The Hidden Risks and Costs of Remaining an S Corporation

• September 24, 2018
• Amanda Garnett

For decades, many financial institutions have chosen to operate as S Corporations in order to avoid double taxation and to take advantage of lower tax rates that may exist at the shareholder level.  With a much lower 21% corporate tax rate as well as various other tax law changes, the Tax Cuts and Jobs Act has changed the equation when it comes to tax planning.

Many institutions are now considering making the switch back to a C Corporation.  Beyond the mathematical differences in personal tax rates, corporate tax rates, and the Section 199A deduction, there are less obvious factors that corporations should consider when deciding whether to revoke their S elections.

The Risk of Involuntary Termination

S corporations are limited in the number of shareholders that can own stock as well as the types of shareholders that are eligible.  If even one share of stock is transferred to an ineligible shareholder, the corporation’s S election is involuntarily terminated.

We have seen this happen to S Corporation banks in situations where a trust fails to be eligible under the S Corporation rules either because of a change in the trust document or because the original grantor dies and the shares are not transferred timely after death.  Generally, the situation is inadvertent and the financial institution is not at fault.

Though many of these situations can be corrected by filing documents with the IRS, the process is onerous and can be costly both in terms of management time and professional fees.  In one situation we encountered, it cost the S Corporation over $50,000 between IRS filing fees and professional expenses to correct the problem.

As shareholder groups at many community banks continue to grow, age, and move away from their local communities, the risk of involuntary terminations also increases.

Other Hidden Costs

There are a number of other costs that S Corporations, especially those that are widely-held, may also want to consider.

• The ongoing costs of managing stock transfers such as reviewing family lineage and shareholder trust documents
• The additional annual cost for each shareholder when filing their personal tax return, which includes federal and state K-1s
• The time spent by management answering shareholder questions about K-1s, tax distributions, and projected taxable income
• The additional cost associated with out-of-state shareholders being taxed in your state on their K-1 income particularly for shareholders living in states with no personal income tax regime
• The additional cost required to prepare S corporation tax returns, K-1s, and basis schedules versus C corporation returns

A Case for Simplicity

C Corporations may have to record monthly tax expense and deferred tax assets, but at the shareholder level they provide a lot of simplicity.

Many S Corporation owners have a difficult time understanding how the corporation’s earnings impact their personal tax situation and how much of the distributions they receive each year are going towards their taxes.  Our office routinely gets phone calls from shareholders each spring asking why the amounts reported on their K-1 don’t match the distribution checks they got from the bank so we know that shareholders continue to struggle with S Corp complexity.

C Corporations issue 1099-DIVs instead of K-1s so the correlation between the cash shareholders receive and the tax they pay is much more direct.  There is less volatility from year to year and it can be easier for shareholders to understand the after-tax rate of return they are receiving.

How CLA Can Help

CLA is here to help you analyze how tax reform impacts your institution and its shareholders.  The rules are complex and every situation is unique.  We can assist you in performing a detailed assessment.  Please contact us.

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