corrective
action authority that can be used to restrict
dividend payouts. FDIC's comment stating that it
is unclear what our basis is for the conclusion
that S-corporation status can allow community
banks to be more competitive with credit unions
appears to rely on differences between S-
corporation banks and credit unions involving
profit motive and tax treatment. Our conclusion is
not that the playing field will be fully leveled.
Rather, it is that the tax advantages community
banks can obtain by converting from C-corporation
to S-corporation status can improve the ability of
community banks to compete with credit unions that
are exempt from federal level income taxation.
We are sending copies of this report to the
requesting congressional committees. We are also
sending copies of this report to the Honorable
Alexis Herman, Secretary of Labor; the Honorable
Lawrence Summers, Secretary of the Treasury; the
Honorable Donna Tanoue, Chairman, the Federal
Deposit Insurance Corporation; the Honorable Alan
Greenspan, Chairman, the Federal Reserve Board of
Governors; the Honorable John D. Hawke, Jr.,
Comptroller of the Currency; the Honorable Ellen
Seidman, Director, the Office of Thrift
Supervision; and the Honorable Norman D'Amours,
Chairman, the National Credit Union
Administration. Copies will be made available to
others upon request.
This report was prepared under the direction
of William B. Shear, Assistant Director, Financial
Institutions and Markets Issues. Please contact me
or Mr. Shear at (202) 512-8678 if you or your
staffs have any questions about this report. Other
major contributors are acknowledged in appendix
XI.
Thomas J. McCool
Director, Financial Institutions and Markets
Issues
LIST OF CONGRESSIONAL COMMITTEES
The Honorable Bill Archer
Chairman
The Honorable William V. Roth
Vice Chairman
Joint Committee on Taxation
The Honorable Phil Gramm
Chairman
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking, Housing and Urban Affairs
United States Senate
The Honorable William V. Roth, Jr.
Chairman
The Honorable Daniel Patrick Moynihan
Ranking Minority Member
Committee on Finance
United States Senate
The Honorable James A. Leach
Chairman
The Honorable John J. LaFalce
Ranking Minority Member
Committee on Banking and Financial Services
House of Representatives
The Honorable Bill Archer
Chairman
The Honorable Charles B. Rangel
Ranking Minority Member
Committee on Ways and Means
House of Representatives
_______________________________
1 In this report, we refer to federally insured
bank and thrift institutions as banks.
2 Although no commonly accepted definition of a
community bank exists, the term is often
associated with smaller banks (e.g., under $500
million or under $1 billion in assets) that
provide traditional "relationship" banking
services to the local community, and have
management and board members who reside in the
local community.
3 Section 1362 (c)(i) of the Internal Revenue Code
defines passive investment income as gross
receipts derived from royalties, rents, dividends,
interest, annuities, and sales or exchanges of
stock or securities. We discuss the restrictions
on passive investment income for S-corporations in
more detail in appendix V.
4 12 U.S.C. 1813(a)(2). For purposes of
determining eligibility for federal deposit
insurance, the term "state bank" is defined as any
bank, banking association, trust company, savings
bank, industrial bank, or other banking
institution that is (1) engaged in the business of
receiving deposits and (2) incorporated under the
laws of any state.
5 26 U.S.C. sec. 581.
6 Section 1361 of the Internal Revenue Code.
7 An S-corporation may hold stock in a controlled
subsidiary but may not be a subsidiary of another
company unless it is wholly owned by a parent
company that is also an S-corporation. The parent
S- corporation must make an election to treat the
subsidiary S-corporation as a Qualified Subchapter
S Subsidiary (QSSS). The QSSS would essentially
not be treated as a separate corporation.
8 Insurance companies, domestic international
sales corporations (DISCs), and corporations
electing to take the possessions tax credit are
also ineligible corporations.
9 We discuss this in more detail in appendix IV.
10 S-corporations with accumulated earnings and
profits from years as C-corporations are subject
to a corporate-level tax on net passive investment
income exceeding 25 percent of gross receipts for
any year.
11 We cite this list in appendix V.
12 Par value is equal to the nominal or face value
of a security. The par value could represent the
original investment or the price paid for the
share, which would not necessarily represent the
market value of the share.
13 Preferred stock is a class of capital stock that
generally pays dividends at a specified rate and
has preference over common stock in the payment of
dividends and the liquidation of assets.
14 Built-in gains (losses) generally refer to gains
(losses) embedded in the asset portfolio at the S-
corporation conversion date.
15 Other built-in gains generally are recaptured
over a 10-year period.
16 A husband and wife who each own shares in the S-
corporation bank are counted as a single
shareholder.
17 Credit union membership is limited to its
members with a "common bond," defined as "a common
bond of occupation or association, or to groups
within a well-defined neighborhood, community, or
rural district." The Credit Union Membership
Access Act of 1998 (P.L. 105-219) expanded credit
union powers and made the "common bond"
requirement less restrictive. Credit unions can
now serve multiple groups.
18 The Gramm-Leach-Bliley Act of 1999 permits
eligible bank holding companies to add affiliates
that engage in securities and insurance activities
within a "financial holding company." The extent
to which community and larger banks make use of
the expanded powers will also affect the
competitiveness of community banks relative to
credit unions and larger banks. Of the 187
declared domestic financial holding companies, 145
or about 78 percent, had assets of less than $1
billion as of May 10, 2000.
19 Section 38 of the Federal Deposit Insurance Act
requires regulators to categorize depository
institutions on the basis of their capital levels
and to take increasingly severe supervisory
actions as an institution's capital level
deteriorates. For further discussion of the prompt
corrective action provisions and their
implementation by the supervisory agencies, see
Bank and Thrift Regulation: Implementation of
FDICIA's Prompt Regulatory Action Provisions
(GAO/GGD-97-18, Nov. 21, 1996).
20 The comparison group for this analysis was
defined as the 1,284 banks that were active during
the 4-year period, had never become S-
corporations, had assets of less than $1 billion,
and had made 25 percent or more of their loans for
agricultural purposes in at least one quarter.
Some of the findings in our report could change if
a different comparison group were used.
21 The median ratio means that half the banks fell
above and half fell below this ratio.
22 The ratio is defined as the cash dividends
declared divided by net income. The FDIC adjusts
this ratio in the Uniform Bank Performance Report
to reflect the Subchapter S tax status to
facilitate comparative analysis with non-S banks.
Although this adjustment improves comparability,
it does not provide exact comparability between
the two groups.
23 This ratio is Tier one capital divided by
adjusted average assets as defined in the Uniform
Bank Performance Report.
24 12 C.F.R. 325 establishes the criteria and
standards FDIC will use in calculating the minimum
leverage capital requirement and in determining
capital adequacy. The other bank regulators have
similar regulations. See Risk-Based Capital:
Regulatory and Industry Approaches to Capital and
Risk (GAO/GGD-98-153).
25 This ratio is defined in the Uniform Bank
Performance Report as net income to average assets
and equals net income after securities gains or
losses and applicable taxes, divided by average
assets. FDIC adjusted this ratio in the Uniform
Bank Performance Report to reflect the Subchapter
S tax status to facilitate comparative analysis
with non-S-corporation banks. Although this
adjustment improves comparability, it does not
provide exact comparability between the two
groups.
26 The Office of Thrift Supervision stated in a
March 17, 1999, memo to thrift examiners that it
is difficult to compare S-corporations to other
thrifts because of tax differences and suggested
that examiners compare S-corporations using the
measure of reinvested earnings for better
comparability. We also analyzed the measure of
reinvested earnings for the two groups of banks.
Our analysis was consistent with the trends on the
return on assets ratios for these two groups of
banks.
Appendix I
History and Background of S-Corporations
Page 36 GAO/GGD-00-159 S-Corporation Banks
Banks Represent a Small Percentage of All S-
Corporations
S-corporations are corporations that elect to pass
through corporate income and losses to their
shareholders for federal tax purposes.
Shareholders of S-corporations report their pro
rata shares of income or losses on their own tax
returns and are assessed tax at their individual
income tax rates. At the end of 1997, there were
approximately 2.5 million S-corporations in the
United States, according to Internal Revenue
Service data. S-corporations operate in every
industrial sector and in every state. However,
banks account for less than 1 percent of the total
S-corporation population.
Figure I.1: Percentage of S-Corporations by
Industrial Sectors
Source: GAO analysis of IRS Statistics of Income
Data, 1997.
