The Sub S Bank Report – June 2015 (Volume 18, Issue 2)

The Capital Access for Small Business Banks Act, H.R. 2789, was introduced into the House of Representatives by Congressman Kenny Marchant (TX –R) on Tuesday June 16, 2015. The introduction of the bill was the result of more than a years’ work by a dedicated group of industry leaders who came together through a grass roots effort led by the Subchapter S Bank Association. Prominent members of the Task Force include Cynthia Blankenship, Al Jones, Jim Goudge, Harold Reynolds & Keith Sebade, John and Marty Madden, Kirk Whorf, Guy Colado, Scott Wade, Jackson McConnell and Boyce Brown. Chris Williston from the Independent Bankers of Texas and his team have provided significant support and will continue to play an important role in building support for the bill. as well as other community bank associations that we have been in contact with.

Congressman Marchant was the perfect lead sponsor for this bill since he has a long history of service to and involvement and leadership in the community banking industry. He is a senior member of the Ways and Means Committee to which the bill has been referred. His staff has been very professional and thorough in preparing for the bill’s filing and has spent countless hours researching and discussing the bill with all of the regulatory agencies and many other constituencies. Mr. Marchant released the following statement after filing the bill.

“Small banks are vital to a healthy and growing American economy. Subchapter S banks in particular make up roughly one-third of all U.S. banks and 90 percent of them are located in rural communities. These local banks provide invaluable support to working families and have helped countless American entrepreneurs put their ideas in motion. Yet, when small banks seek to raise capital so they can better serve their communities, our tax code restricts their access to new investment. I have introduced theCapital Access for Small Business Banks Act to fix this problem.

“At a time when many small banks are struggling just to stay in business, H.R. 2789 would offer these trusted financial institutions greater freedom to take on new investors and raise capital. In doing so, the bill would bring renewed strength to Subchapter S banks, the communities they serve and the American economy as a whole – without added risk to the broader U.S. financial system. Most importantly, the Capital Access for Small Business Banks Act would bring us one step closer to a tax code that better supports American families and job creators. That’s what small banks and our local communities deserve.”

The Subchapter S Bank Association calls on all its members and associates to support this bill and ask their representatives in Congress to sign on as sponsors of the bill. We cannot emphasize the significance of bankers in Congressional Districts reaching out directly to their Congressional representative and/or their staffs and ask them to support the bill. The Association or a member of our Task Force will be pleased to follow up with Congressional representatives or their staffs with further details on the bill. We are in need of financial support to continue meetings in Washington to build support for passage of the bill. We ask you to email or call Amy Trevino at 210-551-0094 or atrevino@kslawllp.com for instructions on where to send checks, wires or other inquiries or expressions of support.

The law firm of Kennedy & Sutherland LLP which provides substantive content and direction to the Association has undertaken a professional leadership role with the task force and has conducted numerous meetings with the Tax Counsel for the Ways and Means Committee as well as a majority of the members of the Committee or their staffs. Numerous technical questions have arisen during the preparation of the bill and clearly will continue to arise during its journey to passage.For further information contact Amy Trevino at 210-551-0094 or atrevino@kslawllp.com.

Patrick J. Kennedy, Jr. is founder of the Subchapter S Bank Association and Kennedy Sutherland LLP, All rights reserved. This material is proprietary and may not be reproduced in whole or in part without written permission which provides comprehensive legal services to banks, bank holding companies, and directors, officers and shareholders. He can be reached at pkennedy@kslawllp.com or 210-228-4431.

Introduction
As counselors and advisors to community banks and bank holding companies, we often engage with our clients in strategic discussions and planning sessions about senior management succession, new products and services, the acquire or be acquired question, and capital planning. However, oftentimes when we try to engage the board in a substantive discussion about shareholder planning and the need to explore what liquidity options are, or should be, available, we are met with a look of confusion or complete reticence to engage in the discussion. For community banks to survive, even those that are very closely held, it is critical to begin a discussion about how aging shareholders or the next generation who may not be interested in the banking business are going to be cashed out and new shareholders are going to be brought in.

