BANKING TAXATION

Implications of

Proposed Revisions

Governing SCorporations on

Community Banks

United States General Accounting Office

GAO Report to Congressional Committees

June 2000

GAO/GGD-00-159

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 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 Scorporation 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 Scorporations; (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

 

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.
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distribution. At the end of 1997, there were approximately 2.5 million Scorporations 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.

We studied five possible revisions to the tax rules governing Scorporations. 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 Scorporations 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 Scorporation 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.

Results in Brief
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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.

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

 

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.

Background
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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 Scorporation.

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)

 

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 Scorporation 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.
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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.

Our analysis addresses (1) the implications of individual proposed

provisions; and (2) the overall impact of the provisions, if passed, primarily

on community banks.

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.

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 Scorporations as of the end of December 1997. Of these 2.5 million Scorporations 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

Analysis

Two Provisions Affect SCorporations in All

Industries

Increasing the Number of

Eligible Shareholders Appears

More Important to the Banking

Industry than to Other Industries

Wishing to Become SCorporations
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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.

Individual retirement accounts (IRAs) are ineligible shareholders for Scorporations. 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 Scorporation. 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

 

9

 We discuss this in more detail in appendix IV.

IRA Shareholders Must Be

Eliminated During Conversion

Process
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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 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.

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 “catchall” 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 lowgrowth 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.

 

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.

Three Proposed Provisions

Affect S-Corporation Banks’

Operations

Clarifying Current Tax

Treatment of Passive Investment

Income Could Improve

Converting Banks’ Liquidity
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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 Scorporation 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.

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 Scorporation 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

 

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.

Share Agreements of National

Bank Directors May Need to be

Rewritten to Qualify for SCorporation Status
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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 Scorporation 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.

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 Scorporation, 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

 14 Built-in gains (losses) generally refer to gains (losses) embedded in the asset portfolio at the Scorporation conversion date.

15 Other built-in gains generally are recaptured over a 10-year period.

Technical Change in Banks’ Tax

Accounting for Bad Debts

Lowers Cost for Converting to SCorporation
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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.

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.

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

 

16 A husband and wife who each own shares in the S-corporation bank are counted as a single

shareholder.

Obstacles that Banks Face

in Electing Subchapter S

Status Are Situational

Impact on Community

Banks
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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 Scorporation 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.

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.

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

Competitive Impact on

Community Banks Depends on

the Characteristics of Banks

That Choose to Convert to SCorporation Status

Difficult to Project Potential

Universe of Eligible Banks
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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-Scorporation 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. 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

 

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.

S-Corporation Status Could

Allow Community Banks To Be

More Competitive With Credit

Unions
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the proposed provisions on community banks could differ from the

historical impacts of federal tax exemption on credit unions.

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 Scorporations, 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.

Although the banking regulators expressed few specific concerns about

individual proposed provisions, they were concerned about the

supervisory implications of possible behavioral differences between Scorporation 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 Scorporations to pay out dividends would likely continue so that individual

 

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.

Competitive Pressures for

Community Banks Could

Increase if Larger Banks Become

S-Corporations

Regulators Concerned About the

Incentive for S-Corporation

Banks to Pay Dividends in the

Event of an Economic Downturn
B-284651

Page 14 GAO/GGD-00-159 S-Corporation Banks

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.

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).

 

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.

Key Performance Measures

Differ between S-Corporation

Banks and Other Banks
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Page 15 GAO/GGD-00-159 S-Corporation Banks

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 Ccorporation 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.

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-Scorporation 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).

 

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.

Dividends Increasing
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Page 16 GAO/GGD-00-159 S-Corporation Banks

Source: GAO analysis of FDIC data.

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

 

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).

Figure 1: Median Cash Dividend to Net

Income Ratios for S-Corporation Banks

and Comparison Banks From 1996 to

1999

Slight Decline in Capital-to-Asset

Ratios
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Page 17 GAO/GGD-00-159 S-Corporation Banks

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.

Source: GAO analysis of FDIC data.

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.

 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

Figure 2: Median Tier 1 Leverage

Capital Ratio for S-corporation Banks

and Comparison Banks From 1996 to

1999

Higher Return on Assets
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Page 18 GAO/GGD-00-159 S-Corporation Banks

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.

Source: GAO analysis of FDIC data.

 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.

Figure 3: Median Return on Assets

Ratios for S-corporation Banks and

Comparison Banks From 1996 to1999
B-284651

Page 19 GAO/GGD-00-159 S-Corporation Banks

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).

Source: GAO analysis of FDIC data.

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.

