New S Corporation Rules
By: THOMAS W. GARTON
December 2004
On October 22, 2004, with little fanfare, President Bush signed into law the American Jobs Creation Act of 2004. It is a massive piece of legislation. Among other important changes, it contains a section called "S Corporation Reform and Simplification.” While the changes relate to S Corporations generally, there are some changes that relate specifically to banks that are S Corporations. Some of the more important changes are described here.
All Family Members Count as One Shareholder
Spouses have been counted as a single shareholder for purposes of meeting the shareholder limit for S Corporation qualification. Now, at the election of a family member, all family members will be counted as a single shareholder for that purpose. "Members of the family" means the common ancestor, lineal descendants of the common ancestor, and spouses (or former spouses) of such lineal descendants. The common ancestor cannot be more than six generations removed from the youngest generation at the time the election is made. This change, along with the next one described below, significantly increase the flexibility for S Corporations.
Increase in Number of Shareholders
The old limit of 75 shareholders has been increased to 100 for taxable years beginning after December 31, 2004. When combined with the new "family counts as one" rule described above, the actual number of individual taxpayers who can be shareholders of an S Corporation has been dramatically expanded.
IRAs Can Be Bank S Corporation Shareholders
Where an IRA, including a Roth IRA, holds stock of a bank as of the date of the enactment of this legislation (October 22, 2004), that IRA will not be a disqualifying shareholder as to shares held on that date. The individual for whose benefit the IRA holds the stock will be considered the shareholder. This section applies only to shares held by an IRA on October 22, 2004. It does not apply to new IRAs or permit additional shares to be transferred to an IRA. This is a special one-time exception to the general rule that an IRA is a disqualifying S Corporation shareholder. The provision by its terms relates only to banks, not bank holding companies. Unless this limitation is changed by a technical correction, the provision will be of no help in the most common situation where an IRA holds holding company stock rather than bank stock.
Transfer of Suspended Losses in a Divorce
Where losses are allocated to a shareholder in excess of that shareholder's basis in his or her stock, the loss cannot be currently deducted, but can be carried forward by that shareholder to a future year where S Corporation income is recognized. Under the new law, where stock is transferred from the shareholder who experiences the suspended loss to a spouse incident to a divorce, the transferee spouse is entitled to take advantage of the previously suspended loss as if it had been realized by the transferee.
Exclusion of Bank Investment Income from Passive Income Test
One limitation on a corporation's ability to continue as an S Corporation relates to its level of passive investment income. Interest and dividends can be a significant proportion of a bank's income, and therefore have the potential of causing S Corporation disqualification. The Act provides that in the case of a bank or a bank holding company, the term “passive investment income” does not include interest income earned by the bank or dividends on assets required by regulatory agencies to be held by the bank. Although prior law provided some limited protection for lending institutions, this change provides a broader and more explicit exception.
Directors’ Qualifying Shares
There is no provision in the Act relating to S Corporation treatment of bank directors' qualifying shares. It is typical for those shares to be subject to agreements requiring purchase by the director and resale to a bank at a fixed value, often par, and for the holders to waive dividend distributions. Under current S Corporation rules, as described in Private Letter Ruling 200217048, this arrangement creates a disqualifying second class of stock. Nothing in the Act changes this outcome.