As of December 1999, there were 1,318 S-
corporation banks, representing about 13 percent
of the total banks and thrifts in the United
States. Based on the share of total bank assets
nationwide, S-corporation banks make up a small
proportion, holding about 2 percent. We found that
most S-corporation banks were geographically
located in the central portion of the United
States. The five states with the most S-
corporation banks were Minnesota, Texas, Iowa,
Illinois, and Kansas.
Figure I.2: Dispersion of S-corporation Banks by
State
Note: At the end of 1999, Hawaii had one S-
corporation bank and Alaska did not have any S-
corporation banks. The U.S. Virgin Islands had one
S-corporation bank. Data were not available for
the other U.S. territories.
Source: GAO analysis of FDIC data, year-end 1999.
Based on year-end 1999 data from the Federal
Deposit Insurance Corporation (FDIC), FDIC is the
primary federal regulator for about two-thirds of
S-corporation banks. The Office of the Comptroller
of the Currency (OCC) is the primary regulator for
23.1 percent of S-corporation banks and the
Federal Reserve is the primary regulator for 8.3
percent of S-corporation banks. The Office of
Thrift Supervision is the primary federal
regulator for the remainder of the S-corporation
thrift population-33 thrifts, or about 2.5 percent
of the banking industry.
Current S-Corporation Requirements
To qualify for S-corporation status, a business
must meet the following requirements:1
� The business must be a domestic corporation.
� The business must have only one class of
stock.
� There must be no more than 75 shareholders.
� The shareholders must be only individuals;
estates (including estates of individuals in
bankruptcy); certain trusts; and, for tax years
beginning in 1997, certain tax-exempt
organizations. 2 Nonresident aliens, partnerships,
limited liability companies, and individual
retirement accounts are not qualifying
shareholders.
� The business cannot be a financial
institution that uses the reserve method of
accounting for bad debts for tax purposes. Certain
other types of corporations3 also do not qualify.
� All shareholders must agree to the business'
decision to be an S-corporation.
A firm's tax status as an S-corporation is
automatically terminated if any of the criteria
are no longer met. The business subsequently would
be taxed as a C-corporation.
Subchapter S is a Hybrid of Other Business
Structures
Congress added Subchapter S to the Internal
Revenue Code (the Code) as part of the Technical
Amendments Act in 1958. According to the
legislative history, the provision was enacted for
two reasons: (1) to diminish the effect of federal
income tax considerations in the organizational
choices of businesses and (2) to permit
incorporation and operation of certain small
businesses without the incidence of income
taxation at both the corporate and the shareholder
levels. The provision originally allowed a
domestic corporation, which was not a member of an
affiliated group, to make the Subchapter S
election with the consent of 100 percent of its
shareholders. However, it also required the
corporation to meet requirements that included
limitations on the number and identity of its
shareholders. As originally enacted, a Subchapter
S election would be terminated if (1) 100 percent
of the shareholders consented to a revocation; (2)
the corporation ceased to be a "small business
corporation;" (3) for any taxable year, the
corporation derived more than 80 percent of its
gross receipts from sources outside the United
States; (4) for any taxable year, more than 20
percent of the corporation's gross receipts were
derived from royalties, rents, dividends,
interest, annuities, and sales or exchanges of
stock or securities; or (5) a new shareholder did
not consent to the election within the time
prescribed by regulations.
Subchapter S of the Code combines aspects of
federal tax treatment under Subchapter C and
Subchapter K. Under Subchapter C of the Code,
businesses organized as corporations are generally
treated as taxpaying entities separate and
distinct from their shareholders. That is, a
corporation must generally pay tax on its profits,
although subsequent distributions from these
profits (through dividends or at liquidation) will
also be taxed to the individual shareholders as
part of their own taxable income. Subchapter S tax
status allows small businesses to function as
corporations, thereby giving them the nontax
benefits4 of incorporation. These benefits include
limited liability, unlimited life, or ease of
ownership transfer, with no requirement to pay a
corporate income tax on profits. Unlike C-
corporations, S-corporations are not subject to
the corporate alternative minimum tax or the
accumulated earnings tax.
Businesses may wish to avoid the double level of
taxation generally associated with the corporate
structure. Businesses organized as partnerships
and S-corporations generally are not separate
taxpaying entities. As in partnerships under
Subchapter K, corporate income and losses in S-
corporations are passed through to shareholders5,
whether or not profits are distributed. S-
corporation shareholders and partners then pay
taxes on their requisite shares. However, unlike
partnerships, the outstanding shares of an S-
corporation must confer identical rights to
profits and assets. An exception is made, however,
to allow differences in voting rights.
Former C-corporations Face Corporate Taxes After
Conversion to Subchapter S
Businesses that operated as C-corporations before
making the Subchapter S election could face two
corporate-level taxes after the election is made.6
S-corporations are taxed on any built-in gain that
must be recognized if they dispose of assets that
appreciated during the years as a C-corporation
within the first 10 years of S-corporation
election. Consequently, double taxation is imposed
on this appreciation of assets if the S-
corporation does not hold the assets for a
substantial period of time after making the
election.7
S-corporations with accumulated earnings and
profits from years as C-corporations are subject
to a corporate-level tax on net passive investment
income that exceeds 25 percent of gross receipts
for any year. In addition, and perhaps more
importantly, a company's S-corporation election
will be terminated if passive investment income
exceeds 25 percent for 3 consecutive years.
According to the legislative history, to reduce
the likelihood of terminations, Congress repealed
the provision in the original act that
automatically terminated a corporation's
Subchapter S election if the corporation had
excess passive investment income in any taxable
year.
Besides having excess passive investment income
for 3 consecutive years, there are two other ways
a Subchapter S election can terminate. First,
shareholders holding a majority (more than 50
percent) of the corporation's shares may
voluntarily revoke the election. If S-corporation
shareholders revoke the election on or before the
15th day of the 3rd month of the S-corporation's
taxable year, the revocation will be retroactively
effective as of the first day of that taxable
year. If the election is revoked after that date,
it will be effective on the first day of the next
taxable year. Alternatively, the termination
agreement may itself specify a prospective
effective date. Second, a corporation's S-
corporation election also terminates if it ceases
to meet the initial requirements for eligibility.
A termination resulting from the corporation no
longer qualifying as a "small business
corporation" is effective on the first date the
corporation fails to meet the eligibility
requirements, as discussed above.
An invalid Subchapter S election or an inadvertent
termination may be waived by IRS. The S-
corporation must take steps to meet the
eligibility requirements within a reasonable
amount of time after the discovery of the invalid
election or inadvertent termination. The S-
corporation and its shareholders must also agree
to make any adjustments prescribed by IRS that are
consistent with treatment of S-corporations.
According to the legislative history of the
Subchapter S Revision Act, Congress intended IRS
to be reasonable in granting waivers. This was
intended to provide IRS flexibility in dealing
with corporations whose Subchapter S eligibility
requirements had been violated inadvertently. The
waiver does not exempt small corporations from
paying the tax consequences of a termination, if
the firm would not avoid paying taxes resulting
from the continued Subchapter S treatment.8
Subchapter S Has Been Revised Several Times
Several revisions have been made to the original
Subchapter S provisions dealing with the allowed
number and type of shareholders. According to the
legislative history, the maximum number of
shareholders in an S-corporation originally was
set at 10 but was increased to 35 by the
Subchapter S Revision Act of 19829 to correspond
to the private placement exemption of federal
securities law.10 The Small Business Job Protection
Act of 199611 set the current shareholder limit on
S-corporations at 75. According to the legislative
history of the 1996 act, the maximum number of
shareholders was increased to 75 to facilitate
corporate ownership by additional family members,
employees, and capital investors.
The 1996 act also allowed tax-exempt charitable
organizations and qualified retirement plans,
including employee stock ownership plans (ESOPs),
to be eligible shareholders. According to the
legislative history of the act, the existing
shareholder eligibility restrictions may have
"inhibited employee ownership of closely-held
businesses, frustrated estate planning,
discouraged charitable giving, and restricted
sources of capital for closely-held businesses."
Congress sought to lift these perceived barriers
by allowing certain tax-exempt organizations to be
shareholders in S-corporations. However, Congress
also sought to preserve the concept that all
income of the S-corporation would at least be
subject to a shareholder-level income tax.
Accordingly, the 1996 act provided that all income
flowing through to a tax-exempt shareholder
(including gains and losses from the disposition
of stock) will be treated as unrelated business
taxable income. The Taxpayer Relief Act of 199712
repealed the provision treating items of income or
loss from an S-corporation as unrelated business
taxable income with respect to employer securities
held by an ESOP.
