Under its administration of the troubled asset relief program (TARP), the Treasury has updated its term sheet and released answers to frequently asked questions (FAQs) to provide relief to qualified financial institutions thatare S corporations. Unlike previous terms under the TARP, the Treasury announced that it will use debt instruments, rather than preferred stock, to assist struggling S corporation financial institutions. This ends concern, voiced at the inception of TARP, that S corporation banks, which are typically small community banks,would not share in the relief available to the rest of the financial industry.

Subordinated Debt

The terms of the TARP program for S corporations require the Treasury to acquire subordinated debentures from a qualified financial institution, with each note having a principal amount of $1,000. According to the FAQs,debt instruments were chosen to provide relief to these entities because S corporations under the Tax Code can only have one class of stock (Code Sec. 1361(b)(1)(D)). The Treasury could not own preferred stock in these entities without disqualifying them from S corporation status.

The interest rate on subordinated debt owed by subchapter S corporations will be 7.7 percent for each of the first five years of the program (versus 5 percent for preferred stock) and 13.8 percent afterwards (versus 9 percent for preferred stock). The Treasury stated that this rate is higher than the dividend rate imposed on preferred stock in other participating qualified financial institutions in order to establish equal treatment among taxpayers. The use of debt instead of preferred stock for S corporations allows the participants to claim a tax deduction for interest payments that would otherwise reduce the net tax effectively paid to the Treasury.

As consideration for this debt, the financial institution is required to grant warrants to the Treasury for the purchase of additional debentures, equal to 5 percent of the amount purchased, with an exercise price of $0.01.  These warrants are entitled to the same rights, preferences, privileges and voting rights as the debentures, with interest rates of 13.8 percent per year.

By Torie Cole, CCH News Staff
Treasury Department News Release, TDNR HP-1354
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