Sub-Chapter S Conversions for Banks
Excerpted from Mercer Capital's upcoming book, "The Bank Director's Valuation Handbook: What Every Director Needs to Know About Valuation," to be published Fall 2008.
An S "election" represents a change in a bank's tax status. When a bank "elects" S corporation status, it opts to become taxed under Subchapter S of the U.S. Tax Code, instead of Subchapter C of the Code. When taxed as a C corporation, the bank pays federal income taxes on its taxable income. By making the S election, the bank no longer pays federal income tax itself. The tax liability does not disappear altogether, though. Instead, the tax liability "passes through" to the shareholders. This means that the bank's tax liability becomes the obligation of the bank's shareholders. While no guarantees generally exist, the bank will ordinarily intend to distribute enough cash to the shareholders to enable them to satisfy the tax liability.
AN EXAMPLE
The following table shows what happens when a bank makes an S election. In the table, the bank no longer incurs any federal tax liability following the S election. However, the $350 tax obligation simply "passes through" to the shareholders.
S ELECTION BENEFITS
In the preceding table, the bank's pre-tax income generated a $350 tax obligation, regardless of whether the bank was taxed as a C or S corporation. In the C corporation scenario, the bank directly paid the tax obligation to the government; in the S corporation alternative, the shareholders paid the taxes due on the bank's earnings. Since the taxes due remain constant at $350 regardless of whether the bank elects S corporation status or not, what incentive exists for banks to elect S corporation status?