FDIC Grants S-Corporation Banks Relief Under Basel III Capital Conservation Rules

On July 21, 2014, the FDIC issued Financial Institution Letter FIL-40-2014 clarifying its policy to allow FDIC supervised S-Corporation banks and saving associations to pay dividends to shareholders to cover taxes on pass-through earnings. Under certain circumstances, the FDIC will now allow dividend payments even if the payments are not permitted under the capital conservation buffer requirements found in the new Basel III rules. The letter can be found here.

This is an important development because S-Corporations are treated, for tax purposes as disregarded entities and do not pay federal income taxes. Instead, their shareholders are responsible for paying the tax on the S-Corporation’s income, whether or not that income is distributed to them. Thus, under Basel III, a financial institution could have net income but not be allowed to pay a dividend which could result in shareholders not receiving cash to pay their individual tax liability on the bank’s income.

Generally, a financial institution may not pay a dividend to its shareholders if the dividend payment would leave the financial institution undercapitalized. See 12 U.S.C. § 1831o(d)(1)(A). Under the new Basel III rules, a financial institution cannot pay dividends if its risk based capital ratios are less than 2.5 percentage points above the minimum amounts set forth in 12 CFR 324.10.

Under the new policy, the FDIC will consider requests from noncompliant financial institutions to pay dividends to cover taxes on pass-through earnings on a case-by-case basis after evaluating the following factors found in 12 CFR 324.11(a)(4)(iv):

• Whether the dividend is 40 percent of net income or less;
• Whether the financial institution believes the dividend payment is necessary for shareholders to satisfy tax obligations;
• Whether the financial institution has a CAMELS ratings of 1 or 2 and not otherwise subject to a written supervisory directive; and
• Whether the financial institution would remain adequately capitalized after the dividend payment.

Despite this relief from the FDIC, S-Corporation banks and saving associations should evaluate whether a S-Corporation election remains practical under the new Basel III rules.

If you have questions concerning Basel III capital conservation rules, please contact James Kaplan at (312) 715-5028 / james.kaplan@quarles.com, Stanley Orszula at (312) 715-5123 / stanley.orszula@quarles.com, James Friedman at (414) 277-5735 / jim.friedman@quarles.com, Don Martin at (602) 229-5700 / don.martin@quarles.com, or your Quarles & Brady LLP attorney.