Independent Community Bankers of America (ICBA) Helping Community Banks Increase Small Business Lending

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1 Memorandum TO: Gene Sperling Counselor to the Secretary of Treasury FROM: Independent Community Bankers of America (ICBA) DATE: May 7, 2009 RE: Helping Community Banks Increase Small Business Lending This memo outlines a variety of policies recommendations that would help community banks increase their ability to lend to small businesses Tax Reforms In General Expand Loss Carryback to Five Years or More One-third of banks nationwide or more than 2,657 reported a loss in the latest FDIC quarterly banking profile. Allowing community banks of $10 billion in assets or less to simply spread out their current losses to preserve capital to leverage for lending would help entire communities weather the deep recession. Expanding the current Net Operation Loss Carryback (NOL) period to five years or more from two years will help free up small business resources now to help support investment and employment at a time when capital is needed most. Expanding the NOL to a five-year carryback simply allows businesses to accelerate the use of allowable NOL deductions that can be claimed in future years under current law anyway. Subchapter S Tax Reforms One-third, or 2,505 banks in our nation are Subchapter S corporations. They are wellpositioned to help boost lending throughout communities across America. However, many onerous rules and obstacles prevent S corporation banks from reaching their full potential.

2 Increase the maximum number of S corporation shareholders to 150 For all small businesses, raising capital is critical to the start-up, survival, and growth of the business. Bank regulators are demanding banks raise additional capital given the current economic slowdown. Unfortunately, arbitrary and restrictive limits on the number of allowable Subchapter S shareholders can jeopardize the ability of S corporations to raise capital. Notably, other business forms such as LLCs and partnerships have no restrictions on the number of shareholders. When the S corporation rules were first enacted, the maximum number of shareholders was 10. Throughout the period Congress increased the number to 35. The Small Business Job Protection Act increased the maximum number of eligible S corporation shareholders from 35 to 75 for tax years beginning after December 31, The American Jobs Creation Act of 2004 increased the number of eligible shareholders from 75 to 100. However, similar pass-through tax structures have no shareholder limits at all. Today, the rigid Subchapter S shareholder limits are still out of sync with the modern capital and operating needs of small businesses. Reflecting their nature, many community banks were created by involving a large number of shareholders in a community to raise capital. This helps assure that the institutions are widely owned by members of the local communities they serve. The provision of the S corporation rules limiting the number of shareholders to no more than 100 often forces community banks that wish to become an S corporation to disenfranchise shareholders, severely limiting ownership and its ability to raise capital in the future. Additionally, other corporate structures such as a LLP or LLC do not have any limitation on the number of shareholders. ICBA recommends increasing the maximum number of allowable S corporation shareholders to 150. ICBA believes that increasing the number of allowable shareholders will permit more community banks to make the S corporation election and, at the same time, continue to be widely owned by members of their communities. Allow new IRAs as eligible S corporation shareholders Many of our nation s banks need to raise additional capital if they are going to be able to increase lending. Current law restricts the types of individuals or entities that may own S corporation stock. S corporation community banks seeking to raise capital may not allow new IRA shareholders. Traditional and Roth IRA stock are permitted only to the extent that that IRA stock was held on or before October 22, Subchapter S community banks are put at a disadvantage relative to other less restrictive business forms in their ability to attract capital due to the rigid IRA shareholder restriction. ICBA recommends that new IRA investments in a Subchapter S bank be allowed regardless of timing. IRA shareholders should be allowed to participate in Subchapter S corporations. ICBA believes this will grant more community banks the needed flexibility in attracting IRA shareholder capital from existing owners and new shareholders. 2

