A recent Financial Institution Letter provides guidance on the FDIC’s methodology when entertaining requests from banks or savings associations organized as Subchapter S corporations (S-corporation banks) to pay dividends to shareholders to cover taxes on their pass-through share of the bank’s earnings when such dividends would be impermissible under the agency’s capital regulations. S-corporation banks do not pay federal income taxes; instead, income and losses are passed through to the bank’s shareholders. In a situation where the S-corporation has income but does not pay dividends, its shareholders are responsible for meeting the increased tax liability from their own resources.
Since the Federal Deposit Insurance Corporation Improvements Act of 1991, an insured depository institution (IDI) is forbidden from paying a dividend if, after such payment, the institution would be undercapitalized under the prompt corrective action (PCA) regulations. Moreover, IDIs that are poorly rated or subject to written supervisory actions often are specifically directed not to pay dividends to ensure adequate capital exists to support their risk profile.
The Basel III capital rules, which were finalized this past April, include a capital conservation buffer that prohibits or limits the dividends a bank can pay if its risk-based capital ratios fall below certain thresholds. If each of an IDI’s risk-based capital ratios exceeds the requisite minimum levels by more than 2.5 percentage points, the IDI is not subject to dividend restrictions under the capital conservation buffer. Otherwise, an IDI may distribute as much as 60 percent of its eligible retained income, provided the risk-based capital ratios all remain more than 1.875 percentage points above the minimum required levels.
Consequently, an S-corporation bank meeting the PCA well-capitalized standard could distribute 60 percent of its eligible retained income, an amount that should be more than sufficient to meet shareholders’ tax obligations. If risk-based capital ratios should deteriorate, however, the limit on capital distributions under the capital conservation buffer diminishes, first to 40 percent of eligible retained income, then to 20 percent, and finally to zero if any risk-based capital ratio is equal to or less than 0.625 percentage points above the minimum required levels.
The Basel III rules contain a provision allowing any IDI to request approval from its primary federal regulator to make a dividend payment that would not otherwise be permitted by the capital conservation buffer. The FDIC’s regulations permit it to approve such a request, despite the restrictions imposed by the buffer, if the FDIC determines that the circumstances warrant the payment of dividends, that the payment is not contrary to the buffer’s purposes, and that the payment of dividends would not be detrimental to the safety and soundness of the IDI.
The capital conservation buffer will be phased in during the years 2016-2018 and will be fully effective in 2019. Recognizing the concern that the new capital conservation buffer could increase the frequency with which S-corporation shareholders face a tax liability without having received dividends, and the concern that investors’ fear of this scenario could make it more difficult for S-corporation banks to attract capital, the FDIC has announced the factors it will consider when determining whether to permit dividends otherwise impermissible under the buffer. These factors are:
Whether the S-corporation bank is requesting a dividend of no more than 40 percent of net income
Whether the S-corporation bank believes the dividend payment is necessary to shareholders to pay income taxes associated with their pass-through share of the IDI’s earnings
Whether the requesting S-corporation bank has a CAMELS bank examination rating of 1 or 2 and is not subject to a written supervisory directive
Whether the S-corporation satisfies the pre-existing PCA requirements (at least adequately capitalized and would remain so after paying the requested dividend)
If the FDIC determines that the S-corporation satisfies each of these factors, the requested dividend generally would be approved, so long as there are no significant safety-and-soundness concerns, such as an ongoing examination with adverse trends identified, a pending written directive or downgrade to a less than satisfactory status, or a case where the buffer is triggered by an aggressive growth strategy.
We note that the FDIC guidance focuses on whether the shareholders can meet their tax obligations at the 60 percent dividend level but does not explain that they will likely fall short at the 40 percent level and that the 20 percent level will be clearly inadequate. Furthermore, if S-Corporation banks have shareholder agreements with typical tax distribution language (as do other S Corporations), consideration should be given to revising those agreements to include an FDIC override of the contractual terms.