Writing in the May issue of BankDirector.com, FKHF Managing Partner, Chet Fenimore discusses potential pitfalls in acquiring an S-Corporation and why thorough pre-sale due diligence is so critical.
HOW SUBCHAPTER S ISSUES COULD SNAG A SALE
BY: CHET FENIMORE
Nearly 2,000 banks in the U.S. have elected Subchapter S tax treatment as a way of enhancing shareholder value since 1997, the first year they were permitted to make the election. Consequently, many banks have more than 20 years of operating history as an S corporation.
However, this history is presenting increasingly frequent challenges during acquisition due diligence. Acquirers of S corporations are placing greater emphasis on due diligence to ensure that the target made a valid initial Subchapter S election and continuously maintained eligibility since the election. Common issues arising during due diligence typically fall into two categories:
- Failure to maintain stock transfer and shareholder records with sufficient specificity to demonstrate continuous eligibility as an S corporation.
- Failure by certain trust shareholders to timely make required Qualified Subchapter S Trust (QSST) or Electing Small Business Trust (ESBT) elections.
A target’s inability to affirmatively demonstrate its initial or continuing eligibility as an S corporation creates a risk for the acquirer. The target’s S election could be disregarded after the deal closes, subjecting the acquirer to corporate-level tax liability with respect to the target for all prior periods that are within the statute of limitations. This risk assessment may impact the purchase price or the willingness of the buyer to proceed with the transaction. In addition, the target could become exposed to corporate tax liability, depending on the extent of the compliance issues revealed during due diligence, unless remediated.
Accordingly, it is important for S corporation banks to ensure that their elections are continuously maintained and that they retain appropriate documentation to demonstrate compliance. An S corporation bank should retain all records associated with the initial election, including all shareholder consents and IRS election forms. S corporation banks should also maintain detailed stock transfer records to enable the substantiation of continuous shareholder eligibility.
Prior to registering a stock transfer to a trust, S corporation banks should request and retain copies of all governing trust instruments, as well as any required IRS elections.
It is also advisable to have the bank’s legal counsel review these trust instruments to confirm eligibility status and any required elections. Banks that are relying on the family aggregation rules to stay below the 100 shareholder limitation should also keep records supporting the family aggregation analysis.
While S corporation banks have realized significant economic benefits through the elimination of double taxation of corporate earnings, maintaining strong recordkeeping practices is a critical element in protecting and maximizing franchise value, especially during an acquisition. Any S corporation bank that is contemplating selling in the foreseeable future should consider conducting a preemptive review of its Subchapter S compliance and take any steps necessary to remediate adverse findings or secure missing documentation prior to exploring a sale.