New Rules Benefit Small Bank Holding Companies

holding-companies-12-25-15.pngConfirming an important regulatory concession Congress previously granted to community banks, the Federal Reserve Board recently amended its regulation and related Policy Statement governing “small bank holding companies” (SBHCs) to include companies up to $1 billion in total assets, up from $500 million. The Policy Statement now applies to about 90 percent of all U.S. bank holding companies.

Significance of the Change
This is good news for community banks because the regulation was designed to cut smaller banks and bank owners some slack when it comes to using internal leverage as a source of capital funding. Effectively, Congress has given community banks an “ownership” advantage to help balance against the marketplace advantages enjoyed by larger banks.

Key Benefit of SBHCs
The regulation basically exempts qualifying SBHCs (but not their bank subsidiaries) from the higher consolidated capital generally required for larger banks. Stated differently, the SBHC is deconsolidated from its bank subsidiary, such that only the subsidiary bank is subject to minimum capital ratios. This enables SBHCs to offset the investment inefficiency of maintaining excess capital at the bank level by incurring debt at the holding company level.

Investment Advantage
For shareholders, the principal advantage of the SBHC structure is that it allows the shareholder’s investment to be internally leveraged with holding company debt, which simultaneously reduces the amount of common equity required from shareholders to support the bank’s capital while increasing the shareholders’ return on the capital invested. Moreover, the cost to the issuer of debt capital is typically about half that of equity capital, partly because interest on the debt would be tax deductible whereas dividends on preferred stock would not. In addition, leverage provides a non-dilutive source of bank-level capital to support growth, as compared to common stock. Accordingly, taking advantage of the opportunities afforded to SBHCs can have a material and lasting impact on shareholder value.

Operational Flexibility
An even more important attribute is operational flexibility, because management can readily tap holding company debt to meet common strategic challenges and opportunities, such as:

  • Providing growth capital for a bank subsidiary,
  • Buying another bank or branch, and
  • Repurchasing stock to support shareholder liquidity.

These situations often demand more rapid and decisive action than might be possible if funding must wait for a successful equity stock offering, especially one undertaken in a small community. In fact, having ready access to capital funding through holding company debt could be the key resource that enables some community banks to preserve their independence. The 1,500 community banks without a bank holding company should consider this advantage as well.

Benefit for Subchapter S Banks
The SBHC advantage will be especially helpful for growing Subchapter S banks because it enables these banks to raise capital without affecting the constraints on numbers and types of shareholders permitted for S corporations.

Regulatory Leverage Limits and Conditions
Holding companies are not required normally to obtain regulatory approval to incur debt up to 100 percent of the holding company’s net equity (typically 50 percent of bank equity). The Policy Statement sets out various conditions and requirements that become applicable when debt exceeds that level or when the company has previously been instructed not to incur debt.

In practice, most SBHCs needing capital for any reasonable purpose (except perhaps to cover loan losses) will be eligible under the rule to borrow more money than their directors would have imagined possible or considered desirable. The limiting factor is more likely to be the marketplace’s appetite for the holding company’s debt rather than regulation. 

Sources of Funding
The best resource for senior debt financing will often be an up-stream correspondent or bankers’ bank. These lenders normally expect borrowers to amortize principal over 5 to 10 years, maintain acceptable ratios throughout the financing period and pledge the bank stock owned by the holding company as collateral for the loan. Because of the latter requirement, these loans are often referred to as “bank stock” loans.

Longer term, less restrictive and unsecured or subordinated debt financing could also be sought from major shareholders or other local investors as well as from institutional investors. These instruments tend to provide more flexibility in terms (fixed vs. floating) and can be structured to include conversion features. Moreover, bank holding companies have the ability to issue subordinated debt without the onerous covenants and events of default typically inherent in senior debt instruments.

The Takeaway
Well-managed community banks of tomorrow will wish to use every tool possible to deliver value for shareholders. The SBHC could prove to be the most important tool in the box for many smaller banks.

