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The IRS has simplified the process for banks to reapply for S corporation status, but banks should take steps to avoid having its status terminated.

Avoiding Involuntary Terminations of S Corporation Tax Status for Community Banks

  • 9/12/2013

Avoiding Involuntary Terminations of S Corporation Tax Status for Community Banks

S Corporation community banks that incur an involuntary termination and no longer qualify as an S corporation may now have an easier time re-establishing their elective status. The IRS recently issued new provisions that simplify the steps a bank must take to repair its status.

“Although the new process is more streamlined, it is still costly and time-consuming to reapply for S corporation status,” warns John Matthiesen, a financial institutions partner with CliftonLarsonAllen. “It is extremely important for banks that elect S Corporation status to be aware of the restrictions and responsibilities that come with this tax status, and how to avoid becoming disqualified.”

Many community banks want to avoid double taxation by electing to be an S corporation for tax purposes. However, a bank must maintain its status as a “small business corporation”, or else its S election automatically terminates. Unless a bank takes certain steps to repair its S corporation status, it reverts to a tax-paying C corporation. This can have a significant effect on a bank’s earnings and capital, especially since it must generally wait five years before it can re-elect its S status.

Disqualifying situations

There are a number of situations that may result in a bank no longer qualifying for S corporation status. This includes banks that have:

  • More than 100 shareholders
  • An ineligible shareholder (e.g., a corporation, partnership, ineligible trust, or nonresident alien)
  • More than one class of stock

The most common disqualification involves shareholders who become ineligible for S corporation status due to wills and trusts. For instance, upon the death of a shareholder, a bank’s stock may be passed on to an ineligible shareholder or trust. Similarly, the death of a trust’s primary beneficiary or the modification of a trust document could result in a disqualification.

Repairing an S election

Under the IRS’s new procedures, a bank first has to correct the issue. It then has to send a letter to the IRS explaining the facts and circumstances of its disqualification, and ask to be reinstated. The bank also must prove that the situation was not reasonably within its control or that it took place without the bank’s knowledge.

If the IRS finds that the bank has satisfied all of these requirements, it will issue a letter notifying the corporation that its S status has been retained.

“Unfortunately, the cost associated with a private letter ruling including the IRS filing fee and related professional fees can be significant, so it is important to avoid involuntary terminations whenever possible,” says Matthiesen.

Avoiding involuntary terminations

To avoid the problems associated with involuntary terminations of S corporation status, banks should proactively manage their shareholders.

Consider establishing a formal agreement requiring shareholders to actively protect the S election during stock transfers. Trust documents should also be reviewed by the bank’s legal counsel, CPA, or another qualified party whenever a shareholder wishes to transfer stock to a new trust or when trust documents are revised. This will help ensure that the trust is a qualified shareholder and that any necessary qualified subchapter S trust (QSST) or electing small business trust (ESBT) elections are filed.

By working closely with shareholders to review trusts and wills and by educating shareholders about the requirements to maintain the S election, many of the common causes of involuntary terminations can be avoided.