Queries persist on Sub S for banks

Since the beginning of the New Year, our consulting and legal firms have been contacted by multiple community banks who are either in a Subchapter S structure currently or are contemplating converting to it. The Tax Cuts and Jobs Act of 2017, which was signed into law in late December 2017, has some specific provisions affecting Subchapter S corporations and the taxation of their shareholders. Their basic question is, are these provisions beneficial to Subchapter S community banks?

This is a complicated subject in view of the new Act, but I thought I would briefly address it in this blog.

Our firm has studied this issue a great length and has run numerous financial analyses for community banks across the nation related to their operations as a Sub S community bank. Our conclusion has been the same in each case. For virtually every community bank, remaining in a Subchapter S corporation structure continues to make sense provided the bank ultimately wants to get its earnings into the hands of its shareholders in some fashion, whether through distribution or the sale of its shares.

Looking at the law

Why does Subchapter S continue to make the most sense for community banks? Because C corporation earnings remain subject to double taxation under the new tax law. The tax rates may be different, but the analysis is not.

Under the Tax Cuts and Jobs Act, the federal corporate tax rate dropped from 35% to 21% and the maximum marginal federal individual income tax rate dropped from 39.6% to 37% (exclusive of a 3.8% Medicare surtax).

The more complicated part, however, was that the Act also gave certain shareholders of certain pass-through entities, such as Subchapter S corporations, a 20% deduction on taxable income. The wrinkle, if you will, is determining under what circumstances this 20% deduction is available.

In the most simple terms I can muster (I am a lawyer after all), the 20% deduction is not available under two scenarios:

• The first scenario is if 50% of the company’s W-2 wages paid is less than 20% of net income.

If that is the case, the 20% deduction phases out once a shareholder’s net income exceeds $315,000 as a married filing jointly taxpayer. Fortunately (if you can talk about expenses in such terms), salaries expense is a significant expense for all community banks. In all but the most unusual cases, 50% of W-2 wages paid will exceed 20% of net income, which means this particular limitation should not impact most Subchapter S community bank shareholders.

• The second limitation on the availability of the 20% deduction is if banking falls within the category of “specified service or trade or business.”

This is the more technical limitation of the two, but the short of it is that the applicable definitions found in the U.S. Code make a distinction between “financial services” and “banking.”

Strictly looking at the language of the statutes, “financial services” are clearly a “specified service or trade or business,” but “banking” should not be. This means that community banks should not be subject to a phase-out of the 20% deduction.

While it is a technical distinction, we do believe it is the proper reading of the applicable statutes, as do the American Bankers Association and the Independent Community Bankers of America.

With that said, this will probably be a gray area until the powers that be issue guidance on the issue.

Where this leaves things

Because shareholders of Subchapter S community banks should be able to take advantage of the 20% deduction on net income, Subchapter S still makes the most sense.

To work this through:

• C corporations will continue to pay tax on corporate earnings, albeit at a lower rate, and then the shareholders will pay tax on any dividends paid to them.

• S corporation shareholders will pay tax once on their portion of S corporation earnings, less the 20% deduction.

This works out to an effective tax rate of approximately 36.8% for C corporation community banks and their shareholders and an effective tax rate of approximately 29.6% for S corporation shareholders. Unless I am missing something, most people would prefer to pay 29.6% in taxes instead of 36.8%. For those people, Subchapter S status is still the better way to go.

If any of you would like any additional information on this, our firm has put together a more comprehensive article on the topic. I am happy to send it to whoever wants to see it.