Cash dividends in the savings and loan industry

Cash Dividends in the Savings and Loan Industry

The combination of deregulation and fluctuating interest rates has altered the manner in which the savings and loan industry operates. One of the main changes has been the emergence of the stock form of organization as the predominant corporate structure of the future. This form or organization has been increasing with the conversion of mutual associations and the chartering of new stock associations. For example, during the first nine months of 1983, approximately $2.7 billion of equity was raised by mutual associations converting to the capital stock form of ownership. The increase in the number of stock associations has, in turn, led to both an expanding base of S&L investors and increasing interest in the industry by Wall Street.

Investors in any entity usually expect a return on their investment. This return has traditionally been received on other stock investments in the form of:

1. Capital appreciation (including stock dividends) which is realized either if a trading market exists for the security or upon the sale/merger of the enterprise, or

2. Cash dividends.

The possibility of a return in the form of capital appreciation appears to be a reasonable expectation of an S&L investor, provided that the institution is operating profitably and is successfully coping with the interest rate cycle. However, payment of cash dividends in the S&L industry can be severely hampered by a variety of forces which do not necessarily impede cash dividends in other industries: liquidity, asset/liability structure, the future direction of deregulation, regulatory net worth requirements, and the tax policies of Congress. Of these forces, the effect of tax legislation and regulatory net worth requirements are probably the least understood when the S&L industry is compared with other industries.

This article will discuss both of the above areas in order to highlight the factors inhibiting an institution's payment of cash dividends and will cover:

1. The S&L bad deduction which has produced favorable income tax treatment, but which restricts cash dividends;

2. The income tax rules concerning distributions by capital stock associations which complement the bad debt deduction;

3. Mergers which may have resulted in current earnings for financial reporting but not in taxable income and, in some cases, result in the reverse-tax losses; and

4. The regulatory restrictions on net worth which, at the present time, require an insured institution to have net worth equal to three percent of liabilities, subject to certain phase-in and averaging provisions.

It is hoped that this article will increase the geneal awareness of the potential impediments to cash dividends in the savings and loan industry.

The S&L Bad Debt Deduction

Savings and loan associations are entitled to claim a bad debt deduction for federal income tax purposes under one of three methods: (1) percentage of taxable income, (2) percentage of loans, or (3) experience. The use of a particular method for a taxable year is not a binding election by the S&L to apply such method eitehr for such taxable year or for subsequent taxable years. Accordingly, an S&L may change methods without obtaining IRS consent. In years in which taxable income is reported, the great majority of S&Ls utilizes the percentage of taxable income method.

For a taxable year beginning in 1979 or thereafter, the percentage of taxable income method allows a bad debt deduction in the amount of 40 percent of taxable income (computed before any deduction for bad debts). However, under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the bad debt deduction under this method (and the percentage of loans method) is reduced by 15 percent of the amount by which the otherwise allowable deduction exceeds the amount which would have been allowable on the basis of actual experience. This change applies to taxable years beginning after 1982 and results in the bad debt deduction being reduced from 40 percent to 34 percent, assuming no experience. (TEFRA further provided that only 71.6 percent of the otherwise determined bad debt preference will be included in the minimum tax computation. Thus, the overall increase in the effective tax rate of most S&Ls is minor.)

The use of the percentage of taxable income bad debt deduction is not wihout certain statutory restrictions and requirements set forth in the Internal Revenue Code. Among some of these are:

1. The percentage of assets test which requires that 82 percent of the S&L's assets be invested in certain qualifying categories. If not, the percentage deduction must be reduced based on the short-fall.

2. The amount of bad debt reserves on dualifying real property loans may not exceed six percent of such loans at year-end.

3. The amount of surplus, reserves, and undivided profits, determined on the basis of tax accounting methods used, may not exceed twelve percent of total deposits and withdrawable accounts at year-end.

4. The requirement that bad debt reserves be maintained as a permanent part of the regular books of account. This has not been interpreted as requiring conformity between bad debt reserves for financial statement and income tax purposes but, rather, as requiring a permanent record of bad debt reserves in an appropriate format.

5. The requirement that any charge, other than for bad debts, to the bad debt reserves, results in the reporting of gross income for tax purposes. (Note that the IRS has held that dividends, paid in stock, are not charges to bad debt reserves provided certain bookkeeping requirements are met.)

The S&L bad debt deduction is one of the two major tax factors that materially reduce taxable income below the amount reported as income for financial reporting purposes. The second factor is the prevalence of "timing differences' which are items that affect the determination of taxable income in periods different from the periods in which they affect the determination of financial statement income.

