impact of taxes and ownership oncapital structure s corp banks may2010 to jfi

8/13/2019 Impact of Taxes and Ownership OnCapital Structure S Corp Banks May2010 to JFI

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The Impact of Taxes and Ownership on the

Performance and Capital Structure of S Corporation Banks *

Ken B. CyreeUniversity of Mississippi

Scott E. Hein **Texas Tech University

Timothy W. KochUniversity of South Carolina

May 2010

Abstract

Since 1997, commercial banks have been allowed to operate as S Corporations therebyavoiding taxation at the federal corporate income taxlevel. This research investigates the impact ofownership on the profitability and capital structure of S Corporation banks in comparison to CCorporation banks. Because ownership and managerial control of S Corp. banks are highlyconcentrated relative to that for C Corp. banks, the agency hypothesispredicts that S Corp. banksexhibit greater operating profits on both a pre-tax and after-tax basis. We find evidence consistentwith S Corporation banks having lower agency costs of equity and thus higher profitability even

before tax. The fact that interest expense is not tax deductible at S Corp. banks leads to thetradeoff hypothesis, which implies that S Corp. banks operate with less interest-bearing debtrelative to comparable C Corp. banks. One the other hand, if S Corp. banks see themselves as moreprofitable, they may feel better able to add to the capital stock when needed, and thus choose tohold less capital on average. Indeed, we find empirical evidence that S Corporation banks operatewith less equity capital than C Corporation banks, ceteris paribus, as well as reduce their capitalholdings following conversion.JEL: G21, G32, M40, C30

Keywords: Agency cost of equity, Bank Performance, Capital structure, Commercial banks, S

Corporations, Taxes

* We thank David Becher, George Cashman, Jack Cooney, Ray DeGennaro, Bill Dukes, AltonGilbert, William Jackson, Jeff Mercer, Mike Stegemoller, Steve Swidler, Sergey Tsyplakov,Larry Wall, Drew Winters, Tim Yeager, John Ziegelbauer and participants at several conferencesessions and seminars for comments on earlier versions of this paper.** Corresponding Author: Ken B. Cyree, University of Mississippi, 253 Holman Hall,University, MS 38677. [email protected],phone 662-915-1103.
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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The Impact of Taxes and Ownership on the

Performance and Capital Structure of S Corporation Banks

May 2010

Abstract

Since 1997, commercial banks have been allowed to operate as S Corporations thereby

avoiding taxation at the federal corporate income taxlevel. This research investigates the impact ofownership on the profitability and capital structure of S Corporation banks in comparison to CCorporation banks. Because ownership and managerial control of S Corp. banks are highlyconcentrated relative to that for C Corp. banks, the agency hypothesispredicts that S Corp. banksexhibit greater operating profits on both a pre-tax and after-tax basis. We find evidence consistentwith S Corporation banks having lower agency costs of equity and thus higher profitability evenbefore tax. The fact that interest expense is not tax deductible at S Corp. banks leads to thetradeoff hypothesis, which implies that S Corp. banks operate with less interest-bearing debtrelative to comparable C Corp. banks. One the other hand, if S Corp. banks see themselves as moreprofitable, they may feel better able to add to the capital stock when needed, and thus choose tohold less capital on average. Indeed, we find empirical evidence that S Corporation banks operatewith less equity capital than C Corporation banks, ceteris paribus, as well as reduce their capitalholdings following conversion.JEL: G21, G32, M40, C30

Keywords: Agency cost of equity, Bank Performance, Capital structure, Commercial banks, S

Corporations, Taxes


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The Impact of Taxes and Ownership on the Performance and Capital

Structure of S Corporation Banks

A popular criticism of U.S. federal income tax policy is that owners of corporations are

taxed twice, first at the corporate level under the corporate income tax and again at the

shareholder level as individuals pay personal income tax on any dividends and capital gains.

Such criticism, however, applies only to C Corporations. S Corporations avoid this double

taxation, with certain limitations, because the underlying entity does not pay corporate federal

income taxes. Instead, individual shareholders pay tax at personal tax rates on any income

allocated to them. To the extent that S Corporations are able to avoid double taxation they

provide a natural experiment to examine the impact of taxes on the firms choice of capital

structure. Furthermore, because S Corporations are closely held due to restrictions on the number

of shareholders, their owner-managers may exhibit different perspectives on risk and profitability

objectives.

Researchers, such as Modigliani and Miller (1958 and 1963), Scott (1976), and Miller

(1977), have long debated the influence of taxes on the capital structure decisions of

corporations. Many argue that corporations find it optimal to hold at least some debt because

interest payments are tax deductible for the corporation, while dividend payments on equity are

not similarly treated. In a survey of firm managers, Graham and Harvey (2001) verify that firm

managerstrade-off the benefits versus distress and tax costs of debt via target debt ratios.


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Adherents of this trade-off theory implicitly argue that S Corporations, which pay no federal

income tax and thus have no advantages from debt, would hold proportionately less interest-

bearing debt and more capital.

Whether a firm operates as an S or C Corporation also likely affects operating

performance and managements risk tolerance. Clearly, the avoidance of corporate income taxes

should improve a firms bottom line. Equally important, however, is the prospect that

concentrated ownership may reduce agency problems and subsequently improve risk

management practices. When Congress initiated legislation allowing certain corporations to elect

S Corporation structure, it imposed limits on the maximum number of shareholders allowed. The

current maximum is 100 shareholders with broad definitions that, in some instances, allow

family members to constitute one shareholder. The possibility of improved risk management

practices is linked to the types of firms that select S Corporation status and the tendency of

owner-managers to lead the firms.

With constraints on the number of shareholders, S Corporations are generally smaller in

terms of asset size and market value than their C Corporation counterparts. Limiting the number

of shareholders concentrates ownership, especially among the Board of Directors and

management. According to Berle and Means (1932), Jensen and Meckling (1976) and

subsequent researchers, concentrated ownership mitigates negative consequences of the

separation of ownership from control of the corporation. As such, S Corporations could have

smaller agency problems and stronger operating profits, ceteris paribus.

While S Corporations outnumber C Corporations in recent years, little research has

examined the structure and performance of S Corporations likely due to data limitations. Because

S Corporations are generally small in size and non-public, comprehensive financial data are not


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as readily available as for publicly-traded corporations. However, detailed balance sheet and

income statement data are available for S Corporation commercial banks. The Small Business

Job Protection Act of 1996 authorized qualifying insured commercial banks to be taxed as S

Corporations (S Corp. banks) effective in 1997.1 Not surprisingly, the ability to avoid federal

corporate income taxes (and in some cases, state taxes) has been quite attractive and the number

of banks that selected S Corporation status has increased sharply. Figure 1 highlights changes in

the number of S Corp. banks from 1999 to 2009 when almost one-third of U.S. commercial

banks operated as S Corporations.

