Banker arguments that credit unions enjoy an "unfair" competitive advantage because of their tax status begin to fall apart when they are viewed in the context of the banking industry's drive to avoid paying its own fair share of taxes.
Twenty-five percent of U.S. banks have given up their C Corporation status to reorganize as Subchapter S banks that pay no corporate tax at all. Profits are taxed as personal income at the shareholder level.
"Banks call me daily to find out what they need to do to become eligible" to operate as Sub S institutions, said Mark Baran, the American Bankers Association's senior tax counsel. "It's become a big part of the banking business." In the first quarter of 2003, 154 banks converted to Subchapter S, bringing the total to 1,954 an 8.3%increase over the end of last year. When all S&L conversions are added, the total stands at 2,009.
Baran said that the number is unlikely to increase much for the rest of the year, since most banks make the switch in the first quarter for accounting reasons. Currently, a bank can have a maximum of only 75 shareholders in order to qualify for Sub S, but bankers are pressing Congress to expand perhaps even double this number (see related story, page 50). A change of this magnitude would undoubtedly accelerate the rate of conversions.
"The most common reason banks don't change to Subchapter S is because they have too many shareholders," Baran said.
Paul Merski, ICBA Director for Tax Policy, calls the emphasis on lowering the bank tax burden "a fundamental shift in strategy" for the banking industry. But he doesn't think it will take any of the passion out of the banker attack on credit unions.
"The banking community has shifted to finding ways to alleviate its high, effective tax burden, but we'll continue to see bankers complain about the tax-exempt status of credit unions," he said. "There will still be pressure to keep the size and scope of credit unions in check."
Sub S Decision Unrelated
The lawsuit brought by the ABA and the Utah Bankers Association against NCUA over its approval of a six-county FOM and several charter conversions is the latest example. Merski said the decision to convert to Sub S is usually unrelated to the presence of credit union competition.
"It is irrelevant to the business plan that credit unions are tax exempt," he said. "Banks generally do it because they are operating in a limited geographic area and have a certain asset size" of $100 million or less. "It's attractive to small banks."
In the vast majority of cases, this is true. The smallest bank on the Federal Deposit Insurance Corporation's list of Sub S banks is tiny Heritage First Bank Inc. in Lowes, Kentucky, with $3.9 million in total assets. Many other very small institutions are clustered at the bottom of the list, but the majority of the banks are in the $100 million range. At the top of the list, however, is Beal Bank SSB of Plano, Texas with $4.5 billion in total assets, followed by seven other billion-dollar-plus banks.
All eight of the top asset banks are ranked in the second highest of the FDIC's four classifications of banks by size.
"That to me is shocking," said Tun Wai, chief economist of the National Association of Federal Credit Unions. "They say 'greed is good,' but there are different levels of 'good'."
Wai said the large Sub S banks are an unintended consequence of a law that was meant to help small institutions. The limit placed on the number of shareholders, however, failed to limit the size of the banks.
"Congress thought it was passing a law that would help small community banks that were struggling, but just look at the list," he said.
According to the ICBA's Merski, even a large bank's decision to adopt the Sub S structure "dramatically changes a bank's growth plan since it can only raise so much capital," due to the limited number of shareholders. "It is a very limiting business plan."
'No Question' About Playing Field
"I don't think there's anything wrong with credit unions paying no tax, but I think community banks should pay no tax as well. It's vital to their growth," said Ron Blasi, the Georgia State University professor who is the nation's leading authority on bank taxation. "There is no question that there is an uneven playing field."
Blasi likes the Sub S deal for banks, but said he would like it even better if they were allowed to become limited liability corporations (LLCs). "There are so many constraints on becoming a Subchapter S that many banks can't qualify," he said. Like Sub S corporations, LLCs pass all tax liability directly through to investors; there is no tax paid at the corporate level. And the LLC does not have the most conspicuous disadvantage of the Sub S structure; it can raise money in the market through stock offerings since there is no limit on the number of shareholders.
CUNA recently warned a House Ways and Means subcommittee that allowing banks to organize as LLCs would cause an even more dramatic revenue loss to the Treasury than the $13.5-billion CUNA estimates will be lost to Sub S banks in the next decade.
" . . . (I)f the remaining restrictions on the establishment of bank-LLCs are removed, the number of banks that would be organized as LLCs would dwarf the number of Subchapter S banks and banks would reap even greater tax benefits than the substantial ones already afforded under current law," CUNA said in a statement for the record.
Problems With LLCs
ICBA's Merski said he does not expect banks to convert to LLCs with the same enthusiasm they have shown for Sub S, mainly because they would have to pay a huge tax on their valuation at the time of conversion. The FDIC has adopted a regulation that would allow state banks organized as LLCs to be eligible for deposit insurance, but the Internal Revenue Service has not yet acted to change its own regulations that prohibit it.
