As the industry gains a greater understanding of the proposed Basel III capital rules, some management teams are identifying potential problems for their organizations in the rules. One such problem is the broad-based dividend restrictions and the consideration of how those restrictions may impact S Corporations.

Many states recognize in their banking laws and regulations that a different set of standards should apply in determining dividend restrictions for S Corporation banking institutions and their holding companies. Because the taxable income of these entities is passed through to the shareholders of the organization, it is expected that these entities will pay distributions that allow their shareholders to fund their personal tax liabilities attributable to the taxable income of the organization.

The proposed Basel III capital rules have a number of dividend restrictions. Most bankers are familiar with the dividend restrictions imposed under Prompt Corrective Action, but the new capital rules also contain dividend restrictions if the organization is not in full compliance with the requirement to maintain the required capital conservation buffer: a requirement for banking organizations to maintain common equity Tier 1 capital equal of 2.5% of total risk-weighted assets in addition to the minimum risk-based capital requirements.

If a banking organization does not maintain the full capital conservation buffer, it becomes subject to restrictions on the payment of dividends and on payments of discretionary bonuses to executive officers. These restrictions increase as the organization’s capital conservation buffer decreases, and if the organization does not maintain a capital conservation buffer of at least 1.25% of risk-weighted assets, it will be able to pay dividends of no more than 20% of its eligible retained income in dividends, subject to receiving a waiver of these restrictions from its regulators. Eligible retained income is defined as the organization’s net income for the previous four quarters, net of dividends and discretionary bonus payments to executive officers during that period.

As a result, if an S Corporation’s capital levels do not satisfy the new capital requirements, it may not be able to pay distributions to its shareholders to fund their tax liabilities attributable to the taxable income of the organization. As stated above, in order to completely avoid restrictions on dividends and bonus payments, a banking organization would need to maintain a capital conservation buffer of at least 2.5%. In order to be able to distribute at least 40% of eligible retained income to shareholders (as many S Corporations seek to do), banking organizations will need to maintain a capital conservation buffer of at least 1.25% of risk-weighted assets.

Many S Corporation banking organizations intend to continue to maintain robust capital levels that meet the requirements unless, of course, they encounter tremendous operating losses: maintaining a capital conservation buffer of 1.25% would only require a common equity Tier 1 ratio of 5.75%, a Tier 1 risk-based ratio of 7.25%, and a total risk-based capital ratio of 11.25%. However, it is important to remember that under the new rules, capital levels can change quickly, even if the organization is operating profitably. The prime example is the proposal within the rules that accumulated other comprehensive income (AOCI) will flow directly to the calculation of common equity Tier 1 capital. As a result, a steep rise in interest rates could negatively affect the value of a bank’s securities portfolio, which would directly impact the bank’s common equity Tier 1 capital without affecting taxable income.

Because there is no exception within the proposed rules for distributions for S Corporations, we encourage S Corporations to comment on the proposed capital rules in an effort for the rules to reflect that S Corporation “tax distributions” should be treated differently from other dividends. The deadline for comments is currently set at September 7, 2012.