Some timing differences frequently encountered in the S&L industry are as follows:

In general, all of the above tend to reduce taxable income below the amount of income reported in the S&L's accrual basis financial statements. When coupled with the "permanent' differences resulting from purchase accounting adjustments to be described, the result is that taxable income and tax-paid earnings and profits are substantially less than financial statement income and retained earnings.

To demonstrate the difference in federal income tax treatment between a savings and loan association and a commercial enterprise, the following example is provided:

Distributions by Capital Stock S&Ls

Any S&L making a distribution to the holders of its capital stock must determine the effect of such a distribution on its bad debt reserves. Depending on the type of distribution, there are prescribed ordering rules which may result in a recapture of bad debt reserves and an addition to gross income for tax purposes under Section 593(e) of the Internal Revenue Code. Any amount recaptured may not be included in "taxable income' for purposes of the percentage of taxable income bad debt deduction.

If the distribution is not in exchange for the S&L's stock (not a stock redemption or liquidation), the order of distribution is as follows:

1. Earnings and profits (E&P) of the taxable year,

2. E&P accumulated in post-1951 taxable years,

3. Bad debt reserves, and

4. Such other accounts as may be proper.

In determining the amount of the distribution charged to bad debt reserves, no recapture is required for the portion of bad debt reserves, if any: (1) that would have been accumulated had the S&L been on the experience method for all years after 1951; and (2) added due to the reserve realignment required by the 1962 Revenue Act to the extent its source was E&P accumulated in years before 1952.

If the distribution is treated as having been made out of bad debt reserves, these reserves are recaptured into gross income for tax purposes by an amount equal to the lesser of: (1) the balance of the reserves or (2) the amount which, when reduced by the amount of income tax attributable to the inclusion of such amount in gross income, is equal to the amount of such distribution. (See Example 2.) The computation described in Example 2 is a "gross up' under which approximately twice the amount of the dividend actually distributed to stockholders may be includible in the S&L's gross income for tax purposes. (It does not increase income for financial reporting purposes.) As previously indicated, the increase in gross income caused by the recapture may not serve as a basis for a percentage of taxable income bad debt deduction. However, it could be reduced by any losses being reported for tax purposes, including net operating loss carryovers from prior years. This latter point needs to be carefully considered by S&Ls with large net operating loss carryovers.

To demonstrate the "gross up' referred to above, Example 2 is provided. In this example, it is assumed that the S&L has: (1) bad debt reserves of $4 million, (2) no accumulated E&P, and (3) no net operating loss carryovers.

In considering the above ordering rules on dividend distributions, the amount of E&P, both current and accumulated, is a critical determinant. Only when current and accumulated E&P are enhausted will the bad debt reserves be recaptured. The amount of earnings and profits also has significant ramifications to the stockholders of the S&L as it determines the amount of the distribution taxable as a dividend.

E&P must be distinguished from income for financial reporting and even from taxable income. In general, E&P can be computed by making certain adjustments to taxable income, such as:

Adding

Interest income exempt under 103, IRC,

Life insurance proceeds,

NOL carryovers,

Capital loss carryovers,

Accelerated depreciation (see 312(k), IRC), and

85 percent dividends received deduction.

Subtracting

Federal income taxes,

Dividends distributed to shareholders,

Interest expense disallowed under 265, IRC,

Excess charitable contributions,

Excess capital losses, and

Other nondeductible expenses.

Since E&P is not specifically defined in the Internal Revenue Code, there are many unresolved questions concerning its basic computation and how it is affected by such corporate transactions as distributions of appreciated property and acquisitions of other entities.

Impact of Purchase Accounting

In the past several years, there have been many mergers of savings and loan associations. Since 1981, the great majority of these combinations was accounted for as purchases under generally accepted accounting principles. A complete discussion of purchase accounting is beyond the scope of this article; however, it is necessary to focus on two of the more significant aspects of this accounting:

1. When an association is acquired in a purchase accounting transaction, the loan portfolio is recorded at its fair value based upon current interest rates. (See Accounting Principles Board Opinion Number 16 and Statement of Financial Accounting Standards Number 72.) When the historical interest rate on the loan portfolio is below current rates, loan discounts are recorded.

2. If the fair value of the identifiable liabilities assumed exceeds the fair value of the identifiable assets acquired, an intangible asset (termed goodwill or excess of cost over net assets acquired) is recorded.

While the above accounting is for financial reporting purposes, the tax accounting frequently is different. The transactions are generally structured to be tax-free reorganizations in order to avoid both the recapture of the prior bad debt deductions and the recording of goodwill, amortization of which would not be deductible for tax purposes.

