BANK'S ACCUMULATED EARNINGS ARE NOT IN EXCESS OF ITS REASONABLE BUSINESS NEEDS.

UIL Number(s) 0531.00-00

                                             Date: January 27, 1988

Does the accumulated earnings tax imposed by section 531 of the Internal Revenue Code apply to a bank under the circumstances described below?

FACTS

B is a publicly held bank incorporated in State Y. By law, a specified minimum amount of capital is required for a bank to commence operations in State Y, but there is no other capital specifically required by statute. The Bank Examining Office for State Y, however, encourages banks to maintain a capital to assets ratio (total balance sheet equity divided by total balance sheet assets) of m percent or higher. The average capital to assets ratio (in recent years) for State Y banks is n percent.

In 19x1 B's ratio of capital to assets was o percent. in 19x2 B's ratio was p percent.

Also in 19x1 and 19x2, B made several loans to its shareholders totalling $q. Each of these loans is evidenced by a written note and carries a market rate of interest. Finally, B has paid a dividend of $r per share for each of the past six years.

LAW

Section 531 of the Code provides that an additional tax is imposed for each taxable year on the accumulated taxable income of every corporation described in section 532.

Section 532 of the Code provides, in part, that the accumulated earnings tax imposed by section 531 shall apply to every corporation [with exceptions not here relevant] formed or availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed.

Section 533 of the Code specifies that, for purposes of section 532, the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.

Section 537 of the Code sets forth the general rule that the term "reasonable needs of the business" includes the reasonably anticipated needs of the business.

Section 1.537-1 of the income tax regulations elaborates that an accumulation of the earnings and profits is in excess of the reasonable needs of the business if it exceeds the amount that a prudent businessman would consider appropriate for the present business purposes and for the reasonably anticipated future needs of the business.

Section 1.533-1 of the regulations provides that the existence of the purpose to avoid income tax may be indicated by the particular circumstances of each case. Thus, all circumstances which might be construed as avoidance of the purpose to avoid income tax, including personal loans between the corporation and its shareholders and the extent to which the corporation has distributed its earnings and profits, should be considered in determining whether the accumulation is unreasonable.

ANALYSIS

Liability for the accumulated earnings tax of Code section 531 is predicated on the existence of two factors: An accumulation of earnings beyond the reasonable needs of the business; and the determination that the purpose of the accumulation was to avoid the payment of the individual tax by the corporation's shareholders or the shareholders of another corporation. If earnings and profits have been accumulated beyond the reasonable needs of the business, section 533(a) of the Code raises a rebuttable presumption that the prohibited purpose is present. Without a finding of both an excess accumulation and intent to avoid the individual tax, however, the accumulated earnings tax does not apply.

Whether a corporation's accumulated earnings exceed the reasonable needs of the business is ultimately a subjective determination, one that relies on all relevant factors. Section 1.537-1(a) of the regulations looks to the standard of the "prudent businessman," but no court has ever considered how much a bank might prudently acquire before running afoul of section 531 of the Code. The formula set out in Bardahl Mfg. Corp. 24 T.C.M. 1030 (1965), which has gained widespread acceptance for determining reasonable business needs in some industries, seems to offer little guidance for banks.

In the instant case, B has amassed earnings sufficient to push its capital to assets ratio over the state average. B has also paid only nominal dividends for the past six years, and has made a substantial number of loans to its shareholders. Each of these factors can indicate an accumulation that exceeds the reasonably anticipated needs of the business. See section 1.537-2(c) of the regulations; cf. section 1.533-1. But it appears that B's capital to assets ratio is not significantly greater than the average capital to assets ratio maintained by State Y banks. Moreover, the record shows that the banks in State Y that have fallen to or below the minimum capital to assets ratio recommended by the bank examiner's office have subsequently failed. That fact, as well as the troubled state of the banking industry overall in State Y, supports B's assertion that its accumulated earnings are not unreasonable.

B has similarly been able to justify its loans to shareholders. Although such loans may indicate accumulations beyond the reasonable needs of the business, the observation of normal borrower-lender formalities and the payment of a market rate of interest on the loan undercuts such an assertion. Al Goodman, Inc. 23 T.C. 288 (1954); R.C. Reynolds, Inc. 44 B.T.A. 356 (1941).

Under these circumstances we are unable to conclude that the earnings accumulated by B exceed its reasonably anticipated needs in the tax years at issue. Since the accumulated earnings tax is a penalty tax, it must be strictly construed and not applied in cases of reasonable doubt. Ivan Allen Co. v. U.S., 422 U.8. 617 (1975). This is not to foreclose the possibility that, under other circumstances, section 531 of the Code might apply to a bank.

Inasmuch as we have not concluded that B accumulated earnings beyond the reasonable needs of the business, we need not address the question of the shareholder's purpose.

CONCLUSION

The facts presented do not establish that B's accumulation of earnings is in excess of its reasonable business needs under section 537 of the Code, and thus the accumulated earnings tax of section 531 does not apply.

A copy of this technical advice memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.