This research empirically examines the operating performance and capital structure of S

Corporation commercial banks relative to that of C Corporation commercial banks. In doing so, we

examine a tradeoff hypothesis associated with managementschoice of financial leverage and an

agency hypothesis associated with firm operating performance. First, because interest expense on

debt is not tax deductible for S Corp. banks, the tradeoff hypothesisimplies that S Corp. banks

operate with less interest-bearing debt relative to comparable C Corp. banks. Second, because

ownership and managerial control of S Corp. banks are highly concentrated relative to that for C

Corp. banks, the agency hypothesisstipulates that S Corp. banks exhibit greater operating profits

after controlling for risk. This latter hypothesis reflects, in part, reduced agency problems

associated with managers and owners who are closely aligned when making managerial decisions.

In conducting the empirical analysis, we address potentially serious endogeneity problems.

For example, while we could easily compare key performance ratios between banks representing

the two groups, differences might be driven by the types of banks that choose to be taxed as S

1 Prior to 1997, commercial banks and savings associations were prohibited from electing to be organized as S

Corporations regardless of the number of stockholders.


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Corporations versus C Corporations. Given the limitations on the maximum number of

shareholders, S Corporations are likely to be smaller, more frequently located in rural settings, and

more likely to be regulated by state banking departments rather than the OCC or Federal Reserve

System. Differences in performance or capital structure may simply reflect these structural

differences.

We focus our attention on banks in large part because of data availability. S corporations,

by their very nature, are small entities and thus generally dont have publicly-traded securities.

However, all U.S. commercial banks are heavily regulated and are required to publicly provide

basic financial information on a quarterly basis. Regulation, in turn, encompasses allowable

balance sheet mix, minimum capital standards, and other elements that make commercial banks

unique. We discuss some of these unique features in our development of hypotheses. Finally, our

research does not allow us to explore market prices for securities which are not available for

virtually all S Corp. banks. As such, we are forced to consider non-traditional measures of risk and

return (i.e. those not directly related to modern portfolio theory) in our analysis. The remainder of

the paper describes the nature of the empirical analysis and presents estimates of differences in

performance and capital structure.

1. RELATED BANKING LITERATUREGiven that S Corporation banks have only been in existence in the U.S. following 1996

Congressional legislation, little empirical research exists regarding their performance. Hodder,

McAnally and Weaver (2003, HMW) were among the first to examine S Corp. banks and

identified tax and nontax factors likely to influence the choice to incorporate as an S

Corporation. They find that banks are more likely to convert to S Corporation status when the


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conversion lowers dividend taxes and minimizes state income taxes. They also find that banks

are less likely to convert when conversion would lead to capital constraints or create penalty

taxes on unrealized gains.

Hein, Koch and MacDonald (2005, HKM) build on the importance of relationship

banking to smaller, community banks in the U.S. They note that a growing proportion of smaller

banks organize as S Corporation banks each subsequent year. These smaller banks, in turn, are

shown to be more profitable than larger banks. HKM (2005) emphasize that part of this increased

profitability is simply attributable to the fact that S Corporations pay no federal income tax such

that after-tax comparisons between S Corporation banks and C Corporation banks are not

appropriate. Gilbert and Wheelock (2007, GW) go one step further and show that S Corporation

banks have higher earnings than their peer C Corporation banks even after the formersearnings

are reduced by estimated federal income taxes. The better profitability is largely attributed to

higher net interest margins and greater operating efficiency. GW does warn, however, that there

is no perfect way to compare S Corporation and C Corporation bank earnings to one another.

Thus, there is some evidence suggesting that S Corporation banks are more profitable

than their C Corporation counterparts, even after controlling for tax differences. There are two

limitations to this evidence, however, that this paper attempts to rectify. First, no theory has

been offered to explain why these differences exist. We argue that because S Corporation banks

are likely to be smaller and more closely-held, they will engage in more relationship banking

activities, which have been shown to be more profitable, and they are likely to be better able to

mitigate the agency costs of equity. Second, the earlier evidence has not controlled for problems

with self-selection bias. For example, it might be the case that more profitable banks have an


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incentive to convert to S Corporations and the evidence of greater profitability may be

attributable to this fact rather than S Corporation status.

The hypothesis linking S Corporation status to increased bank profitability is related to

literature on smaller organizations ability tobetter exploit soft information and to literature on

mitigating the agency costs of equity. Brickley, Linck and Smith (2003), for example, provide

evidence showing that locally-owned bank offices in Texas grant more decision-making

authority to local managers, allowing for better exploitation of soft information. They find that

small locally-owned banks have a comparative advantage over larger banks. While they do not

examine the corporate status of the banks in their study, S Corporation banks are more likely to

be locally-owned. Berger, Miller, Petersen, Rajan, and Stein (2005) also find evidence

consistent with the observation that small banks are better equipped to collect and act on soft

information than are large banks.

Mehran and Suher (2009) also give explicit consideration to S Corporation banks. They

focus primarily on dividend payouts and bank acquisitions and find evidence that S Corporation

banks dividend payouts increase following conversions from C Corporations. They also find

evidence that S Corporation banks are significantly less likely to be sold relative to C

Corporation banks. Finally, they find that S Corporation banks operate less efficiently on a

pretax basis in contrast with the results of GW (2007).


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2. A PRELIMINARY COMPARISON OF C CORPORATION AND S CORPORATIONBANK PERFORMANCE

To conduct our preliminary analysis, we use year-end balance sheet and income

statement data from Federal Financial Institutions Examination Council (FFIEC) bank reports of

income and condition (Call Reports) for 1999-2008.2We initially report key bank performance

and balance sheet ratios for S Corp. banks in the year of conversion versus the same measures for

C Corp. banks. Generally, S Corporations cannot own other S Corporations.3

We conduct our analysis at the bank level as opposed to the holding company level.4

Figure 1 shows recent trends in the number and proportion of S Corporation banks. As indicated,

the proportion of S Corporation banks increased dramatically over time from 16 percent in 1999

to 30 percent in 2008 and higher thereafter. Summing the number of banks across all years gives

a final sample of 15,637 S-Corporation and 44,360 C-Corporation bank-years.

S Corporation banks differ from their C Corporation counterparts in many ways.

Consider the summary univariate data in Table 1 which document size, location, and capital

differences for all banks separated according to S or C Corp. status. For comparative purposes, C

Corp. banks are those operating in each year with total assets no greater than that of the largest S

Corp. bank that year. At year-end 2008, 48percent of S-Corp. banks had less than $100 million

in assets and only 160 had more than $500 million in assets. The largest S Corp. bank in our

sample at the end of 2008 had $3.5 billion in assets. Not surprisingly, almost 70 percent of S

2

While banks were first allowed to choose S Corporation status in 1997, we omit data for 1997 and 1998 because

the FFEIC reports do not explicitly identify which banks are S Corp. banks.

3An S Corporation that owns 100 percent of the stock of another corporation, however, can elect to treat the

subsidiary as a qualified subchapter S subsidiary.

4We have also conducted the analysis at the holding company level with similar results. These results are availableupon request.


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Corp. banks were headquartered in rural areas. The number of S Corp. banks increases

systematically over time as does the relative size of the average bank. Generally, the reported

data for capital ratios, equity-to-total assets and the adjusted capital ratio (stockholders equity

divided by the difference between total assets and non-interest bearing deposits) are

systematically lower for S Corp. banks, but sufficiently close to the ratios for C Corp. banks to

necessitate further investigation.

