Is your bank holding company an S corporation? If so, now is a good time to revisit your governing documents to ensure you have the best protections in place to maintain S corporation status.
In 1996, the Small Business Job Protection Act made significant changes to Subchapter S of the Internal Revenue Code (the Code). Among the changes were provisions allowing certain banks and bank holding companies to elect to be treated as S corporations for federal tax purposes. Many banks and bank holding companies have taken advantage of this opportunity to eliminate the entity-level tax that is otherwise applicable to corporations under the Code and instead pass income and loss through pro rata to their shareholders.
Subchapter S imposes limitations on how many and what type of individuals or entities may own stock in an S corporation. Therefore, well-advised shareholders of companies electing S corporation status put in place buy-sell or other shareholder agreements restricting stock transfers. These provisions protect companies from inadvertent termination of their S corporation status by prohibiting and invalidating any sale or other transfer of company stock to persons or entities who are ineligible as S corporation shareholders or who would cause the number of shareholders to exceed the permitted maximum.
Because of the application of certain banking laws, the shareholder agreements of bank holding companies are likely to be finite in duration. Pursuant to the Bank Holding Company Act of 1956 (the BHC Act), a shareholder agreement can in some cases be considered a “company” and thereby subject shareholders to undesirable regulatory scrutiny and filing requirements. In a Board Interpretation of Section 2(b) of the BHC Act, the Board of Governors of the Federal Reserve (the Board) advised that shareholder agreements with certain features, including termination within 25 years, would not be treated as companies under the BHC Act. Therefore, shareholder agreements typically include termination dates 25 years or less from the time of execution so as to fit within the Board’s safe harbor.
When bank holding companies that elect S corporation status see their shareholder agreements terminate, the restrictions on stock transfers in such agreements which protect a company’s S corporation status will also terminate. In such cases, shareholders would be free to transfer shares without regard to the eligibility of the transferee to hold S corporation stock or the number of existing shareholders. Under Subchapter S, such a transfer could cause an immediate termination of S corporation status.
Termination of S corporation status generally means an immediate return to taxation at both the entity and shareholder level, along with a prohibition on re-electing S corporation status within the next 5 years. While there are relief measures under Subchapter S that can help mitigate the consequences of an inadvertent termination, it can be a time-consuming, administratively difficult, and expensive process. Prevention is therefore the best course of action.
Depending on the facts and circumstances particular to your company, there are several ways to maintain existing restrictions and strengthen the protections against inadvertent termination of S corporation status going forward, including renewal of an existing shareholder agreement, the incorporation of restrictive provisions into other governing documents, and coordinating shareholder approval and ratification.
Bank holding companies’ shareholder agreements typically expire within 25 years, and when they do, their provisions which protect against termination of S corporation status also expire. Plan ahead to protect your S corporation status. Solutions can be addressed at appropriate times prior to the expiration of current restrictions.