I. INTRODUCTION
The FDIC has issued a Financial Institution Letter (FIL) describing how it will consider requests from S-corporation banks or savings associations (“banks”) to pay dividends to shareholders to cover taxes on their pass-through share of the bank’s earnings, when these dividends would otherwise not be permitted under the capital conservation buffer requirements in the Basel III rule. Absent significant safety-and-soundness concerns about the requesting bank, the FDIC generally would expect to approve exception requests by well-rated S-corporation banks that are limited to the payment of dividends to cover shareholders’ taxes on their portion of an S-corporation’s earnings.
Because of the extended phase-in of the capital conservation buffer, this issue is unlikely to present itself in specific cases for a number of years. Moreover, historical experience with bank capital ratios suggests that few S-corporation banks likely would be affected by this pass-through tax issue solely because of the operation of the capital conservation buffer. Nevertheless, since the capital conservation buffer has been a source of concern for many S-corporation banks, the FDIC has issued the FIL to clarify the application of the capital conservation buffer, including how it will consider exception requests.
II. DIVIDENDS AND THE BASEL III CAPITAL CONSERVATION BUFFER
FDIC-supervised depository institutions generally are free to pay dividends to their shareholders except in limited specific situations. By statute, an insured depository institution may not pay a dividend if, after the payment of the dividend, the institution would be undercapitalized pursuant to the agencies’ prompt corrective action (PCA) regulations. Moreover, institutions that are poorly rated or subject to written supervisory actions often are specifically directed not to pay dividends in order to ensure adequate capital exists to support their risk profile.
The new Basel III capital rules include a capital conservation buffer that limits the amount of dividends a bank can pay when the bank’s capital ratios are below the threshold levels of the buffer. The new Basel III capital rules place additional regulatory limits on the distributions and discretionary bonus payments that an adequately capitalized bank, or a bank whose capital ratios exceed by less than 0.5 percentage points any of its well-capitalized risk-based capital ratio thresholds, may potentially pay. The capital conservation buffer is designed to encourage banks to maintain capital ratios well above regulatory minimums and to remain well-capitalized.
Under restrictions imposed by the capital conservation buffer which become fully effective on January 1, 2019, an institution whose risk-based capital ratios each exceed the minimum levels required by more than 2.5 percentage points is not subject to dividend restrictions under the capital conservation buffer. Otherwise, and provided the risk-based capital ratios all remain more than 1.875 percentage points above the minimum required levels, a bank may distribute up to 60 percent of its eligible retained income. As risk-based capital ratios deteriorate further, the limit on capital distributions under the capital conservation buffer becomes, respectively, 40 percent and 20 percent of eligible retained income, and finally zero if any risk-based capital ratio is equal to or less than 0.625 percentage points above the minimum required levels.
The new Basel III capital rules also provide the ability for banks to request exceptions to the buffer restrictions. Thus, FDIC-supervised institutions may request, and the FDIC may approve, dividend payments despite the restrictions imposed by the capital conservation buffer if the FDIC determines that the circumstances warrant the payment of dividends, that the payment is not contrary to the purposes of the buffer, and that the payment of dividends would not be detrimental to the safety and soundness of the bank.
III. S-CORPORATION REQUESTS FOR DIVIDEND EXCEPTIONS TO COVER TAXES ON PASS-THROUGH INCOME
The FDIC is clarifying the factors it will consider in response to requests for exceptions to capital conservation buffer dividend limits specifically to cover the payment of taxes by S-corporation shareholders. In evaluating such requests, the FDIC would consider each of the following factors based on the specific facts and circumstances of the requesting bank:
If the FDIC determines that the S-corporation satisfies each of these factors, the requested dividend generally would be approved absent significant safety-and-soundness concerns, such as an ongoing examination with adverse trends identified, a pending written directive or downgrade to a less than satisfactory status, or a case where the buffer is triggered by an aggressive growth strategy. Since evaluating these factors should be relatively straightforward, the FDIC anticipates it would be able to respond affirmatively and in a timely manner to requests where the factors are satisfied. The FDIC will provide instructions on how to request an exception pursuant to this streamlined review process well in advance of when the buffer comes into effect.
With regard to the second factor, it is noted that S-corporation banks may not know the exact amount of dividends that would cover the marginal tax liability associated with the share of the banks’ income attributed to each of its shareholders, given that individual shareholders may have unique tax situations. The FDIC does not intend to review such information and generally would rely upon the requesting bank’s statement that it believes that this factor is satisfied.
This FIL only applies to requests for exceptions from the capital conservation buffer limitations for dividends used by an S-corporation bank’s shareholders to pay taxes on income attributed to the bank. The factors described are not meant to limit any bank’s ability to request dividend exceptions, including, for example, banks that had experienced difficulties but are returning to health. The FDIC will consider all requests on a case-by-case basis.