Cash dividends in the savings and loan industry

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

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.