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Avoiding Double Taxation: The Case of Commercial Banks
Abstract
Recently, there has been a marked increase in the number of banks choosing to operate as Subchapter-S Corporations. The apparent motivation is tax savings as Subchapter-S firms do not pay federal income taxes on income at the firm level, but transfer income to stockholders where it is taxed as individual income at personal tax rates. Given the apparent advantages of Sub-S status, there must be mitigating reasons for not choosing this organizational form. We empirically investigate factors affecting the choice of Subchapter-S status and key performance differences between Sub-S banks and those taxed as C-corporations. Empirical findings indicate that Sub-S banks are significantly smaller, pay higher dividends, have lower taxable income before Sub-S formation, higher profitability, lower capital and loan loss reserves, rely more on core deposits, and have higher agricultural but lower commercial and total loans. Sub-S banks are more likely to be rural and less likely to be de novo, or have publicly-traded stock.
... This may bias our tests against finding a tax-motive for loan selling. Cyree, Hein, and Koch (2005) also find that S-corporation banks tend to be smaller and more likely to be located in rural areas compared to C-corporation banks. S-corporation banks also have relatively more core deposits but make less loans and hold less capital. ...
Most banks are subject to corporate income taxes while special purpose vehicles that hold securitized loans are corporate tax-exempt. We present a model that shows how this tax asymmetry creates an incentive for banks to sell loans. However, because moral hazard costs arise when banks inefficiently credit screen and monitor sold loans, only some banks will choose to sell particular loans. The model shows that if a bank has significant loan origination opportunities but limited deposit market power, its tendency to sell loans increases as its corporate income tax rate and its equity capital requirement rise. Empirical tests are performed using U.S. commercial banks’ originations and sales of mortgages reported on Home Mortgage Disclosure Act (HMDA) filings for the years 2001 to 2008. Consistent with the model’s predictions, banks operating in markets with relatively high lending opportunities are more likely to sell mortgages when they face higher state corporate income tax rates. An implication is that corporate taxation of bank income contributed to excessive growth in securitization. Moreover, raising banks’ required equity capital without a radical redesign of their corporate taxation could induce further tax-motivated securitization.
This paper investigates the effect at the bank and industry level of a 1996 tax law change allowing commercial banks to elect S-corporation status. By the end of 2007, roughly one in three commercial banks had either opted for or converted to the S-corporation form of organization. Our study analyzes the effect of this conversion on bank dividend payouts. It also examines the effect S-corporation status has on a community bank’s likelihood of sell-off and measures a firm’s sensitivity to tax rates based on its choice of organizational form. We document that dividend payouts increase substantially after a bank’s conversion to S status. Moreover, community banks that convert are significantly less likely to be sold than their C-corporation peers. We estimate a tax rate elasticity of conversion in the range of 2 to 3 percent for every 1-percentage-point change in relative tax rates. Overall, our results provide evidence that Subchapter S status has significant effects on bank conduct and industry structure.
This paper identifies tax and nontax factors that influence commercial banks' conversion from taxable C-corporation to nontaxable S-corporation from 1997 to 1999, after a 1996 tax-law change allowed banks to convert to S-corporations for the first time. We find that banks are more likely to convert when conversion saves dividend taxes, avoids alternative minimum taxes, and minimizes state income taxes. Banks are less likely to convert when conversion restricts access to equity capital, nullifies corporate tax loss carry forwards, and creates potential penalty taxes on unrealized gains existing at the conversion date. Banks with significant deferred tax assets are less likely to convert, presumably because the write-off of deferred taxes at conversion decreases regulatory capital and exposes the bank to costly regulatory intervention. We also investigate the strategic choices banks make before converting to S-corporations. Converting banks alter their capital structures, deliberately sell appreciated assets, and strategically set dividends to augment net conversion benefits.
We examine the profit efficiency of US banks chartered between 1980 and 1994. Our results suggest that profit efficiency improves rapidly at the typical de novo bank during its first three years of operation, but on average takes about nine years to reach established bank levels. Excess branch capacity, reliance on large deposits, and affiliation with a multibank holding company are associated with low profit efficiency at de novo banks. De novo national banks are initially less profit efficient than are state-chartered de novos, perhaps reflecting differences in the chartering philosophy of federal and state bank regulators.
