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.