For community banks that are “family owned,” meaning one or several families are the largest shareholders and act in some form of board or management capacity with the next generation expected to step up to manage the bank, the board of directors may not see a need to engage in shareholder succession planning. And while keeping the bank largely family owned and operated sounds appealing (after all, Granddaddy said that we better not ever sell a share of bank stock), according to the Family Business Institute, only 30% of these businesses last into a second generation, 12% make it into the third generation, and a mere 3% operate into the fourth generation or beyond. So rather than leaving the legacy of the bank to chance, wouldn’t it make more sense to deploy those well-earned risk management skills in the practice of shareholder succession planning?

This article provides a brief overview of the benefits of an employee stock ownership plan (ESOP) and how they work. The second article in this series will discuss the use of subordinated debt as a tool for shareholder succession planning and the expanded limit of the small bank holding company policy statement to bank holding companies with assets <$1B.

Questions to ask:

•  If there are particular individual family members who are interested in and capable of leading the bank for the next decade or two, should the BHC look for a way to allow them to buy out existing shareholders who don’t have an interest in remaining active?
• While not a fun conversation to have, are there shareholders that need to be taken out because they are not going to provide any long term value to the BHC while other potential shareholders with the ability to create value sit on the sideline?
• Are there aging shareholders who are going to devise their shares to children or grandchildren with no real ties or interest in the BHC?
• Does the BHC have the ability (retained capitalat the BHC level, subordinated debt, BHC stock loan, etc.) to buy-out large shareholders as they get older and look for liquidity?
• Does the BHC need to explore the idea of an employee stock ownership plan as a succession planning measure to create shareholder liquidity, motivate employees, and remain locally owned?

As BHCs look for ways to manage their shareholder base and their future, the above questions need to be asked and discussed in a candid and productive way to ensure
the long-term viability of the bank and BHC. Below is a discussion about employee stock ownership plans (ESOPs) and its ability to facilitate the necessary shareholder
succession planning moves that might need to occur.

What is an ESOP?
An ESOP is “tax qualfied” defined contribution retirement plan which is designed to invest primarily in the bank’s stock. ESOPs are regulated by the Internal Revenue Service (Internal Revenue Code) and the Department of Labor (Employee Retirement Income Security Act) just like pension and 401(k) plans. Congress’ purpose in authorizing ESOPs was to encourage employee ownership and the opportunity to build equity and wealth among a broader base of individuals than would normally be possible.

Simply put: an ESOP is a way to provide employees the ability to invest in a BHC’s stock at no cost. ESOPs are also an incredible retirement plan option, as discussed
below under the [E&Y S corp ESOP Study] section.

ESOP Benefits:

Build employee engagement

• Attract top talent
• Establish a business succession plan or create shareholder liquidity
• Manage capital in a tax-advantaged manner
• Protect employees and the community
• Transfer wealth in a way no other retirement plan can do
• Encourage an employee ownership culture

ESOP Benefit as a Retirement Plan
Study Finds S ESOPs Total Return Beats S&P 500 by 62%, Employee-Owned S Corporations of America (Mar. 31, 2015), http://www.esca.us/news-room/
newsroom/2548?task=view.

Study by EY
WASHINGTON, D.C. (March 31, 2015) – New data compiled by EY’s Quantitative Economics and Statistics (QUEST) practice, shows that private employee stock ownership retirement plans (S corporation ESOPs) outperformed the S&P 500 Total Returns Index in terms of total return per participant by 62%, while net assets increased over 300%, and distributions to participants totaled nearly $30 billion from 2002 to 2012.

The EY study found that the total return for S ESOP participants from 2002 through 2012 was $99,000 for an 11.5% compound annual growth rate, 62% percent higher than the S&P 500 Total Returns Index’s 7.1% growth rate over the same period. Distributions to plan participants totaled nearly $30 billion in the same ten-year period, and paid significantly more benefits per participant than 401(k)s. 

“This striking new study confirms what our members know from direct experience,” commented ESCA Chairman Steve Smith, Vice President-General Counsel of Amsted Industries. “They know first-hand that S ESOPs are providing secure retirements for their workers and economic benefits to their communities. These compelling findings—showing strong and continuing growth in net assets, distributions, average account balances, and number of participants with accounts—make that even more apparent. S ESOPs are a model for how to make retirement security a reality for the broad American middle class.”

“The report finds that S ESOPs are providing an increasingly important role in supporting the retirement security of their participants,” said Robert Carroll, National Director of QUEST and one of the study’s authors.

