The Sub S Bank Report – May 2012 (Volume 15, Issue 1)

   2012 marks the 15th Anniversary of the founding of the Sub S Bank Association (the “Association”). To mark this important year, our 15th Annual Conference will be held November 8-9th, 2012 in the heart of downtown San Antonio at the Omni La Mansion Hotel, the original site of the first Annual Conference.

     Since the legislation was first enacted permitting banks and thrifts to elect Subchapter S tax treatment in 1997, over 2500 banks and thrifts have become Subchapter S corporation banks. The elimination of double taxation has significantly benefited the banking industry. Pass-through taxation has permitted increased net income and created opportunities for shareholder cash flow far in excess of what had previously been possible under the traditional C corporation structure. Clearly, however, shareholders in S corporation banks have paid significantly more taxes due to the fact that such shareholders recognize and pay income tax on bank earnings.
     This sharply contrasts the credit union world, where no income tax is paid at either the entity level or the shareholder level. This incredible “subsidy” has undoubtedly created a significant advantage for credit unions and a substantial disadvantage to banks, once credit unions were given the power and authority to compete with the banking industry, which its members are always seeking to broaden.
   The Association was formed after the enactment of the legislation permitting Subchapter S elections for banking institutions to make certain that the right to make such elections was not diminished, as well as to serve as an educational forum for many of the unique opportunities and challenges that the Subchapter S election presents. Since its inception, the Association has been a medium for similarly-minded bankers to advocate for legislative, regulatory and judicial change or problem solving.
     Although some thought that the value of the Association would wane after the first few years, anyone who attended the most recent Annual Conference can attest that the substantive content put forward by the Association continues to be incredibly valuable for our members, with new ideas and issues constantly being generated. With 1 1/2 days of panels consisting of 21 presenters and hundreds of pages of material, it is difficult to highlight only a fraction of such an informative event; however, I have attempted to distill what I considered to be the top ideas/topics of interest discussed at the Annual Conference.
     1) Jeff Caughron of the Baker Group and Randy Rouse, Chief Investment Officer of Broadway Bank emphasized the increased need for a disciplined investment strategy during uncertain economic times. Since many S corporation banks invest heavily in municipal securities, the need to be particularly vigilant to the institution’s portfolio is heightened in these challenging regulatory and economic times. Strict credit analysis and documentation should be maintained on each security well in advance of purchase and monitored frequently. Today’s low rate environment coupled with weak loan demand and strong deposit growth requires institutions to routinely undertake important liquidity scenarios, taking into consideration the bank’s profile in both ordinary times and potentially stressed times.
     2) Paul Sirek of Eide Bailly, LLP provided a very informative presentation extolling the benefits of Subchapter S elections for financial institutions, even when such institutions are in distressed situations. Given the significant economic challenges banks have faced over the past several years and the increasing regulatory aggressiveness, some S corporation banks have been forced to terminate or consider terminating their S corporation status, largely as a result of the unwillingness of federal regulators to permit distributions in order to make shareholder tax payments. A number of important issues should be considered when evaluating whether to terminate your election. In particular, post termination distributions, accounting, income allocation and potential benefits derived from switching back to booking deferred tax assets, returning to the accrual method of accounting and utilizing the reserve method of allocating for loan losses should be considered by an institution contemplating a shift to C corporation status.
     3) Dave Silagi of Crowe Horwath, LLP shared a number of key tax issues and opportunities for S corp banks of recent importance:

a) There is a special election which permits allocation of income and expense when a transfer or issuance of 20% or more of an S corp stock is involved [under Reg. Sec. 1.1368 – 1(g)]. The benefit is that a seller will no longer be allocated income after the shares are transferred and a buyer will be allocated losses incurred after the transaction date.
b) A growing number of IRS audits have been requiring the capitalization of OREO carrying costs on non-income producing properties on the theory that such OREO is “inventory” for resale. This is in contrast to the common position that such costs are currently deductible because the properties are acquired in the ordinary course of the loan relationship to mitigate loss and are generally not anticipated to be sold at a profit.
c) The IRS has been challenging the deductibility of success based M&A fees unless hourly time documentation exists. However, Rev. Proc. 2011-29, adopted in April 2011, provides a safe harbor election to treat 70% of such fees as deductible and 30% capitalized without any documentation.