Slightly Lower Liquidity

Figure 4: Median Net Loans and Leases

to Assets Ratio for S-Corporation Banks

and Comparison Banks, 1996-1999

Estimated Tax Revenue Loss for

Proposed Provisions
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Page 20 GAO/GGD-00-159 S-Corporation Banks

Provision 5-year estimate (2000-2004) 10-year estimate (2000-2009)

1. Affecting all industries

(A) Increase shareholders to 150 $580 million revenue loss $1,544 million revenue loss

(B) Include IRAs as eligible shareholders No estimatea No estimatea

Subtotal #1 $580 million revenue loss $1,544 million revenue loss

2. Affecting only banking industry

(C) Exclude investment securities income

from passive income tax treatment $10 million revenue loss $23 million revenue loss

(D) Treatment of qualifying director shares $26 million revenue loss $100 million revenue loss

(E) Improve bad debt tax treatment $132 million revenue loss $201 million revenue loss

Subtotal #2 $168 million revenue loss $324 million revenue loss

Total revenue impact $748 million revenue loss $1,868 million revenue loss

a

At 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.

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 Scorporation 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

Table 1: Tax Revenue Loss Estimates for 1999 Proposed Provisions

IMPACT OF S-CORP TAX

TREATM

Impact on Community Banks

Depends on Agency Comments and

Our Evaluation
B-284651

Page 21 GAO/GGD-00-159 S-Corporation Banks

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 Ccorporations and S-corporations, even in cases where there is no

difference in economic substance. Fifth, Treasury stated that Scorporations 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.
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Page 22 GAO/GGD-00-159 S-Corporation Banks

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 Ccorporation 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,
B-284651

Page 23 GAO/GGD-00-159 S-Corporation Banks

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
B-284651

Page 24 GAO/GGD-00-159 S-Corporation Banks

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
Page 25 GAO/GGD-00-159 S-Corporation Banks
Page 26 GAO/GGD-00-159 S-Corporation Banks

Contents

1 Letter

30

Banks Represent a Small Percentage of All SCorporations30 Appendix I

History and

Background of SCorporations

37

Analysis of Proposed Tax Revisions and Potential

Impacts

37

Agency Comments 41

Appendix II

Scope and

Methodology

42

Proposed Tax Provision 42

Shareholder Limit Cited as an Obstacle for Becoming an

S-Corporation Bank

42

Appendix III

Proposed Tax

Provision To Increase

the Maximum Number

Of Shareholders

47

Proposed Tax Provision 47 Appendix IV

Proposed Tax

Provision To Allow

Individual Retirement

Accounts As

Shareholders

50

Proposed Tax Provision 50

Passive Income Regulations Predate Banks’ Eligibility to

Become S-Corporations

50

Appendix V

Proposed Tax

Provision to Clarify

Passive Investment

Income Rules
Contents

Page 27 GAO/GGD-00-159 S-Corporation Banks

Appendix VI 54

Proposed Tax

Provision to Redefine

Treatment of Bank

Director Shares

Proposed Tax Provision 54

58

Proposed Tax Provision 58

Bad Debt Recapture Cited as Obstacle to Subchapter S

Election

59

Proposed Change Would Likely Lower Banks’ Tax Costs

During Conversion to Subchapter S Status

60

Appendix VII

Proposed Tax

Provisions to Improve

Bad Debt Treatment

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
Contents

Page 28 GAO/GGD-00-159 S-Corporation Banks

Appendix XI

GAO Contacts and

Staff

Acknowledgments

66

Tables Table 1: Tax Revenue Loss Estimates for 1999 Proposed

Provisions

20

Figure 1: Median Cash Dividend to Net Income Ratios for

S-Corporation Banks and Comparison Banks From

1996 to 1999

16

Figure 2: Median Tier 1 Leverage Capital Ratio for Scorporation Banks and Comparison Banks From 1996

to 1999

17

Figure 3: Median Return on Assets Ratios for Scorporation Banks and Comparison Banks From 1996

to1999

18

Figure 4: Median Net Loans and Leases to Assets Ratio

for S-Corporation Banks and Comparison Banks, 1996-

1999

19

Figure I.1: Percentage of S-Corporations by Industrial

Sectors

30

Figure I.2: Dispersion of S-corporation Banks by State 31

Figure III.1: Percentage Comparison of the Number of

Shareholders between S-Corporations From all

Industries and S-Corporation Banks

43

Figures
Contents

Page 29 GAO/GGD-00-159 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
Appendix I

History and Background of S-Corporations

Page 30 GAO/GGD-00-159 S-Corporation Banks

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.

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 Scorporation 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.

Banks Represent a

Small Percentage of All

S-Corporations

Figure I.1: Percentage of SCorporations by Industrial Sectors
Appendix I

History and Background of S-Corporations

Page 31 GAO/GGD-00-159 S-Corporation Banks

Note: At the end of 1999, Hawaii had one S-corporation bank and Alaska did not have any Scorporation 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 twothirds of S-corporation banks. The Office of the Comptroller of the

Currency (OCC) is the primary regulator for 23.1 percent of S-corporation

Figure I.2: Dispersion of S-corporation Banks by State
Appendix I

History and Background of S-Corporations

Page 32 GAO/GGD-00-159 S-Corporation Banks

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.

