The Tax Exemption to Subchapter S Banks: Who Gets the Benefit?

• DOI: http://doi.org/10.1111/fire.12107
• Author: Ajeet Jain,Edward R. Lawrence,Arun J. Prakash,Chun‐Hao Chang
• Date: 01 August 2016
• Published date: 01 August 2016

The Financial Review 51 (2016) 329–362

The Tax Exemption to Subchapter S Banks:

Who Gets the Benefit?

Chun-Hao Chang

Florida International University

Ajeet Jain

Alabama A and M University

Edward R. Lawrence∗

Florida International University

Arun J. Prakash

Florida International University

Abstract

The Small Business Job Protection Act of 1996 allows U.S. banks to adopt the Subchapter

S status. We investigate if the Subchapter S banks use tax benefits for the intended purposes

of “protecting jobs,” “creating opportunities” and “increasing take home pay of workers.” We

find that the tax benefits: (a) are not used in expenses related to protection of jobs, (b) do not

lead to greater employment opportunities within the Subchapter S banks, and (c) do not benefit

the employees in the form of increased salaries and benefits. Our results indicate that bank

owners are sole beneficiaries of the tax exemption benefits.

∗Corresponding author: Department of Finance, College of Business Administration, RB 207A, Florida

International University, Miami, FL 33199; Phone: (305) 348-0082; Fax: (305) 348-4245; E-mail:

elawrenc@fiu.edu.

We thank the participants at the Southern Finance Association Conference in 2011, Midwest Finance

Conference in 2013 and the 21st Annual Conference of the Multinational Finance Society in 2014, for

their helpful comments and suggestions. We also thank two anonymous referees and the Editor, Dr.

Srinivasan Krishnamurthy,for their detailed reviews and constructive comments. All the remaining errors

are ours.

C2016 The Eastern Finance Association 329

330 C.-H. Chang et al./The Financial Review 51 (2016) 329–362

Keywords: Small Business Job Protection Act of 1996, Subchapter S banks, tax exemption,

benefits from tax exemption

JEL Classifications: G21, G28

1. Introduction

The Public Law 104–188 enacted by the 104th U.S. Congress on August 20,

1996, which was termed as the Small Business Job Protection Act of 1996, has the

following intents: “Toprovide tax relief for small businesses, to protect jobs, to create

opportunities, to increase the take home pay of workers, to amend the Portal-to-Portal

Act of 1947 relating to the payment of wages to employees who use employer owned

vehicles, and to amend the Fair Labor Standards Act of 1938 to increase the minimum

wage rate and to prevent job loss by providing flexibility to employers in complying

with minimum wage and overtime requirements under that Act.”

The Small Business Job Protection Act of 1996 allows banks to convert to

Subchapter S corporations and avoid double taxation. The Subchapter S bank is

treated as a partnership for tax purposes. Its shareholders pay federal income taxes

on pass-through earnings and thus, avoid taxes at the corporate level.Allowing banks

to adopt Subchapter S status is a political decision. The law does not state the reason

for its implementation, only the intents for the law are provided. The intents are

“to protect jobs,” “to create opportunities” and “to increase the take home pay of

workers.” According to the standard economic theory, imposing tax on a product will

move the product’s supply curve to the left, raising the market equilibrium price and

lowering the market equilibrium quantity, thus creating a deadweight loss in social

welfare. Along the same line of reasoning, a tax relief would result in a right-shift

of the supply curve, causing a reduction in market equilibrium price and an increase

in market equilibrium quantity, thus producing a rise of welfare to the society as a

whole. Since the bank’s conversion to Subchapter S status creates a tax relief to the

bank, one would expect a nontrivial welfare increase to the economy. Economic

theory does not predict the forms in which the welfare increase would take. The

language in the Small Business Job Protection Act of 1996 seems to suggest that the

welfare increase should be in protecting jobs, creating opportunities, and increasing

the take home pay of the workers.

The tax exemption conferred to Subchapter S banks at the corporate level clearly

offers Subchapter S banks a competitive advantage over C-Corporation banks. We

examine the benefits from tax exemption to see if they are utilized for the stated

intents of the Small Business Job Protection Act of 1996, that is, “to protect jobs,”

“to create opportunities,” and “to increase the take home pay of workers.” Subchapter

S banks can afford to offer higher deposit rates and lower loan rates to their customers

and a lower spread would make Subchapter S banks more competitive. As a result of

tax exemptions, Subchapter S banks have more cash on hand, which can be used to

C.-H. Chang et al./The Financial Review 51 (2016) 329–362 331

increase lending, provide more loan products, and offer better services to customers.

The more the bank increases its competitiveness and improvesthe services it provides

to its customers, the more it increases its probability of survival and decreases the

probability of employee layoffs. Bank owners can also reinvest the available cash

from tax reduction back into the bank which may lead to a higher growth in the

banks that adopt Subchapter S status. A growing bank would need more employees

to meet the demand and would not lay off employees. Hence, passing some of the tax

benefits to bank customers or reinvesting tax dollars back into the bank would lead

to the “protection of the jobs” for the bank employees. Another intention of the Act

is to “create opportunities” which can be realized when the tax relief is utilized to

hire and expand the competitive workforce. The findings of our paper contribute to

the ongoing debate of whether tax exemptions to businesses lead to job creation. Yet,

another intention of the Act is to “increase the take home pay of the workers.” We

investigateif the tax relief results in an increase in salaries and benefits for Subchapter

S bank employees.

The following are our research investigations and findings of tax exemptions

granted to Subchapter S banks. First, we investigate whether the tax subsidy is passed

on to the borrowers (depositors) in the form of lower (higher) loan (deposit) rates.

In our study, this research question, is similar to what has been done by Depken,

Hollans and Swidler (2010). Similar to their results, we find that bank customers,

both depositors as well as borrowers, do not receivebenefits as a result of the adoption

of Subchapter S status, in terms of more favorable rates.1Second, we investigate if

the conversion to a Subchapter S bank leads the bank to offer better services to its

customers. The improvement in services to customers is not explicitly observable,

but it may be measured by using the increase in operating expenses (excluding the

wage/salary expenses) as a proxy. An increase in operating expenses (excluding the

wage/salary expenses) may signal an improvement in service to the customer. We

find that the tax subsidy does not result in any increase in operating expenses. Third,

we investigate if adoption of Subchapter S status leads to an increase in a bank’s

lending or an increase in the number of products offered by the bank. Our results

1Apart from reduced loan rates and higher deposit rates banks may provide nonpricing terms of loans,

a number of additional services, and relationship banking. Depken, Hollans and Swidler (2010) argue

that banks may practice some type of bundling strategy (include offering a free credit card to savings

customers or granting credit card customers additional services such as fraud protection and online

account management) to maximize profits, then the tax status of the bank may not have any effect on

deposit and loan rates. Koderisch, Wuebker, Baumgarten and Baillie (2007) state that, for customers,

bundling of products and services may lead to increased satisfaction, clarity of banking transactions, and

ultimately a reduction in the full cost of purchasing financial services. By comparing the average loan

rates and average deposit rates for the banks that adopt Subchapter S status with the non-Subchapter S

banks we cannot conclusively establish that customers do not receive any benefits from bank’s adoption

of Subchapter S status. We thank an anonymous referee for pointing out this limitation of our analysis.

As banks do not publicly disclose information about bundling of services they provide, and the SNL

database does not have any information on bundling of services, we are unable to make direct comparison

of bundling services between banks.