Category Archives:Basel III

Yellen Responds to Basel III Letter

Federal Reserve Chairman, Janet Yellen, declined to pursue a policy change that would solve a tax liability problem for Subchapter S shareholders should the bank’s capital levels fall below the Basel III capital conservation buffer. Basel III’s capital conservation buffer prevents banks from making distributions to shareholders when capital falls below a threshold — but because federal tax liability passes through a Sub S bank to individual shareholders, Sub S shareholders can face tax liability even when they have not received a distribution. This puts Sub S banks subject to the buffer at a disadvantage to C corporation banks, which pay any taxes due directly out of the bank’s income.

The Subchapter S Bank Association has sent letters and advocated for a solution to this along with many other banking associations. Yellen said, in a response to a letter sent in October 2014 from several House members urging a solution, that the Fed “continues to believe that the capital conservation buffer should be applied equally to all banking organizations.” In addition, “By holding more than 1.25 percent capital above the minimum regulatory capital requirement, a state member bank can distribute up to 40 percent of eligible retained earnings as dividends,” she wrote. “As a result, shareholders should be able to pay their tax liabilities under most circumstances.” Unfortunately, going forward the Federal Reserve plans on monitoring the effects of the revised capital rule throughout its implementation.


FDIC Guidance for Subchapter S Banks

The FDIC, yesterday afternoon, issued guidance outlining the circumstances under which the Agency would approve an S corporation bank’s request for relief from the dividend restrictions imposed under the Basel III capital conservation buffer. Exceptions will generally be granted to 1- and 2- rated banks which are adequately capitalized and are not subject to a written supervisory directive. While the guidance only applies to capital conservation buffer considerations, it does recognize that there may be other circumstances such as a bank returning to a healthy condition that might present circumstances where a dividend exception could be granted. The Agency noted that it does not expect the concern to be an issue for some time as a result of the three year phase-in through 2019. We are pleased that the FDIC recognizes the unique circumstances under which S corporation banks operate and hope this guidance will result in greater recognition and willingness by the Agencies to consider case by case dividend approvals to pay taxes in a broader set of circumstances, beyond the capital conservation buffer issue. Importantly, the Agency recognizes that the ability to pay dividends is a crucial element of an S corporation bank’s capital access strategy.  A more detailed description of the issuance follows.

Financial Institution Letter (“FIL”) 40-2014, issued by the FDIC, provides detail on the considerations for approving exceptions from the capital conservation buffer dividend restrictions as contemplated by 12 CFR 324.11(a)(4)(iv). The FIL was issued in response to broad-based industry concern about the ability of S corporation bank shareholders to satisfy their tax liability under dividend payout restrictions imposed by the capital conservation buffer.

Under the Basel III capital rules, a capital conservation buffer – measured as a percentage of a bank’s risk-based based capital ratio above the minimum requirements – serves to limit the amount dividends a bank can pay when the capital ratios fall below the buffer. Beginning in 2016, the capital conservation buffer will be phased-in over three years to a maximum buffer of 2.5% above minimum requirements, effective in 2019. If a bank’s risk-based capital ratio is greater than 2.5% above the minimum requirements, no dividend payout restrictions are imposed. As the capital ratio falls below this buffer, dividends are limited to between 20% and 60% of eligible retained income and bank’s with capital ratios that are not 0.625% above the minimum requirements may not pay any dividends.

These dividend payout restrictions have a unique effect on S corporation banks, where income, and thus tax liability, is passed through to its shareholders. Most S corporation shareholders rely on distributions from the corporation to satisfy this tax liability. The dividend payout restrictions imposed by Basel III can impair bank shareholders’ ability to pay the tax due by creating a situation in which S corporation bank shareholder recognize income from the S corporation, but regulatory restrictions prohibit a corresponding distribution to the shareholder.

FIL-40-20-14 explains that in certain circumstances an exception from the capital conservation buffer and dividend payout restrictions is available where (i) the circumstances warrant the payment of dividends, (ii) such payment is not contrary to the purpose of the rule, and (iii) the payment would not impair the safety and soundness of the bank. The FDIC emphasizes that this inquiry will be based on the particular facts and circumstances of each bank making a request. The FIL goes on to describe four factors that will be considered in each request for an exception from the rules:

1.   Is the S corporation requesting a dividend of no more than 40%  of net income?
2.   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?
3.   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?
4.   Is the requesting S corporation bank at least adequately capitalized, and would it remain adequately capitalized after the requested dividend?

The FIL goes on to describe how it will evaluate each of these factors and states that generally, request for an exemption to allow a dividend to S corporation bank shareholders to satisfy their tax liability will be granted where the above-described factors have been met by the requesting bank.

For further information, see the full text of FIL-40-2014 and the accompanying press release. If you have any questions regarding the FIL or implementation of the capital conservation buffer, please contact us at (210) 228-9500.

Congressional Letter on Sub S Banks and Basel III

The American Bankers Association along with the Subchapter S Bank Association continues to urge bankers to contact the Agencies to express their concerns and ask that the rules be amended to eliminate the negative impact of the capital conservation buffer requirement’s limitation/prohibition on distribution on S Corp banks. The goal is to get the Agencies to effect a change during the phase-in period of the Final Rule that will address the problem. This is a Basel rule problem that should be resolved by the banking agencies. They are asking that the Basel rules take into account the unique structure of S-Corps in a way that provides equal treatment for C-Corp and S-Corp banks.