Prior reports have shown that S ESOP companies have lower default rates and weather economic storms better than their non-ESOP counterparts. In 2014, the National
Center for Employee Ownership compiled new data showing that private employee-owned businesses default on their loans far less than other businesses. In 2010 by economists Phillip Swagel and Bob Carroll, both former senior Treasury Department officials, found that, during the most recent economic recession, S ESOP firms they
surveyed increased employment by nearly 2%, at the same time that overall, employment in the private sector fell by nearly 3%. In his 2013 study, Macroeconomic
Impact of S ESOPs on the U.S. Economy, economist Alex Brill of Matrix Global Advisors wrote, “Beyond the immediate benefit they provide to employees and customers, S ESOPs’ positive outcomes yield benefits to the U.S. economy broadly.” Brill’s analysis found that total direct and indirect output from these companies accounts for nearly 2% of gross domestic product.

How Does an ESOP Work?

An ESOP, like other tax qualified retirement plans, has a tax-exempt trust which holds the ESOP’s assets. There are two types of ESOP structures that may be utilized to acquire BHC stock: non-leveraged and leveraged.

Non-leveraged ESOPSs
A non-leveraged ESOP is funded through annual deductible contributions of cash or stock from the BHC to the ESOP which are allocated to each employee account according to the ESOP’s terms. A BHC can also give participants a special one-time opportunity to transfer 401(k) assets to the ESOP to purchase shares of stock through the ESOP. The later type of non-leveraged transaction is a special type of securities offering which is typically exempt from state and federal securities laws.

Leveraged ESOPs
ESOPs are the only retirement plan which can borrow money. A leveraged ESOP allows the ESOP to borrow funds from the BHC to purchase the stock which serve
as collateral for the loan until they are distributed to participants’ accounts in accordance with the plan document upon loan payments by the ESOP. The discussion and diagram below describe a typical leveraged ESOP where the BHC borrows funds from a third-party lender and then makes a loan to the ESOP. 

When the BHC issues a distribution to its shareholders, the ESOP receives the pro rata income for the shares it purchased and can use that income to make a loan payment ot the BHC, pay plan expenses, pay benefits or save the distribution to acquire additional shares at a future date. If the distribution is used to make a loan payment, the BHC can use the loan repayment from the ESOP to make payments on its loan from the third-party lender.

Through an ESOP employees are able to acquire BHC stock without paying income tax on the stock at the time it is allocated to their ESOP account. The BHC receives the benefit of using pre-tax dollars to provide liquidity for shareholders who want or need liquidity while optimizing its shareholder base, and it provides a tool to finance future growth.

Some additional points about ESOPs:

1. Under Section 1042 of the Internal Revenue Code, if the ESOP acquires 30% or more of the outstanding stock of a privately-held company, any capital gains tax on the transaction is deferred indefinitely, provided that the seller reinvests the proceeds in “qualified replacement property” within 12 months of the date of sale. This is only available to C Corp ESOPs, though legislation has recently been introduced in Congress to extend this treatment to S Corp ESOPs as well.
2. Unlike a sale or merger, the ESOP enables the seller to sell any portion of his or her stock. A sale or merger usually requires the seller to sell 100% control.
3. The ESOP enables the company to repay principal on a third-party loan with tax-deductible dollars.
4. In a C Corp ESOP, dividends paid on stock held by an ESOP are fully tax-deductible, provided that such dividends are either passed through to participants or are used to make principal or interest payments on an ESOP loan. S Corp ESOPs are not subject to federal income tax on earnings or dividends.
5. In the case of an S corporation, the ESOP’s share of S corporation earnings is not subject to federal or state corporate taxation or to taxed as “unrelated business taxable income,” unless the ESOP runs afoul of certain “anti-abuse” provisions. Thus, in the case of a BHC that is 100% owned by its ESOP, the BHC’s earnings will be entirely tax-exempt.
6. An ESOP enables controlling shareholder employees to keep control until they are ready to fully retire. When the owner does retire, the ESOP enables the owner to pass control to management.
7. An ESOP enables an owner to provide for business continuity for the bank he or she has grown and nurtured over many years. Unlike a sale or merger, an ESOP enables a company to retain its separate identity rather than become a branch or division of a larger company.
8. An ESOP enables a bank to attract, retain and motivate key employees through offering employees the ability to beneficially own stock.
9. Studies have shown that ESOP-owned companies become more productive and profitable than comparable firms in the same industry that are not ESOP-owned.