    4) Sharon Hearn and Alexander Mounts of Krieg DeVault provided an excellent presentation on the use of ESOPs by S corporation banks. While the issues are too numerous and complex to try to capsulate here, we do think that Mr. Mounts’ point about the special “capital-raising features” of ESOPs warrants special attention. As described, participants in a 401k can transfer assets to the ESOP that can be used to purchase bank stock, thereby increasing capital. Cash contributed by the bank to an ESOP increases capital through the purchase of newly issued shares. If distributions are made in stock, capital is increased.
     5) Jon McDowell and Debbie Scanlon of BKD covered a number of emerging accounting issues including credit disclosures, goodwill impairment and accounting for leases. Perhaps most compelling was their discussion of Troubled Debt Restructuring and new guidance issued by FASB in ASC 310-10-35. Regulators are placing much greater emphasis on TDR identification and reporting. Importantly, the valuation questions are significant. According to the new guidance, a TDR should be valued based on the present value of cash flows of the original loan rate, the fair value of the loan, or the collateral (if the loan is collateral dependent and foreclosure is probable). There can be a very significant difference between these two valuation measures and that difference is required to be charged off as a valuation allowance. Regulators are pushing for more collateral-based valuations, even when foreclosure is not probable.
     As you can see, the Association continues to provide a wealth of up-to-date information for our members. We look forward to another successful year and hope that you join us in celebrating our 15-year dedication to Subchapter S banks this November in San Antonio.

     The Communities First Act (H.R. 1697) (the “Act”) has received renewed attention from many of the industry’s leading trade associations with Congress moving into its 2012 legislative session. Most recently introduced by Representative Blaine Luetkemeyer (R-MO) in May of 2011, the bill has since been stalled in committee hearings despite significant backing of cosponsors in the House. The bill’s Senate counterpart, S. 1600, has remained in the Senate Committee on Finance since last September.

Reduction in Federal Income Tax Liability

     The most widely publicized feature of the Communities First Act is the bill’s Title IV, which grants certain financial institutions tax credits to offset their respective federal income taxes. Under the Communities First Act, C corporations falling within the definition of “community bank” would have their federal income tax liability reduced by 20%, to a maximum of $250,000. For such banks located in economically distressed areas, the institutions’ tax liability would be reduced to an even greater extent—50% or $500,000. Subchapter S banks would be permitted to obtain similar incentives under the Communities First Act. The bill would amend Section 1366 of the I.R.C. to reduce the net amount required to be taken into account by the shareholders of a Subchapter S community bank by 20% or $1,250,000. As with C corporations, the reduction is increased to 50% (or $2,500,000) for Subchapter S banks operating in economically distressed areas.
     The Communities First Act defines “community bank” as any bank, bank holding company, savings association, or savings and loan holding company with gross assets of $10 billion or less. The economically distressed areas referred to within the bill are (i) empowerment zones and enterprise communities designated under Section 1391; (ii) renewal communities designated under Section 1400E; (iii) low-income communities, as defined in Section 45D; and (iv) distressed communities, as defined in 12 U.S.C. 1834a(b)).

Subchapter S Reform

     Not to be overlooked, Title V of the Communities First Act would substantially level the playing field for financial institutions operating under Subchapter S restrictions. Section 501 of the bill would amend the tax code to increase the present shareholder limitation from 100 to 200 shareholders. The Act would also incorporate a new subsection (h) to Section 1361 of the federal tax code. Subsection (h) would permit qualified preferred stock to not be treated as a second class of stock. If adopted, sub-section (h) would allow Subchapter S banks to seek capital contributions from investors in preferred stock without running afoul of the one class of stock prohibition imposed upon Subchapter S corporations. Furthermore, under the Act, holders of qualified preferred stock would not be deemed shareholders of the institution. Consequently, Subchapter S banks would not be handicapped by shareholder limitations (even if increased to 200) when formulating their capital raising strategies in consideration of qualified preferred stock. Finally, all IRAs would be permitted trusts qualifying to be shareholders in S corporation banks. Under the Act, the restrictive “as of the date of the enactment of this clause” provision presently in effect would be removed from Section 1361(c)(2)(A)(vi). Such change would open a large door for Subchapter S banks that has been closed since the statutory scheme’s inception.

