As Todd Langenfeld, president of Farmers Trust & Savings Bank in Earling, Iowa, followed the legislative wrangling over tax reform during November and December, he said he “felt like a ping pong ball, going back and forth on remaining a sub-S bank.” Langenfeld engaged in multiple conversations with the bank’s Chief Executive Officer Roger Kenkel about the possibility of converting the bank to a C-corp.
“Under the new law, the highest marginal effective rate comes in right at 30 percent with the 20 percent passive income exemption,” Langenfeld said. “Under C-corp tax laws, I would be under a 41 percent effective rate — the 21 percent corporate rate plus the 20 percent dividend rate. I know this is an over-simplification but I am good at math and 30 percent is better than 41 percent.” Langenfeld, who owns 65 percent of the $87 million bank’s stock, decided it made sense to maintain subchapter S incorporation status.
Bankers in subchapter S institutions all over the country are having similar discussions about whether it makes sense for them to maintain their S election. When President Donald Trump signed the new tax law on Dec. 22, the distinctions between C corporations and subchapter S corporations changed.
It’s a numbers game
The top individual income tax bracket has dropped to 37 percent from 39.6 percent. Shareholders in sub-S corporations can deduct 20 percent of income from those entities, subject to various limitations. Accounting firm Eide Bailly explains on its website that “in those instances where the full 20 percent deduction is available, the top tax bracket for S corporation owners essentially drops from 37 percent to 29.6 percent.”
The new law establishes a tax rate of 21 percent for C corporations. This creates a spread of 8.6 percent, Eide Bailly notes, between the C-corp rate and the S-corp rate. Under the old law, the spread was 4.6 percent, where the corporate rate was 35 percent and the top personal individual rate was 39.6 percent.
Entering the tax reform debate, subchapter S advocates wanted parity with C corporations. Patrick Kennedy Jr., president of the Sub S Bank Association, said the advocacy process in the weeks prior to the bill’s passage was intense. “The pass-through entities did not get what they were promised,” Kennedy summarized. The issues involving taxation of sub-S or pass-through companies are complex, said the San Antonio, Texas-based attorney. He said policymakers worked in good faith, and they worked quickly in an effort to meet an aggressi
ve timeline for passing the legislation.
In a communication with members, the Independent Community Bankers of America noted it worked on several aspects of the legislation, including provisions for sub-S shares held in trusts and estates to be eligible for the 20 percent deduction. “Though the final agreement falls short of parity, it was dramatically improved during the legislative process,” the ICBA wrote.
C-corp shares are still subject to double taxation. Depending on a person’s annual income, dividend income is taxed at a rate of 20 percent, 15 percent or 0 percent.
The pass-through provisions in the tax bill expire after 2025; the C-corp tax cut is permanent.
Kennedy said that depending on the state, subchapter S incorporation still offers advantages. “Should every bank stay sub S? It is definitely something everyone should look at. It is not suitable for everyone,” he cautioned.
The landscape
The Midwest has a large portion of the country’s 1,963 subchapter S banks. With 223 sub-S banks, Minnesota has more than any other state. Sub-S banks tend to be smaller than C-corp banks. S&P Global Market Intelligence reported Dec. 20 that the median size S-corp bank had $153 million in assets, compared to the median C-corp bank, which had $257.9 million.
As the total number of banks declines across the country, S corporations are growing as a percentage of all banks. Today, S-corps account for 34 percent of the country’s banks, compared to 2005 when it was closer to 25 percent. The actual number of sub-S banks across the country is down, however, having peaked at about 2,500 in 2008.
Annual tax liability is not the only difference between sub-S and C-corp institutions. S corporations can benefit from a stepped-up basis when the corporation is sold. This can save the seller significant money in capital gains taxes.
“The basis increase really comes into play if any shareholder individually or any organization sells its entire bank. If you’re an S-corp, your basis will increase each year so it ultimately reduces the amount of gain you’ll have on a transaction when you sell your stock,” said Neil Falken, principal at CliftonLarsonAllen, Minneapolis. “We have proven that over some situations where it’s probably saved some shareholders millions of dollars by being an S-corp compared to being a C-corp over that period of time, just because of that basis increase.”
If owners have no intention of selling the bank and hope to pass bank stock on to heirs, they will not realize one of the key benefits of subchapter S incorporation, said Blake Crow of Eide Bailly.
Crow, who works in the firm’s Sioux Falls, S.D., office, noted that different approaches to capital planning will affect the impact of incorporation status. “If you’re distributing all of your earnings out because you don’t need that capital to support growth, the double taxation of a C-corp is going to be quite burdensome,” Crow said. Banks that retain earnings to build capital avoid double taxation. For those banks, C-corp status might be the way to go, Crow said.
Langenfeld, who described himself as semi-retired, clearly has studied the tax rules. “Every bank is different in making the sub-S versus C-corp decision,” he said. “If a bank has a large and diverse number of stockholders, it may want to convert back to C-corp status. If capital retention is foreseen as needed, C-corp status is also a better option. In the case of majority ownership being in the hands of a few people, sub-S status will make more sense if cash flow to the shareholders is important.”
A subchapter S bank interested in filing its taxes as a C-corp must convert by March 15 in order to avoid having to also file a sub-S tax return for 2018. The decision to relinquish sub-S status, however, should not be made in haste. Typically, a bank that has converted to a C-corp from an S corporation cannot convert back to an S corporation for five years.