The Sub S Bank Report – March 2013 (Volume 16, Issue 2)

The Sub S Bank Association leadership believes that the Basel III Capital NPR will be issued sometime within the next 45 days. In advance of the finalization of the rule, we held meetings in Washington DC with senior officials of the OCC and FDIC  to express the particular concerns of sub s banks.

The Association submitted a comprehensive comment to the agencies last year, one of an unprecedented 2000 comment letters that were received in response to the proposed rulemaking. While many banks and industry observers had hoped that the rule would be withdrawn or limited to only the largest and most complex organizations (where it was originally intended), the current expectation is that it will be issued and have broad application to all banks in the US.

The key issues for Sub S banks as expressed in the comment letter and as discussed recently with the Agencies are as follows:

• Increased capital requirements from the proposal including the capital conservation buffer which would prohibit payment of dividends and bonus’ in the event the buffer is not met.
• The  impact of unrealized gains and losses being a capital adjustment. 
• The elimination of trust preferred securities as a viable capital instrument despite the fact that Dodd Frank Section 171 (the Collins Amendment) specifically exempted banks under $15 billion and small bank holding companies.
• The chilling effect of increased risk rating on residential mortgages with balloon payment features, and the related QRM rules.
• Pension plan liability treated as an adjustment to capital.

The meetings which were held with the Comptroller’s senior staff and the FDIC were attended by 6 CEO’s from Subchapter S Banks from  different parts of the country as well as Sub S Bank Association leadership and senior staff from the American Bankers Association, who played a significant role in organizing the meetings. The group  provided a short primer on Sub S Banks and framed up the important value of the election in preserving community banks independence and viability. Specifically, each one of the banks described their own shareholder group and corporate motivations for making the election, affirming that they likely would not be around or independently owned except for Sub S.

Each described the impact of having AOCI as an adjustment to capital as well as the cumulative effect of the other capital and risk weightings changes proposed in the rulemaking. Emphasis was placed on the combined effect of all of these proposals on bank capital.

The group pointed out the inequality a Sub S banks suffers in comparison to a C corp banks in the application of these rules, because if dividends are prohibited, the Sub S shareholders must come out of pocket personally to pay taxes on attributed income. Specifically, we asked that the agencies permit sub s banks to permit a dividend regardless of the circumstances, in an amount which would be equal to the amount of taxes the bank would pay if it were a C corp.  This at least would put Sub S banks on an equal footing with C corp banks.

The agencies were well represented by senior leaders in their respective organizations. The message was respectfully and thoughtfully received. Because of the rulemaking process, none of the participants was able to comment or to provide any real reaction to our asks and key points. Reading between the lines; however, we think our concerns were taken very seriously and it was reiterated that the agencies had heard these same messages loud and clearly from many quarters. This gives us some hope for favorable changes to the original proposal.

A Similar meeting with the Federal Reserve Board Staff was held by telephone convference in which similar points were expressed by the Bank CEO Group.The fact that legislation in the Senate, Brown Vitter S.798, was introduced to make community banks subject only to prompt corrective action capital rules and not risk based rules, also seems to send a message to the agencies that there ought to be some distinction between community banks and the big guys.
We urge each of you to continue to send the message to your senators and congressman that we need regulatory relief and we need it substantively and quickly. There is a growing sentiment on Capitol Hill that something must be done and that it inevitably will be done. How quickly and how effectively will be up to the industry.

We urge a grass roots efforts by committed bankers to be outspoken and to provide some solutions. This is not something that can be delegated to trade associations but must be front line, certainly assisted and coordinated by them, but the real difference will be bankers talking to Members of Congress and the Senate, one on one and making the case for these distinctions.

Significantly, we encourage all to review the fine work of Richard Fischer, President of the FRB Dallas, who has been a thoughtful and articulate spokesman for community banks as well as a strong opponent of the concept of too big to fail, as well as to the implicit “subsidy” that big banks enjoy over small banks. While this has been talked about and written about for years, it is a highly important point that all Sub S banks and other community bankers need to continue to make.

Sub S Banks should continue to be vigilant about managing their shareholders to make certain that none become disqualified resulting in a termination of S status. The most common occurrences involve wills, estates and trusts. We recommend establishing some procedures which outline certain potential situations which could result in an S corp termination. These might be ase follows:

• Death of a Shareholder

identify the date of death, obtain a copy of the will and other probate proceedings, identify the estate plan and ownership of the sub s stock, set a deadline of not more than 22 months after date of death to communicate with Executors and/or heirs regarding the winding up of the estate. Make a determination with the assistance of counsel, whether the estate plan is reasonable and will continue to support qualification of the estate as an eligible shareholder.  Likely the only circumstances that would justify a delay in distribution of the shares from the estate would be utilization of the 15 year installment payment available to a small closely held corporation or a protracted tax/valuation dispute with the IRS.

• Trusts as Shareholders

Changes in types of trusts through death of beneficiaries or other changes in beneficiaries which might require an additional filing of a QSST or ESBT election.

If you suspect that you may have a problem, do not delay investigating. Contact competent counsel immediately to assist in evaluating the situation. Failing to take action can result in your never being able to remedy the situation. If you move quickly upon discovery and verification of an inadvertent termination, you will be able to report the situation to the IRS through a private letter ruling process. In this process, you must demonstrate that you acted promptly to remedy the situation and that you initiated and filed the private letter ruling within a few months of discovery. Delaying much more than that can result in denial of the “inadvertent termination” which could have disastrous results, particularly if years have gone by where S corps have issued K-1s and shareholders have paid individual taxes and the corporation has not paid C corp taxes when it should have. Penalties and interest and the resulting chaos would be significant.

Shareholder agreements should certainly contain clear obligations on the part of shareholders and their legal representatives to take action to protect the sub s election and hold them responsible.

In the event that an S corp must request a private letter ruling, the costs are significant. The filing fees with the IRS alone are $18,000.00 and this does not include legal fees incurred in investigating the situation, making the proper determination, preparing the ruling request, which is a very detailed recitation of the relevant facts as well as preparing a legal brief on the law and why the election should be considered inadvertent and as such permitted to conditionally be considered not to have occurred.

The implementation of the particular conditions in a favorable ruling request must be carefully implemented and care needs to be taken that a re-occurrence to does not happen.