Are your S Corporation’s Tax Distributions at Risk?

It seems every time you turn around, there is a new regulation creating unique opportunities, challenges and risks for banks. The new Basel III capital rules are no different, and for S corporations the capital conservation buffer could have a significant impact on future tax distributions.

Phased in between 2016-2018, the Basel III capital conservation buffer will be fully effective in 2019. Under this regulation, when a bank’s risk-based capital ratios fall below certain thresholds, regulators will have the ability to limit or prohibit future dividends or distributions.

Earnings for S corporation banks are passed on to shareholders for tax purposes. For that reason, the bank’s ability to pay tax distributions is particularly critical to shareholders’ ability to cover their tax liabilities. The FDIC is aware of the potential impact and recently issued Financial Institution Letter (FIL 40-2014) to help alleviate this risk.

Details of the FDIC Financial Institution Letter

Presuming an absence of serious safety-and-soundness concerns, the FDIC generally will approve exception requests by well-rated S corporation banks, specific to the payment of dividends to cover shareholders’ taxes on their share of a S corporation’s earnings. Because of the capital conservation buffer and extended phase-in period, the FDIC anticipates that few S corporation banks will be affected by this tax issue. Nonetheless, it is important to highlight what the impact of the new Basel III rules could mean, despite relief from the FDIC. 

Take for example a bank that is adequately capitalized, but one or more of its risk-based capital ratios is equal to or less than 1.25 percentage points above the minimum. According to the Capital Conservation Buffer and Maximum Payout Ratio table, the bank would only be able to distribute between zero and 20% of its eligible retained income. Since the beginning of 2013, some passive shareholders have been faced with a Federal tax burden of up to 43.4% of taxable income (39.6% top marginal rate plus 3.8% Net Investment Income Tax), in addition to any additional state and local taxes that may be imposed.

Dividend restrictions are not new. Many banks, including S corporation banks, have dealt with dividend restrictions. But with this new capital conservation buffer, the increased frequency of S corporation shareholders incurring tax liability without receiving dividends could make it more challenging for S corporation banks to attract new capital.

1. In the FIL, the FDIC clarifies the factors it will consider in response to requests for exceptions to these dividend limits.
2. Is the S-corporation requesting a dividend of no more than 40 percent of net income?
3. Does the requesting S corporation believe the dividend payment is necessary to allow the shareholders of the bank to pay income taxes associated with their pass-through share of the institution’s earnings?
4. Is the requesting S corporation bank rated 1 or 2 under the Uniform Financial Institutions Rating System and not subject to a written supervisory directive?
5. Is the requesting S corporation bank at least adequately capitalized, and would it remain adequately capitalized after the requested dividend? (If not, the dividend is not permitted pursuant to statutory PCA, 12 U.S.C. § _1831o(d)(1)(A).) 

It is presumed that if you satisfy each of these factors, then requested dividends would be approved. The FDIC is expected to issue instructions explaining how to request exceptions pursuant to this review process well in advance of when the buffer is effective.

Recommendations

In light of Basel III and the new capital conservation buffer, we recommend banks take a proactive stance in establishing target capital ratios and dividend payout policies. The relief provided by the FDIC should limit your risk, but history has shown that putting too much control in the hands of the regulators can be very risky and create an uncertain future.

Is your bank prepared for the new Basel III regulations? The HORNE banking team is here to guide you through the process and help you assess the impact to your institution.