Congressional Letter on Sub S Banks and Basel III


Patrick J. Kennedy Jr. Quoted in American Banker Basel III Article

Kennedy Sutherland attorney, Patrick J. Kennedy Jr., was quoted in the April 25th American Banker article entitled, “S Corp Consolidation Could Be Side Effect of Basel III.” In the article Mr. Kennedy, who is the managing partner of Kennedy Sutherland and President of the Subchapter S Bank Association which are headquartered in San Antonio, Texas, joins others in expressing concern that Basel III could be the last straw for countless S corporation banks as they mull their futures.

Currently, banks would be required by Basel III to hold a certain level of capital; failure to do so could result in a prohibition against paying dividends to shareholders. Dividends are critical to those investors, who rely on the payments to cover tax obligations if the bank is profitable. For that reason, S Corp banks believe they face a greater burden under Basel III than C corporations, where the company is taxed for its profit. Concerns also exist that the proposed rules could force more S Corps to delay growth plans or opt to sell themselves.

Basel III will require banks to have a common equity Tier 1 capital ratio of 4.5% plus a 2.5% capital conservation buffer. Banks that fall below 7% can have their ability to deploy capital, like paying dividends or bonuses, limited. S Corp shareholders are responsible for paying their share of the company’s profits on their personal tax returns. Shareholders would have to pay those taxes out of pocket if a profitable S Corp is barred from paying dividends to cover their costs. That burden could discourage some people from investing in S Corps, industry experts say.

In the article, Mr. Kennedy states, “If the rule is implemented, more S Corps could choose to switch to a C Corp structure. But this could also cause more banks to consider selling. The C Corp structure isn’t an effective structure for a closely held bank since you are basically double taxed and you’re competing against credit unions that aren’t taxed at all.”

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Basel III Capital Rule for Subchapter S Banks

Kennedy Sutherland attorney, Patrick J. Kennedy, Jr., sent a letter to Chair Yellen, Comptroller Curry and Chairman Greenberg expressing continued concern regarding the unequal treatment depository institutions and their holding companies that elect to be taxed under Subchapter S of the Internal Revenue Code (IRC) receive compared to their peers taxed under Subchapter C, especially when considered in the context of the capital conservation buffer rules presently contained in Basel III and regulatory dividend restriction policy.

In addition to revisiting the dividend restriction rule contained in the Basel III Capital Conservation Buffer provisions, he encouraged the Agencies to support efforts to expand access to capital for Subchapter S banks by supporting an increase of the shareholder limit from 100 to 500 and permitting entities other than natural persons and trusts to hold shares of an S corporation. Finally, he encouraged the Agencies to support expansion of capital instruments for Subchapter S banks to include preferred stock.

These issues are of critical importance to one-third of the banks in the United States, 90% of which are under $1 billion in assets and serve as the essential credit back bone of smaller communities and their local businesses throughout the country.

In the letter Mr. Kennedy strongly urges the Agencies to embrace the Subchapter S bank community and undertake a concerted effort to promote their health and ability to raise capital and function as freely as possible in the best interest of their shareholders and communities. Mr. Kennedy further states that he believes this can only be achieved through discussion and policy-making that includes the needs and interests of Subchapter S banks at the outset of the process rather than as a mere afterthought.

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ABA Urges Action on Basel III for Subchapter S Corporations

ABA urged federal regulators to remedy a provision in the Basel III capital standards that disadvantages the 2,000 community banks organized as Subchapter S corporations.

Basel III’s capital conservation buffer prevents banks from making distributions to shareholders when capital falls below a threshold, but because federal tax liability passes through a Sub S bank to individual shareholders, Sub S shareholders might face tax liability even when they had not received a distribution. C corporation banks subject to the capital buffer pay any taxes due directly out of the bank’s income. ABA said: “The rule will force identical S-Corp and C-Corp banks to accumulate capital at different rates, and likely will result in a powerful disincentive to invest in community banks that have elected Subchapter S status. This will be critically harmful to the growth and perhaps even viability of S-Corp community banks, and an invalidation of the purpose of Congress in creating the S-Corp category to stimulate investment in small businesses.”

ABA urged the regulators to allow Sub S banks to make distributions equal to the taxes due on the bank’s undistributed income, thus eliminating the disadvantage. It also posted a sample letter to help Sub S bankers write to the agencies themselves seeking action.

Read the letter.
Take action now.

Regulatory Capital Estimation Tool for Community Banks

The federal bank regulatory agencies today released an estimation tool to help community banks understand the potential effects of the recently revised regulatory capital framework on their capital ratios.The revised framework implements the Basel III regulatory capital reforms and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The estimation tool is available at:

An earlier version of the Estimation Tool, based upon the proposed version of the Capital Rule, was made available by the Agencies in 2012.  The Agencies noted that the Estimation Tool is intended to be useful for smaller, non-complex banks. The estimation tool is not part of the revised capital framework and not a component of regulatory reporting. Results from the tool are simplified estimates that may not precisely reflect banks’ actual capital ratios under the framework. Additionally, banks should be aware that the estimation tool requires certain manual inputs that could have meaningful effects on results and should reference the revised capital framework when using the estimation tool.

Basel III Creating Headaches for S corp Banks

In the article, ” Basel III Creating Headaches for S corp Banks” in the American Banker, Mr. Kennedy along with several s corp bank members discusses how the Basel III-related dividend structure could make it harder for more than 2,000 banks with sub-s corporation tax status to attract investors. The rules will require banks to hold more capital, and failure to do so would prompt a ban on dividend payments. That risk would be especially troublesome for banks structured as S corporations, where shareholders receive dividends to pay taxes on company earnings. If an S Corp bank is profitable but is barred from paying the tax distribution because of low capital levels, then its shareholders are responsible for paying taxes out of pocket. This could put additional strain on S Corp banks and their shareholders.

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