Do Your Part

     The Communities First Act contains bold proposals to return the competitive advantage of financial institutions’ Subchapter S elections back to such entities and to level the playing field for community banks across the country. The Congressional Budget Office has not yet weighed in on the feasibility of the proposals suggested under the Communities First Act, and as with any federal legislation, the report from the CBO can often be a decisive factor in the future prospects of pending legislation. Accordingly, the bill will have its best chance at becoming a reality only if more support is gained before the bill is sent to the CBO. Furthermore, as reported by IBAT President Christopher Williston earlier this January, the Act is poised to soon make it to the House floor for open debate. Recognized support for the initiative will be critical to its successful debate in the House. The Subchapter S Bank Association is dedicated to supporting the Communities First Act and needs the concentrated effort of all its members to move this bill forward in Washington. Members are strongly encouraged to contact their respective congressional leaders in order to garner as much support as possible for the Act.

     Uncertainty this term seems to sum up the current banking environment better than any other single word. Unfortunately for Subchapter S banks, the possibility for tax reform means that uncertainty has a farther reaching effect. While all banks share in the possibility of reduced earnings for the foreseeable future, Subchapter S banks must confront the possibility that reduced earnings and a number of internal or external events and circumstances may cause the bank to reconsider whether or not to maintain their status as an S corp.
     A decision of this magnitude should be approached carefully and thoughtfully. It must weigh short term needs with long term objectives and chart the most prudent course. Here we try to outline some of the potential triggering events for evaluating the termination of S corp status and how to approach the conversation with your board and shareholders.

Potential Causes of Considering S Corporation Termination

     Slow or no earnings growth combined with regulatory enforcement actions, that may include dividend restrictions, create a unique business challenge for Subchapter S banks. Further, many banks are ex-periencing balance sheet growth, due to an increase in deposits, without corresponding interest income, and therefore must face the possibility of terminating their Subchapter S election due to pressure on their tier 1 leverage ratio, despite the fact that their risk weighted capital ratios are more than sufficient. Why is this?
    In most instances, the source of a bank holding company’s cash flow is dividends, which require earnings from the bank. If a bank has experienced loan losses, increased loan classification levels, or increased deposits, to name a few instances, there may be stress on the bank’s capital levels which can result in a de facto inability or regulatory barrier to paying dividends to the holding company.
     Even if earnings are sufficient at the bank level to pay a dividend to the bank holding company, there may be other considerations and expenses which prevent the bank holding company from distributing to shareholders. The result of this restraint on dividends to shareholders is that the shareholders must satisfy the income tax liability created by the bank or bank holding company through their own means, rather than relying on the dividend from the bank or bank holding company to cover such liability. Some shareholders may not have sufficient cash flow to meet that burden, and may have to borrow against or sell their bank or bank holding company stock in order to meet their tax obligations. However, limitations on the number of shareholders and the specific problems that have put the bank in a situation where dividends are restricted, create a situation where it will likely be difficult for a shareholder to sell shares in order to pay their tax liability.
     If your bank has sustained losses and has been previously paying out most of your earnings for taxes, you may have little or no AAA (discussed below) from which to dividend funds to pay new taxes due.
    A bank can rebuild their AAA through regular earnings or through a gain on the sale of assets, for example a branch or other asset sale.

Re-electing as a Subchapter S Corporation

     One reason for careful consideration before terminating your status as an S corp is the fact that the bank will have to wait five years before it is eligible to reelect. Former Sub S banks are eligible to apply for reelection status with the IRS before five years, but waivers are only allowed in a limited number of circumstances. The most likely scenario for reelecting Subchapter S status prior to five years is in a situation involving new majority ownership. Where there is a change in control of greater than 50 percent of the bank or bank holding company, there may be an opportunity to obtain an exemption to the five year waiting period.