We compare key performance measures for S Corporation banks to the same measures

for C Corporation banks matched by total asset size. Variables are separated into three

categories: 1) profitability, 2) balance sheet mix and risk, and 3) capital measures. The measures

are widely used in the banking literature, but some might be new to those not familiar with

banks. Table 2 presents means of key ratios for S Corporation banks versus means for a size-

constrained, matched sample of C Corporation banks. Specifically, the matched sample for each

year includes all C Corporation banks that reported total assets no greater than the amount of

total assets for the largest S Corporation bank in that year. The table provides t-statistics, testing

for differences in the means between S Corporation and C Corporation banks. Because these

results are simple partial comparisons and we have not controlled for potential endogeneity

problems, we view these findings as primarily descriptive. Still, the results described here are

broadly consistent with the more sophisticated two-stage estimation provided in Section 5.

2.1 Profitability

Our findings regarding bank profitability comparisons are broadly consistent with those

of GW (2007) as S Corporation banks have, on average, much higher after-tax aggregate profits

measured by both ROE and ROA. They also report net interest margins (NIMs) that are 17 basis


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points higher, on average, while our estimate is 24 basis points. In order to neutralize the tax

advantage of S Corp. status, we also construct pre-tax profit ratios. Importantly, S Corp. banks

report significantly higher average ratios for pre-tax ROE and pre-tax ROA. This finding is

similar to that of GW (2007), but the opposite finding of MS (2009). The difference in the pre-

tax and after-tax ROA for S Corporation banks is small and largely reflects differential state

taxes. This preliminary evidence supports the view that S Corp. banks earn higher returns, even

ignoring their tax advantages, with the differences in pre-tax ROE and ROA between the two

groups at 1.84 percent and 0.16 percent, respectively. After subtracting taxes, average ROE and

ROA are approximately 60 percent greater at S Corporation banks. This latter comparison clearly

demonstrates the error in treating these two corporate structures equally when evaluating

performance based on traditional benchmarks like ROE and ROA. Not surprisingly, S Corp.

banks pay a higher fraction of income as dividends as most S Corp. shareholders are subject to

income taxes on their share of bank profits. This finding is consistent with the evidence provided

in MS (2009). Finally, profit growth is significantly higher for S Corporation banks over the

prior three years.

2.2 Balance Sheet Mix and Risk

Data for the balance sheet mix variables reveal that S Corp. banks fund their operations

differently. First, they operate with proportionately more demand deposits but fewer other core

deposits, such as small time deposits, MMDAs, and savings accounts. Second, they have fewer

purchased liabilities, such as repurchase agreements and FHLB advances, compared with their C

Corp. bank peers. Demand deposits are unique to commercial banks as they represent non-

interest bearing liabilities. Historically, individuals viewed their primary bank relationship to be


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with the firm that provides these checking account services. Demand deposits held by individuals

are highly interest inelastic and represent a stable, low cost source of funds. Thus, most banks

view demand deposits as a core driver of firm value. Banks pay market rates on purchased

liabilities which are generally higher than rates paid on core deposits. The overall funding

characteristics suggest that S Corp. banks have a lower average cost of funds and less liquidity

risk. The fact that other core deposits is lower at S Corp. banks may mitigate this claim, but may

also reflect the widespread acquisition of time deposits and MMDAs via internet CDs and rate

boards during this time frame by C Corp. banks. Finally, as noted below, S Corp. banks have

lower equity-to-asset ratios and thus greater financial leverage. This raises interest expense,

ceteris paribus.

On the asset side, S Corp. banks hold proportionally fewer total loans, but more

agriculture and commercial loans. With the different loan mix and loan levels, S Corp. banks

report higher past-due loan ratios, but there is no difference in net charge-offs suggesting that

their credit risk management experience has been comparable to that of C Corp. banks, on

average. Interestingly, S Corp. banks have lower asset growth than their C Corp. counterparts.

Given that we havent controlled for whether S Corp. banks compete in more restricted

geographic markets, the differential asset growth may simply reflect that more C Corp. banks

operate in faster-growing metropolitan areas. Additionally, S Corp. banks are more likely to be

de novo banks and thus might purposely limit asset growth, something we control for in the

following analysis. It may also reflect the fact that S Corp. banks pay more in cash dividends.

Finally, S Corp. banks hold more liquid assets possibly reflecting a greater need to pledge

securities against public deposits and greater reliance on unpledged securities for liquidity given

their more limited access to purchased liabilities.


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2.3 Capital

Finally, the various capital ratios indicate that S Corp. banks operate with less

stockholders equity to assets, both before and after adjusting for non-interest bearing demand

deposits, and lower Tier 1 risk-based capital ratios.5A banks equity-to-asset ratio is a traditional

measure of financial leverage. The adjusted capital ratio subtracts demand deposits from total

assets in the denominator in recognition that most banks will accept all the demand deposits that

they can attract. They can effectively spread the deposit servicing cost over a larger base and

easily invest the funds earning a positive spread. The adjusted capital ratio attempts to control for

financial leverage not associated with interest expense.

Given likely constraints on the amount of common stock that a limited number of

individual shareholders can often acquire, even if tax considerations dont matter, S Corp. banks

likely obtain proportionately more capital in the form of trust preferred stock that is sold to

external constituents. The data, however, indicate that S Corp. banks operate with relatively less

preferred stock and subordinated debt financing.

5The Tier 1 risk-based capital ratio is a measure of capital adequacy that was developed with the Basel I capital

standards. The ratio is simply Tier 1 capital to risk weighted assets. Tier 1 capital is the regulatory definition of

capital that is most closely aligned with common stock holders equity. The risk-weighted assets of a bank are found

by classifying all assets into one of four categories, each with weights between 0% and 100%. The measure of risk-

weighted assets also includes certain off balance sheet items to capture non-balance sheet financial risks. S Corp.

banks similarly have greater demand deposit financing which is quite stable. They may choose to operate with

relatively less equity given the lower risk sources of debt utilized.


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3. EMPIRICAL DESIGNThe previous findings are consistent with those of GW (2007) indicating that S

Corporations are generally more profitable, even allowing for their tax advantage, than their C

Corporation counterparts. Our univariate findings are also generally contrary to the tradeoff

theory, as S Corporation banks have less equity than their counterparts, on average. Finally, the

findings are consistent with the agency view that S Corporations have higher risk-adjusted

returns. However, this investigation suffers from potential endogeneity problems, as we have not

controlled for factors that might shape the decision to elect S Corporation status. The univariate

analysis may simply indicate that banks which elect to become S Corporations may themselves

be more profitable and hold less capital. We attempt to mitigate the endogenous variables

problem by using the Heckman (1979) correction procedure which requires the empirical

analysis of factors that are likely to lead a commercial bank to elect the S Corporation structure.

Fortunately, HMW (2003) suggest factors that appear to influence this choice. We begin by

outlining their analysis, which is used to develop the first step in our Heckman estimation. The

empirical results follow.