When the loan discounts and intangible asset (goodwill) are subsequently accreted and amortized, these income and expense items are not included in the computation of taxable income. In some cases, this difference between financial statement and tax income has been further accentuated through the subsequent sale of the acquired loans.

Due to the controversy over the application of purchase accounting (primarily the perceived mismatching of income and expense as loan portfolio discounts were accreted over a short life relative to the life assigned to the goodwill), the Financial Accounting Standards Board issued Statement No. 72 (FASB No. 72), which is effective for mergers of thrift institutions initiated after September 30, 1982. This statement minimizes, if not eliminates, the mismatch but does not require that goodwill be "attached' to the acquired loan portfolio and enter into the computation of gain or loss on a subsequent sale.

Examples 3 and 4 demonstrate the impact on book and tax income resulting from: (1) the amortization of goodwill and accretion of the loan portfolio discount and (2) the sale of the loans at a book gain. Both examples relate to purchase accounting transactions not covered by FASB No. 72.

When the stockholders review the financial statements of this institution, they could surmise that the association has net income which could be used to pay dividends. However, the reality of the situation is that possibly no amount could be paid as dividends from the earnings of this period. The tax basis earnings were negative and unless earnings and profits exist, dividends cannot be paid without the adverse tax consequences previously described.

After an acquisition has been consummated, if interest rates decline, it is possible for the acquiring association to sell the acquired loans at a gain. Since the loans were recorded at fair value at the date of acquisition, a decline in interest rates will cause the value of the portfolio to increase. When this occurs, the gain which may result for book purposes does not exist for tax purposes (as the loans retain their historical book value for tax purposes) and the resulting income statement would reflect the results shown in Example 4.

Regulatory Restrictions on Net Worth

Section 12 CFR 563.13 of the Rules and Regulations for the Federal Savings and Loan Insurance Corporation sets forth the minimum amounts of net worth that an insured institution must maintain. Presently, this minimum amount is the sum of:

1. Three percent of all liabilities of the insured institution at the beginning of the fiscal year or the average of such balances on such date and one or more of the four immediately preceding fiscal years; plus

2. Two percent of recourse liabilities resulting from the sale of any loan; and

3. Twenty percent of the institution's scheduled items.

The above requirements are subject to certain phase-in requirements for institutions insured less than 20 years and other modifications contained in the regulations, such as the special rules applicable to newly chartered S&Ls.

Unless the institution meets the requirement set forth above, no dividends can be paid without supervisory approval. In addition, if the payment of the dividend would reduce the net worth of the institution below the level required by this section, the dividend would have to be reduced in order to satisfy the minimum net worth requirement.

Further, an association that has converted from mutual to stock is not permitted to pay dividends on its common stock after conversion if its net worth would thereby be reduced below the amount then required for the "liquidation account' established for the benefit of the depositors at the time of the conversion. Also, for a period of three years, a converted association is not permitted to pay a cash dividend in any one year in an amount in excess of one-half of the greater of its net earnings for the current fiscal year or the average of the current fiscal year and not more than the two immediately preceding fiscal years.

It must be noted that the net worth requirement is not static. As an association grows in size (through the accumulation of savings deposits), the net worth requirement will also grow. For illustration purposes, assume that an association is 26 years old, has a compounded annual growth rate of 10 percent, and has no scheduled items and has not sold loans on a recourse basis. Given these assumptions and assuming that the total liabilities were $100,000,000 five years ago, the information in Example 5 can be developed.

Thus, in order for this institution merely to meet the required regulatory net worth, it is necessary for the institution to earn $366,306 (or to attract a combination of equity capital and earnings in at least the same amount) for the year. Are such earnings possible? Will increased earnings be sufficient to fund a greater net worth requirement caused by accelerated deposit growth? These questions can only be answered by the passage of time.

The example association which was just discussed had no scheduled items nor did it sell loans on a recourse basis. If an association has to contend with either of these situations, the increased requirement for regulatory net worth could further limit cash dividends.

Conclusion

Capital stock S&Ls have unique constraints on their ability to pay cash dividends to their stockholders. These constraints emanate from the provisions of the Internal Revenue Code and regulatory net worth requirements applicable to insured S&Ls. Together, they create a framework of complex rules that need to be thoroughly understood by stockholders of these institutions. With this understanding and informative disclosures contained in the financial statements, associations can be fairly evaluated in the capital markets. Further, the understanding of the rules discussed in this article is a prerequisite to effective financial management of capital stock associations contemplating the payment of cash dividends.

Table:

Table: Example 1

Table: Example 2

1. Tentative computation

II. Bad debt reserves recaptured

III. Final computation

Table: Example 3

Table: Example 4

Table: Example 5.--Required Regulatory Net Worth Versus Asset Growth

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