Keep the Big Picture in Mind

     Be certain that you have good financial statements including parent-only, consolidated and bank-only statements. You should ensure that someone maintains your S corp capital account balances and presents them in such a way that they are easy to review and discuss. The capital accounts discussed below are typical for an S corp, assuming that the C corp that preceded the S corp had earnings and profits:
     1) Accumulated Adjustment Account (“AAA”) – The AAA is a cumulative total of undistributed net income items (excluding tax exempt income), and any distributions to shareholders from the AAA are not taxable. On the first day of the first year for which the corporation is an S corp, the balance of the AAA is zero. The AAA is increased by income and keeps track of cumulative amount of net taxable income that has not yet been distributed by the S corp.
   2) Earnings & Profit (“E&P”) – This account holds C corp accumulated earnings that are retained by the S corp after an election. Any dividends paid from this account are taxable.
      3) Other Adjustments Account (“OAA”) – The OAA is used as a reconciliation account for S corps that have accumulated E&P. It is used to determine basis where nontaxable events have occurred. It is increased by tax-exempt income and decreased by related expenses and distributions to shareholders from the account.
     If your bank does not currently have the tools to project income and expense at the holding company level as well as cash needs at the holding company and shareholder level, you should develop them in conjunction with the exercise of reviewing your capital accounts. This kind of information bears reviewing at least semi-annually at banks with solid earnings and strong asset quality, and much more frequently if you are in a situation involving low or no earnings, losses, or are facing the prospect of sharp losses due to loan write-offs.
     Special bank rules also govern the bank’s ability to pay dividends. Under 12 U.S.C. § 56 (for national banks) and Regulation H (for state member banks) dividends may be paid in an amount not to exceed the sum of the bank’s undivided profits or net income during the calendar year and the retained net income for the prior two calendar years, respectively. As such, even if the consolidated entity has positive AAA for S corp dividend purposes, other regulatory restrictions may affect the organization’s ability to maintain its dividend flow and, ultimately, its S corp election.
     Timing is important also. If, for example, an S corp bank has had a financial loss in one year and recovers the following year, losses sustained at the shareholder level can be carried forward to reduce tax liability created in the following year and potentially resolve any potential income created by having S corp income without an ability to dividend cash to pay taxes on such income.

Preparation and Planning

     Practically speaking, what can be done to prepare the bank or bank holding company for this potentiality? If you find yourself facing asset quality issues, low or no earnings, or potential regulatory action from your prudential regulator, make sure your bank and bank holding company board are apprised of the situation and keep the conversation going. Knowing in advance can frequently save a lot of time, trouble and money. Also, it is best to involve legal, accounting and tax advisors in the planning of S corp change occasioned by abnormal swings in income or circumstances where dividends may have to be suspended.

     After beginning the year with renewed optimism and brightening prospects for more economic vigor, one month into the second quarter finds many observers wondering if the bloom is, once again, off the rose. The 3% GDP growth in the final three months of 2011, while still anemic by historic post-recession standards, created high hopes for 2012. Steady declines in the unemployment rate coupled with substantial growth in the manufacturing sector seemed to, at long last, provide evidence of the kind of traction that has been absent from this putative recovery. Even the housing market began to show signs of life as consumer confidence climbed steadily out of the depths of last summer’s despair. So, it appeared, the stage was set for finally achieving the kind of economic recovery that past business cycles had typically produced.
     In an unwelcome reprise of previous episodes of heightened expectations; these, too may prove to be fleeting. While jobs reports do indicate that additions are being made to non-farm payrolls, the notion that labor market conditions are improving may have more to do with reductions in the labor force participation rate than with actual job creation. New jobless claims, while improving, continue to come in at stubbornly high levels.
     As for the consumer, increases in consumption have come at the expense of savings as that rate has declined while wage growth has just barely been positive. When adjusted for the current rate of inflation, modest though it is, purchasing power is actually on the decline. Also on the decline are home prices (Case-Shiller 20 City Index) as that market continues to search for a bottom. That situation is not helped by declining sales of both new and existing single family homes.
     At the March meeting of the Federal Open Market Committee, the architects of monetary policy acknowledged that we may have more to worry about than just our own domestic challenges. The potential for spillover negative effects of the European debt crisis still remains. They also reiterated their perception that the need to keep rates at their current low levels will continue until at least the latter part of 2014 (see chart on Page 6). They recognize that every path has its puddles.

     Information herein is believed to be reliable, but The Baker Group does not guarantee its completeness or accuracy. Opinions constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes in rates of exchange may have an adverse ef-fect on the value of investments. This material is not intended as an offer or solicitation for the purchase of financial instruments.