Small, closely held corporations must rely disproportionately on managerial shareholdings to mitigate the agency costs associated with hired managers, because market discipline and motivated outside monitors are typically absent for such firms. We study a random sample of 266 small, closely held US commercial banks with a broad range of ownership and management arrangements. Our results suggest that hiring an outside manager can improve profitability, but these gains depend on aligning hired managers with owners via managerial shareholdings. We find that over-utilizing this control mechanism results in entrenchment, while under-utilization is costly in terms of foregone profits.
Agency theory implies that asset ownership and decision authority are complements. Using 1998 data from Texas commercial banks, we test whether the likelihood of local ownership of bank offices increases with the importance of granting local managers greater decision authority (for example, due to location or customer base). Our empirical evidence is consistent with this hypothesis. It suggests that complementarities between strategy and organizational structure can foster differentiation among firms in terms of location, customers, and products. It also supports the growing view that small locally-owned banks have a comparative advantage over large banks within specific environments.
We test hypotheses about the effects of bank size, foreign ownership, and distress on lending to informationally opaque small firms using a rich new data set on Argentinean banks, firms, and loans. We also test hypotheses about borrowing from a single bank versus multiple banks. Our results suggest that large and foreign-owned institutions may have difficulty extending relationship loans to opaque small firms. Bank distress appears to have no greater effect on small borrowers than on large borrowers, although even small firms may react to bank distress by borrowing from multiple banks, raising borrowing costs and destroying some relationship benefits.
The number of US community banks is falling rapidly. Is this reduction being driven in part by banks’ desire to geographically diversify to reduce their vulnerability to local economic shocks? A comparison of the performance of banks in counties that suffered economic shocks in the 1990s with similar banks in counties that did not suffer economic shocks shows that banks withstand local economic shocks quite well. This result suggests that the geographic concentration risk that community banks must bear to focus on relationship lending is small and is not an important factor contributing to the decline of community banks.
This paper presents a theory of liquidity where we explicitly model the liquidity of the security as a choice variable, which enables the manager raising the funds to screen for "deep pocket" investors, i.e. these that have a low likelihood of a liquidity shock. By choosing the degree of illiquidity of the security, the manager can influence the type of investors the firm will attract. The benefit of liquid investors is that they reduce the manager's cost of capital for future fund raising. If inside investors have fewer information asymmetries about the quality of the manager than the outside market, more liquid investors protect the manager from having to return to the outside market, where he would face higher cost of capital due to asymmetric information problems. We test the predictions of our model in the context of the private equity industry. Consistent with the theory, we find that transfer restrictions on investors are less common in later funds organized by the same private equity firm, where information problems are presumably less severe. Contracts involving the close-knit California venture capital community - where information on the relative performance of funds are more readily ascertained - are less likely to employ many of these provisions as well. Also, private equity partnerships whose investment focus is in industries with longer investment cycles display more transfer constraints. For example, funds focusing on the pharmaceutical industry have more constraints, while those specializing in computing and Internet investments have fewer constraints. Finally, we investigate whether the identity of the investors that invest in a private equity fund is related to the transferability of the stakes. We find that transferability constraints are less prevalent when private equity funds have limited partners that are known to have few liquidity shocks, for example endowments, foundations, and other investors with long-term commitments to private equity
Mutual insurers generally face higher costs of raising new capital than stock insurers. Other things being equal, the higher costs of raising capital should cause mutual insurers to have higher ex ante target capital to liability ratios than stock insurers. Mutual insurers' capital ratios also should be more sensitive to income than capital ratios for stock insurers and therefore adjust more slowly toward their long-run targets. We provide evidence concerning these issues using aggregate time series data for stock and mutual insurers during 1984-1999 and a large panel data set during 1991-1998. Our regressions provide strong evidence that annual changes in capital to liability ratios are more sensitive to income for mutual insurers than for stock insurers. We also provide evidence that mutual insurers' capital ratios are on average higher than those for stock insurers after controlling for several factors that could influence capital ratios.