As briefly demonstrated above, ESOPs are a powerful tool at the disposal of S corporations willing to devote the time and resources required to effectively implement an ESOP strategy. An S corporation ESOP can generate liquidity for shareholders and aid in succession planning, provide employees with an incredibly taxefficient
retirement savings plan, and ensure the overall health of an organization by creating owners out of the stakeholders (shareholders and employees alike) that are vital to the long-term success of the company.

William “Dub” Sutherland VI is a partner at Kennedy Sutherland LLP and advises the firm’s banking, business and not for profit clients on a range of corporate and strategic issues. He can be reached at 210-228-4444 or dsutherland@kslawllp.com.

The author wishes to express his gratitude to Alex Mounts, a partner at Krieg|Devault LLP for reviewing and providing editing on certain techincal provisions of this article.

This spring the Association hit the road, traveling to to meet with bankers in Minnesota, Illinois, Florida, Missippi
and Louisianna.We want to thank all the bankers who attended and especially the Illinois Bankers Association,
Silas Simmons, LLP, and Commerce Street Bank of Winter Park, FL for helping us coordinate each of our events.
The goal of each regional meeting was for fellowship, to learn more about the activities of the Sub S
Bank Association, meet other Sub S bankers from the region in an informal setting, and to ask questions
and discuss specific Sub S issues. At each meeting our attendees discussed challenges & opportunities
in managing Sub S shareholders, regulatory matters and specific thoughts on succession planning.
Below please find a summary of what our meetings covered:

BACKGROUND ON SUBCHAPTER S BANKS
Subchapter S Bank Profile

• -One third of the banks in the United States have elected Subchapter S tax treatment (approx. 2,200 today)
• 90% of those are under $1 billion in total assets
• 90% of those are located in rural communities across the country (defined by US Census as 1,000 persons per square mile)
• 88% of those are in even smaller communities (500 persons per square mile)
• Subchapter S Banks make nearly twice as many small business loans as C corp. banks

Unique Capital Challenges
Because Sub S banks are limited to 100 shareholders and a single class of stock, they have a particular challenge obtaining capital to grow; thus the need to increase the number of shareholders and provide the opportunity to issue preferred stock ( a nondilutive popular way for banks to obtain capital).

The Dodd-Frank Act, Basel III and the general regulatory environment have increased the pressure on banks to raise capital and Subchapter S banks in particular face a threat that the regulators will limit allowed dividends to pay individual taxes – a terrible situation which has led to the termination of over 100 Sub S elections by banks in the US over the past 4 years.

CAPITAL ACCESS INITIATIVE FOR SUBCHAPTER S BANKS UPDATE

Regulators Approve of the Initiative

Last October, we led a group of Sub S Bank CEOs to discuss this initiative with senior staff of the Federal Reserve, the Comptroller of the Currency, and the Conference of State Bank Supervisors; all of the agencies and CSBS are supportive of the initiative and indeed seemed genuinely interested learning some of the above facts and data about Sub S banks.

Discussions with Ways and Means Committee Members
After our initial meetings in October 2014 we initiated conversations with the staff of the House Financial Services Committee and key members of the Committee. Since the jurisdiction on the bill lies within the Ways and Means Committee, we began meetings with members of that committee and their staffs, as well. In addition, we initiated conversations with tax counsel for the committee.

We also have held extensive discussions with an important member of the Senate Finance Committee whose staff has assisted in many of the procedural and political discussions. 

These discussions have taken place over the past 6 months and there seems to be good support for the bill and no real opposition. So far the bill has three co-sponsors: Congressman Lamar Smith (R-TX), Congressman Diance Black (R-TN) and Congressman Blaine Luetkemeyer (R-MO). We have targeted Representatives of the Ways and Means Committee and have met with over 20+ staff members regarding the initative with several of them still exploring co-sponsorship of the bill.