3.1 Factors Influencing the S Corporation Election

HMW focus on tax matters that shape a banks decision to elect the S Corporation

structure. The comparison of tax benefits between S and C Corporations, in turn, requires an

analysis of expected taxable income and dividend payouts and the relationship between marginal

corporate and personal income tax rates. HMW represent the tax benefit of conversion to an S

corporation as the sum of two terms; the savings from avoiding individual taxation of dividends

and an offset reflecting incremental taxes due because marginal corporate income tax rates are


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less than marginal personal income tax rates (at least for the maximum income tax rate

schedules):

Tax benefit = [dividends x ti] + [taxable income ( tc - ti) ] , (1)

where dividends and taxable income represent cash dividend payments and earnings subject to

taxes as a C Corporation, respectively, and tcand tirefer to the banks marginal corporate and

shareholder marginal personal income tax rates, respectively. Equation (1) indicates that higher

dividends should produce a greater tax benefit from S Corporation conversion, ceteris paribus,

and that an increase in taxable income, holding dividends constant, may result in a lower net

benefit because income may be taxed at the higher individual shareholder tax rate. The special

circumstances of individual stockholders and the amount of taxable income determine the

magnitude of the overall tax benefit. For example, consider a bank owned by one stockholder

who is a dairy farmer with an effective personal tax rate of zero (ti= 0). Operating as a C Corp.

bank generates a dead weight cost by reducing the amount of income available for payment as

dividends. In contrast, S Corp. taxation avoids this cost and increases the after-tax value of cash

dividend payments to the stockholder. Similarly, a C Corporation with substantial built-in gains

will be required to pay taxes on the unrealized built-in gains over time at the maximum corporate

tax rate if it converts to an S Corporation. Thus, conversion to an S Corp. bank would sharply

increase taxable income. Not converting defers any recognition of the gain which may induce

management to not seek S Corporation status until the built-in gains are minimal.

The role of dividends is likely to be even more important than that suggested by this

framework. Suppose a commercial bank makes a positive profit, retains all earnings, and pays no

dividends. As a C Corporation, it would pay corporate taxes on all earnings but the double

taxation is minimal as shareholders pay no income taxes because they receive no dividends. In


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this scenario, shareholders can effectively postpone individual tax obligations indefinitely. A tax

event at the individual level occurs only when the shareholder sells stock with the tax impact

determined by whether the sale is at a gain or loss and whether the marginal personal income tax

rate is greater (lower) than the capital gains tax rate. As an S Corporation, the bank would pay no

corporate income tax, but taxable income would be allocated to shareholders regardless of

whether cash dividends were paid, so shareholders would pay income tax at a (presumably)

higher tax rate with tc- ti< 0.

HMW generally argue that banks are more likely to convert from a C to an S Corporation

when conversion reduces stockholder dividend taxes and state income taxes and helps

stockholders avoid the alternative minimum tax.6They also argue that smaller banks are more

likely to make the S Corporation election. On the other hand, banks in growth markets with

limited access to the capital markets and those with significant corporate tax loss carry-forwards

are less likely to convert.

HMW estimate a logistic regression model where the choice of S Corporation status is

related to a banks cash dividend payments, taxable and tax-exempt income, growth rate in total

assets and purchased liabilities during the three prior years, unrealized gains on investment

securities, the existence of tax loss carry-forwards, age of the bank since incorporation, and the

natural log of total assets. They also include a series of dummy variables to capture favorable tax

and regulatory factors, labeled tax variables, non-tax variables and control variables. Tax

6

When a C Corp. elects to operate as an S Corp., it must treat any unused AMT credit as a carry-forward item and

can use it to offset built-in-gains taxes over the 10-year recognition period. Many banks buy municipal bonds that

pay interest exempt from federal income taxes and this interest increases the banks alternative minimum taxable

income under the AMT. The key issue is how to determine how many municipals to own and the amount of the

AMT credit.


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benefits are determined by the amount of dividends paid along with aggregate bank taxable

income. Importantly, dividends will have a positive impact on the election of S Corporation

status as long as the respective marginal corporate tax rate is less than the relevant marginal

individual income tax rate. In general, any factor that creates less benefit of conversion to S

Corp. status, such as having large built-in-gains that would offset the tax benefit, should decrease

the likelihood of conversion.

In order to assess performance differences, we need to control for selection bias. Our first

stage analysis is based largely on the framework proposed by HMW that models managements

decision to elect the S Corporation organization form. We estimate a probit regression of the

form:

S Corporation = f (BUILTIN, LOSSCF, AMT, DIVPAY, Yearly Dummies,

STATEDUM, RURAL, AGE, LNASSETS) (2)

with S Corporationequal to one if the bank chooses to be an S Corporation for the first time in

that year, and zero otherwise;BUILTINequals unrealized capital gains on investment securities

scaled by total assets if positive, and zero if a capital loss exists;LOSSCFis a zero-one indicator

that takes a value of one if the prior three years losses are greater than the current years profit;

AMTis HMWs proxy for the alternative minimum tax, defined as tax-exempt interest divided

by assets;DIVPAYis the banks total cash dividends for the year divided by operating profits;

Yearly Dummies, YR00-YR08, are indicator variables that equal one if in the year suffix, and

zero otherwise with 1999 the excluded set; STATEDUMis an indicator for the state in which the

bank is located and zero otherwise, omitting Washington, DC7;RURALis one if the bank is not

7While for sake of space we do not report the coefficients on the state dummy variables, we should note these

coefficients are generally highly significant. This reflects the fact that the treatment of S Corp. banks varies greatly


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in an MSA, and zero otherwise;AGEis the number of years from charter date; andLNASSETSis

the log of total assets.

The Heckman (1979) correction uses the inverse Mills ratio from the first stage probit

regression that estimates the probability of selecting S Corporation status. The correction helps

account for possible selection bias because banks that elect to become S corporations may also

have better profit performance, differential capital ratios, and balance sheet mix. We are

particularly concerned whether banks that choose to be S corporations generate higher profits or

may operate with differential financial leverage independent of the choice.

3.2 Comparative Bank Tax Treatment, Operating Performance and Capital Structure

The different tax treatment of S Corp. versus C Corp. banks potentially leads to

different balance sheet structures and operating performance which may be compounded by

differences in ownership structure of the two types of banks. We are first interested in bank

performance and agency effects on risk management practices. We hypothesize that the close

alignment of ownership and control of many S Corp. banks mitigates potential agency conflicts

between owners and managers. One implication is that S Corp. banks may, on average, better

manage banking risks and subsequently produce higher risk-adjusted profits. For example,

managers of S Corporations are likely less willing to engage in perquisite consumption due to

their (generally) larger pro-rata share of ownership than most C Corporation managers. They are

also likely to be better incentivized to find profitable, risk-adjusted investment opportunities.

This discussion leads to the agency hypothesis:

from state to state which is reflected in the fact that some states have very few S Corp. banks while other states have

large numbers of S Corp. banks.


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Agency Hypothesis: S Corp. banks exhibit greater profits than comparable C Corp. banks.

This should be obvious in the case of after-tax returns, as S Corp. banks avoid the federal income

tax burden of their C Corp. brethren. However, we also argue that S Corp. banks will be more

profitable than their C Corp. peers on a before-tax basis.

