Tax Issues for S Corporations Participating in the Capital Purchase Program
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EESA TARP Update
Tax Issues for S Corporations Participating in the Capital Purchase Program

By Kevin F. Powers, CPA

S Corporation banks and bank holding companies (S Corp banks) were required to submit by Friday, Feb. 13, 2009, their applications to participate in the TARP Capital Purchase Program (CPP) that was announced in October 2008. Although the U.S. Department of the Treasury has released a term sheet for S Corp banks intending to participate in the CPP1, a draft of the definitive agreement has yet to be made available. The remaining questions are not likely to be answered until the S Corp banks receive approval for the CPP funding – which could be weeks or months from now – and have an opportunity to review the specific terms of the definitive agreement.

Of particular concern to S Corp banks is the ability to make distributions to cover the federal and applicable state income tax liabilities of their shareholders. S Corp banks that have applied for funding under the CPP should pay particular attention to the following tax issues, for they could have an impact on their decision about whether to accept the Treasury’s terms.

Basic Terms
The terms of the CPP program for S Corp banks require the Treasury to acquire subordinated debentures, with each note having a principal amount of $1,000. The debentures are being used in place of preferred stock because of restrictions that prohibit S corporations from having more than one class of stock. S Corp banks are also required to grant warrants to the Treasury for the purchase of additional debentures, equal to 5 percent of the amount purchased, with an exercise price of $0.01. The Treasury is expected to exercise these warrants immediately upon receipt.

For example, an S Corp bank issuing $10 million of subordinated debentures would issue an additional $500,000 of warrant debentures. In all, the S Corp bank would have to repay $10.5 million while receiving only $10 million. This situation would likely result in the S Corp bank having original issue discount, which would be amortized as an additional tax deduction over the term of the debt.

The interest rate on the subordinated debt will be 7.7 percent for each of the first five years of the program and 13.8 percent afterward. These rates contrast with 5 percent and 9 percent, respectively, for the preferred stock issued to participating corporations under the earlier rounds of the CPP. The warrant debentures will carry an interest rate of 13.8 percent for their entire term.

The Treasury justifies the higher interest rate with the fact that S Corp banks will receive a tax deduction for the interest payments on the debt. Interestingly (no pun intended) enough, the increased rate was based on the highest current marginal federal income tax rate for individuals – 35 percent. However, this rate fails to take into consideration that not all shareholders will necessarily be in the highest marginal tax rate. The impact of state income taxes also was not considered.

Restrictions on Shareholder Distributions
One of the biggest concerns, if not the biggest concern, of S Corp banks is their ability to make dividend distributions to cover the federal and applicable state income tax liabilities of their shareholders. The CPP term sheet provides that S Corp banks cannot increase their dividend rate without the consent of the Treasury until the third anniversary date of the Treasury’s investment. After that, but prior to the 10th anniversary date, the dividend rate can be increased by 3 percent annually without the consent of the Treasury. After the 10th anniversary, S Corp banks are completely prohibited from making dividend distributions, including distributions to cover shareholders’ tax liabilities. Of course, by that time, it is unlikely that any of these debentures would be outstanding. In addition, no dividends can be paid if there is any unpaid interest on the debentures.

The term sheet for S Corp banks provides that the Treasury consent shall not be required for any increase in dividends where the increase is based solely on a proportionate increase in taxable income and the increased dividends are distributed to shareholders in order to fund their individual tax payments on such allocable taxable income. However, the Treasury (and subsequent investors that purchase the debt) shall have the right to challenge the amount of the proposed tax distributions to the extent that the Treasury believes the distributions exceed the amount necessary for shareholders to pay their allocable share of income taxes. Presumably, procedures outlined in the definitive agreement will resolve this apparent contradiction between not needing consent yet allowing for the challenge of proposed dividend increases.

Second, the term sheet does not address any increases in taxable income as a result of extraordinary transactions, such as acquisitions or business transactions in new states. Presumably, the definitive agreement will not provide special exclusions or other restrictive provisions for these situations.

Finally, the term sheet provides no discussion related to S Corp banks that had losses in pre-CPP periods but might become profitable during their years of CPP participation. Again, we would have to presume that the definitive agreement would allow for an increase in dividends even if the “base” dividend rate in the pre-CPP period was zero.

Whether or not clear answers are forthcoming, S Corp banks are well advised to prepare projections of taxable income and required dividend distributions (both federal and state) for the CPP participation years. These projections might be required to thwart a possible challenge by the Treasury of the annual dividend distributions, but another reason to prepare them is so that S Corp banks can make an informed decision about accepting the terms of the CPP funding in the first place.

Compensation Limits
Based on the term sheet released by the Treasury, S Corp banks will be subject to executive compensation restrictions similar to those applicable to corporations issuing preferred stock under the earlier rounds of the CPP – which, based on the recently enacted American Recovery and Reinvestment Act of 2009, include:

  • $500,000 tax deduction limit for compensation paid to the top five highest-paid senior executive officers;
  • No payments for departures for any reason, except payments for services performed or benefits accrued, to the 10 most highly paid employees;
  • No bonus, retention, or incentive compensation awards to certain employees (based on the amount of CPP funding received), except for limited amounts of long-term restricted stock; and
  • Recovery of incentive compensation paid to the 25 highest-paid employees if it is later found to be based on materially inaccurate statements of earnings, revenue, or other criteria.

There are also restrictions on compensation plans encouraging excessive risk taking or manipulating earnings reports, as well as requirements for various corporate oversight and annual certification procedures. S Corp banks will have to examine these restrictions carefully when deciding whether to participate in the CPP.

Interest Expense Disallowance
S Corp banks may be subject to certain interest expense disallowance provisions by investing in tax-exempt municipal obligations. The interest expense incurred from the subordinated debentures could have an impact on the interest expense disallowance related to these investments if the bank is actually the entity issuing the debt. However, if the bank holding company issues the debt, the bank will not be the debtor and thus will not directly incur the interest expense. It is possible that the Internal Revenue Service could put out some specific guidance related to this issue, but nothing has been published so far.

Summary
This discussion is intended to provide S Corp banks with an overview of the relevant tax issues that might affect the decision of whether to participate in the CPP. As with most decisions, however, consideration must also be given to non-tax factors – for example, the bank might have no other way to obtain the funds they need to meet regulatory capital requirements. Although many S Corp banks have already applied for the funding, they still have time to sort through these and other issues before making a final decision to accept the Treasury’s terms or not.

Contact Information
Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or
kevin.powers@crowehorwath.com.



1 www.treas.gov/initiatives/eesa/docs/scorp-term-sheet.pdf

 

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