Our conversations with Ways and Means Committee staff have been productive but, as tax lawyers, they have a bias towards keeping Subchapter S “simple,” especially
regarding the preferred stock opportunity. Nevertheless, they do understand the need Subchapter S Banks have for more ways to access capital and raised the idea of
permitting banks to organize as limited liability companies.

LEGISLATION TO ALLOW PASSTHROUGH TAX TREATMENT FOR LLC BANKS

We have been studying the idea and presented a position paper to the staff and members during our most recent visits. The plan was very well received and drafting of
these additional provisions is under way in cooperation with the Committee staff. Interestingly the idea of allowing banks to be organized as LLCs is precisely how
the amendment to Subchapter S of the Code occurred in 1996 which allowed banks to elect S tax treatment.

Background on Limited Liability Company Banks
In 1993 Texas passed the Texas Limited Banking Association which allows banks to organize as LLCs and be taxed as passthrough entities, but the IRS in a special ruling
request we had submitted determined that banks could not be organized as flow through entities and the following year added banks to the list of per se corporations, part
of the entity classification regulations. The crux of their rational was that banks were required to be corporations under the Federal Deposit Insurance Act and National
Bank Act and therefore could not be “unincorporated business organizations,” taxed as partnerships.

The IRS took this position (we believe incorrectly) despite the fact that the FDIC authorized certain limited liability company banks to obtain federal deposit insurance. FDIC regulations provide that certain limited liability company banks can be considered “incorporated” for purposes of the Federal Deposit Insurance Act if they are organized with the traditional attributes of a corporation, including (i) perpetual duration, (ii) free transferability of interests, (iii) limited liability, and (iv) management authority vested in a board of directors or managers with substantially similar rights and responsibilities as a board of directors of bank chartered as a corporation.

In anticipation of the negative action by the IRS, we asked then Chairman Archer to consider legilegislation that would fix the IRS’s concern over the Texas LBA statute or consider allowing banks to elect Subchapter S tax treatment, which would benefit all banks in the United States. He selected the S corporation route in October 1995 and the following year, we got the legislation passed. This effort was very much a “grass roots” effort led largely by individual bank owners and professionals, including our law firm.

Flexibility of LLC Banks
Allowing Banks to convert to LLCs would be another welcome addition to community banking and would go a long way towards improving capital access for banks
in a passthrough environment. In essence, an LLC bank would not be constrained by the Subchapter S shareholder rules and limits, but would be free to have any shareholder they wished including limited partnerships, other LLCs, IRA’s, any trusts or other forms of business organizations, individual and foreigners. There effectively would be no limit on the number of shareholders until you reached the publicly traded status of 2000 or more.

There are some important differences that LLCs have compared to corporations in the way they are managed, treatment of employees versus partners, and other technical
issues that will need to be addressed; however, we believe the advantages of this form of business organization would far outweigh the concern presented by some of these issues. In addition an LLC cannot presently have an ESOP.

Legislation will now include provisions allowing banks organized as LLCs to be taxed as partnerships With the support of the Ways and Means Committee staff
and key members of the Committee, legislation is being drafted which will permit limited liability company banks to be taxed as partnerships under Subchapter K. In addition to specifically permitting passthrough tax treatment for LLC banks, the legislation will permit existing S corporations and C Corporations to convert to a limited
liability company under state or federal law (national banks and federal thrifts) without the tax implications of a deemed liquidation. We anticipate this window of
tax-free conversion would be for at least 3 years, giving organizations time to study and organize their plans.

FLOW THROUGH TAX TREATMENT FOR BANKS IS CRITICAL FOR INDUSTRY SURVIVAL

We believe having passthrough status under Subchapter S is the reason so many community banks are still around and competitive; the only other way to unlock value in a C Corporation (efficiently) is to sell. Anecdotally, we have had many bank owners tell us if it were not for Subchapter S tax treatment they would have sold their bank long ago. 

Grassroots Involvement from the Industry is CriticalThe legislation that was passed in 1996 permitting banks to elect Subchapter S tax treatment was the result of an
intensive grass roots effort among bankers and bank owners who had the vision and foresight to see and understand the far reaching benefits that passthrough tax
treatment would have on the industry. There was very little involvement from any national associations in the movement to get Subchapter S, but rather individual
effort and support from bankers and professionals, including our law firm. While we do have the support of ICBA and ABA, as well as many state associations and organizations such as The Bank Holding Company Association, we cannot over-emphasize the importance of financial and personal support of individual banks.