Law Expanded in 1996 to Allow Banks to Elect
Subchapter S Tax Status
Until 1997, financial institutions were not
allowed to elect Subchapter S status because of
the special methods of accounting for bad debts
that were available to them for tax purposes. The
Small Business Job Protection Act of 1996
eliminated this total prohibition against banks
electing Subchapter S status but limited it to
banks that do not use the reserve method of
accounting for tax purposes.13 Thus, large banks
that are ineligible to use the reserve method and
small banks that choose to use the specific charge-
off method for deducting bad debt expenses are now
eligible to elect Subchapter S status. According
to the legislative history of the 1996 act,
Congress believed that any otherwise eligible
corporation should be allowed to elect to be
treated as an S corporation regardless of the type
of trade or business conducted by the corporation,
as long as special corporate tax benefits provided
to such trades or businesses did not flow through
to individual taxpayers.
_______________________________
1 Section 1361 of the Internal Revenue Code.
2 An S-corporation may hold stock in a controlled
subsidiary, but may not be a subsidiary of another
company unless it is wholly owned by a parent
company that is also an S-corporation. The parent
S- corporation must make an election to treat the
subsidiary S-corporation as a Qualified Subchapter
S Subsidiary (QSSS). The QSSS essentially would
not be treated as a separate corporation.
3 Insurance companies, domestic international
sales corporations (DISCs), and corporations
electing to take the possessions tax credit also
are ineligible corporations.
4 Businesses organized as C-corporations also have
nontax benefits, such as limited liability,
unlimited life, or ease of transfer of ownership.
The liability of corporate shareholders is
generally limited to the amount of their
investment. Unlike partnership interests,
corporate stock generally may be transferred
without having any effect on the continuity of the
business.
5 The character of items of income did not
originally pass through to the shareholders of S-
corporations, as was the case with partnerships.
Instead, the income that passed through to the S-
corporation shareholders would be treated as
ordinary income (except for long-term capital
gains) without the retention of any special
characteristics it might have in the hands of
corporations. The Subchapter S Revision Act of
1982, P.L. 97-354, amended the Subchapter S
provisions to allow the complete pass through of
the tax characteristics of items of income and
loss to the Subchapter S shareholders.
6 These two exceptions would not apply to start-up
companies making the Subchapter S election.
7 This same double taxation concept applies to C-
corporations only to the extent that gains and
earnings are paid out to the shareholders in
dividends.
8 Section 1362(f) of the Internal Revenue Code.
9 P.L. 97-354.
10 There were several other increases to the
allowed number of shareholders in S-corporations
during the intervening years. The maximum number
of shareholders was increased to 15 for certain
corporations by the Tax Reform Act of 1976, P.L.
97-455. The Revenue Act of 1978, P.L. 95-600,
increased the limit to 15 for all electing
corporations. The limit was increased to 25 by the
Economic Recovery Tax Act of 1981, P.L. 97-34, and
then to 35 by the Subchapter S Revision Act.
11 P.L. 104-188.
12 P.L. 105-34.
13 This provision became effective January 1, 1997.
Appendix II
Scope and Methodology
Page 39 GAO/GGD-00-159 S-Corporation Banks
Analysis of Proposed Tax Revisions and Potential
Impacts
To respond to a mandate in the Gramm-Leach-Bliley
Act of 1999, we analyzed proposed tax revisions
and the potential impact of these proposed
provisions primarily on community banks.
Specifically, we focused on the proposed
provisions that were contained in S. 875 and H.R.
1994 to (1) increase the permissible number of
shareholders in S-corporations; (2) permit shares
of S-corporations to be held in individual
retirement accounts (IRAs); (3) clarify that
interest on investments held for safety,
soundness, and liquidity purposes should not be
considered as passive investment income; (4)
discontinue treatment of stock held by bank
directors as a disqualifying second class of stock
for S-corporations; and (5) improve federal tax
treatment of bad debt. The scope of our review was
on federal-level tax effects, and we did not
address state-level tax impacts.
Analysis of Proposed Tax Revisions
To understand the proposed provisions and the
effects of current and prior legislation on S-
corporations, we reviewed legislative history and
pertinent tax studies and literature. We also
reviewed the U.S. Tax Code and relevant guidance
from the IRS and banking regulators. We met with
officials from IRS and the Department of the
Treasury to discuss their perspectives on the tax
policy implications regarding the proposed changes
to Subchapter S of the tax code. We interviewed
industry representatives from the S Corporation
Association, the Subchapter S Bank Association,
the American Bankers Association (ABA),1 and the
Independent Community Bankers of America (ICBA)2
and obtained information on the proposed
provisions. On the basis of discussions with
industry representatives, we interviewed experts
who specialize in the field of Subchapter S
banking law and accounting. We also reviewed the
ABA3 and ICBA4 industry surveys of their members
on obstacles to Subchapter S election. To confirm
the findings of these industry surveys, we spoke
to some bankers who had already converted their
banks to S-corporations or were interested in
converting to S-corporations. We chose bankers on
the basis of recommendations by legal and
accounting experts. We also spoke to some bankers
interested in electing Subchapter S status at
ICBA's annual conference in San Antonio, TX.5 We
met with banking and thrift regulators from the
Federal Reserve, the Office of the Comptroller of
the Currency (OCC), the Federal Deposit Insurance
Corporation (FDIC), and the Office of Thrift
Supervision (OTS). We also met with
representatives from the National Credit Union
Administration. To further understand the
treatment of IRAs and the Department of Labor's
prohibited transaction exemption process for IRAs,
we interviewed officials and reviewed documents
from the Pension and Welfare Benefits
Administration of the Department of Labor.
Impacts on Community Banks
To determine the impact of these proposed
provisions on community banks, we first sought to
define community banks and the potential universe
that might be affected by these tax changes. The
definition of community banks varied among those
we interviewed. Common elements of their
definitions for community banks included the types
of activities and services, community locale,
asset size of bank, and level of sophistication in
banks' lines of business. To define the potential
universe, we analyzed IRS' Statistics of Income
data and banking data from FDIC and OTS. Bank and
thrift regulators did not track S-corporations
differently from other banks and thrifts. Bank and
thrift regulators also did not routinely track the
number of bank shareholders to determine which
banks might be likely to elect Subchapter S status
if the shareholder limit were increased to 150.
The Securities and Exchange Commission (SEC)
requires a firm to register only when it has 500
or more shareholders or publicly traded stock and
$10 million or more in assets. To determine the
potential universe of banks that may be affected
by or would likely become eligible to elect
Subchapter S status under the proposed tax
changes, we requested estimates from FDIC, OTS,
and industry representatives.
To further determine the impact of these proposed
provisions on community banks, we interviewed and
reviewed documents from bankers, legal and
accounting experts, and banking regulators about
their views on what the potential impacts might
be. We also reviewed information on the history of
banks related to corporate structure, individual
retirement accounts, bank director requirements,
passive investment income, and accounting
treatment of bad debt.
Also, to determine the potential impact of these
proposed provisions on community banks, we
analyzed the movements of several financial
performance indicators for S-corporation banks,
both before and after Subchapter S election, and
compared them to non-S-corporation banks that had
similar characteristics over the same period of
time. Using quarterly reports of financial
condition (Call Reports) submitted to regulators,
we compiled performance data on the 520 commercial
banks that (1) elected S-Corporation status in the
first quarter of 1997, (2) did not revert to C-
Corporation status at any time afterwards, and (3)
were in business under the same charter for all 16
quarters from March of 1996 through December of
1999. That is, we compared the performance of non-
S-corporation banks to S-corporation banks across
4 quarters before and 12 quarters after S-
Corporation election. Our purpose was to determine
if there were any significant changes in financial
behavior and performance that could be associated
directly with S-Corporation status and not solely
with extraneous factors such as economic
conditions. To measure financial performance, we
analyzed certain statistics used in bank
examinations, including measures of capital
levels, asset strength, profitability, liquidity,
and sensitivity to market risk. Specifically, the
four ratios we analyzed from the Uniform Bank
Performance Report (UBPR) were the (1) cash
dividend to net income ratio, (2) Tier 1 leverage
capital ratio, (3) return on assets ratio, and (4)
net loans and leases to assets ratio.6
In this report, we (1) summarized the absolute
differences in these financial performance
measures between the S-corporation banks and
comparison group banks over the study period, (2)
determined the existence and direction of trends
in any of these four performance measures for the
two groups of banks, and (3) determined whether
any of the trends for S-corporation banks diverge
from the trends seen among the comparison group
banks.
