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.