Cash dividends in the savings and loan industry

Federal Home Loan Bank Board Journal, Jan, 1984 by Doug McEachern, Henry D. Forer

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.