The House version of the regulatory relief bill (HR1375) that grants considerable relief to credit unions also contains a provision that would allow the Comptroller of the Currency to allow national banks to become LLCs. This also would require action by the IRS, something no one expects anytime soon. In the meantime, Sub S banks appear to be doing far better than C Corporation banks. The Sub S ROA for the first quarter of 2003 was 1.70% against a 1.07% average ROA for non-S banks with under $1 billion in assets. The FDIC uses institutions with assets below $1 billion for comparison with Sub S banks. The figure is misleading, however, since at this point, the C Corporation banks have paid tax and the Sub S banks have not.
No tax has yet been paid on Sub S dividends, and this comes out of the pockets of the shareholders. Since many C corporations do not issue dividends, something all Sub S banks must do, further comparison becomes impossible. The industry's overall return on assets (ROA) rose to a record 1.38% in the first quarter of 2003, up from 1.29% in the same quarter last year. The previous record of 1.37% was set in the second quarter of 2002.
The ROA figures from the FDIC also contain profits for thrifts, and the figure for commercial banks alone was 1.40% in the first quarter. CUNA calculates the dollar amount of the year-on-year increase at almost 16%.
"Considering what is going on in the rest of the world with low interest rates and low inflation, a 16% increase in profits is enormous," said CUNA chief economist Bill Hampel.
The biggest gains were realized by banks that focus on consumer business, which. Hampel said, are "becoming profit-building empires. One wonders what might happen to bank profits if the credit union alternative were eliminated as banks seem to be attempting to do," he mused. "If a 1.38% ROA is not enough, what is? One-point-five percent? Two percent? Subchapter S banks do not appear to be using their freedom from corporate income tax to gain any competitive advantage whatever. If anything, the opposite is true."
Sub S Banks Charge Higher Fees
CUNA's research revealed that Sub S banks actually charge somewhat higher deposit fees than their C Corporation counterparts, a tactic not generally associated with attracting new customers or even hanging on to old ones.
In some cases, the claims by bankers that credit union competition is putting a pinch on their bottom lines is true. Bank of New Glarus, with $93 million in assets, is just 30 miles from the Madison, Wis. Offices of CUNA, the $252.4-million CUNA Credit Union, and the $592.2-million University of Wisconsin CU. Small wonder that Bank of New Glarus President and CEO Gof Thomson feels like credit unions are knocking at his door.
Much of the problem for banks like his is a shift in demographics, he said, a "hollowing out of middle America" at a time when the suburbs of cities like Madison press ever more deeply into rural areas. The town of New Glarus is now just a 20-minute drive from the west side of Madison and its powerful credit union community. Thomson's nearest bank competitor is 75 miles away. His bank's business has shifted from agricultural loans to mortgage lending because of the population changes of recent years.
"We have more people to lend money to, but life is a lot more complicated," he said.
It is likely that a Wisconsin State Department of Revenue audit will soon further complicate Thomson's life, because his is one of many Wisconsin banks and corporations that have set up paper investment subsidiaries in Nevada to avoid paying his state's corporate income tax.
"One of my embarrassments is that I don't pay state income taxes. I park my investment portfolio in Nevada," he said. "I'm not happy about that because it's not part of being a good corporate citizen. But at least at the state level I have parity with credit unions."
The practice of setting up a paper subsidiary in Nevada, a state with no corporate income tax, has been embraced by 80% of Wisconsin's bankers along with a large number of non-bank for-profit corporations operating in the state.
It's not just happening in Wisconsin. Nationwide, banks and other corporations have skipped out on their state taxes in large numbers through subsidiaries in Nevada and Delaware. Many of the states that are losing large sums of revenue through the practice, including Wisconsin, are gearing up for a crackdown.
Kim Sponem, president and CEO of CUNA CU, admits that credit unions are "more competitive with small community banks than they are with large banks," but calls banker claims that they can't compete "a silly argument."
She said she doesn't want to drive small community banks out of business and thinks their disappearance would be a loss to the communities they serve.
Room For Both
"I think you want as much variety and choice for the community as possible. There's room in the market place for both" credit unions and community banks.
Community banks, Sponem said, always have an option they have not tried. "If credit unions have such an advantage over them, why not convert to become a credit union? If you don't like your structure, you can change it."
For his part, Thomson doesn't want Bank of New Glarus to be anything but a bank and he relishes his role as his community's banker, talking with customers on the town's main street, discussing their needs over a friendly cup of coffee.
Thomson said he is not considering Sub S status for Bank of New Glarus because he sees no way to whittle the number of his shareholders from 350 to 75.
"I would have to tell shareholders to go away," a move that could have both personal and business costs. Increasing the number of shareholders a Sub S is allowed to have, he said, would solve a lot of problems for banks and take away much of the pressure to impose taxes on credit unions. He thinks banks like his and credit unions have more in common than either is willing to admit. "We have a lot in common. We both deliver services to people who need them in a defined community."
Tax The Big
He views big businesses of all stripes from WalMart to Citicorp as eroding the tradition and history of small business in America. He wants to see big business pay more tax and the tax burden lifted entirely from small business entities.
"What is the counterweight to big corporations? We're the alternative to big," he said. "We need every nickel we can get."
In the meantime, CUNA Credit Union's Sponem said she expects the banking industry's biggest guns to keep up the tax attack on credit unions.
"I don't think there's an end to it. My advice to them is to move on down the road."