3 Allow community bank S corporations to issue certain preferred stock Current law only allows S corporations to have one class of stock outstanding. C corporations that want to make the S corporation election must eliminate any second class of stock prior to the effective date of the S corporation election. Likewise, issuing a second stock class by an S corporation terminates its S corporation status. Community banks must maintain certain minimum capital ratios to be considered a well-capitalized institution for regulatory purposes. As a community bank grows in size, its earnings alone may not provide sufficient capital to fund its growth and to continue providing new loans. Banks needing more capital can raise additional capital by issuing common stock, preferred stock, or, in some cases, trust-preferred securities. Many community banks avoid issuing additional common stock to fund growth so that they can protect their status as an independent community bank and serve their local community lending needs. Instead, they frequently use preferred stock to fund growth and retain control. However, S corporation banks are not allowed to issue commonly used preferred stock because preferred stock is considered a second class of stock. This prevents small community banks from having access to an important source of capital vital to the economic health and stability of the bank and the community it serves. ICBA recommends exempting convertible or "plain vanilla" preferred stock from the "second class of stock" definition used for S corporation purposes. This would help more community banks become eligible to make the S corporation election as well as help those that currently are S corporations seeking to raise additional capital. Allowing community bank S corporations to issue preferred stock would allow them to reduce the burden of double taxation like other pass-through entities and, at the same time, fund future growth. To provide community banks one more important option in attracting capital to fund business operations and serve their communities, ICBA strongly recommends passage of the provision in the Communities First Act, which would allow the use of preferred stock by S corporation banks. Preserve 35% top marginal tax rate on Subchapter S income Small businesses are facing extremely difficult economic times. A troubled credit market combined with a slowdown in U.S. economic growth, high energy prices, and sharp inflationary costs across-the-board for inputs are crimping small business profits and viability. Maintaining cash flow is vital to the ongoing survival of any small business and taxes are typically the second highest expense for a business after labor costs. As pass-through tax entities, Subchapter S taxes are paid at the individual income tax level. Marginal income tax rates do play a critical role in a small business viability, entrepreneurial activity, and choice of business form. Today more than half of all business income earned in the United States is earned by pass-through entities such as S corporations and limited liability corporations. 3

4 The top corporate income tax rate and individual income tax rate are currently set at 35%. Much discussion has been given to addressing the corporate tax rate for international competitiveness concerns and raising the individual income tax rate. ICBA believes significant shifts in the existing marginal tax rates and changes in parity between corporate and individual tax rate can trigger unwanted and costly shifts in business forms. ICBA believes it is important to consider maintaining parity between the top corporate and individual income tax rates in the Code. Additionally, during this difficult economic period, at a minimum, the current top tax rate of 35% should be preserved on both small business Subchapter S income and C corporation income, not increased. Prevent new threats to Subchapter S status from the TEFRA disallowance proposed IRS change ICBA also wants to highlight to the Treasury a counterproductive IRS proposed rule that would greatly threaten the strength of Subchapter S banks. The IRS rule would reverse long-standing tax treatment and precedent on the use of bank qualified bonds that are permissible investments for banks. Banks are allowed to invest in bank qualified tax-exempt bonds in order to help cities and towns served by community banks finance needed local projects such as schools, water treatment plants, firehouses and hospitals in an affordable way. Unfortunately, the IRS proposed a new regulation that would contradict an existing statute. (IRS Proposed Regulation (b) (IRS-REG ).) The community banking industry has in good faith relied on the statute and informal IRS guidance in applying the so-called TEFRA tax disallowance for Subchapter S banks that hold bank qualified bonds for the past seven tax years or more. The existing practice by S corporation banks, that the 20% TEFRA disallowance terminates three years after the S election, is soundly based on existing law. The IRS should not have the authority to override a statute with a regulation. The ICBA believes this proposed regulation is unwarranted, and if further advanced, would be tremendously damaging to Subchapter S banks, their taxpaying shareholders and the communities they serve. The ICBA strongly opposes the proposed regulation and has respectfully urged the IRS to promptly withdraw it. ICBA believes these recommendations would go a long way in helping more small businesses and community banks stay strong and competitive and increase their lending capacity. They would allow small businesses to more fairly and efficiently choose the corporate structure that would best suit the need of their businesses, customers and communities they serve. Allow a national bank limited liability company (LLC) charter Community banks are small businesses yet are often unable to use preferred business forms available to other small businesses such as a limited liability corporation (LLC). Additionally, even as some S corporation rules and restrictions have been addressed in 4

