AL 2003-1
OCC Advisory Letter
 
Subject: Buy-Sell Agreements between Subchapter S Corporations and
National Bank Directors

Date: January 2, 2003

TO: Chief Executive Officers of All National Banks, Department and
Division Heads, and All Examining Personnel


PURPOSE

This advisory letter is intended to refer national banks, especially 
community national banks, that seek to qualify as Subchapter S 
corporations for federal tax purposes to an Internal Revenue Service 
ruling that may be relevant to them.


BACKGROUND

The Internal Revenue Service (IRS) issued a private letter ruling that
may be of interest to national banks and bank holding companies that 
seek to qualify, or continue to qualify, as Subchapter S corporations 
for federal tax law purposes. (A Subchapter S corporation generally is 
treated as a “conduit” for tax purposes.  The net income or loss of a 
Subchapter S corporation is passed through to the corporation’s 
individual shareholders, who include it in their individual tax 
returns.  Subchapter S status results in corporate earnings being taxed
only once, rather than being taxed twice like the earnings of other 
corporations, which are taxed once at the corporate level and then 
taxed again at the shareholder level when the earnings are distributed 
as dividends.  See 26 USC 1361 et seq.)  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). (Priv. Ltr. Rul. 2002-17-048 (Jan. 24, 
2002)(the IRS Letter).  The IRS Letter is available on the IRS Internet 
Website at http://www.irs.gov/pub/irs-wd/0217048.pdf.)  The IRS Letter 
discusses how the Directors Agreement may have affected the ability of 
the bank holding company to qualify as a Subchapter S corporation.  In 
particular, 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.
 
DISCUSSION

The IRS Letter is of particular interest to community national banks 
and their holding companies.  These entities often seek Subchapter S 
status and could have buy-sell agreements similar to the Directors 
Agreement.  Under 12 USC 72, directors of national banks must own 
“qualifying” shares.  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.

Under section 72, a national bank director generally must own a 
qualifying equity interest of $1,000 in the stock of a national bank or 
its holding company.  In an interpretive ruling, the OCC has stated 
that the qualifying equity interest may include common or preferred 
stock that has an aggregate par value of $1,000, an aggregate 
shareholders’ equity of  $1,000, or an aggregate fair market value of 
$1,000.  The value of the qualifying interest is determined as of the 
date purchased or the date on which a person became a director, 
whichever value is greater. (See 12 CFR 7.2005.)  The OCC also has 
endorsed legislation that would amend section 72 to enable the OCC to 
allow a national bank director to satisfy the qualifying share 
requirement by holding a subordinated debt instrument that would not be
treated as a separate class of stock for Subchapter S purposes. (See 
Financial Services Regulatory Relief Act of 2002, H.R. 3951, 107th 
Cong. 101.)   


Under Subchapter S, a small business corporation can have no more than 
75 shareholders. (26 CFR 1.1361-1(b)(1)(i).)  In order to limit the 
total number of shareholders to no more than 75, qualifying shares 
sometimes are subject to buy-sell agreements 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 
qualifying shares may, depending on their specific terms, affect the 
ability of a national bank or its holding company to qualify as a 
Subchapter S corporation.  National 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.


General Description of Relevant IRS Regulations

Under Subchapter S of the IRS Code (26 USC 1361 et seq),  a corporation
may have only one class of stock outstanding. (26 USC 1361(b)(1)(D))  
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. (26 CFR 1.1361-1(l)(1))  A bona fide buy-sell
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.  As 
indicated in 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.” (IRS Letter (citing 26 CFR 1.1361-1(l)(2)(iii))) 

Facts of the IRS Letter

As indicated above, the IRS Letter involved a bank holding company that 
sold shares of its stock to the directors of its subsidiary bank 
subject to a buy-sell agreement. (The IRS Letter also is relevant to 
situations involving a national bank that does not have a holding 
company.  Such a bank could also seek to qualify for Subchapter S 
treatment and have a qualifying share arrangement similar to the one 
described in the IRS Letter.)  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.  Sometime 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 holding company, therefore, 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 did not create a second 
class of stock.

CONCLUSION

As a private letter ruling, the IRS Letter is expressly nonprecedential
and nonbinding upon the IRS. (See 26 USC 6110(j)(3).)  National banks 
should recognize, however, that its reasoning could be applicable to 
their situations.  Accordingly, a national bank that has a qualifying 
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.




_____________________________
Julie L. Williams
First Senior Deputy Comptroller and Chief Counsel