Next, we consider two competing theories and their capital structure implications. First,

we consider the tradeoff hypothesis, which emphasizes the lack of tax deductibility of debt for

S Corp. banks. In particular, the avoidance of federal corporate income taxes eliminates the tax

advantages of interest-bearing debt for S Corp. banks, suggesting a tradeoff hypothesis:

Tradeoff Hypothesis: S Corp. banks operate with less interest-bearing debt and more

equity capital than C Corp. banks.

To the extent that S Corp. banks do not directly derive tax benefits from the interest expense on

debt, they may hold relatively less of this debt relative to their C Corp. counterparts. Importantly,

S Corp. banks may rely proportionately more on trust preferred stock. Banks with a limited

number of shareholders and strong growth prospects historically found such stock attractive due

to its low cost and ready availability without diluting the ownership of existing shareholders.

Trust preferred stock and subordinated debt qualify, with limitations, as Tier 1 capital which

helps meet regulatory capital requirements. Trust preferred stock has the distinct advantage over

common equity because dividend payments are effectively tax deductible. Thus, the use of

preferred stock and subordinated debt lowers a banks cost of capital and we include bothin our

capital structure equations.8

In contrast to the tradeoff hypothesis, we build on the agency benefits of the S Corp.

structure and develop an alternative hypothesis. Traditional theories of capital structure start with

a presumed target level for the capital stock that is achieved by flow changes over time. The

8The use of trust preferred stock by community banks largely disappeared with the credit crisis that began in 2007.


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conversions around the initial regulation. Additional independent variables also includePUBLIC,

which equals one if the bank is publicly-traded and zero otherwise; RURAL, which equals one if

the bank is located in a non-MSA county and zero otherwise;DENOVO, which equals one if the

bank is less than five years old and zero otherwise because start-up banks typically have worse

performance as shown by DeYoung and Hasan (1998);AGEis the banks age since inception in

years;ASSETGROis the banks past three years arithmetic average growth rate in total assets;

PROFGROis the past three years arithmetic average growth rate in netincome;LNASSETSis

the log of total assets;LLR2TAequals loan-loss reserves to total assets;AGLOANS is

agricultural loans to total assets; CNILOANSis commercial and industrial loans-to-total assets;

LOAN2DEPis the ratio of loans-to-deposits;DD2AST, OTHCOREAST and PURLIABAST

equal demand deposits, other core deposits under $100,000 and purchased liabilities,

respectively, each divided by total assets; SD2ASTis subordinated debt to total assets and

PREF2AST equals preferred stock to total assets. TheLAMBDAvariable is the inverse Mills

ratio from the first-stage Heckman correction to account for possible sample bias. We test these

hypotheses using balance sheet and income statement data for U.S. commercial banks from

1999-2008.

4. EMPIRICAL EVIDENCETable 3 contains the probit results for S Corp. selection by banks. The first two columns

present the probit regression estimates and p-values for the raw data, while the last two columns

contain standardized coefficient estimates (each variable is standardized by dividing the value by

the full sample standard deviation for that variable) and the rank of each variables impactbased

on the standardized data. The standardized data estimates indicate which variables have the


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greatest influence on the probability of becoming an S corporation for banks in this sample. The

last column contains the ranking (1 indicates the highest and 17 the least impact) based on the

absolute value of the effect.9

Our first stage findings are similar to those of HMW except for investment capital gains

as a fraction of assets (BUILTIN) where the coefficient estimate is not statistically different from

zero andLOSSCFwhere we find that a higher loss of tax benefits is associated with a higher

probability of S Corporation election. Regarding the LOSSCF variable, we follow HMW and

have an indicating variable that take on a value of one if the prior three years losses are bigger

than this years profit.These differences may be due to our longer sample period or the different

empirical specification. However, we confirm HMWs finding forAMT, where higher

proportions of tax-exempt securities owned are associated with lower probabilities of S

Corporation election. Similarly, the coefficient on the dividend payout rate variable has the

anticipated positive sign and is significantly different from zero indicating that banks electing to

become S Corporations generally have higher dividend payout rates. Dividends better enable S

Corp. shareholders to satisfy their personal income tax obligations which have been passed on to

them at the personal income level. The dividend payout variable is the most significant variable

in shaping the decision to adopt S Corporation status as indicated by the highest rank for the

standardized estimates (aside from the yearly dummy variables and intercept). Surprisingly,

rural banks are not more likely to elect S Corp. status, on average.

Table 4 presents the results from the second stage regressions which represent our tests of

the trade-off and its alternative, as well as the agency hypotheses.First, consider the results for

9 Note that for consistency with the raw data results, we do not report the standardized state indicator estimates even

though they are included in the model.


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CAPRATIO and the capital structure implications. While the control variables exhibit the

anticipated signs, S Corp banks appear to operate with less equity-to-assets, ceteris paribus, and

thus greater financial leverage in contrast to the predictions of the tradeoff hypothesis.

Importantly, the more banks rely on preferred stock the lower are overall capital ratios such that

this other form of regulatory capital appears to contribute to lower traditional equity ratios.

While the evidence is broadly inconsistent with the tradeoff hypothesis as outlined above with S

Corporations having less equity than C Corporations, it is supportive of the alternative view that

managers of S Corp. banks feel that they dont need as large of a capital stock to begin with since

they are better equipped to add to it by retaining earnings from their higher profits.

The significant LAMBDA coefficient estimate suggests that the sample bias correction is

necessary in all three models. The interpretation is that the higher the probability of choosing S

corporation status, the lower is pre-tax and after-tax ROA, but the higher is the capital ratio.

These effects offset the higher performance and lower capital of actual S Corp. election as shown

by the indicator variable, hence the differences in the model accounting for selection bias and the

one that does not.

Consider next the agency hypothesis. The results for pre-tax ROA demonstrate that S

Corp. banks have higher pre-tax ROAs than their C Corp. counterparts, ceteris paribus,

suggesting that S Corp. banks perform better even after accounting for possible selection bias.

The estimates indicate a 42 basis point increase in pre-tax ROA, a 76 basis point increase in

after-tax ROA, and an approximate 86 basis point decline in the capital ratio.10The estimates are

10The derivative of the inverse Mills ratio is not linear so that including the LAMBDA variable as an independent

regressor in a second stage OLS model does not give a true derivative. These results are thus not true partial

derivatives for S Corporation status.


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similar to the model without the Heckman correction (not shown), which indicates a statistically

significant 17 basis points pre-tax ROA, 49 basis points after-tax ROA, and 38 basis points lower

capital ratio. Regardless of the model used, these estimates are economically meaningful and

indicate higher performance and lower capital ratios for S Corp. banks that are not due to sample

bias. The implication is that S Corp. banks appear to manage risk comparably with C Corp.

banks while generating greater profitability. As such, we cannot reject the agency hypothesis

which suggests that S Corp. banks operate with higher risk-adjusted profits than C Corp. banks.