We used a variety of statistical tests to conduct
these three analyses. To determine whether there
was a difference in the absolute level of scores
on a performance measure between two groups, we
calculated the probability that we would have
observed a difference equal to or greater than the
one we actually observed between the average value
of the 16 (quarterly data over a 4-year period) S-
corporation median scores and the average value of
the 16 comparison group medians, had these two
sets of scores been randomly selected from the
same underlying population. The small
probabilities we calculated indicate that the S-
corporation banks and comparison group median
scores were not drawn from the same population.
These differences are statistically significant
for all four performance measures.
To determine whether there have been trends over
the study period among S-corporation banks and
comparison group banks on a particular performance
measure, we conducted linear regression tests on
the 16 quarterly medians, cross-classified by S-
corporation status or comparison group. We
computed 95 percent confidence intervals around
the slopes of the regression lines to see whether
they contained the value zero, which would
indicate that there was no trend, either positive
or negative. We also conducted nonparametric trend
tests on the medians of the four performance
measures among the two groups of banks, testing a
hypothesis of no statistically significant trend
against the alternative hypothesis that capital-to-
asset ratios decreased, dividend payout ratios
increased, return on asset ratios decreased, and
the (il)liquidity ratio increased, respectively.
To determine whether or not the observed trends on
each of the performance measures were different
for S-corporation banks, we conducted linear
regression tests, as described above, on
differences between the S-corporation bank medians
and the comparison group medians for each of the
performance measures. We also conducted
nonparametric trend tests as described above on
the differences between S-corporation bank and
comparison group medians. That is, we determined
whether the gap between the median value of S-
corporation bank performance and comparison group
performance was widening or narrowing over time.
We created comparison groups of banks that were as
similar as possible to the group of S-corporation
banks but had not elected S-corporation status at
any time from 1996 through 1999. A number of
possible comparison groups of non-S-corporation
banks were defined using criteria such as asset
size, agricultural lending activity, number of
offices, and rural/urban location. The comparison
group for this analysis was defined as the 1,284
banks that were active during the 4-year period,
had never become S-corporations, had assets of
less than $1 billion, and had made 25 percent or
more of their loans for agricultural purposes in
at least one quarter.7 Some of the findings in our
report could change if a different comparison
group of banks were used or if data were available
over a longer time period for banks that converted
to S-corporations. We did not verify or otherwise
assess the reliability of the Call Report data
obtained from FDIC, because it is a well-known
database that is widely used in official
statistics and a wide range of studies of the
banking industry.
Agency Comments
We requested comments on this report from the
Departments of Labor and the Treasury, the Offices
of the Comptroller of the Currency and Thrift
Supervision, FDIC, and the Board of Governors of
the Federal Reserve System. The Director, Internal
Review, Office of Thrift Supervision and the
Director of Exemption Determinations, Pension and
Welfare Benefits Administration, Department of
Labor provided technical comments that we
incorporated in the report where appropriate.
Treasury and FDIC provided written comments on our
draft report; they are included in appendixes VIII
and IX, respectively, and are discussed in the
body of this report. The Board of Governors of the
Federal Reserve System appreciated our consulting
with them as well as considering their
observations on our draft report. They provided us
written comments on our draft report; they are
included in appendix X, and are discussed in the
body of this report. The Office of the Comptroller
of the Currency did not have any comments on our
report.
We conducted our work in Washington, D.C., and San
Antonio, TX, between November 1999 to May 2000, in
accordance with generally accepted government
auditing standards.
_______________________________
1 ABA is a trade association that represents banks
of all sizes on issues of national importance for
financial institutions and their customers.
Substantially all large banks are members of ABA,
and most ABA members are banks with assets of
under $70 million.
2 ICBA (formerly the Independent Bankers
Association of America) is a trade association for
about 5,500 community banks nationwide.
Approximately 54 percent of ICBA members serve
rural communities, 29 percent are in suburban
locations, and the remaining 17 percent are in
urban communities.
3 ABA conducted the Subchapter S Survey during the
second and third quarter of 1999. The survey
collected data on banks' Subchapter S status; the
reasons why banks are not eligible; and, if
eligible, why they choose not to make the
conversion. ABA sent its survey to 5,872 banking
institutions; a total of 817 institutions
responded to the survey, for a response rate of
13.9 percent.
4 ICBA conducts annual surveys of its membership
on issues and concerns facing community banks.
Grant Thornton, an international accounting and
management consulting firm, conducted the survey
and mailed questionnaires to 5,400 community banks
in November 1998. Grant Thornton received 815
completed surveys, for a response rate of 15
percent. One part of the survey focused on S-
corporation conversions and obstacles banks face
during the conversion process.
5 Over 2,000 community bankers attended the ICBA
annual conference in March 2000.
6 For banks that elect Subchapter S status for
income taxes, the UBPR adjusts after tax earnings
and dividends used in ratios. This adjustment is
performed to improve the comparability of those
items between banks that are taxed at the
corporation level (non-S corporation banks) and
those that have shifted income taxation to the
shareholder level (S-corporation banks). In
essence, an estimated tax is substituted for any
reported taxes then deducted from income and a
flat tax rate is applied to dividends. Although
this adjustment improves comparability, it does
not provide exact comparability between C-
corporation and S-corporation banks.
7 Of the 520 S-corporation banks we analyzed, 176
(34 percent) of the S-corporation banks had 25
percent or more of their loans for agricultural
purposes in at least one quarter.
Appendix III
Proposed Tax Provision To Increase the Maximum
Number Of Shareholders
Page 45 GAO/GGD-00-159 S-Corporation Banks
Proposed Tax Provision
The proposed tax provision we studied would
increase the number of eligible shareholders in S-
corporations from 75 to 150.1
Present and Prior Law
Under current law, an electing "small business
corporation" must have no more than 75 qualifying
shareholders.2 As originally enacted in 1958,
Subchapter S status was elective for corporations
which had no more than 10 individual shareholders.
However, over the years, the number of permissible
shareholders has been increased.3
Shareholder Limit Cited as an Obstacle for
Becoming an S-Corporation Bank
ABA and ICBA cited the 75-maximum shareholder
limit as a major obstacle for banks wishing to
elect Subchapter S status. According to an ABA
survey, of the 342 survey respondents that had
considered becoming an S-corporation, 86.5 percent
indicated that the reason their banks were
ineligible to become S-corporations was because
they had more than 75 shareholders. Twenty-nine
percent of respondents to an ICBA survey of its
community bank membership considered the maximum
shareholder limit as an obstacle to conversion.
Bankers and legal and accounting experts whom we
interviewed told us that in order to meet the
maximum shareholder limit, banks wishing to elect
Subchapter S status often were forced to eliminate
minority shareholders. Bankers felt that their
banks lost goodwill in the community by
eliminating community shareholders and also lost,
in some cases, the ability to pass on family
(generation) ownership in the banks.
About 13 Percent of Banks Have Become S-
Corporations Since 1997
Recent growth trends in S-corporations illustrate,
in part, the impact of current tax laws for S-
corporations. As of year-end 1997, there were 2.5
million S-corporations, according to IRS'
Statistics of Income data. In 1996, when the
maximum number of shareholders was increased from
35 to 75, the number of S-corporation tax returns
grew from 2.3 million to 2.5 million, or about 6
percent. Since being permitted to become S-
corporations beginning in tax year 1997, 1,318
banks have become S-corporations. According to
FDIC data, these banks represent about 13 percent
of the U.S. banking industry, as of the end of
1999. S-corporation banks represent less than 1
percent of all S-corporations.
Increasing the Number of Shareholders Would Likely
be More Important to Banks
As of year-end 1997, most S-corporations in all
industries (about 91 percent) had three or fewer
shareholders. A small percentage (less than 1
percent) of S-corporations in all industries had
31 or more shareholders. By comparison less than
half (about 40 percent) of S-corporation banks had
3 or fewer shareholders, and about 11 percent had
31 or more shareholders as of year-end 1997. The S
Corporation Association indicated that its
membership (primarily nonbank S-corporations) did
not view the maximum shareholder limit as a
current obstacle because the majority of its
members (1) have 3 or fewer shareholders; and (2)
would prefer to limit the number of shareholders
who have control over their businesses (i.e.,
maintain being a "closely-held" firm). The S
Corporation Association generally did not oppose
increasing the shareholder limit.
Figure III.1: Percentage Comparison of the Number
of Shareholders between S-Corporations From all
Industries and S-Corporation Banks
Source: Provided by IRS, Statistics of Income,
1997.