We examine the impact of selling Monthly Income Preferred Stock (MIPS) on the common share prices of the issuing firms. We find that issuing MIPS to retire preferred stock raises the value of the firm, and that government policy can significantly affect the present value of the tax savings. Using proceeds to retire bank loans negatively impacts common share value. This negative response is larger for MIPS users with lower credit ratings on their senior debt. These findings support the view that banks perform a valuable monitoring service, which, if removed, can invoke an adverse market reaction.
The distance between small firms and their lenders is increasing, and they are communicating in more impersonal ways. After documenting these systematic changes, we demonstrate they do not arise from small firms locating differently, consolidation in the banking industry, or biases in the sample. Instead, improvements in lender productivity appear to explain our findings. We also find distant firms no longer have to be the highest quality credits, indicating they have greater access to credit. The evidence indicates there has been substantial development of the financial sector, even in areas such as small business lending. Copyright The American Finance Association 2002.
: We develop a framework for analyzing the capital allocation and capital structure decisions facing financial institutions such as banks. Our model incorporates two key features: i) value-maximizing banks have a well-founded concern with risk management; and ii) not all the risks they face can be frictionlessly hedged in the capital market. This approach allows us to show how bank-level risk management considerations should factor into the pricing of those risks that cannot be easily hedged. We examine several applications, including: the evaluation of proprietary trading operations; and the pricing of unhedgeable derivatives portfolios. I. Introduction One of the fundamental roles of banks and other financial intermediaries is to invest in illiquid financial assets--assets which, because of their information-intensive nature, cannot be frictionlessly traded in the capital markets. The standard example of such an illiquid asset is a loan to a small or medium-sized company. A m...
This paper models the inner workings of relationship lending, the implications for bank organisational structure, and the effects of shocks to the economic environment on the availability of relationship credit to small businesses. Relationship lending depends on the accumulation over time by the loan officer of "soft" information. Because the loan officer is the repository of this soft information, agency problems are created throughout the organisation that may best be resolved by structuring the bank as a small, closely-held organisation with few managerial layers. The shocks analysed include technological innovations, regulatory regime shifts, banking industry consolidation, and monetary policy shocks. Copyright Royal Economic Society 2002
Using data from regulatory reports, we examine the relationship between stock repurchases and financial performance for a large sample of bank holding companies. The sample includes both publicly-traded and non-publicly traded banking companies. The primary result is that higher levels of repurchases in one year are associated with higher profitability and a lower share of problem loans in the subsequent year. Our results appear to be driven primarily by bank holding companies with publicly-traded stock, especially those companies whose stock is traded on major exchanges. In assessing the source of the repurchase-performance link, we find evidence suggesting that it may be driven by different factors for different types of bank holding companies. In particular, the evidence is consistent with free-cash-flow considerations for banks traded on major stock exchanges, but only weakly supports this explanation for smaller, closely-held companies.
Does Distance Still Matter? The Information Revolution in Small Business LendingThe Demise of Community Banks? Local Economic Shocks are not to Blame
- M Peterson
- R Rajan
Peterson, M and R Rajan, “Does Distance Still Matter? The Information Revolution in Small Business Lending,” Journal of Finance, 57, 2002, 2533-2570. Yeager, Timothy, “The Demise of Community Banks? Local Economic Shocks are not to Blame,” Journal of Banking & Finance, September 2004, Vol. 28, No. 9, 2135-2153.
The Illiquidity Puzzle: Theory and Evidence from Private Equity r39 Nakamura, L, “Small Borrowers and the Survival of the Small Bank: Is Mouse Bank Mighty or Mickey?” Business Review, Federal Reserve Bank of Philadelphia
- J Lerner
- A Schoar
Lerner, J. and A. Schoar, The Illiquidity Puzzle: Theory and Evidence from Private Equity, Journal of Financial Economics, 2004, 72, 3-40. r39 Nakamura, L, “Small Borrowers and the Survival of the Small Bank: Is Mouse Bank Mighty or Mickey?” Business Review, Federal Reserve Bank of Philadelphia, November-December 2004, 3-15
De Novo Bank Growth Choices and Performance: Implications for the Future of Community Banking
- K B Cyree
- J W Wansley
Cyree, K.B., and J.W. Wansley, " De Novo Bank Growth Choices and Performance:
Implications for the Future of Community Banking, " 2004 Working Paper.