Other control variables provide additional insight into S Corp. bank performance and

risk. Rural banks have higher ROAs while de novo banks have lower ROAs as expected, and

correspondingly operate with less and higher capital, respectively. De novo banks must have

sufficient start-up capital to offset poor early performance. S Corp. banks that have grown assets

quickly have lower performance and capital ratios suggesting a tradeoff between asset growth

and accounting performance. Larger banks have higher profitability and lower capital ratios, all

else equal.11 Banks with higher loan losses have lower profitability and capital ratios while

banks with higher proportions of total loans and commercial lending have higher performance

and lower capital. Finally, the structure of funding greatly influences performance. Banks with

the greatest proportion of funding from demand deposits are more profitable and operate with

less equity, while those that rely proportionately more on other core deposits and purchased

liabilities are less profitable yet also operate with less equity.

4.1 A Comparison of Bank Performance after versus Before S Corp. Selection

In this section, we incorporate another method for analyzing performance differences

after controlling for conversion to S Corp. status. Specifically, we examine differences in means

11Note that the largest banks in the sample have total assets no greater than the largest S Corp. bank.


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in key variables for S Corp. banks in the 3-year period prior to conversion versus the first three

years after conversion. The final two columns of Table 5 provide t-statistics and z-statistics,

respectively, for differences in means and medians when comparing post-conversion minus pre-

conversion performance variables. The results demonstrate that capital ratios did not change

significantly, except for the Tier 1 risk-weighted ratio, which fell, on average after conversion.

Again, the lower Tier I capital ratio finding is consistent with our alternative hypothesis to the

trade-off theory. Post-conversion, S Corp. banks also relied proportionately less on preferred

stock as a capital component.

In terms of profitability, after-tax ROA and ROE increased sharply, as expected, but both

pre-tax ROA and ROE declined, on average. This latter finding is not expected, but may reflect

the different timing of when banks converted to S Corp. status relative to the economic cycle or

alternatively a general decline in profitability at S Corp. banks over time. Or, it may reflect the

view that S Corp. banks follow expense preference behavior after conversion when there are

fewer owners and managers consuming greater perquisites. As expected, S Corp. banks pay

much higher dividends after conversion.

In terms of balance sheet mix, S Corp. banks increased loan-to-asset and loan-to-deposit

ratios, but also experienced greater past due loans and net charge-offs after conversion. These

results may similarly reflect timing differences between when banks converted across the

business cycle. Finally, S Corp. banks appear to have reduced their reliance on other core

deposits but increased their reliance on purchased liabilities after conversion. This change in mix

of liabilities would have contributed to lower profits, ceteris paribus.

In order to control for changes in the business cycle, we conduct the same tests pre- and

post-conversion after subtracting the yearly mean or median for all banks from each variable.


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These results are presented in Table 6 and serve to confirm the previous analysis. Using adjusted

means, capital ratios generally fell post-conversion except for S Corp. banks use of preferred

stock. In terms of profitability, both pre-tax ROA and ROE increased after conversion, as did

post-tax ROA and ROE, net interest margin, profit growth and the dividend payout ratio when

accounting for industry performance. In other words, the results in Table 5 where pre-tax

performance fell after S Corp. conversion were due to yearly effects and performance did

increase for S Corp. banks after conversion when accounting for these annual industry effects.

Combined with the earlier results, the implication is that S Corp. banks reduce their capital, but

increase their aggregate profitability, both pretax and post-tax, following conversion.

5. SUMMARY AND CONCLUSIONS

S Corporations provide an interesting corporate structure to examine the influence of

taxes on financial decision making. Because these organizations generally avoid income taxes at

the corporate level, leverage and tradeoff theories appear to suggest that S Corporations would

employ more equity and less debt in their capital structures given that debt is not tax-advantaged

at the corporate level. Our examination of the behavior of S Corporation banks, however,

provides no evidence consistent with this hypothesis. Indeed, S Corporation banks are found to

operate with less equity, ceteris paribus, than their C Corporation counterparts. We view these

results as consistent with our alternative hypothesis to the trade-off theory that emphasizes the

strong profitability of S Corp. banks. Specifically, managers of these banks recognize their

greater ability to add to their capital by retaining earnings in the future, so they have a lower

capital stock target. Our results suggest that tax associated with interest expense on debt play a


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LITERATURE CITED

Berger, Allen, Nate Miller, Mitchell Petersen, Raghuram Rajan, and Jeremy Stein. (2005) Doesfunction follow organizational form? Evidence from the lending practices of large and smallbanks.Journal of Financial Economics, 76, 237-269.

Berle, Adolph, and Gardiner Means. (1932) The Modern Corporation and Private Property.New York. Macmillan Publishing Co.

Brickley, James, James Linck, and Clifford Smith Jr. (2003) Boundaries of the firm: evidencefrom the banking industry.Journal of Financial Economics, 70, 351-383.

DeYoung, Robert, and Iftekar Hasan. (1998) The Performance of De Novo Commercial Banks:A Profit Efficiency Approach.Journal of Banking and Finance, 22, 565-587.

Gilbert, Alton, and Gilbert Wheelock. (2007) Measuring Commercial Bank Profitability:

Proceed with Caution.Federal Reserve Bank of St. LouisReview, November/December, 515-532.

Graham, John, and Campbell Harvey. (2001) The theory and practice of corporate finance:evidence from the field.Journal of Financial Economics, 60, 187-243.

Heckman, James. (1979) Sample Selection Bias as a Specification Error.Econometrica, 47,153-161.

Hein, Scott, Timothy Koch, and Scott MacDonald. (2005) On the Uniqueness of CommunityBanks.Federal Reserve Bank of AtlantaEconomic Review, 90(1), 15-36.

Hodder, Leslie, Mary Lea McAnally, and Connie Weaver. (2003) The Influence of Tax andNontax Factors on Banks Choice of Organizational Form.The Accounting Review, 78 (1), 297-325.

Jensen, Michael, and William Meckling. (1976) Theory of the firm: managerial behavior,agency costs and ownership structure.Journal of Financial Economics, 3 (4), 305-360.

Mehran, Hamid, and Michael Suher. (2009) The Impact of Tax Law Changes on BankDividend Policy, Sell-offs, Organizational Form, and Industry Structure. Federal Reserve Bankof New York Staff Report No. 369, April.

Miller, Merton. (1976) Debt and Taxes.The Journal of Finance, 32 (2), 261-275.

Modigliani, Franco, and Merton Miller. (1958) The Cost of Capital, Corporate Finance, and theTheory of Investment.American Economic Review, 48, 261-297.

Modigliani, Franco, and Merton Miller. (1963) Corporate Income Taxes and the Cost ofCapital: A Correction.American Economic Review, 53, 433-443.


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Scott, James. (1976) A Theory of Optimal Capital Structure.The Bell Journal of Economics, 7No. 1, 33-54.


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Table 1Demographic Characteristics of S Corporation and C Corporation Banks by YearS Corporation banks are those indicated in the FFIEC call reports for each year. CCorporation banks are those that have total assets in each year no greater than the total

assets of the largest S Corp. bank that year. Rural banks are those not located in SMAs.Adjusted Capital is equity divided by the difference between total assets and non-interestbearing deposits.

