In general, when an S corporation sells its assets, the gain on sale flows through to, and is reportable by, the shareholders and is not subject to a corporate level tax. In the case of an S corporation that previously was a C corporation, however, such S corporation is subject to a corporate level tax on its “built-in gain” if the asset sale occurs during the “recognition period.”
Generally, an asset’s built-in gain is the amount of gain that would be recognized if the corporation sold such asset immediately before it converted to an S corporation and the recognition period is the first ten years following the conversion to an S corporation. The recognition period was shortened to seven years for sales occurring during a taxpayer’s 2009 and 2010 tax years and to five years for sales occurring during a taxpayer’s 2011 tax year. The recently enacted American Taxpayer Relief Act of 2012 extended this shortened five-year recognition period for any built-in gains recognized during either the 2012 or 2013 tax years. For the 2014 and later tax years, the recognition period will again be ten years, unless legislation to the contrary is passed before then. Thus, an S corporation that converted from a C corporation at least five years ago should consider the tax benefits of an asset sale occurring in 2013 to avoid the corporate level tax on built-in gain.
If you would like to discuss how this matter may affect your bank, please contact a member of Bryan Cave’s Financial Institutions or Tax Advice and Controversy client service groups. We also encourage you to attend our 2013 S-Corp Conference.
In today’s environment, many bank directors are faced with difficult strategic decisions regarding the future of their organizations. We have been involved in many great board discussions of whether it is best for the bank to continue to grind away at its business plan in this slow growth environment or to look for a business combination opportunity that will accelerate growth. There is rarely a clear answer in these discussions, but some guidelines are helpful: All directors must respect the conclusion of the full board of directors and follow the appropriate process established by the board with respect to merger opportunities.
Over the years, we have seen a number of instances in which one or more bank directors conduct merger discussions with potential partners without bringing the opportunity to the full board of directors immediately. In many cases, these directors are acting in good faith and simply leveraging relationships they have with other bankers or bank directors. In other cases, these directors may feel the need to engage in these discussions because they disagree with the full board’s strategy of remaining independent. However, all directors should understand that it is in the bank’s best interest, and the director’s own personal best interest, not to take matters into their own hands without authorization by the board of directors.
In its earnings release issued on January 28, 2011, First Banks, Inc. (the “Company”) announced the successful completion of its consent solicitation addressed to the holders of the trust preferred securities issued by First Preferred Capital Trust IV (the “Trust”). The securities are listed on The New York Stock Exchange under the symbol “FBSPrA.” As a result of the consent solicitation, the Company was able to effect amendments to the related indenture, trust agreement and guarantee agreement that are designed to provide additional capital planning flexibility for the Company.
The amendments relate primarily to covenants restricting the Company’s activities during a period in which interest and dividend payments have been deferred in accordance with the terms of the securities. They provide an “exchange exception” to covenants against the Company’s or its subsidiaries’ acquisition of their capital stock during a deferral period, which the Company entered in September 2009. As a result of the amendments, the Company and its subsidiaries and affiliates may issue capital stock during a deferral period in exchange for or upon conversion of outstanding Company, subsidiary or affiliate capital stock or for outstanding Company indebtedness ranking pari passu with or junior to the debentures. The amendments also eliminate a covenant against the Company’s acquisition of any of the trust preferred securities issued by the Trust or less than all of the related debentures during deferral. These and other amendments are attached as exhibits to the Company’s Current Report on Form 8-K filed with the SEC on January 27, 2011 .
In the earnings release, the Company reported that the success of the consent solicitation better positions the Company to consider certain potential capital planning strategies to improve the its regulatory capital ratios and further strengthen its overall financial position.
Bryan Cave represented First Banks in the consent solicitation and has significant experience in dealing with trust preferred securities.
Court Highlights the Significance of Other Factors in the Bona Fide Prospective Purchaser Defense
Anyone who has been involved in a real estate transaction relating to commercial or industrial property has likely dealt with conducting “All Appropriate Inquiry” into the site, which generally includes the preparation of a Phase I Environmental Site Assessment and may include Phase II sampling work. All Appropriate Inquiry (“AAI”) is one necessary component of the “bona fide prospective purchaser” (“BFPP”) defense established under the 2002 Brownfields amendments to Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”). The BFPP defense is intended to protect property owners from liability for contamination that clearly occurred prior to their period of ownership. However, conducting AAI is not the only prerequisite to establishing a BFPP defense. The BFPP requirements beyond AAI are highlighted in Ashley II of Charleston, LLC v. PCS Nitrogen, et al., 2010 U.S. Dist. LEXIS 104772 (D.S.C. Sep. 30, 2010), one of the first cases to address in detail the BFPP defense.