One effect of current law is that banks with more
than 75 shareholders wishing to elect S-
corporation tax status may be forced to eliminate
minority shareholders even if they would prefer to
be more widely held. Bankers and legal and
accounting experts told us that in order to elect
S-corporation tax status, banks often must
eliminate shareholders through complex corporate
reorganizations. Specifically, they have
eliminated minority shareholders through reverse
stock splits4 or through the formation of new
holding companies. Both are generally considered
expensive strategies due to legal, accounting, and
independent valuation costs. Legal experts told us
that banks often have to pay a premium on the
stocks they repurchase from these minority
shareholders or face legal action from the
minority shareholders, adding time and costs to
the conversion process.
Bankers and legal experts we interviewed told us
that some banks have rewritten shareholder
agreements to restrict the sale of their shares
and to give banks the first right to repurchase
those shares, so that they maintain their current
subchapter S status. We were also told, however,
that changing banks' shareholder agreements limits
estate planning by restricting the current
shareholders' ability to pass their shares on to
family members in the event of death. One legal
expert told us that although he was in favor of
increasing the number of shareholders, he was more
in favor of treating family members as a single
shareholder. He emphasized that minority
shareholders often are forced out when a bank has
more shareholders than allowed by S-corporation
rules. He pointed out that in other tax contexts,5
families (across generations) are treated as one
shareholder. He proposed that if the law were
changed to allow family members to be counted as
one shareholder, it would be more conducive for
maintaining family-owned banks and conducting
estate planning. Currently, under Subchapter S, a
husband and wife (and their estates) owning shares
in an S-corporation are treated as a single
shareholder.6 A legal expert from the Office of
Thrift Supervision pointed out that allowing
family members to be treated as one shareholder
could perpetuate insider preference and favoritism
in the event of a reorganization to reduce the
number of shareholders.
Likely Impacts of Proposed Change
Increasing the maximum number of shareholders
would affect firms in all industries, not just
banks. The tax revenue loss from increasing the
maximum number of shareholders to 150 was
estimated to be $580 million over a 5-year period
and $1.5 billion over a 10-year period.7 Overall,
increasing the number of shareholders would permit
more firms to become eligible to elect Subchapter
S status. It is difficult to estimate the
potential universe that might be affected by the
proposed change because data are not readily
available to determine the number of shareholders
firms currently have, if the firms' stock is not
publicly traded. (We discuss this limitation more
fully in our Scope and Methodology, app.II.)
Increasing the Shareholder Limit Could Potentially
Affect A Large Number of Banks
Officials and tax experts we spoke with estimated
the potential universe of banks and thrifts that
may be affected by the proposed tax changes to be
between 300 and 5,662. Regulators estimate that
5,385 banks and 277 thrifts could potentially be
eligible to elect subchapter S status if the
maximum number of shareholders were increased to
150. ABA estimates that 4,665 banks would consider
Subchapter S election if Congress removed
obstacles for electing Subchapter S. Of the 4,665
banks, 2,892 would convert if the obstacles were
eliminated; and 1,773 would consider Subchapter S
status, but they may not convert for other
reasons. ICBA estimated that more than 2,400
community banks plan to convert to Subchapter S
status.
Bankers and legal and accounting experts whom we
interviewed indicated that the proposed increase
in shareholders would increase the continuity of
family ownership and reduce the need for banks to
undergo complex corporate reorganizations to
eliminate minority shareholders. Industry
representatives projected that the proposed
increase would allow more community banks to
become eligible to make the S-corporation election
and, at the same time, allow community banks to
continue to maintain wider ownership by their
communities. Bank regulators told us that one
advantage to increasing the number of shareholders
would be that current S-corporations would find it
easier to raise additional capital, which may
become important during an economic downturn.
The unanimous shareholder consent rule could
complicate the election process if the number of
permissible shareholders were increased to 150.
Current law requires that all eligible
shareholders consent to the Subchapter S election.
Some legal experts told us that obtaining the
consent of all shareholders for banks wishing to
elect Subchapter S tax status has been difficult
at times. According to some legal experts we spoke
with, the unanimous consent provision may have
been more relevant to the election process when S-
corporation rules limited the number of
shareholders to 10.
The proposed increase in shareholders would lead
to a large, but nonquantifiable, increase in the
number of S-corporation banks. Many banks that
currently have between 75 and 150 shareholders,
such as community banks with a long legacy of
family ownership, would be likely to convert.
However, although 99.6 percent of existing S-
corporation banks have total assets of less than
$1 billion, predicting the size distribution of
banks that would convert with the proposed
increase in shareholders is difficult. For
example, some larger banks that currently have
over 150 shareholders may choose to undergo
complex corporate reorganizations to eliminate
minority shareholders. In such an event, some of
the larger converting bank holding companies may
be ones that provide a wide array of financial
services that would be facilitated by the Gramm-
Leach-Bliley Act of 1999. Therefore, banks that
may convert could include some banks that have
characteristics not commonly associated with the
classification of a bank as a community bank.
However, of the 187 bank holding companies that
have become domestic financial holding companies
under this act, 145 (78 percent) had less than $1
billion in assets as of May 10, 2000.
The proposed increase in shareholders could help
community banks become more competitive in
relation to credit unions to the extent that
converting banks provide the same banking services
offered by credit unions. The benefits of the
proposed increase in shareholders for community
banks in relation to larger banks would depend on
the characteristics of the converting banks.
_______________________________
1 The proposed increase in shareholders is based
on S. 875 and H.R. 1994.
2 26 U.S.C. sec. 1361(b)(1)(A). Qualifying
shareholders include only individuals who are U.S.
citizens or residents, estates, certain trusts,
and certain tax-exempt organizations. An S-
corporation may not have a shareholder that is a
nonresident alien, a corporation (other than a tax-
exempt charitable organization), partnership, or a
limited liability company.
3 The Tax Reform of 1976 increased the maximum
number of shareholders to 15 for electing
corporations in existence for more than 5 years.
The Revenue Act of 1978 increased the limit to 15
for all electing corporations. The limit was
increased to 25 by the Economic Recovery Tax Act
of 1981 and then to 35 by the Subchapter S
Revision Act of 1982. The maximum number was
increased to 75 shareholders by the Small Business
Job Protection Act of 1996.
4 A reverse stock split is a procedure whereby a
corporation reduces the number of shareholders.
5 26 U.S.C. 302(c)(1) and 318(a)(1). For example,
the corporate tax redemption rules generally treat
an individual as "constructively" owning the
shares owned by the individual's spouse, children,
grandchildren, and parents.
6 26 U.S.C. sec. 1361(c)(1).
7 Based on estimates prepared by the Joint
Committee on Taxation for the 1999 tax bill.
Appendix IV
Proposed Tax Provision To Allow Individual
Retirement Accounts As Shareholders
Page 49 GAO/GGD-00-159 S-Corporation Banks
Proposed Tax Provision
The proposed tax provision would permit S-
corporation shares to be held by individual
retirement accounts1 (IRA).
Present and Prior Law
IRAs are not eligible to be S-corporation
shareholders under present law. S-corporation
shareholders are restricted to individuals who are
U.S. citizens or residents, estates (including
estates of individuals in bankruptcy), certain
trusts, and certain tax-exempt organizations. An S-
corporation may not have a shareholder that is a
nonresident alien, a corporation2 (other than a
tax-exempt charitable organization), partnership,
or a limited liability company. Beginning January
1, 1998, the S-corporation rules were changed to
allow qualified pension plans, including employee
stock ownership plans (ESOPs), to be shareholders
in S-corporations.
Reasons Cited for Proposed Change
Legal and accounting experts we interviewed
indicated that eliminating IRA shareholders
increases the cost and length of the Subchapter S
conversion process for banks and their
shareholders. They told us that banks and their
shareholders incur high costs when obtaining the
necessary stock appraisals and repurchasing the
stock held in IRAs. They also told us that when C-
corporation banks offer stock to their employees,
it is not uncommon for an employee to choose to
hold the stock in an IRA. An ABA survey of its
membership showed that of the 273 respondents, 42
percent of the ineligible shareholders that S-
corporation banks removed were IRAs. However, the
S Corporation Association, primarily representing
nonbank S-corporations, indicated that its
membership generally does not consider the IRA
restriction a significant obstacle to electing
Subchapter S status.
Impacts of Current Law
Eliminating IRA shareholders complicates the
Subchapter S conversion process. Legal and
accounting experts told us that stock appraisals
required in the transactions used to remove bank
stock from IRAs increase the overall costs and
time associated with the conversion process. An
independent and qualified appraiser must determine
the fair market value of the stock because the
stock of banks with fewer than 500 shareholders is
not publicly traded.