1999

S Corporation Banks C Corporation Banks

Minimum Mean Maximum Minimum Mean Maximum

Number of banks 1034 5315Percent in rurallocations 0.0000 0.6905 1.0000 0.0000 0.5883 1.0000Percent state-chartered 0.0000 0.7631 1.0000 0.0000 0.7466 1.0000Total Assets (TAin $000s) 6587 91686 1771333 2306 153191 1729259

Trust PreferredStock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0082 3.9766Tier 1 Capital/TA 5.29 9.33 21.40 5.28 9.79 22.09AdjustedCapital/TA 5.72 10.76 25.80 5.56 11.19 26.90

2000

Number of banks 1164 5027Percent in rurallocations 0.0000 0.7079 1.0000 0.0000 0.5753 1.0000Percent state-chartered 0.0000 0.7663 1.0000 0.0000 0.7513 1.0000Total Assets (TA

in $000s) 5899 96776 2353746 4304 173986 2306571Trust PreferredStock x 1000 /TA 0.0000 0.0018 2.0471 0.0000 0.0057 3.3947Tier 1 Capital/TA 5.91 9.88 22.65 5.86 10.12 22.70AdjustedCapital/TA 6.63 11.39 25.91 6.14 11.56 26.66

2001

Number of banks 1194 4433Percent in rurallocations 0.0000 0.6993 1.0000 0.0000 0.5552 1.0000Percent state-chartered 0.0000 0.7563 1.0000 0.0000 0.7528 1.0000Total Assets (TA

in $000s) 6470 109847 2354825 4342 198900 2328256Trust PreferredStock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0011 1.4106Tier 1 Capital/TA 5.81 9.98 22.58 5.78 10.06 22.57AdjustedCapital/TA 6.34 11.53 29.26 6.01 11.51 29.00


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Table 1 cont.S Corporation Banks C Corporation Banks


2002

Number of banks 1356 4281Percent in rural

locations 0.0000 0.6888 1.0000 0.0000 0.5445 1.0000Percent state-chartered 0.0000 0.7471 1.0000 0.0000 0.7585 1.0000Total Assets (TAin $000s) 6935 114168 2171743 4570 209240 2164971Trust PreferredStock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0007 1.2205Tier 1 Capital/TA 6.31 10.27 22.94 6.23 10.35 23.08AdjustedCapital/TA 6.80 11.84 26.92 6.60 11.84 50.03

2003



2004

Number of banks 1674 4280Percent in rurallocations 0.0000 0.6864 1.0000 0.0000 0.5343 1.0000Percent state-chartered 0.0000 0.7522 1.0000 0.0000 0.7754 1.0000Total Assets (TAin $000s) 7114 131553 2642138 4486 247304 2612423Trust PreferredStock x 1000 /TA 0.0000 0.0000 0.0000 0.0000 0.0004 0.7629Tier 1 Capital/TA 6.23 10.07 23.65 6.19 10.42 23.71AdjustedCapital/TA 6.64 11.79 30.43 6.50 12.04 34.11

2005

Number of banks 1752 4192Percent in rurallocations 0.0000 0.6832 1.0000 0.0000 0.5270 1.0000

Percent state-chartered 0.0000 0.7637 1.0000 0.0000 0.7732 1.0000Total Assets (TAin $000s) 7946 143671 2896153 6028 269002 2846117Trust PreferredStock x 1000 /TA 0.0000 0.0007 1.1727 0.0000 0.0006 0.9255Tier 1 Capital/TA 6.08 9.89 22.96 6.07 10.40 24.18AdjustedCapital/TA 6.78 11.67 52.33 6.36 12.16 80.58


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Table 1 cont.S Corporation Banks C Corporation Banks


2006



2007



2008

Number of banks 2026 3585Percent in rurallocations 0.0000 0.6846 1.0000 0.0000 0.5180 1.0000Percent state-chartered 0.0000 0.7764 1.0000 0.0000 0.7986 1.0000Total Assets (TAin $000s) 8835 180477 3480952 6123 321061 3440854Trust PreferredStock x 1000 /TA 0.0000 0.0029 3.3070 0.0000 0.0071 4.2775Tier 1 Capital/TA 5.54 10.28 26.37 5.34 10.72 27.69AdjustedCapital/TA 5.86 11.98 37.27 5.47 12.22 38.32


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Table 2Means and t-tests for differences in means for S Corporation banks versus C Corporation banksfrom 1999 through 2008.

VariableS Corp. Bank(N = 15,637)

C Corp. Banks(N = 44,360) t-statistic for

difference in

means

Wilcoxonz-stat. formedian

differencesMean Median Mean MedianProfitability

EBTROA (%) 1.4563 1.4727 1.2944 1.3342 25.70** 25.04**EBTROE (%) 15.0726 14.9521 13.2300 13.2124 25.46** 27.48**ROA (%) 1.4196 1.4297 0.9007 0.9399 90.34** 97.81**ROE (%) 14.6892 14.5353 9.1809 9.3156 87.03** 94.33**NIM 0.0438 0.0431 0.0421 0.0414 21.76** 22.78**Dividends/Pre-Tax Income 0.6703 0.6611 0.2829 0.2203 114.80** 121.58**Profit Growth (3 year) 0.1303 0.0990 0.0899 0.0674 8.71** 18.26**

Balance Sheet Mix & Risk

Total Loans/Total Assets 0.6370 0.6495 0.6453 0.6604 6.53** -7.22**Total Loans/Total Deposits 0.7585 0.7666 0.7804 0.7896 -13.29** -13.57**

Past Due Loans/Total Assets 0.0388 0.0000 0.0311 0.0000 10.25** 10.68**Past Due Loans/Total Loans 0.0619 0.0000 0.0499 0.0000 9.73** 10.74**Net Charge-offs/Total Loans 0.0022 0.0010 0.0022 0.0010 0.42 2.04*Agriculture Loans/Total Loans 0.1165 0.0624 0.0637 0.0085 43.99** 56.57**Commercial Loans/Total Loans 0.1529 0.1394 0.1425 0.1263 12.97** 16.47**Liquid Assets/Total Assets 0.2911 0.2778 0.2831 0.2656 6.46** 7.17**Demand Deposits/Total Assets 0.1323 0.1226 0.1162 0.1080 28.04** 30.28**Other Core Deposits/Total Assets 0.5716 0.5582 0.5978 0.5798 -18.24** -16.97**Purchased Liabilities/Total Assets 0.1922 0.1731 0.2025 0.1829 -10.09** -8.76**

Capital Ratios

Equity/Total Assets (%) 10.0655 9.3745 10.3230 9.5531 -9.84** -8.19**Tier 1 Capital/Risk-wt. Assets (%) 14.9138 13.2210 15.3695 13.3231 8.01** -2.90**

Adjusted Capital Ratio (%) 11.7700 10.9803 11.8856 11.0174 -3.55** -1.25(Sub. Debt & Pref. Stock)/Assets 0.0108 0.0000 0.0224 0.0000 -6.93** -9.73**(Pref. Stock/Total Assets)*100 0.0020 0.0000 0.0139 0.0000 -11.90** -11.86**Asset Growth (3 year) 0.0759 0.0542 0.1046 0.0706 -29.94** -28.28**

Sample size is bank-years. The adjusted capital ratio is Equity/(AssetsNon-Int. Deposits); EBTROA is earningsbefore taxes and extraordinary items, divided by total assets; EBTROE is earnings before taxes and extraordinaryitems, divided by total equity; ROA is return on assets defined as after-tax income divided by total assets; NIM isnet interest margin defined as (Interest IncomeInterest Expense)/Earning Assets; past-due loans are those withpromised principal an/or interest payments over 90 days past due, scaled by total assets.* and ** signify significant at the five- and one-percent level, respectively.


