About to Get Sweeter: The Price for S Corporation Banks
By: THOMAS W. GARTON
June 2006
In the next year or so, a lot of banks and bank holding companies will be celebrating their tenth anniversaries as S Corporations. There may be more to celebrate than the number of candles on the cake. There may be a sweetener.
Beginning with tax years starting after December 31, 1996, banks and other financial institutions have been permitted to elect to be taxed under Subchapter S of the Internal Revenue Code. Many banks made the election right away. Some needed a year or two to eliminate non-qualifying shareholders before the election could be made. On January 1, 2007, the most mature of the S Corporation banks will have completed ten years in that status.
The income of an S Corporation is passed through to its shareholders who pay income tax on their pro rata share of the corporation’s income. With one important exception, the corporation pays no income tax on its earnings. That exception applies during the first ten years after the effective date of the S Election. Under the exception, the corporation is required to pay tax on gain from the sale of assets (including goodwill) to the extent the gain is attributable to asset appreciation that occurred prior to the date of the S Election. The result is a potential double tax on a portion of the gain from an asset sale. In a transaction for the sale of a bank, this Built In Gains tax (“BIG tax”) would generally make asset sales more tax costly to the seller than a stock sale.
After a bank has completed ten years as an S Corporation, the BIG tax is no longer applicable. With some minor exceptions, the tax cost to the seller of selling the assets of the S Corporation bank is, at that point, equivalent to the tax cost of selling the stock.
In purchases and sales of profitable businesses, income tax considerations drive buyers to seek an asset purchase, while the tax considerations drive sellers to seek stock sales.
From a purely income tax standpoint, buyers have always had a preference for asset purchases. The portion of the price paid for goodwill in an asset purchase can be amortized and deducted by the buyer over 15 years. Assets purchased for a price greater than the seller’s tax basis can be written up to the amount of the price allocated to them thereby creating potential shelter of future taxes of the buyer. On the other hand, in a stock purchase the goodwill portion of purchase price cannot be deducted, and there is no asset basis step up. The buyer is better off purchasing assets.
From a purely income tax standpoint, sellers have always preferred the single tax consequences of selling stock rather than the double tax consequences of a corporate sale of assets followed by the distribution of the sales proceeds to the selling shareholders. Except in the case of mature S Corporations, the seller is better off selling stock.
Some commentators are predicting that banks which have outgrown their BIG tax exposure can be expected to command a higher price upon sale because they can offer the buyer the benefits of the goodwill deduction that accompany an asset purchase without the double tax cost that is associated with C Corporation asset sales. Banks which are not S Corporations would bear a double tax on an asset sale. S Corporation bank sellers, the argument goes, will have a decided pricing advantage over sellers of banks that are not S Corporations.
There is an additional favorable twist that enhances the allure of S Corporation banks to sellers. By making an election under Code Section 338(h)(10), the stock of the bank can be sold and still have the transaction treated for income tax purposes as if the bank had sold its assets to the buyer. Therefore, if a buyer favors the simplicity and administrative ease of a stock purchase over an asset purchase, he can have his stock purchase and also have favorable asset purchase treatment for income tax purposes.
An article in a recent edition of the American Banker noted research that seems to support the proposition that prices for C Corporation banks and for S Corporation banks have been essentially equivalent over the last two years. To the extent of the tax savings that can arise from the sale of “mature” S Corporations, extra value will be realized in S Corporation sales which is not available to C Corporation banks. The logical outcome of this savings is that S Corporation banks may well command a higher price after they mature than their C corporation counterparts. If a sale of an S Corporation bank is anticipated in the near future, it may be a good idea to consider waiting until after the ten year S Corporation period has elapsed. The sales price and the after tax proceeds may be a bit more sweet.