Tax Conundrum: How to Handle the Purchase of an “S” Corporation

treasure-chest.jpgApproximately one-third of all banks in the United States are organized as subchapter S corporations. Since a potential buyer is likely to encounter a seller that is a subchapter S bank, it is important to understand the unique tax consequences to the selling corporation and its shareholders. For example, the selling shareholders may seek concessions, in the form of additional consideration, to reimburse them for any additional tax liability they might incur based upon the chosen structure. Board members, whether representing the seller or buyer, will need to consider these tax issues in order to properly evaluate a proposed acquisition structure and obtain the desired results.

Any buyer purchasing a corporation at a premium typically prefers to structure the transaction in a way that allows the buyer to receive a “stepped-up basis” in purchased assets. In other words, the buyer wants to directly allocate the amount paid for the corporation’s stock to the acquired assets for tax and accounting purposes. While this treatment may be required under U.S. generally accepted accounting principles, it does not automatically apply for federal income tax purposes. In fact, a buyer acquiring the stock of a corporation generally will take a carryover tax basis in purchased assets, as opposed to a stepped-up tax basis, thus potentially leaving tax dollars on the table. While a buyer can purchase assets directly without purchasing stock in order to receive this stepped-up tax basis, it might not always be practical (or permissible) to structure a transaction this way. So what’s a buyer to do?

Internal Revenue Code Section 338(h)(10) provides a special election for “qualified stock purchases,” which are defined as any transactions, or series of transactions, in which at least 80 percent of the stock of one corporation (the target corporation) is purchased by another corporation (the acquiring corporation) during a 12-month period. If the election is made, a purchase of target corporation stock is treated as though the acquiring corporation directly purchases the assets of the target corporation. In other words, the purchase of the stock is disregarded for tax purposes—and for tax purposes only.

There are two situations in which a Section 338(h)(10) election can be made:

  1. The target corporation is a subsidiary in a consolidated group; or
  2. The target corporation is a subchapter S corporation.

It is the latter of these two situations that is more common among bank holding company acquisitions.

It should be noted that a Section 338(h)(10) election can be made only if all parties involved in the transaction agree to the election. If the target is a subchapter S corporation, the approval of every shareholder of the S corporation must be obtained—no exceptions. A single dissenting shareholder can disrupt the entire process (although there are some strategies to avoid that). It should also be noted that the acquiring corporation assumes all liabilities of the target corporation, including tax liabilities.

Now that we have set the table as to why, and under what circumstances, a Section 338(h)(10) election can be made, let’s take a look at the tax consequences for the parties involved, assuming the target corporation is an S corporation bank holding company with a single 100 percent-owned qualified subchapter S bank subsidiary.

For the target corporation:

  • All holding company and bank assets are sold in a taxable transaction.
  • All holding company and bank liabilities are assumed by the acquiring corporation.
  • Corporate-level S corporation built-in gains tax could apply.
  • Corporate-level state income tax applies to net gains from taxable sale of assets (presuming the relevant states follow the federal Section 338(h)(10) treatment).
  • Holding company is liquidated.

For the selling shareholders:

  • Gains (and losses) from the sale of assets pass through to shareholders and are reported on the shareholders’ personal income tax returns; the tax basis in the S corporation stock is increased or decreased accordingly.
  • Shareholders recognize the gain or loss upon liquidation of holding company shares.

For the acquiring corporation:

  • Tax basis of purchased assets, including intangible assets, is stepped up (or stepped down).
  • Premium paid above fair market value of hard assets generally is converted into a tax-deductible intangible asset that can be deducted on a straight-line basis over 15 years.
  • No tax attributes of the target corporation carry over, which would commonly occur in the context of a stock purchase without a Section 338(h)(10) election.

As discussed earlier, subchapter S corporations make up about one-third of all banks in the United States. Because potential buyers are likely to encounter a selling S corporation, it is important to understand the unique tax consequences affecting the parties involved, including the target corporation, its shareholders, and the acquiring corporation. The Section 338(h)(10) tax rules are detailed, and there might be exceptions to the general rules described here. Taxpayers should review their specific fact patterns before deciding on a course of action.