Cash dividends in the savings and loan industry

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

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.