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 Scorporation.

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.

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.

 

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 Scorporation 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.

Current S-Corporation

Requirements

Subchapter S is a Hybrid of

Other Business Structures
Appendix I

History and Background of S-Corporations

Page 33 GAO/GGD-00-159 S-Corporation Banks

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

 

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 Scorporations, as was the case with partnerships. Instead, the income that passed through to the Scorporation 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.
Appendix I

History and Background of S-Corporations

Page 34 GAO/GGD-00-159 S-Corporation Banks

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.

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 Ccorporations 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.

 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.

Former C-corporations

Face Corporate Taxes After

Conversion to Subchapter S
Appendix I

History and Background of S-Corporations

Page 35 GAO/GGD-00-159 S-Corporation Banks

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

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 Scorporation 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 closelyheld businesses.” Congress sought to lift these perceived barriers by

allowing certain tax-exempt organizations to be shareholders in Scorporations. However, Congress also sought to preserve the concept that

 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.

Subchapter S Has Been

Revised Several Times
Appendix I

History and Background of S-Corporations

Page 36 GAO/GGD-00-159 S-Corporation Banks

all income of the S-corporation would at least be subject to a shareholderlevel 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.

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.

 

12 P.L. 105-34.

13 This provision became effective January 1, 1997.

Law Expanded in 1996 to

Allow Banks to Elect

Subchapter S Tax Status
Appendix II

Scope and Methodology

Page 37 GAO/GGD-00-159 S-Corporation Banks

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 Scorporations; (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.

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

 

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.

Analysis of Proposed

Tax Revisions and

Potential Impacts

Analysis of Proposed Tax

Revisions
Appendix II

Scope and Methodology

Page 38 GAO/GGD-00-159 S-Corporation Banks

Subchapter S election. To confirm the findings of these industry surveys,

we spoke to some bankers who had already converted their banks to Scorporations 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.

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

 

5

 Over 2,000 community bankers attended the ICBA annual conference in March 2000.

Impacts on Community

Banks
Appendix II

Scope and Methodology

Page 39 GAO/GGD-00-159 S-Corporation Banks

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 nonS-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

 

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.
Appendix II

Scope and Methodology

Page 40 GAO/GGD-00-159 S-Corporation Banks

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-
Appendix II

Scope and Methodology

Page 41 GAO/GGD-00-159 S-Corporation Banks

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.

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.

 

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.

Agency Comments
Appendix III

Proposed Tax Provision To Increase the

Maximum Number Of Shareholders

Page 42 GAO/GGD-00-159 S-Corporation Banks

The proposed tax provision we studied would increase the number of

eligible shareholders in S-corporations from 75 to 150.1

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

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 Scorporation, 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.

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 Scorporations beginning in tax year 1997, 1,318 banks have become Scorporations. According to FDIC data, these banks represent about 13

 

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.

Proposed Tax

Provision

Present and Prior Law

Shareholder Limit

Cited as an Obstacle

for Becoming an SCorporation Bank

About 13 Percent of Banks

Have Become SCorporations Since 1997
Appendix III

Proposed Tax Provision To Increase the Maximum Number Of Shareholders

Page 43 GAO/GGD-00-159 S-Corporation Banks

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.

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.

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 SIncreasing the Number of

Shareholders Would Likely be

More Important to Banks

Figure III.1: Percentage Comparison of the Number of Shareholders between S-Corporations From all Industries and SCorporation Banks
Appendix III

Proposed Tax Provision To Increase the Maximum Number Of Shareholders

Page 44 GAO/GGD-00-159 S-Corporation Banks

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.

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, 

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.

Likely Impacts of Proposed

Change
Appendix III

Proposed Tax Provision To Increase the Maximum Number Of Shareholders

Page 45 GAO/GGD-00-159 S-Corporation Banks

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.)

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

Increasing the Shareholder Limit

Could Potentially Affect A Large

Number of Banks
Appendix III

Proposed Tax Provision To Increase the Maximum Number Of Shareholders

Page 46 GAO/GGD-00-159 S-Corporation Banks

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.
Appendix IV

Proposed Tax Provision To Allow Individual

Retirement Accounts As Shareholders

Page 47 GAO/GGD-00-159 S-Corporation Banks

The proposed tax provision would permit S-corporation shares to be held

by individual retirement accounts1

 (IRA).

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 Scorporation 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.

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.

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

 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 Scorporation 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.

