by Melaine Brandt

Most financial institutions are familiar with the two most common benefits of an S election:

• The elimination of double taxation on the amount of current-year earnings distributed to shareholders.
• The increase to stock basis for the amount of earnings not distributed to shareholders, which reduces the future capital gain on the stock.

However, there is another benefit that doesn't completely take effect until an institution has been an S corporation for 10 years. That benefit is the opportunity to obtain a higher sales price for an institution (by treating the sale as an asset sale for tax purposes) without owing any built-in gains tax (BIG tax).

The reason buyers are willing to pay more is because they can deduct the premium they pay over 15 years for tax purposes. This can truly be a win-win for buyers and sellers!

For example, say there's a $50 million institution with $5 million in capital that could be sold as a stock deal for $10 million. Let's assume that the entire $5 million in premium was allocable to core deposit and goodwill, which are 15-year assets for tax purposes. If that stock sale was treated instead as an asset sale for tax purposes, the buyers would be able to deduct $333,333 each year, saving $133,333 per year in taxes for 15 years. The present value of those tax savings is $1.3 million.

S-corporation snapshot

Nationally, there are 2,451 S corporations out of 8,579 total financial institutions (28.57 percent). Institutions were first allowed to become S corporations in 1997, which would mean the 10-year period for potential built-in gains tax exposure would have ended December 31, 2006, for those organizations that elected in the first year. 

On a national basis, 906 institutions made their election in 1997 or 1998, which means they will all be able to perform asset sale elections without any built-in gains tax starting in 2008. In addition, there are over 100 de novos that made their S election at inception and consequently have no BIG tax exposure.

Therefore, there are over 1,000 financial institutions nationally that could take advantage of an asset sale election. And each year even more will become eligible.

In this region, the proportion of S-corporation institutions varies considerably between states:

• Minnesota has 300 out of 445 total (67.42 percent).
• Wisconsin has 79 out of 301 total (26.25 percent).
• Iowa has 223 out of 394 total (56.60 percent).
• Illinois has 231 out of 679 total (34.02 percent).

Minnesota has the most and the highest percentage, but many institutions in Minnesota did not make their elections in 1997 or 1998 because Minnesota did not fully allow S-corporation status until 2001. Wisconsin is still slightly lower than the national average but has been growing in recent years due to the curtailed benefits from investment subsidiaries and the increases in the number of allowable shareholders.

Viewpoints from both sides

From a seller's perspective, an asset sale and a stock sale will result in exactly the same tax if all the gains and losses are capital. For example, the appreciation in land and building, the core deposit intangible, and goodwill are all going to generate capital gains, which will flow through to the shareholders. Those gains will also increase the stock basis, which will reduce dollar for dollar the gain on the stock.

Some assets will generate ordinary gains and losses rather than capital. For example, the loans, the securities that are debt obligations, and the mortgage servicing rights would all generate ordinary gains or losses. Typically, the net of all these is not a very large amount, but sellers must do their homework.

From a buyer's perspective, the premium allocated to core deposit and goodwill will be tax deductible over 15 years with an asset sale. The premium allocated to the building would be deductible over 39 years. In a stock sale, these amounts must be pushed down for book accounting purposes but cannot be deducted for tax purposes.

The other benefit emerges

Prior to this year, prices paid for S-corporation institutions have been essentially equivalent to the prices paid for C-corporation institutions. However, once statistics become available for deals closing in 2007 and beyond, the other benefit of being an S corporation will be clearly documented—in actual sales price multiples!