5 recent years to enable greater use of this structure, current restrictions still make Subchapter S unworkable for many community banks. ICBA recommends the limited liability company charter available to small businesses be available to community banks nationwide. ICBA strongly supports the bipartisan Communities First Act (H.R / S. 1405) provision advanced in the 110 th Congress that would allow a bank or savings association to convert to an LLC charter in a tax-free transaction. The U.S. banking regulators ruled favorably that State banks chartered as LLCs would be eligible for federal deposit insurance. ICBA believes allowing community banks the flexibility to use the LLC structure would help overcome the many obstacles preventing a similar Subchapter S election. Unlike Subchapter S, LLC status does not have the stifling limits on the number of shareholders, types of shareholders, or class of stock restrictions that unfairly prevent community banks from electing a pass-through tax structure. LLC-chartered banks could continue to be widely owned and not be forced to restrict or limit ownership as in an S corporation. To preserve their ongoing viability and to serve their local areas, community banks must have options for generating new sources of capital without setting themselves up to become takeover targets. Allowing banks to form as LLCs would go a long way in supporting the viability of community banks and the communities they serve. Program Improvements Finalize SBA Secondary Market Programs (TALF Program and SBA Secondary Market Program) The frozen secondary market for small business loans continues to impede the flow of credit to small business. Several ICBA-backed programs have been launched to help unfreeze the frozen secondary market for pools of Small Business Administration (SBA) guaranteed loans, including the TALF and a new SBA secondary market facility. The Term Asset-Backed Securities Loan Facility (TALF), conducted through the Federal Reserve and U.S. Treasury, was intended to extend billions in nonrecourse loans to holders of high-quality assetbacked securities (ABS) backed by consumer and small business loans in a bid to free up the frozen ABS market. Specifically, the TALF program for SBA secondary market loan pools is very close to success. Unfortunately, one program obstacle requiring third-party direct competitor primary dealers to be middlemen has completely stalled the program. SBA loan poolers will not turn over their customers to their direct competitors nor have the primary dealers engaged in the program to date. ICBA recommends either eliminating the primary dealer middlemen in the process or 5

6 allowing the Federal Reserve Bank of New York to work as the intermediary with the existing SBA loan poolers. Similarly, the new SBA secondary market program is close to success but the debate over potential additional fees to operate the program has stalled its launch. ICBA recommends using the enacted substantial funded budget authority to run the program in combination with user fees so as not to kill the program with unworkable double fees. ICBA believes with these minor adjustments, these targeted SBA secondary market programs will keep money flowing to consumers and small businesses providing the intended value and results. Allow a government insurance program for classified bank assets Allow all FDIC-member banks the opportunity to buy insurance in the amount of the face value of a classified loan for a 3-year term in exchange for payment of an insurance premium of 5-15% of the face value of the classified loan ("Classified Asset Insurance"). If a bank pays the insurance premium, the bank is provided Classified Asset Insurance and permitted to keep the classified asset on its balance sheet as a non-performing asset without writing it down for the period of the 3-year insurance term, which will increase the net capital available for the bank to make loans and attract capital/investors. The insurance will only be payable by the FDIC to the bank in the event that the bank fails and is taken over by the FDIC as receiver while a Classified Asset Insurance term is in effect for any classified assets of that particular bank. By purchasing Classified Asset Insurance, banks will have more capital available to make new loans, and more time and opportunity to workout and repair classified loans and maximize recovery on liquidating collateral securing classified loans. Regulatory and Accounting Improvements Tiered Regulation Congress and the financial regulators have repeatedly adopted differential regulation that benefit community banks. These include: Longer periods between examinations for community banks; Special procedures for community bank CRA examinations. Bills moving through Congress in recent months have included a variety of similar provisions: 6

7 Different treatment on executive compensation rules for banks that have received lower amounts of TARP funding; and Different requirements for small credit card issuers. These provisions reduce costs for community banks, enabling them to better serve their communities, while still carrying out the essence of federal regulatory policies. GSE & Government Loan Policies Government sponsored enterprises and U.S. government loan programs should not reject a loan for the sole reason that the property is in a declining market. Accounting The following regulatory adjustments would help community banks continue to serve their small business customers: A new appraisal should not be required when the loan is performing according to the loan agreements and the bank expects it to continue to perform, even if it s in a declining market. Permit banks to write down real estate-related loan deficiencies on Other Real Estate Owned by 10 percent per year over a maximum of 10 years. Cap Risk Weighting Downgraded Securities at 200% If a securitization (private CMO or, more likely, a trust preferred CDO), is downgraded below BB, the capital required gets grossed up for the tranches above the class the bank owns. The ratings agencies have been very quick to drop to B and lower levels any bond which is expected to bear a loss. As a result, you get (1) an accounting MTM for the credit loss and (2) a regulatory capital requirement to carry exponentially higher amounts of capital against the investment. The effective capital risk weights can easily range from 500% to 1250% (essentially a dollar of capital is required for every dollar of securities). This is a punitive, double hit. While these are riskier items, banks are boxed-in they end up with securities which require dollar-for-dollar capital, essentially writing off the bonds in total, and with no other options to sell efficiently in this market. 7