Since 1996, many bank holding companies and their wholly owned banks have chosen to be taxed under Subchapter S of the Internal Revenue Code (Code). S Corporation holding companies and their wholly owned qualified Subchapter S electing banks (called QSubs), are not separate taxpayers for tax purposes, but rather their combined income and loss is passed through pro rata to their shareholders. Income allocated to the shareholders increases their basis in their holding company stock, and distributions from the holding company are received as a tax free return of basis.
The disregarded nature of the QSub (for tax purposes) creates some unique tax opportunities during the sale or other disposition of the holding company or the bank, depending upon the structure of the transaction. The following menu describes in broad terms the most common transaction structures and the attendant tax treatment of the buyer and seller of bank properties where the S Corporation holding company owns all of the stock of a QSub.
- Sale of Bank Assets. If the transaction is structured as a taxable sale of bank assets, whether an entire bank or a branch of a bank or a loan portfolio (often referred to as a P & A transaction), the gain the bank realizes on the sale of its assets (the excess of sale price over the basis of the assets sold) is taxed only once. The bank gain is passed through to the shareholders, who experience a step up in the basis of their holding company stock. When the sale proceeds are distributed to the shareholders, this higher basis will generally shelter the otherwise applicable gain on this liquidating distribution. In addition, the buyer gets a market value step up in the basis of the bank assets it purchased. This type of transaction is becoming more frequent in today’s market as buyers are reluctant to assume unknown liabilities.
- Sale of Bank Stock. If the transaction is structured in the more traditional form as a taxable sale by the holding company of the bank stock, slightly different tax provisions apply, but the outcome is the same as described in scenario 1. The holding company’s gain on the stock sale is passed through to the shareholders, whose increased basis shelters the distribution of sale proceeds they receive. The result is a single level of tax. The bank, in the hands of the buyer, will be able to step up the basis of the bank assets to fair market value in this transaction as well.
- Sale of Holding Company Stock. Where the shareholders sell their stock of the holding company in a taxable sale, the sale will be a capital transaction taxed at the shareholder level, and neither the holding company nor the bank will have any transactional tax obligations. The disadvantage to this form of transaction is that the bank assets do not get stepped up to fair market value. Although a sale of holding company stock as described above does not allow the step up in the bank’s assets, Section 338(h)(10) of the Code provides a mechanism for achieving that step up without significantly changing the tax consequences to the seller. When the 338(h)(10) election is made, the transaction is treated as though the holding company and bank assets were sold to the buyer, as opposed to the sale of the holding company stock, and the sale proceeds are distributed to the shareholders with the same tax results described in scenario 1 above.
- Merger of Target Bank into Acquiring Bank. If a target bank is a disregarded entity for tax purposes by virtue of being a QSub, and if the target bank is merged into an acquiring bank, the requirements for a tax free reorganization under Code Section 368(a)(1)(A) cannot be met. The transaction generally will be treated as a taxable purchase of target bank assets in the manner and with the consequences described in scenario 1 above. The buyer’s basis in the bank assets will be stepped up to fair market value. There could be unique circumstances under which such a merger could qualify as a tax free reorganization under Code Section 368(a)(i)(C), though such treatment is difficult to achieve unless the merger consideration consists of only stock of the acquiring bank or its holding company. In a rare case where the transaction does qualify for tax free treatment, the assets of target bank will not be subject to a basis step up. This structure, or the structure described in scenario 5 below, may be useful in a “merger of equals” context where banks try to cope with regulatory burdens through economies of scale and where it is important to the parties to convey the concept of merging assets and operations rather than purchasing assets and operations.
- Merger of Target Holding Company into Acquiring Holding Company. If the target holding company is merged into an acquiring holding company and the requirements for a tax free reorganization under Code Section 368(a)(1)(A) are met (including the requirement that at least 40% of the consideration paid consist of stock of the purchasing entity), the transaction will be tax free to all parties, except that the selling holding company shareholders will recognize gain to the extent the purchase price includes cash. The selling shareholders’ basis in the acquiring holding company stock will be determined by their basis in the target holding company stock immediately before the transaction. The basis of bank assets remains unchanged. If the transaction does not qualify for tax free treatment, the transaction will be treated as a sale of holding company stock with the results described in scenario 3 above.
- Merger of Bank into New Subsidiary of Holding Company. If the target bank is merged into a newly formed subsidiary of the buyer, the result will be the same as described in scenario 4, with a fair market value adjustment to the basis of the bank assets in the hands of the buyer.
This summary is only an overview intended to illustrate some of the more commonly used transactional structures in bank acquisitions. It relates to transactions involving QSubs, not C Corporation banks. The form chosen can have significant tax ramifications to the seller and buyer which could (or should) have an impact on price negotiations.
Negotiating the transaction structure should be done at the same time that price is being negotiated. If the price is negotiated in a vacuum, the economic expectations of the parties in reaching an agreed price may not be fully realized.