Bank shareholders generally use three lengthy and
costly methods to remove their bank stock held in
IRAs. Bankers and legal and accounting experts
told us that some bank shareholders holding their
stock in IRAs chose to sell their stock to
qualified shareholders, typically majority
shareholders. However, upon selling the stock, the
individual could cease to be a shareholder in the
bank if he or she owns no other stock in the bank.
By selling the stock, the individual loses future
dividends, loses the potential for capital gains,
and could terminate the IRA. At the bank holding
company level, shareholders often have the holding
company redeem the stock held in their IRAs.
However, depending upon the fair market value of
the stock and the amount held in the IRA,
redeeming the stock could pose a significant
reduction in the holding company's capital. In
this case, the bank also incurs the cost of the
appraisal, and the individual shareholder would
lose future dividends, lose potential capital
gains, and could terminate the IRA.
Legal and accounting experts told us that to a
lesser extent, bank shareholders have applied for
exemptions from sanctions generally associated
with repurchasing stock from their own IRAs. They
indicated that such persons faced high costs and a
lengthy application and exemption determination
process. Current law treats IRA account holders as
disqualified persons3 in a transaction wherein
stock is repurchased from their own IRAs. Such a
transaction generally results in sanctions
stipulated in the Internal Revenue Code.4 Thus,
the IRA account holder must apply to the
Department of Labor5 for an administrative
exemption from these sanctions, which partly,
involves obtaining an independent appraisal of the
stock. Moreover, depending upon the complexity of
the individual exemption application, the
resulting administrative fees could be
significant. Department of Labor (Labor) officials
told us that the time needed to make a
determination on an application similarly depends
upon the complexity and completeness of the
application.
Labor officials told us that they have processed
four exemption applications from IRA account
holders for the purpose of facilitating a bank
conversion to Subchapter S status. They said IRA
account holders were granted exemptions from the
sanctions associated with the prohibited
transaction, provided that the sales of the stock
met certain conditions.6
Impacts of Proposed Provision
Allowing IRAs to be eligible shareholders in S-
corporations would affect S-corporations in all
industries. Among banks choosing to elect
Subchapter S status, the change would reduce the
overall costs associated with making the
conversion. Specifically, allowing IRAs to be
shareholders would eliminate the need for banks
and shareholders to obtain stock appraisals needed
in the transactions to remove the stock. However,
an appraisal of the stock may still be required
for other aspects of the conversion process, such
as eliminating minority shareholders.
The Federal Reserve, FDIC, OCC, and OTS indicated
that they view the proposed provision as a tax
policy issue. They expressed no safety and
soundness concerns with allowing IRAs as eligible
shareholders in S-corporation banks. However,
Treasury generally opposed the proposal. Treasury
indicated that if IRAs were allowed to be S-
corporation shareholders, from a policy
standpoint, the Unrelated Business Income Tax
should be imposed, which parallels similar tax
treatment of other pension funds.
Labor officials stated that from their
perspective, allowing IRAs as S-corporation
shareholders introduces no policy or procedural
concerns. They indicated that the IRA shareholders
that have applied thus far were granted exemptions
from the sanctions associated with the prohibited
transaction.
_______________________________
1 An IRA is a trust or custodial account set up in
the United States for the exclusive benefit of the
account holder or his or her beneficiaries. The
IRA must meet certain requirements generally
established under Section 408 of the Internal
Revenue Code, and it generally permits an
individual to save on a tax-favored basis.
2 An S-corporation may hold stock in a controlled
subsidiary but may not be a subsidiary of another
company unless it is wholly owned by a parent
company that is an S-corporation. The parent S-
corporation must make an election to treat the
subsidiary S-corporation as a Qualified Subchapter
S subsidiary (QSSS). The QSSS essentially would
not be treated as a separate corporation.
3 Internal Revenue Code Section 4975(a)(b).
4 The prohibited transaction would generally
result in sanctions under Section 4975(a),(b), and
(c)(3) of the Internal Revenue Code.
5 By virtue of Reorganization Plan No.4 of 1978,
the authority of the Treasury Department to grant
exemptions for prohibited transaction under the
Internal Revenue Code was largely transferred to
the Department of Labor.
6 The conditions stipulate that (a) the terms and
conditions of the sale of stock would be at least
as favorable to each IRA as those obtainable in
arm's-length transactions with an unrelated party;
(b) sale of the stock would be one-time
transactions for cash; (c) the IRAs would receive
the fair market value of the stock as established
by a qualified, independent appraiser; and (d) the
IRAs would pay no commissions, costs, or other
expenses with respect to the sale of the stock. 63
FR 241 December 16, 1998.
Appendix V
Proposed Tax Provision to Clarify Passive
Investment Income Rules
Page 52 GAO/GGD-00-159 S-Corporation Banks
Proposed Tax Provision
The proposed tax provision seeks to clarify that
interest and dividends on investments maintained
by a bank for liquidity and safety and soundness
purposes would not be treated as "passive" income
for tax purposes.
Present and Prior Law
Under present law, S-corporations must restrict
the amount and type of passive investment income.
Passive investment income refers to income derived
from royalties, rents, dividends, interest,
annuities, and sales or exchanges of stock or
securities (but only to the extent of gains).1
Although income and loss derived from the active
trade or business of S-corporations pass through
to the shareholder and thus are taxed at the
individual rate, excess net passive investment
income is taxed at the highest corporate rate.
Currently, S-corporations with accumulated C-
corporation earnings and profits are subject to 35-
percent tax on passive investment income exceeding
25 percent of gross receipts in a tax year.2
Moreover, the Subchapter S election is terminated
if (1) the corporation has previously accumulated
earnings and profits as a C-corporation at the
close of each of 3 consecutive taxable years
following the election, and (2) during each of the
3 years more than 25 percent of the corporation's
gross receipts are passive investment income.3 The
Subchapter S Revision Act of 1982,4 among other
things, provided the current termination rules
that are applied when an S-corporation has
excessive passive investment income. Until 1982,
the Subchapter S election terminated if more than
20 percent of the corporation's gross receipts
derived from passive investments for any taxable
year.
Passive Income Regulations Predate Banks'
Eligibility to Become S-Corporations
Before banks were permitted to become S-
corporations, IRS issued regulations interpreting
the definition of passive investment income to
exclude income earned in the active conduct of a
trade or business. Subsequently, the Small
Business Job Protection Act of 19965 permitted
banks to become S-corporations beginning in tax
years after December 31, 1996. IRS issued
regulations in Notice 97-5 interpreting active and
passive investment income, with special rules for
lending, financing, and other similar businesses.
IRS regulations generally state that income (gross
receipts) from the business of lending or finance
includes gains and interest income from loans.
However, the interest earned from investments in
short-term securities does not constitute gross
receipts directly derived in the ordinary course
of business (i.e., is not considered active
income).6 Consequently, such interest could be
classified as passive investment income. IRS
Notice 97-5 does not consider income and gain from
the following banking assets subject to the
passive investment limitation for S-corporations:
� all loans and mortgage-backed securities,
such as Real Estate Mortgage Investment Conduits
(REMIC),7 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)(s)(C) are not considered loans).
� assets required to be held to conduct banking
businesses (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 that
represents nonvoting stock in the bank).
� 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); and
� 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.
Banking Industry Wants Passive Income Rules
Clarified
Bankers and legal and accounting experts we
interviewed want the current tax rules clarified
so that bank investment income is treated as
active income (and not as passive investment
income) because it is part of the ordinary
business of banking. Some bankers view the current
rules on passive investment income for S-
corporation banks as an obstacle to electing
Subchapter S status. For example, ABA cited the
passive investment income restriction as an
obstacle for banks wishing to elect Subchapter S
status. According to an ABA survey, of the 125
survey respondents that considered converting to
Subchapter S status, 34.4 percent indicated that
passive investment income was the reason their
banks were not planning to elect Subchapter S
status within the next 2 years.
Specifically, bankers are concerned that if
audited, IRS examiners would consider income from
their U.S. Treasury securities as "passive"
because current IRS guidance does not explicitly
list U.S. Treasuries among banking assets
considered part of the active business of banking.
Bankers and legal and accounting experts we
interviewed emphasized that banks in rural and low-
growth areas that experience cyclical or low loan
demand may not be able to comply with current
passive investment income rules. These banks
typically hold large portfolios of Treasury
securities to offset the cyclical cash flows and
low loan demand in their communities.