Proposed Tax

Provision

Present and Prior Law

Reasons Cited for Proposed

Change

Impacts of Current Law
Appendix IV

Proposed Tax Provision To Allow Individual Retirement Accounts As Shareholders

Page 48 GAO/GGD-00-159 S-Corporation Banks

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.

 

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.
Appendix IV

Proposed Tax Provision To Allow Individual Retirement Accounts As Shareholders

Page 49 GAO/GGD-00-159 S-Corporation Banks

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

Allowing IRAs to be eligible shareholders in S-corporations would affect Scorporations 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 Scorporation 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 Scorporation 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.

 

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.

Impacts of Proposed

Provision
Appendix V

Proposed Tax Provision to Clarify Passive

Investment Income Rules

Page 50 GAO/GGD-00-159 S-Corporation Banks

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.

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 Scorporations 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 Ccorporation 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.

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 

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.

Proposed Tax

Provision

Present and Prior Law

Passive Income

Regulations Predate

Banks’ Eligibility to

Become SCorporations
Appendix V

Proposed Tax Provision to Clarify Passive Investment Income Rules

Page 51 GAO/GGD-00-159 S-Corporation Banks

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 Scorporations:

• 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.

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

 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.

Banking Industry Wants

Passive Income Rules

Clarified
Appendix V

Proposed Tax Provision to Clarify Passive Investment Income Rules

Page 52 GAO/GGD-00-159 S-Corporation Banks

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.

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

Impacts of Current Law
Appendix V

Proposed Tax Provision to Clarify Passive Investment Income Rules

Page 53 GAO/GGD-00-159 S-Corporation 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.

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.

Impacts of Proposed

Provisions
Appendix VI

Proposed Tax Provision to Redefine

Treatment of Bank Director Shares

Page 54 GAO/GGD-00-159 S-Corporation Banks

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.

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

 

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).

Proposed Tax

Provision

Present S-Corporation Law

and National Banking Law
Appendix VI

Proposed Tax Provision to Redefine Treatment of Bank Director Shares

Page 55 GAO/GGD-00-159 S-Corporation Banks

qualifying shares and may execute a revocable or irrevocable proxy

authorizing another person to vote the director’s qualifying shares.9

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.

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

 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.

Reasons Cited for Proposed

Change

Impacts of Current Law
Appendix VI

Proposed Tax Provision to Redefine Treatment of Bank Director Shares

Page 56 GAO/GGD-00-159 S-Corporation Banks

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.

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 Scorporation.

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

 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.

Banks’ Attorneys Have

Developed Methods to

Address Bank Director

Shares

Impacts of Proposed

Changes
Appendix VI

Proposed Tax Provision to Redefine Treatment of Bank Director Shares

Page 57 GAO/GGD-00-159 S-Corporation Banks

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 Scorporations.
Appendix VII

Proposed Tax Provisions to Improve Bad

Debt Treatment

Page 58 GAO/GGD-00-159 S-Corporation Banks

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.

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.

Under current law, to become eligible for Subchapter S tax status, Scorporations (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

 

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.

Proposed Tax

Provision

Definition of “Built-in” Gain

or Loss

Present and Prior Law
Appendix VII

Proposed Tax Provisions to Improve Bad Debt Treatment

Page 59 GAO/GGD-00-159 S-Corporation Banks

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

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.

Industry representatives said the cost of changing to the specific chargeoff 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

 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.

Bad Debt Recapture

Cited as Obstacle to

Subchapter S Election

Tax Accounting Costs

Associated with Subchapter

S Conversion
Appendix VII

Proposed Tax Provisions to Improve Bad Debt Treatment

Page 60 GAO/GGD-00-159 S-Corporation Banks

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.

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.

Proposed Change

Would Likely Lower

Banks’ Tax Costs

During Conversion to

Subchapter S Status
Appendix VIII

Comments from the Department of the

Treasury

Page 61 GAO/GGD-00-159 S-Corporation Banks

Now on p. 4.
Appendix VIII

Comments from the Department of the Treasury

Page 62 GAO/GGD-00-159 S-Corporation Banks

Now on p. 15.
Appendix IX

Comments from the Federal Deposit

Insurance Corporation

Page 63 GAO/GGD-00-159 S-Corporation Banks

No on pp. 1, 50, and 2.
Appendix IX

Comments from the Federal Deposit Insurance Corporation

Page 64 GAO/GGD-00-159 S-Corporation Banks

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 65 GAO/GGD-00-159 S-Corporation Banks
Appendix XI

GAO Contacts and Staff Acknowledgments

Page 66 GAO/GGD-00-159 S-Corporation Banks

Thomas J. McCool (202) 512-8678

William B. Shear (202) 512-4325

William B. Bates, Jeanette M. Franzel, Tonita W. Gillich, Debra R. Johnson,

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