Beware of Unintended Consequences
By: THOMAS W. GARTON
March 2010
Bank regulators are increasing the pressure on community banks to strengthen their balance sheets, to improve the quality of loan portfolios, and generally to conserve cash and capital. Responding to these pressures, banks have found it necessary to focus attention on their loan portfolios and credit relationships with customers. When that focus is not enough to alleviate the regulator’s concerns, the bank’s “internal” economics and practices can be expected to come under pressure.
“Internal” economics refers to those functions and obligations of the bank unrelated to its relationships with borrowers and depositors, such as officer compensation levels, dividend and/or redemption plans and policies, expansion plans, and other cash flow conservation measures. Responding to regulators’ suggestions or demands relating to internal economics can create unexpected and undesirable consequences. A couple of examples follow.
Shareholders of a Subchapter S bank rely on periodic dividends from the bank. These tax dividends provide cash necessary for the shareholders to pay the income tax imposed upon them under Subchapter S with respect to the taxable income of the bank. If the dividends are curtailed by regulatory action, the shareholders may experience tax obligations from bank operations without the cash to cover them. Without this cash, shareholders would need to plan for the negative cash flow they would experience upon curtailment of tax dividends.
One obvious remedy, termination of the S election, would mean the bank would be obligated to pay the state and federal taxes that were previously the shareholders’ obligation to pay (funded by dividends distributed by the bank). If termination of the S election is contemplated, that action should not be taken lightly. Beyond the immediate loss of the familiar tax benefits enjoyed by S corporation banks and their shareholders, there are significant collateral consequences to terminating the election. If a bank holding company terminates its election, S corporation treatment of its wholly owned Qualified S Corporation Subsidiary bank also terminates, along with the subsidiary bank’s treatment as a disregarded entity for tax purposes. Once terminated, the election cannot be reinstated until five years after the termination.
Another cash conservation mechanism might be to modify the deferred compensation obligations the bank may have to its current or former employees. Section 409A of the Internal Revenue Code provides complicated and potentially costly rules where nonqualified deferred compensation arrangements are modified. For instance, if benefits are deferred beyond the date prescribed by the arrangement and that redeferral does not comply with the rules set out in Section 409A, the present value of all future vested benefits will be included currently in the income of the recipient. In addition, a penalty of 20% of that amount is also imposed. Complying with the rules of Section 409A with respect to redeferral of amounts requires, among other things, that the redeferral be accomplished no sooner than 12 months after notice of the election to make the redeferral. Once redeferral is made, the redeferral must extend for a period of not less than five years from the redeferral election. Under Section 409A a postponement or redeferral of deferred compensation benefits is neither a quick nor a short-term cash flow remedy.
Takeaway
Management needs to be aware of the sometimes dire tax consequences any time preservation of bank cash flow is sought to be achieved through curtailment of tax dividends or reductions or redeferrals of deferred compensation obligations of the bank.