S CORP ESOP BILL PROVIDES EXCELLENT ADDITIONAL OPPORTUNITIES FOR BANKS

U.S. Representatives Dave Reichert (R-Washington) and Ron Kind (D-Wisconsin) introduced a bill to encourage the creation of S Corporation Employee Stock Ownership Plans (S ESOPs). The Promotion and Expansion of Private Employee Ownership Act of 2015 (H.R. 2096) includes provisions to encourage owners of S Corporations to sell their stock to an ESOP, expand financing opportunities for S Corporation ESOPs, provide technical assistance for companies that may y be interested in forming an S Corporation ESOP, and ensure that small businesses that become ESOPs retain their Small Business Association certification. Similar legislation has been introduced in the past.

“This legislation is critical to giving employees ownership over their work and retirement in a time when many people are concerned about their retirement
savings,” says Reichert.

“By making it easier for companies to become employeeowned, this legislation will not only grow the number of employee owned businesses, it will provide retirement
security to more Americans,” Kind adds.

“Employee-owned companies perform better – not just for themselves but for every one of their employees as well.” “We need policies to encourage employee stock ownership, and the proposed policies in H.R. 2096, should address core social issues such as adequate retirement security and making sure working Americans have an ownership stake in our capitalistic system,” said ESOP Association President, J. Michael Keeling, in a statement.

• Congrats to Jill Castilla (Citizens Bank Edmond) onbeing named one of Power Woman in FinTech.
• Congrats to BankSouth on being named one of the top 20 Performing Community Banks in the Nation by Independent Banker.
• BankSouth has elected former CEO and President of Georgia Power to Board of Directors, Michael D. Garrett. Mr. Garrett will join of Kay Ford and Gene Kirby who were appointed in late March.
• Jeff Newgard has been appointed president and CEO of the Bank of Idaho, effective July 6.
• Congrats to Armstrong Bank on its purchase of Benefit Bank.

To further foster community among Sub S banks we would like to solicit news and updates from members to be included in future issues. If you have an annoucement, question, or article you would like to share please email atrevino@kslawllp.com for consideration.

LEGISLATIVE WATCH

• S Corporation Modernization Act of 2015 (HR 2788) by Congressman Dave Reichert (R-WA) and Congressman Ron Kind (D-WI). Similar legislation was introduced in 2013.
• The Capital Access for Small Business Banks Act (HR 2789). Read the ICBA’s letter supporting the bill: http://www.icba.org/files/ICBASites/PDFs/ltr062515.pdf

The Association is still following HR 1233 (The Clear Relief Act of 2015), HR 1259, HR 1266, HR 88, S. 423

In the first quarter bank report we provided an update on what you need to know for .BANK. On June 16th, the Sunrise period closed with 782 financial institutions applying for .BANK domains. The General Availability period, for all eligible members of the banking community to register .BANK domains, opens at 8:00 p.m. EDT on June 23. All domains will be awarded on a first-come, first-served basis. If you have any questions or need any assistance please reach out to us at 210-551-0094.

18th Annual ConferenceOctober 28-29, 2015

St. Anthony Hotel, San Antonio, Texas
REGISTER NOW AT: http://conta.cc/1Ni5dum

AGENDA (as of 6/1/15)

Wednesday, October 28, 2015

7:00 – 8:15 am Registration/Continental Breakfast
8:15 – 8:30 am Welcome/Opening Remarks
8:30 – 9:30 am Legislative & Regulatory Update
9:30 – 10:00 am Economic Outlook
10:00 – 10:15 am Break
10:15 – 11:15 am Accounting Update
11:15 – 12:15 pm Tax Update
11:15 – 1:15 pm Lunch and Speaker:
1:15 – 5:00 pm Break Out Sessions:
5:00 – 7:00 pm Reception

Thursday, October 29, 2015
7:00 – 8:15 am Continental Breakfast
8:15 – 10:00 am Investment Portfolio Panel
10:00 – 10:15 am Break
10:15 – 11:00 am M&A Purchase Accounting
11:00 – 12:00 am Exhibits
12:00 – 1:15 pm Lunch and Speaker:
1:15 – 3:00 pm Break Out Sessions