Sub Chapter S Bank Owned Life Insurance?
By Joe B. Jones, Steven J. Terbovich and John Charnes
The American Jobs Creation Act of 2004 that was signed into law on October 22, 2004 made significant changes to the rules governing Subchapter S corporations. The act spurred many closely held community banks to take advantage of the tax benefits available to S corporations. Sub S status eliminates double taxation of corporate income. This encouraged bankers to distribute more of the bank's earnings each year instead of growing the capital as they have in the past.
A growing number of banks have taken advantage of Subchapter S status or are in the process of converting to Sub S status. Many of the Subchapter S banks are either family-owned or independent community banks with the majority being located in the Midwest.
There are downsides to Subchapter S tax status. The most significant is that shareholders are fully taxed on their proportional share of the bank's income, regardless of how much is distributed. To ease shareholder's concerns, most banks distribute at least the amount they would have paid in corporate income taxes. The typical federal and state tax rate for banks is 40 percent. Generally, Subchapter S banks retain between 25 percent and 50 percent of their earnings; however many banks distribute more, which does not allow the bank to grow.
An additional downside to this corporate status is when banks purchase Bank Owned Life Insurance, known as BOLI. The regulatory agencies permit banks to purchase BOLI in an amount equal to 25 percent of their Tier 1 capital plus an allowance for loan losses. They usually cap the amount at 15 percent with any one insurance carrier.
BOLI cash value typically increases at a 4% to 8% rate each year. If the capital of the bank plus loan loss reserve does not increase at a similar rate, then the bank will be in violation of the regulations. The regulators can require the bank to surrender some of their insurance policies, which would be very onerous to the bank.
An example:
A bank that has purchased a modified endowment BOLI contract ("MEC") would suffer from being forced to liquidate these policies. Taxation under a MEC is on income first plus a 10% penalty. The aggregation rule of section 72(e)(11) was enacted to treat all MECs issued by the same insurance company to the same policyholder in the same calendar year as one contract. The aggregation rules may create issues for some forms of bank owned life insurance, where a large number of contracts are purchased under a single premium plan (resulting in classification as MECs). Under the aggregation rules, if a single contract or small group of contracts is surrendered, all of the distribution could be classified as gain, subject both to tax and penalty.
This rule was put into place to stop the marketing of an advertised way to limit the LIFO rule and penalty tax: rather than sinking $1,000,000 into a single MEC, the purchaser would buy 10 contracts, each for $100,000. At 10% interest, each of these individual contracts would have income of $10,000 instead of one large contract having income of $100,000 after one year. Should the policyholder wish to withdraw $100,000, he could simply surrender one of the contracts and recognize income of $10,000 for tax purposes, rather than being deemed to realize income of $100,000 under the single contract alternative. This would have effectively converted the section 7702a distributional rules to a proportional method of taxing distributions, rather than the income-first approach.
If a bank regulator informs the bank that it must surrender a contract to stay within the 25% BOLI capital position, the bank will pay tax and penalty on the full $100,000 surrender in the example above. This is a very onerous penalty and can hurt the bank much more than keeping the contract on the books. Federally-chartered banks have a distinct advantage over state banks in the total amount of BOLI they can hold. It is imperative that Sub S banks manage their capital levels to avoid being forced to surrender MEC insurance policies, or hope that the regulators make an exception to assuage the financial stress they are putting many banks under by having too rigid guidelines.
Mr. Jones and Mr. Terbovich are principals at Executive Benefits Network, a bank compensation consulting firm in Lawrence, KS. Mr. Charnes is a University of Kansas Business School professor.
First published on BankersOnline.com 3/20/06
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