Impacts of Current Law
We observed several impacts of the current law on
passive investment income for S-corporation banks.
The first impact that we observed is that
treatment of passive investment income varies
among banks. Some accountants of S-corporation
banks have interpreted current guidance broadly
and have treated all investment income as active.
Other accountants have interpreted the guidance
conservatively and have treated only some
investments as active. However, legal and
accounting experts told us that banks have strong
justification for treating investments as
"reasonable for liquidity purposes" and think that
their view would prevail in a potential IRS audit.
They submit that investment income gained from
banking assets, including U.S. Treasury
securities, is part of the ordinary course of the
banking business.
The second impact we observed is that S-
corporation banks face competing regulatory
treatment of investments held for liquidity
purposes. Treasury indicated that the current
guidance is sufficiently flexible to provide for
the cyclical nature of business that some banks
experience. Treasury opposes an expansion of the
current passive investment rules, out of concern
that income accumulated while a C-corporation
could avoid corporate taxation without the passive
investment income rules. Conversely, bank
regulators do not share this concern. Bank
regulators want to ensure that banks have
sufficient liquidity for safety and soundness
reasons. They stated that applicable bank laws,
including the Community Reinvestment Act (CRA),
limit the ability of individuals to use banks as
individual investment vehicles. In particular,
bank regulators are concerned that banks, in
reaction to the uncertainty of IRS interpretation,
may shift their investments for liquidity purposes
from the safety of U.S. Treasury securities to
riskier investments such as real estate mortgage
investment conduits.
We also observed an unintended consequence of this
difference between regulatory and current tax
treatment of passive investment income in the
investment behavior in some banks. According to
legal and accounting experts, some banks are
making riskier investments because IRS guidance
considers the investments active income for tax
purposes. For example, some accounting experts and
bankers we interviewed told us that banks were
shifting investments out of less risky
instruments, such as U.S. Treasury securities,
that would generate income that IRS could consider
passive. The banks then shifted those assets into
riskier instruments, such as collateralized,
mortgage-backed securities-considered to generate
active income under IRS rules-to avoid terminating
their Subchapter S election.
Impacts of Proposed Provisions
Bankers and legal and accounting experts stated
that the proposed provision would eliminate the
uncertainty of how IRS examiners would treat the
investment income of S-corporation banks.
Although bank regulators expressed few specific
safety and soundness concerns with the proposed
provision, Treasury and IRS stated that the
current guidance is sufficient on passive
investment income for banks and provides them with
flexibility in applying the law. Treasury
officials were not in favor of the proposed
provision, stating that expanding the current law
could allow income accumulating during an S-
corporation's years as a C-corporation to avoid
the corporate level tax.
Revenue losses associated with excluding
securities income from passive investment income
tax treatment are estimated to be $10 million over
5 years and $23 million over 10 years, from 2000
to 2009.
_______________________________
1 Section 1362 of the Internal Revenue Code.
2 Section 11(b) of the Internal Revenue Code
generally provides a graduated tax on corporate
income, ranging from 15 to 35 percent, based on
the amount of taxable income for a tax year.
3 Section 1362 (d)(3)(C)(iii) of the Internal
Revenue Code.
4 P.L. 97-354.
5 P.L. 104-188.
6 Section 1.1362-2(c)(5)(iii)(B)(2) of the
Internal Revenue Code.
7 Real estate mortgage investment conduits, called
REMICs, are multiclass mortgage securities that
assign cash flows to different classes of
investors.
Appendix VI
Proposed Tax Provision to Redefine Treatment of
Bank Director Shares
Page 56 GAO/GGD-00-159 S-Corporation Banks
Proposed Tax Provision
The proposed provision would provide that any
stock that bank directors must hold under banking
regulations would (1) not be a disqualifying
second class of stock and (2) not count towards
the total number of shareholders.
Present S-Corporation Law and National Banking Law
To be eligible for Subchapter S status, the
current law requires that corporations have only
one class of outstanding stock.1 Unlike with
partnerships, the outstanding shares of an S-
corporation must confer identical rights to
profits and assets. An exception is made, however,
to allow differences in voting rights (i.e.,
includes voting and nonvoting stock).
National banking law requires that a director of a
national bank own stock in the bank. According to
OCC's interpretative ruling, this requirement is
to ensure that the bank director has a sufficient
financial interest in the bank to be vigilant in
protecting the bank's interests. A number of
states have similar requirements for state-
chartered banks. Bank directors' qualifying stock
must be at least $1,000 par value, or an
equivalent interest as defined by the OCC.2 In
addition, a national bank is required to have at
least five directors.3
Under OCC regulations,4 bank directors can meet
the requirement for bank director shares by
holding common or preferred stock in the bank or
its holding company with an aggregate par or fair
market value of at least $1,000.5 A director may
hold qualifying shares in a profit-sharing plan,
IRA,6 retirement plan, or similar arrangement
while retaining beneficial ownership and legal
control over the shares.7 In addition, a director
may hold qualifying shares subject to an agreement
that another shareholder will repurchase the
shares if the director ceases to serve in that
capacity.8 A director may assign the right to
receive dividends or distributions on qualifying
shares and may execute a revocable or irrevocable
proxy authorizing another person to vote the
director's qualifying shares.9
Reasons Cited for Proposed Change
Two major reasons were cited for the proposed
change in tax law. First, legal and accounting
experts told us that some agreements for bank
directors' shares were written in such a way that
they fulfill the national banking requirement but
this creates a second class of stock. Creating a
second class of stock makes the bank ineligible to
elect Subchapter S status. For business reasons,
some community banks or their holding companies
chose to issue shares to bank directors that may
not convey the same economic interests given to
the other shareholders. For example, the bank may
have an agreement to buy back the bank director's
stock at par value rather than at market value
when the director leaves his position. Another
example could be that the director's shares have
preference rights over common stock in the
payments of dividends and the liquidation of
assets. In both situations, the qualifying
director's shares create a second class of stock
because there are economic differences between
shareholders.
The second reason cited for the proposed change is
that the national banking law requirement to
maintain five bank directors counts toward the
total number of shareholders in an S-corporation.10
Some bankers and legal and accounting experts told
us that counting bank director shares towards the
maximum number of shareholders limits the bank's
ability to manage its number of shareholders below
the allowable limit.
Impacts of Current Law
The combined effects of both Subchapter S law and
national banking law could create an obstacle to
Subchapter S bank conversion. National banking law
permits a bank to issue the same stock to its
directors as it issues to other shareholders, but
the law also gives banks latitude in giving
directors different options on their shares. IRS'
stated perspective is that the way some banks have
treated their bank director shares creates a
second class of stock, which makes those banks
ineligible to elect Subchapter S tax status.
This proposed change was considered to be less
important when ranked against other obstacles for
Subchapter S conversion by ABA survey respondents.11
About 17 percent of ABA's survey respondents that
had already converted to S-corporation banks
eliminated a second class of stock. The second
class of stock in this case could have included
preferred stock or bank director shares that
created a second class of stock.
Banks' Attorneys Have Developed Methods to Address
Bank Director Shares
To become eligible to make the conversion, some
banks have rewritten their shareholder agreements
so that there are no longer differences between
bank directors and other shareholders. In other
words, the share agreement is rewritten so the
bank directors receive dividends and pay taxes
proportionately to their share of the bank's
income, the same as other shareholders. Bankers
indicated that involving their attorneys in
rewriting their shareholder agreements or
eliminating shareholders to accommodate the number
of bank director shares has lengthened and added
cost to their conversion process.
Bankers and legal and accounting experts also told
us that some banks became S-corporations despite
differences between their director qualifying
shares and other shares that created a second
class of stock and are not in compliance with S-
corporation rules. One banker told us that "his
bank is operating in limbo" because his S-
corporation bank had not issued stock to a few of
its directors and was waiting for an approval from
OCC examiners.
Some banks chose not to elect Subchapter S status
because they would be forced to eliminate minority
shareholders to accommodate the additional
requirement for bank director shares to become
eligible to be an S-corporation.
Impacts of Proposed Changes
We studied two legislative changes concerning bank
director shares. The first change would not treat
qualifying director shares as a second class of
stock. This proposed change would eliminate the
bank's need, in some cases, to rewrite shareholder
agreements for bank directors. The second proposed
change would not consider the bank director shares
as shareholders in the bank for purposes of the
Subchapter S conversion. This change would help
banks to maintain their current shareholders and
possibly reduce the need to increase the allowable
number of shareholders for S-corporations. If the
proposed provision were passed, the Joint Tax
Committee on Taxation estimated tax revenue losses
from this proposed provision, if passed, at $26
million over 5 years and $100 million over 10
years.
