Is Subchapter S Viable for Community Banks

ABSTRACT With the economic slowdown, boards of directors and management are pressed to examine strategies to protect shareholder interests. For community banks, the slowdown may not be as severe as in the high tech industries. On the other hand, community banks generally don't have much slack to engage in 'downsizing' either. This paper provides an overview of a strategy which can deliver more shareholder wealth through the legal reduction of taxes by shifting to corporation status. The laws concerning S corporations have been around awhile. The procedure to change the tax status is relatively simple. The issue is relevant for community banks. INTRODUCTION There are currently over 5,300 community banks that are members of the Independent Community Bankers of America. These member institutions hold more than $486 billion in insured deposits, $592 billion in assets, and more than $355 billion in loans. They employ more than 239,000 people. Approximately 40 percent of these community banks are found in towns with less than 2,500 population. Two thirds of the community banks have less than $100 million in assets (www.ibaa.org). While this paper is limited in its application to community banks, it may serve as a useful study for finance or banking majors who need to understand the value of legal and tax analysis for the financial services industry. This paper is also written for the benefit of shareholders of community banks who are looking for fairly conventional ways of reducing taxes without undertaking risky and costly strategies. DISTINGUISHING S FROM C CORPORATIONS Corporation law falls under state law. Each state has enacted some form of the Model Corporations Act which specifies a fairly simple and non-arbitrary process for securing a state charter for a corporation. While some people get confused over the distinction between a C corporation and an S corporation, the distinction is quite simple. An S corporation is a C corporation that has applied to the Internal Revenue Service for special designation as an S corporation. Otherwise, all the procedures for creating a C corporation and an s corporation are exactly the same. The general requirement being that articles of incorporation must be filed with the Secretary of State along with the required payment of the filing fee. So long as the founders have not taken another institution's name, the promoters are given a corporate charter. It is not necessary to indicate in the articles of incorporation whether the corporation will seek S corporation status. Nor is it necessary to have any different by-laws or internal procedures. Conducting shareholder elections, maintaining corporate books and records, and other corporate formalities are exactly the same for C and S corporations. The specific requirements for maintaining the corporate charter are set by individual state law. The requirements for electing S corporation status fall under federal law. The S corporation status is defined by the Internal Revenue Code (26 USCS section 1361 (2001). The S corporation status is available for any corporation which does not have more than 75 shareholders, does not have any shareholders that are not persons which excludes foreign trusts for example, and does not have non-resident alien shareholders. Certain types of corporations may not apply for S treatment. These include financial institutions using the reserve method of accounting for bad debts, insurance companies subject to taxes under section L, and corporations organized as a DISCs (DISCs are C corporations that elect special tax treatment for engaging in international transactions) (26 USCS section 1361 (b)). As related to community banks, there is another important concept to consider. The S corporation election is regulated only by the International Revenue Service. Generally, there are no other bank regulations by OCC, FDIC, or other regulators restricting or altering the basic requirements and procedures for an S corporation election. …