Buy-sell agreements between Subchapter S corporations and bank directors

Kentucky Banker Magazine, Mar 2003 by King, Jim

The Internal Revenue Service (IRS) has issued a private letter ruling that may impact bank holding companies that seek to qualify, or continue to qualify, as Subchapter S corporations for federal tax law purposes. The IRS private letter ruling responds to an inquiry from a bank holding company about an agreement between the holding company and the directors of its subsidiary bank (the Directors Agreement). The IRS Letter discusses how the Directors Agreement may have resulted in the bank holding company having more than one class of stock, which under federal tax law would have disqualified the holding company from being treated as a Subchapter S corporation.

The IRS Letter is of particular interest to community banks and their holding companies. These entities may seek Subchapter S status and could have buy-sell agreements similar to the Directors Agreement. For example under 12 USC 72, directors of national banks must own "qualifying" shares subject to such agreements. This statutory qualifying share requirement is designed to ensure that national bank directors will have sufficient interest in their bank to induce them to be vigilant in protecting the bank's interests. State chartered banks no longer have such a requirement.

Under Subchapter S, a small business corporation can have no more than 75 shareholders. In order to limit the total number of shareholders to no more than 75, qualifying shares sometimes are subject to a buy-sell agreement that require a director to sell back the shares on specified terms upon ceasing to be a director. These agreements sometimes also provide that all dividends and other distributions from qualifying shares received by the director will be returned. These agreements and similar arrangements involving Director shares may, depending on their specific terms, affect the ability of a bank or its holding company to qualify as a Subchapter S corporation. Banks and their holding companies that have elected Subchapter S treatment, therefore, should review their qualifying share arrangements for compliance with all applicable IRS requirements.

Also under Subchapter S of the IRS Code, a corporation may have only one class of stock outstanding. A Subchapter S corporation is treated as having only one class of stock outstanding if all the shares confer identical rights to distribution and liquidation proceeds. A bona fide buysell agreement is generally disregarded for purposes of determining whether a corporation's outstanding shares confer identical rights to distribution and liquidation proceeds. However, the buy-sell agreement is not disregarded if, among other things, the agreement establishes a purchase price that, at the time the agreement is entered into, significantly deviates from the fair market value of the stock. According to the IRS Letter, buy-sell agreements "that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a purchase price that is significantly in excess or below the fair market value."

As indicated above, the IRS Letter involved a bank holding company that sold shares of it stock to the directors of its subsidiary bank subject to a buysell agreement. The Directors Agreement provided that each director of the national bank would sell his or her shares back to the holding company for the same price for which the director had purchased the shares upon the director ceasing to hold the office of director. The Directors Agreement also provided that each director would assign to the holding company all dividends and other distributions on the shares. Some time after putting in place the Directors Agreement, the holding company became concerned that the terms of the agreement may have inadvertently resulted in the creation of a second class of stock that would disqualify the holding company for Subchapter S treatment. The IRS Letter ruling confirmed that the above described arrangement would be construed as a second class of stock. Accordingly, the holding company amended the Directors Agreement to: (1) provide that the bank holding company would repurchase the shares at their fair market value and (2) eliminate the requirement that the directors assign dividends and distributions back to the bank holding company. The IRS Letter indicates that the amended Directors Agreement would not create a second class of stock.

As a private letter ruling, the IRS Letter is expressly nonprecendential and nonbinding upon the IRS. Banks should recognize, however, that its reasoning could be applicable to their situations. Accordingly, a bank that has a directors share arrangement similar to the one described in the IRS Letter may wish to consult competent tax counsel to ensure that the arrangement fully complies with all applicable federal tax requirements.

Submitted by Jim King, CPA, Chair, KBA Tax Committee