Bank regulators did not express any safety and
soundness concerns with the proposed provision.
IRS officials discussed the proposed changes with
bank regulators and met with OCC officials to
clarify what qualifies as bank director stock. IRS
officials have not changed current tax regulations
to address bankers' concern about creating a
second class of stock because they believed that
the law needed to be changed first. The proposed
provision would permit IRS to address the bankers'
concern but would change the underlying simplicity
of the one class of stock rule for S-corporations.
_______________________________
1 Internal Revenue Code, Title 26, Sec.
1361(b)(1)(D).
2 See 12 U.S.C. Section 72.
3 See 12 U.S.C. Section 71.
4 See 12 C.F.R. sec. 7.2005(b)(1).
5 OCC interprets national banking law as requiring
national banks to have one class of common stock.
See 12 U.S.C. Section 61.
6 Banks wishing to become S-corporations cited an
obstacle in converting because an IRA is
considered an ineligible shareholder in an S-
corporation. We discussed this in appendix IV.
7 See 12 C.F.R. sec. 7.2005(b)(4)(i.).
8 See 12 C.F.R. sec. 7.2005(b)(4)(ii).
9 See 12 C.F.R. sec. 7.2005(b)(4)(iii) and (iv).
10 Current law limits the maximum number of
shareholders to 75. We discussed the shareholder
limit in more detail in appendix III.
11 On ABA's survey, respondents were asked to rank
the relative importance of proposed changes. On a
ranking of 1 to 5 with 1 equal to a low priority
and 5 equal to a high priority, the change to
allow qualified director stock was ranked as 2.62.
Appendix VII
Proposed Tax Provisions to Improve Bad Debt
Treatment
Page 60 GAO/GGD-00-159 S-Corporation Banks
Proposed Tax Provision
The proposed provision would change the tax
deductions for certain losses embedded in the loan
portfolio at conversion from a C-corporation bank
to an S-corporation. The proposed tax change would
allow "built-in" losses to be matched with certain
"built-in" gains. The proposed tax provision would
treat the charge-off of bad debts1 that were
embedded in the bank's loan portfolio at
conversion as items of built-in loss2 over the
same number of years that the accumulated bad debt
reserve must be recaptured as built-in gains3 for
tax purposes.
Definition of "Built-in" Gain or Loss
For tax purposes, a built-in gain or loss is
defined as the difference between the fair market
value and the adjusted tax bases of the assets
(value of the assets for tax purposes) of the S-
corporation at the beginning of the tax year that
it elected Subchapter S status. As an S-
corporation, realized built-in gains are taxed at
the corporate tax rate.
Present and Prior Law
Under current law, to become eligible for
Subchapter S tax status, S-corporations (including
small banks) use the specific charge-off method of
accounting for bad debts for tax purposes.4 Under
the specific charge-off method for bad debt
expense, firms take a deduction against income or
"write-off" an asset in the tax year in which the
debt is deemed worthless. In contrast, small banks
that use the reserve method for accounting for bad
debts (for tax purposes) are ineligible to elect
Subchapter-S status, unless they change the way
they account for their bad debts. The reserve
method of accounting for bad debts permits small
banks to deduct from taxable income additions to
the bad debt reserve such that the reserve balance
is large enough to absorb anticipated future
losses on the small banks' loan portfolios.
Currently, small C-corporation banks under asset
size of $500 million can use the reserve method of
accounting for bad debts for tax purposes.5 Larger
C-corporation banks with assets greater than $500
million must use the specific charge-off method
for tax purposes. Therefore, small banks wishing
to convert to S-corporation status that have used
the reserve method of accounting must change their
method of accounting for bad debts for tax
purposes. Because of this change in tax
accounting, the banks must "recapture" the bad
debt reserve as taxable income,6 because the
previous additions to the reserve had been allowed
as tax deductions. The recaptured bad debt reserve
is taxed at the corporate rate as a built-in gain.
Prior to 1996, financial institutions were not
allowed to elect Subchapter S status because of
the special reserve method of tax accounting for
bad debts used by financial institutions. The
reasoning for this was that banks were given a
substantial tax break in their ability to use
methods of tax accounting for bad debts that were
more generous than those permitted other
industries. Over time, Congress disallowed some of
the special methods of tax accounting for bad
debts for financial institutions. However, the
difference in tax accounting for bad debts still
exists for small C-corporation banks that use the
reserve method.7
Bad Debt Recapture Cited as Obstacle to Subchapter
S Election
Banking industry representatives cited the cost
incurred from changing the tax accounting methods
for bad debts as an obstacle to electing
Subchapter S status. In an ABA survey of its
membership, the respondents ranked "bad debt
charge-offs to offset reserve recapture" as second
in the relative importance of pending legislation
for S-corporation banks. Under present law, a bank
is permitted to "charge-off" its built-in losses
against its recaptured income in the first S-
corporation year. For banks that are recapturing
large bad debt reserves, the increased tax
liability from recapturing this reserve into
income can add to the costs for conversion to
Subchapter S status. The bad debt reserve is a
more significant issue for small banks converting
to Subchapter S status than for other industries
because of their special tax treatment of bad debt
reserves. In addition, nonbank firms typically do
not have bad debt reserves to the magnitude that
banks do because of the basic loan business of
banking.
Tax Accounting Costs Associated with Subchapter S
Conversion
Industry representatives said the cost of
changing to the specific charge-off method for tax
purposes is significant for many community banks
and their shareholders. Shareholders must
recapture the bad debt reserve into income as an S-
corporation, but the bank often ends up paying a
corporate-level tax (i.e., built-in gains tax) on
the recapture of this income. Industry
representatives and accounting experts assert that
the net federal tax paid as a result can exceed 60
percent of the recaptured amount. Because the
built-in losses, held as of the S-corporation
conversion date, may not be recognized over the
same period that the bad debt reserve must be
recaptured, paying tax on the recapture of the bad
debt reserve is an added cost for converting to
Subchapter S status. Accounting experts told us
that they have advised their banking clients to
change accounting methods prior to electing
Subchapter S status so that the recaptured amounts
would be taxed while in the C-corporation status
to reduce the built-in gains tax passed through to
the shareholders of the S-corporation bank.
Proposed Change Would Likely Lower Banks' Tax
Costs During Conversion to Subchapter S Status
The proposed change would potentially lower
the cost of conversion for banks. Bank tax experts
stated this proposed change would permit banks to
better match their built-in losses against built-
in gains for tax purposes during the recapture
period. The Joint Committee on Taxation estimated
tax revenue losses from this proposed provision,
if passed, at $132 million over a 5-year period
and $201 million over a 10-year period. Bank
regulators did not express safety and soundness
concerns with the proposed change. Treasury
officials indicated a willingness to accept the
change but stated that they believe such a change
further complicates the tax code at a time when
they are trying to simplify it.
_______________________________
1 Section 166 of the Internal Revenue Code.
2 Section 1374(d)(4) of the Internal Revenue Code.
3 Section 1374(d) of the Internal Revenue Code.
4 Section 1361(b)(2)(A) of the Internal Revenue
Code.
5 Section 585 of the Internal Revenue Code.
6 Section 481 of the Internal Revenue Code.
7 "Banks as S Corporations: The Small Business Job
Protection Act of 1996," The Banking Law Journal,
Richard Goldstein, New York, Jul./Aug. 1997.
Appendix VIII
Comments from the Department of the Treasury
Page 62 GAO/GGD-00-159 S-Corporation Banks
Now on p. 4.
Now on p. 15.
Appendix IX
Comments from the Federal Deposit Insurance
Corporation
Page 64 GAO/GGD-00-159 S-Corporation Banks
No on pp. 1, 50, and 2.
Now on p. 12.
Now on pp. 13-14.
Now on p. 7.
Appendix X
Comments From the Board of Governors of the
Federal Reserve System
Page 66 GAO/GGD-00-159 S-Corporation Banks
Appendix XI
GAO Contacts and Staff Acknowledgments
Page 66 GAO/GGD-00-159 S-Corporation Banks
GAO Contacts
Thomas J. McCool (202) 512-8678
William B. Shear (202) 512-4325
Acknowledgments
William B. Bates, Jeanette M. Franzel, Tonita
W. Gillich, Debra R. Johnson, Shirley A. Jones,
Mitchell B. Rachlis, Carl M. Ramirez, Anne O.
Stevens, and John H. Treanor.
*** End of Document ***