Beginning this year, shareholders of S-corporation banks are eligible for the new 20 percent deduction on qualified business income (QBI). While the deduction should result in a reduced tax bill for those shareholders, other contributing factors could prompt some S-corp banks to consider converting back to C-corporation status.
H.R. 1, commonly known as the Tax Cuts and Jobs Act (TCJA), creates a new deduction for owners and shareholders of businesses that operate as so-called pass-through entities, including S-corps and partnerships. But it also slashes the corporate tax rate from 35 percent to 21 percent.
The New Provisions Affecting S-Corps
Previously, owners and shareholders of pass-through entities reported their allocable share of the business income on their individual tax returns and paid taxes on it at ordinary income tax rates as high as 39.6 percent (plus applicable state tax). The TCJA reduces the top individual tax rate from 39.6 percent to 37 percent for 2018 through 2025, while raising the taxable income threshold for the top rate to $500,000 for single filers and $600,000 for joint filers.
The QBI deduction generally allows taxpayers to deduct 20 percent of qualified income from a pass-through entity, not including compensation for services performed for the pass-through entity. The deduction is limited to the greater of 1) 50 percent of the W-2 wages the business paid that tax year or 2) 25 percent of the wages paid plus 2.5 percent of the unadjusted basis of qualified tangible depreciable property. However, a typical community bank should generate sufficient W-2 wages so that the 20 percent deduction should not be limited based on either of these thresholds.
Combined with the reduced top individual tax rate, the QBI deduction gives owners and shareholders in S-corp banks a maximum effective federal tax rate of 29.6 percent. A taxpayer subject to tax at the highest individual rate of 37 percent generally will save $740 in taxes for every $10,000 of pass-through income.
Limitations on the QBI Deduction
Although the QBI deduction generally will equal 20 percent of eligible pass-through income of the S-corp bank (generally, the income on a shareholder’s Schedule K-1, “Shareholder’s Share of Income, Deductions, Credits, Etc.”), certain limitations could affect individual shareholders differently.
The deduction is limited to 20 percent of an individual taxpayer’s overall taxable income on his or her personal return, which takes into account the other deductions applied to compute taxable income. For example, if a shareholder had $200,000 of pass-through income that qualifies for the QBI deduction and no other income, but also had $20,000 of itemized deductions that reduce taxable income to $180,000, the deduction is limited to $36,000 (20 percent of $180,000).
In addition, the QBI deduction does not apply to capital gains, dividend income, or portfolio interest that might be reported on an S-corp shareholder’s Schedule K-1. These items are considered investment income, rather than active business income. The deduction also is not available to offset the additional 3.8 percent tax on net investment income for passive S-corp shareholders.
The Double Taxation Dilemma
The considerations described earlier might lead S-corp banks to lean toward C-corp conversion, particularly given the reduction in the corporate tax rate to 21 percent, but it is worth remembering that S-corp shareholders will continue to enjoy the advantage of avoiding double taxation on their allocable share of the S-corp’s income. If a C-corp bank makes dividend payments to its shareholders, the payments are taxed twice, meaning the corporation and shareholders, on a combined basis, could end up paying more taxes than if the bank were operating as an S-corp.
Distributions to S-corp shareholders remain tax-free to the extent they do not exceed the amount of a shareholder’s initial basis in the stock plus her or his share of undistributed S-corp taxable income. Shareholders also benefit from a basis step-up for this undistributed S-corp taxable income, as well as certain tax-exempt interest income generated from the bank’s investment portfolio. The basis step-up provides the primary advantage of operating as an S-corp versus a C-corp.
Thus, conversion to C-corp status might be advantageous for banks that are in significant growth mode and not planning to pay dividends because they prefer to retain capital for future business needs. It also might prove appealing if the current shareholders expect to hold onto their shares on a long-term basis, possibly until death, at which point they will see an automatic step-up in basis to fair value.
S-corp status might provide another benefit for banks planning on selling in the near future, though. S-corps can more easily structure the sale as an asset purchase, in which the buyer can monetize the purchase premium in the form of a tax-deductible intangible, amortized on a straight-line basis over 15 years. Buyers often will consider paying a higher price for a transaction structured this way because of the tax advantages.
Not for Everyone
The QBI deduction should reduce the tax liability to shareholders of S-corp banks, and, in general, the longer-term benefits of remaining an S-corp likely outweigh the benefits of converting back to a C-corp. S-corp banks considering whether to convert back to a C-corp must carefully weigh the potential benefits and costs, though, taking into account their specific facts and circumstances, including those of their shareholders.