Implications of Subchapter S tax status for commercial banks

Abstract

Scope and Method of Study: Banks first became eligible to elect Subchapter S of the Internal Revenue Code in 1997. Subchapter S status provides institutions the ability to maintain limited liability while avoiding double taxation. The earnings flow through to the individual shareholders on a pro rata basis and are taxed only at the individual level. This paper examines the effect conversion to Subchapter S tax status has on commercial banks. A sample of 1,658 banks that convert to Subchapter S from 1997-2004 are analyzed to detect changes in performance that occur due to the conversion to Subchapter S. I use an event study methodology modified to accommodate accounting data. A sample of banks that did not convert to Subchapter S status is matched with the converting banks to control systemic changes. The primary research question is to determine what banks do with the corporate tax savings that result from conversion.

Findings and Conclusions: The empirical analysis indicates that the sample banks that convert to Subchapter S increase dividends. Furthermore, the results indicate that Subchapter S banks increase dividends more than the added personal taxes incurred by shareholders as a result of paying taxes on all income, whether distributed as dividends or not. The analysis indicates that banks converting to Subchapter S status reduce some types of small business and agricultural lending, reduce the proportion of earnings retained as capital, and reduce salaries. The analysis supports the conclusion that Subchapter S banks direct the tax benefits of conversion to shareholders rather than increasing the amount of small business and agricultural lending, increasing bank capital, or increasing salaries and benefits.