• Are LLC Banks in the Cards? Stay Tuned
  • July 2, 2003 | Author: Thomas W. Garton
  • Law Firm: Fredrikson & Byron, P.A. - Minneapolis Office
  • The FDIC has declared that certain Limited Liability Companies may qualify for depository insurance under the Federal Deposit Insurance Act. Should we be welcoming this development as the first of several dominoes to fall, or should we be smirking at a pointless exercise in regulatory discretion? Time will tell.

    Since 1997, financial institutions have been qualified to make an election to be taxed under Subchapter S of the Internal Revenue Code as "pass through" tax entities and be taxed as an "S Corporation." Banks realized, and quickly became familiar with, the benefits of this pass through treatment. As an S Corporation, a bank's income is subject to a single level of tax, not the double tax (corporate level, and then again at the shareholder level on dividends) that is applied to non-electing corporations under Subchapter C of the Code (C Corporations). Limited Liability Companies (LLCs) can provide the same pass through benefits, but for a number of reasons an LLC has not been a viable form of bank entity.

    In general, LLCs can be preferable to S Corporations (though each entity is subject to relatively similar income tax treatment) because LLCs avoid the sometimes restrictive qualification rules that apply to S Corporations, including the limitation on the number of shareholders, restrictions relating to the characteristics of shareholders, and the single class of stock requirement.

    Under applicable tax rules, an LLC may be taxed under one of three different regimes: as a corporation (either an electing S Corporation, if qualifying tests are met, or as a C Corporation); as a partnership; or, where there is only one member of the LLC, as a disregarded entity. The LLC generally may elect which system of taxation will apply. This election is made under the federal tax "check-the-box" regulations.

    At least five states-not including Minnesota, Wisconsin, North Dakota or South Dakota-expressly permit LLCs to be engaged in the business of banking. So why haven't banks chosen to organize as LLCs?

    There are some prohibitive hurdles to a bank organizing as an LLC. The first is that the bank regulatory rules generally require that the bank be "incorporated" under the authority of the National Bank Act or be "incorporated" under the laws of the regulating state. If "incorporated" is interpreted to mean organized under traditional corporate statutes, an LLC would appear not to meet either of these requirements.

    A second hurdle is found in the definitional sections of the Internal Revenue Code. The regulations under Code Section 7701 prohibit a "state chartered business entity [which would include an LLC] conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act," from making a check-the-box election to be taxed as other than a corporation. That is, for tax purposes, a bank LLC may be taxed only as either a C Corporation or an S Corporation. It cannot elect under the check-the-box regulations to be taxed as a partnership or a disregarded entity.

    A third hurdle is that the Federal Depository Insurance Act defines an insurable bank as an institution which is "incorporated under the laws of any state or which is operating under the Code of Law for the District of Columbia." A bank formed as an LLC would arguably not be such an institution. The key in both situations is the meaning of the words "incorporated under."

    On February 13, 2003, the FDIC announced and published a final rule relating to LLCs as qualifying for depository insurance under the Federal Deposit Insurance Act. This well-considered rule establishes certain structural parameters in order for an LLC to be entitled to be insured, and these parameters are significant. Nonetheless, it is a breakthrough of sorts. The FDIC is now willing to insure deposits of an LLC Bank. This could be a meaningless rule if the other hurdles for Bank LLCs are not overcome.

    The discussion accompanying the announcement of the rule acknowledges that the Code Section 7701 definitional provisions referred to above are a practical bar to an LLC Bank's enjoying the "partnership" or "disregarded entity" income taxation treatment which would be available to other businesses formed as LLCs. The announcement further suggests that the FDIC is not taking action to recommend to the Treasury Department that the regulations under 7701 be changed to accommodate or conform with the FDIC conclusions. Until those definitional provisions of the Code and tax regulations are changed, there is no particular benefit to banks to organize as LLCs. Until other changes are made, the FDIC rule will have no real utility.

    However, if this FDIC rule-making is a signal of further Treasury Department and federal and state regulatory interpretation of the term "incorporated," it may be that this FDIC rule is the start of a cascade of changes that could liberalize the structure and operation of a bank, permitting banks to organize and operate under the provisions of a state's LLC statute. These changes would permit LLC Banks to enjoy the pass through tax treatment of a partnership or a disregarded entity, without being subjected to the limiting restrictions on S Corporation qualification. Stay tuned!