In this case, Ashley purchased property that had a long history of industrial use. In conjunction with that purchase, Ashley’s environmental consultant performed Phase I and Phase II work. After the purchase, Ashley demolished many of the above-ground improvements on the property. When liability for contamination at the property was addressed, a significant battle between several potentially responsible parties arose. Ashley sought to take advantage of the BFPP defense to avoid liability. The elements of the BFPP defense are, in summary: (a) disposal of hazardous substance occurred prior to acquisition; (b) the purchaser conducted AAI; (c) the purchaser provided all required notices with respect to the discovery or release of any hazardous substance; (d) the purchaser exercises appropriate care with respect to hazardous substances found; (e) the purchaser cooperates with agencies; (f) the purchaser complies with institutional controls; (g) the purchaser complies with information requests or administrative subpoena; (h) the purchaser is not affiliated with a potentially responsible party. In the end, the court closely scrutinized each element of the test and determined that Ashley was not a BFPP.
All Appropriate Inquiry
Significantly, this is one of the first cases to address the proper conduct of AAI. The court found that although there were “inconsistencies” between the Phase I reports and the relevant ASTM standard, those inconsistencies lacked significance. The Court stated that “[w]hat is important is that Ashley acted reasonably; it hired an expert to conduct AAI and relied on that expert to perform its job properly.” Because the Court did not explain what the “inconsistencies” are, it is difficult to determine how strictly a Phase I must comply with ASTM. Interestingly, no federal agencies were involved in this case. EPA has stated that they will insist on very strict compliance with the ASTM standards in order to find that AAI was conducted. This case may (or may not) take some wind out of that sail. While strict compliance with the ASTM standards is still highly recommended, this case provides some potential relief for past transactions where the acquiring party is trying to mount a BFPP defense but the adequacy of its AAI is called into question due to the absence of strict compliance with the ASTM.
The court did find that Ashley failed to prove that it exercised appropriate care with respect to known contamination when it did its demolition work. In doing this work, Ashley did not clean out and fill in known underground sumps and concrete pads, which failure could have exacerbated known releases and contamination. Ashley also failed to prevent debris piles from accumulating, and failed to investigate and remove the debris piles on a timely basis. Ashley also failed to maintain run off controls.
Bryan Cave is co-sponsoring a one-day seminar for banks considering FDIC-assisted transactions as a growth strategy. The seminar is designed to provide an opportunity to get inside the process and find out everything you need to know to determine if an FDIC-assisted bank deal is an appropriate growth strategy for your bank!
Discounts are available for Bryan Cave clients. If you’re interested in attending, please contact your regular Bryan Cave contact person.
We have advised a number of banks on the feasibility of bidding to acquire the assets of failed institutions. The loss sharing arrangements currently being offered by the FDIC can be an attractive means to increase market presence or to expand into new markets.
The specific criteria used by the FDIC will vary from project to project based on the characteristics of the troubled institution, the time available for marketing, and other factors. However, the FDIC has indicated the following base criteria:
- Total Risk Based Capital ratio of 10% or higher
- Tier 1 Risk Based Capital ratio of 6% or higher
- Tier 1 Leverage Capital ratio of 4% or higher
- CAMELS composite rating of 1 or 2
- CAMELS Management component rating of 1 or 2
- Compliance rating of 1 or 2
- RFI/C rating of 1 or 2
- CRA rating of at least Satisfactory
- Satisfactory AML Record
The American Recovery and Reinvestment Act of 2009 (the “Act”) contained a number of tax provisions that are likely to be of particular interest to and will directly impact most, if not all, of our bank and other financial institution clients. One of the tax provisions, the provision increasing the period that a net operating loss (“NOL”) can be carried back from two (2) to up to five (5) years, saw the addition of a provision that will substantially limit the number of taxpayers eligible to take advantage of the expanded carryback period. The new limitation makes it likely that only smaller financial institutions will be able to take advantage of the expanded carryback period allowed by the Act. The Act also repealed (with limited transitional protection) the relief provided in Notice 2008-83 issued by the Internal Revenue Service (“IRS”) in the fall of 2008 that exempted certain losses on loans and foreclosure property incurred by banks from the NOL limitation rules applicable to built-in losses.
Increase in the Net Operating Loss Carryback Period
Original provisions coming out of the tax writing committees of the House and Senate included a provision extending the period in which 2008 and 2009 NOLs could be carried back from two (2) to up to five (5) years. The provision also eliminated the 90% limitation on the use of AMT NOLs that were carried back from 2008 or 2009. The limitations in the original provisions were that the expanded carryback period did not apply (i) if the bank or other financial institution received any money under the Troubled Assets Relief Program (TARP) (ii) to Fannie Mae, Freddie Mac, or (iii) any corporation that is a member of the same affiliated group for income tax purposes as a bank or other financial institution that received TARP funds.
