Basel III has bankers at S corporations sweating.

The rules will require banks to hold more capital, and failure to do so would prompt a ban on dividend payments. That risk would be especially troublesome for banks structured as S corporations, where shareholders receive dividends to pay taxes on company earnings.

"Being an S Corp bank can be a real attractive way ... to bring in investors," says Martin Madden, chief financial officer at the $517 million-asset F.N.B.C. of LaGrange in Illinois. "Any regulatory restriction that diminishes that ability to attract new capital is a self-defeating prospect from a capital standpoint."

Basel III will require financial institutions to have a common equity Tier 1 capital ratio of 4.5%, plus a capital conservation buffer of 2.5%. Banks that fall below the 7% threshold can have their ability to take capital actions, like paying dividends and bonuses, diminished.

Banks organized as C corporations pay taxes on their income, while their shareholders pay taxes on dividends. In contrast, shareholders at S Corps are taxed individually on a bank's earnings at their specific rate. Normally, S Corp banks pay shareholders a tax distribution to cover this cost, in addition to other dividends, depending on profits.

If an S Corp bank is profitable but is barred from paying the tax distribution because of low capital levels, then its shareholders are responsible for paying taxes out of pocket. This could put additional strain on S Corp banks and their shareholders, industry experts say.

The American Bankers Association has been pushing to get the capital conservation buffer tweaked for S Corp banks, says Francisca Mordi, the association's senior tax counsel. The association has asked that those banks be allowed to pay a tax distribution — and no other dividends — to shareholders if capital levels fall below the proposed standard.

However, it seems unlikely that regulators will make the concession, industry experts say.

"Regulators have the authority — and have exercised it pretty commonly — to cut off dividends and other payments on capital instruments to preserve the bank and its capital," says Chip MacDonald 3rd, a partner at Jones Day. "Regulators are more worried about capital levels than your tax selections."

Regulators are responsible for "evaluating the capital levels and safety and soundness of the banking organization," the Federal Reserve Board and the Office of the Comptroller of the Currency said in the notice of their final rule. The potential benefit of pass-through taxation also comes with the risk "that the corporation has no obligation to make dividend distributions to help shareholders pay their tax liabilities," the notice said.

Concerns exist that the capital requirements could discourage investors from looking at S Corp banks or force these banks to change their tax structure, industry experts say.

Since 2008, several S Corp banks have already changed their tax status, says Patrick Kennedy Jr., president of the Subchapter S Bank Association. The ranks of S Corp banks have decreased by more than 10% since mid-2008, to 2,232 institutions at June 30, according to the Federal Deposit Insurance Corp.

"A lot of banks have felt tremendous pressure to have higher capital ratios," Kennedy says. "If there is income then the shareholders have to pay taxes regardless, and the Basel rules put even more pressure on those individuals."

Executives will have to disclose to potential investors the possibility of being unable to pay a tax distribution, says Beth Knickerbocker, the ABA's senior regulatory counsel. That "could be a deterrent."

S Corp banks already have restrictions that make raising funds more difficult, a problem that could be exacerbated by Basel III, says Mark Long, the president and chief executive of the $132 million-asset First Commercial Bank in Seguin, Texas. S Corp banks that need capital and are nearing the 100-shareholder cap will have limited options, he says.

To make matters worse, regulators tend to expect banks to maintain capital levels that are higher than stated minimums, Long says.

Banks might dump S Corp status for other reasons. As individual tax rates rise, the S Corp structure also becomes less desirable.

Also, investors at S Corp banks already faced the possibility of having to cover tax liabilities out of pocket during the financial crisis, when regulators hit banks with enforcement actions that restricted dividend payments, says Jeffrey Gerrish, the chairman of Gerrish McCreary Smith Consultants.

Banks need "to figure what they want to do with their lives" before becoming an S Corp, Gerrish says. This structure is usually best for small banks with no plans for extensive growth or acquisitions.

Many bankers, directors and shareholders may have overlooked the implications of the capital conservation buffer since it won't be fully phased in until Jan. 1, 2019, industry experts say. Rather, they are focused more on immediate regulatory challenges.

Madden and Long still tout the S Corp as a great way to maximize shareholder value. The executives say they will work to remain S Corp banks despite upcoming challenges. Still, they admit that changing circumstances could force them to reconsider the structure.

"There are distinct advantages, but as things change and regulations change we will have to make a strategic decision" about keeping the structure, Long says.

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