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Table 3First-stage Probit Regression with S Corporation Equal to One in the Year of Conversion,Zero Otherwise from 1999 to 2008.

Raw Data Standardized Data

estimate p-value estimate Rank

INTERCEPT -2.0995


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Table 4Second Stage 2SLS regressions for performance and capital structure from 1999 through2008.

CAPRATIO(%) EBTROA (%) ROA (%)

Variable estimate p-value estimate p-value estimate p-value

Intercept 17.8927


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Table 5Means, medians, and tests for differences in means and medians for S Corporation banks from 3 years before to 3years after S Corporation conversion. Sample size is the number of banks in year -3 or+3. The adjusted capitalratio is Equity/(AssetsNon-Interest bearing Deposits); EBTROA is earnings before taxes and extraordinaryitems, divided by total assets; EBTROE is earnings before taxes and extraordinary items, divided by total equity;ROA is return on assets defined as after-tax income divided by total assets; NIM is net interest margin defined as(Interest IncomeInterest Expense)/Earning Assets; past-due loans are those with promised principal an/orinterest payments over 90 days past due, scaled by total assets. * and ** signify significant at the five- and one-percent level, respectively.

Before Conversion(N = 1,563)

After Conversion(N = 1,563)

Afterminus

before

After minusbefore

Variable Mean Median Mean Median

t-statisticfor

differencein means


differences

ProfitabilityEBTROA (%) 1.7189 1.7064 1.5576 1.5487 7.41** 7.42**EBTROE (%) 17.6473 17.0585 15.8325 15.6697 7.49** 7.09**

ROA (%) 1.1888 1.1732 1.5257 1.5079 -18.23** -18.31**ROE (%) 12.1718 11.8558 15.5224 15.2599 -16.45** -16.17**NIM 0.0466 0.0457 0.0451 0.0443 4.98** 4.85**Dividends/Pre-Tax Income (%) 36.5086 31.0485 68.1923 66.8441 -27.26** -29.00**Profit Growth (3 year) 0.1029 0.0666 0.1218 0.0903 -1.31 -4.11**

Asset & Liability Mix

Total Loans/Total Assets 0.5788 0.5854 0.6277 0.6358 -10.67** -10.49**Total Loans/Total Deposits 0.6705 0.6774 0.7460 0.7551 -13.41** -12.92**Past Due Loans/Total Assets 0.0104 0.0000 0.0879 0.0000 -15.33** -25.63**Past Due Loans/Total Loans 0.0165 0.0000 0.1408 0.0000 -15.42** -25.64**Net Charge-offs/Total Loans 0.0020 0.0010 0.0024 0.0012 -3.40** -3.67**Agric. Loans/Total Loans 0.1482 0.0929 0.1188 0.0697 5.71** 4.58**

Comm. Loans/Total Loans 0.1555 0.1389 0.1506 0.1391 1.62 -1.27Liquid Assets/Total Assets 0.3500 0.3410 0.2965 0.2839 11.87** 11.84**Demand Deposits/Total Assets 0.1275 0.1182 0.1304 0.1205 1.54 -1.08Other Core Deposits/Total Assets 0.5932 0.5904 0.5739 0.5661 4.15** 5.55**Purchased Liabilities/Total Assets 0.1258 0.1116 0.1803 0.1616 -17.02** -16.71**

Capital Ratios

Equity/Total Assets (%) 10.2476 9.4730 10.2337 9.6029 0.14 -0.99Tier 1 Cap./Risk-wt. Assets (%) 15.7951 13.9834 15.0261 13.4138 2.21* 2.02*Adjusted Capital Ratio (%) 11.7625 10.9604 11.8728 11.1383 -0.93 -1.78Sub. Debt & Pref. Stock/Assets 0.0000 0.0000 0.0000 0.0000 0.63 0.38(Pref. Stock/Total Assets)*100 0.0670 0.0000 0.0000 0.0000 1.68 2.65**Asset Growth (3 year) 0.0749 0.0542 0.0711 0.0570 1.23 -0.58

Sample size is the number of banks in year -3 or+3. The adjusted capital ratio is Equity/(AssetsNon-Interestbearing Deposits); EBTROA is earnings before taxes and extraordinary items, divided by total assets; EBTROE isearnings before taxes and extraordinary items, divided by total equity; ROA is return on assets defined as after-taxincome divided by total assets; NIM is net interest margin defined as (Interest IncomeInterest Expense)/EarningAssets; past-due loans are those with promised principal an/or interest payments over 90 days past due, scaled bytotal assets. * and ** signify significant at the five- and one-percent level, respectively.


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Table 6Means, medians, and tests for differences in means and medians for S Corporation banks from 3years before to 3 years after S Corporation conversion adjusted by subtracting the yearly mean ormedian for all banks.

Before Conversion(N = 1,563)

After Conversion(N = 1,563)

Afterminus

before

After minusbefore

Variable Mean Median Mean Median

t-statisticfor

differencein means


differences

Profitability

EBTROA (%)- t 0.1064 0.0899 0.1682 0.1514 2.90** 3.10**

EBTROE (%)- t 0.8027 0.2415 1.7952 1.5588 4.19** 4.67**

ROA (%)- t 0.0438 0.0337 0.4468 0.4253 22.21** 21.59**

ROE (%)- t 0.2370 -0.0860 4.6411 4.3802 22.04** 21.05**

NIM - t 0.0559 -0.0497 0.1944 0.1234 4.68** 5.44**

Dividends/Pre-Tax Income (%)- t 0.0343 -0.0177 0.3090 0.3002 23.48** 26.07**

Profit Growth (3 year) - t -0.0182 -0.0538 -0.0020 -0.0396 1.12 -2.53*

Capital Ratios

Equity/Total Assets (%)- t 0.2071 -0.5834 -0.1903 -0.8416 -3.88** -3.81**

Tier 1 Cap./Risk-wt. Assets (%)- t 0.1575 -1.5868 -0.3537 -2.0335 -1.47 -0.90

Adjusted Capital Ratio (%)- t 0.2302 -0.5939 -0.1366 -0.7826 -3.11** -3.27**

Sub. Debt & Pref. Stock/Assets- t 0.0000 0.0000 -0.0001 -0.0001 -3.22** -47.99**

(Pref. Stock/Total Assets)*100- t -0.0010 -0.0025 -0.0001 -0.0001 -2.29* -46.14**

Asset Growth (3 year %) - t -0.0196 -0.0394 -0.0313 -0.0461 -3.85** -3.98*** and ** signify significant at the five- and one-percent level, respectively.


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impact of taxes and ownership oncapital structure s corp banks may2010 to jfi

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