The Act retains the expanded carryback period for NOLs, but only for those generated in 2008 (or, at the election of the taxpayer, taxable years beginning in 2008). Further, only taxapayers that are “eligible small businesses” may take advantage of the expanded carryback period. An “eligible small business” that elects may carryback a 2008 NOL for up to five (5) years. An eligible small business is a taxpayer having less than $15,000,000 in average annual gross receipts for the three (3) years prior to the year in which the NOL occurs. Thus, the usefulness to most financial institutions of the expanded NOL carryback provisions appears to have been severely limited by the change in eligibility requirements.
Repeal of IRS Notice 2008-83
The Act retains the provisions repealing IRS Notice 2008-83 originally included in the House bill and subsequently added to the Senate bill. An explanation of these provisions is set forth below.
The current versions of the economic stimulus tax bills under consideration by the Senate Finance and the House Ways and Means Committees contain two (2) provisions that are likely to be of particular interest to and will directly impact most, if not all, of our bank and other financial institution clients. The provisions are (i) changes in the rules allowing for the carryback of a net operating loss (“NOL”) of up to five (5) years instead of the current carryback period of only two (2) years, and (ii) a repeal (with limited transitional protection) of the relief provided in Notice 2008-83 issued by the Internal Revenue Service (“IRS”) in the fall of 2008 that exempted certain losses on loans and foreclosure property incurred by banks from the NOL limitation rules applicable to built-in losses.
Increase in the Net Operating Carryback Period
The provisions of the Senate Finance and the House Ways and Means Committees’ bills increasing the NOL carryback period to two (2) to five (5) years are essentially identical. The increased carryback period only applies to NOLs arising in 2008 and 2009. In addition, the 90% limitation (or the 10% haircut required) on the use of NOL carrybacks when computing a corporation’s alternative minimum tax is suspended. For those banks or other financial institutions with NOLs in 2008 and 2009, the bill will provide three (3) additional years (i.e., 2003, 2004, and 2005) from which they can obtain a refund of federal income taxes paid.
On January 2, 2009, the Wall Street Journal ran a story on the possibility of the FDIC agreeing to assume future losses on the troubled assets of a failed institutions. The FDIC has used versions of the loss-sharing model several times last year, but with the exception of the initial attempt to rescue Wachovia, only as part of the receivership of a failed institution.
“It is something that we plan on doing in the future where it’s appropriate,” says Herb Held, assistant director in the FDIC’s division of resolutions and receiverships. “I think it’s a good deal for everybody: the FDIC, the acquiring bank and the borrowers. It keeps the assets where they were.”
This leaves open the question of whether the FDIC will begin using a loss-sharing approach to facilitate open bank transactions. Some advisers believes that the FDIC will use this approach to effectively entice sound financial institutions to purchase struggling banks, or those which may be in imminent danger of failing. While there is no existing precedent during this period of economic turmoil, open bank assistance was a well regarded and oft used solution in earlier troubled times. Where FDIC does provide stop loss or other support, it comes ahead of shareholders in the troubled institution, so it does not help shareholders in most instances; however, it does prevent the extra disruption of a failure. Traditionally, FDIC officials informally estimated the additional loss upon a failure was at least 15% higher than the loss where the troubled bank is acquired by a healthy bank in an open bank transaction. As a result, properly structured stop loss or other assistance programs should save the deposit insurance fund real dollars.
For now, the FDIC appears tied to the position that it can only offer loss-sharing following receivership and a full auction of the troubled or failing institution in order to comply with its legal obligation to provide the least-costly solution. If a tangible proposal for a loss sharing were presented to a regional FDIC office, such a proposal would be have to be structured to assure “least costly” status and would be forwarded to DC for review.
Accordingly, we recommend that neither acquiring banks, nor troubled institutions looking to be acquired, put too many eggs in the basket hoping for FDIC loss-sharing assistance.
One of the consequences of the TARP Capital program is that some banks will use some of the capital infusion to acquire other banks. We believe that the “winners” in the TARP race will also attract additional private capital as investors decide who the long-term survivors are. The Internal Revenue Service recently released two notices intended to provide relief to banks and other financial institutions that are looking to raise capital from the tax rules limiting the use of losses after there has been an ownership change in the stock of a corporation. We believe that once it is widely understood by banks it will add momentum to the merger activity.
Generally, a corporation that has a taxable loss (i.e., tax deductions in excess of taxable income and gains) for federal income tax purposes during a taxable year generally may carry that loss back to each of the two (2) preceding years (to recoup federal income taxes paid in those years) and then forward to each of the following twenty (20) taxable years. There are special rules, however, that limit the use of a tax loss (commonly referred to as a net operating loss or “NOL”) carryforward that arose prior to the time when the corporation underwent an ownership change with respect to its stock.