Communities First Act,: A Banking and Taxation Measure

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This report provides an overview of a proposal to provide small-bank regulatory and tax relief via ^th
legislation, H.R. 1869/S. 1405, 110 Congress. The measure’s official title is specified as either
the “Community Banks Serving Their Communities First Act,” or the “Communities First Act.”
Representative Velazquez introduced the legislation on April 17, 2007; the bill was referred
jointly to the House Financial Services Committee, the House Ways and Means Committee, and
the House Small Business Committee. Senators Brownback, Coburn, and Roberts introduced
companion legislation on May 16, 2007; it was referred to the Committee on Finance. Proponents
indicate that they have developed the bill to give regulatory and tax relief to community banks.
Going further, the proposed act provides a number of non-bank tax benefits. This report presents
its major provisions in legislative issue context. It will be updated as events warrant.

Introduc tion ..................................................................................................................................... 1
Regulatory Provisions.....................................................................................................................1
Tax Provisions.................................................................................................................................2
Outlook ........................................................................................................................ .................... 4
Author Contact Information............................................................................................................4

Seeking to enhance the ability of community banks to foster economic growth and serve their
communities, boost small businesses, increase individual savings, and for other purposes,
Representative Velazquez and Senators Brownback, Coburn, and Roberts have introduced a two-
part measure, H.R. 1869/S. 1405. The first part addresses the regulatory burdens of small banks,
although some changes would benefit lenders of all sizes. The second part addresses the tax
comparability of small banks with other small businesses and their tax-exempt competitors, the
credit unions. A third part pertains to subchapter S corporations. It additionally provides tax
benefits for individuals subject to the alternative minimum tax (AMT), small business investment,
young savers, savers owning certificates of deposit, bankers in rural and distressed areas, and
certain farms and industrial businesses via the treatment of their debts. This report provides
description and analysis of the issues it addresses.

The Communities First Act is an asset-based banking measure, affording regulatory relief to
smaller banks. A small bank is defined as having assets less than $1 billion, to be adjusted
annually by the growth rate of total assets of all federally insured depository institutions. Key
provisions include
• allowing qualified banks to file a shorter version of the quarterly call reports
twice per year (non-consecutive quarters);
• providing an exemption from Section 404 of the Sarbanes-Oxley Act, which
requires documentation and auditing of internal controls over financial reporting;
• increasing the debt-to-income ratio allowable for a small bank holding company
to pay a corporate dividend and still remain eligible for expedited processing
processing from 1:1 to 3:1;
• requiring a community bank impact analysis when a federal banking agency
revises or issues regulations of insured depository institutions and;
• establishing a seasoned customer CTR exemption, which would exempt
depository institutions from reporting currency transactions for qualified
customers.
In addition, the bill would give banks that do not share customer information the option of
sending privacy notices to customers only when the bank’s privacy policy changes, instead of ¹
annually as the Gramm-Leach-Bliley Act requires. The bill would direct regulators to give more
leeway for bank borrowers to waive their three-day right of rescission so they might use their loan
funds more quickly.
Its benefits above are targeted at banking companies forming the membership base of two trade
associations: the Independent Community Bankers of America and America’s Community
Bankers. These groups believe that banks above the smallest sizes, ranging up to perhaps as much

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as $5 billion in assets, have become disadvantaged by many regulations and taxes. In their view,
the smallest institutions and their competitors such as credit unions are exempt from many of
these burdens, while the largest financial players can comply at lower costs because of
efficiencies of scale from larger operational and income bases. They state that they are currently ²
caught in the middle, so that a merger with a larger institution might be the only alternative to
withering away under “regulatory and tax burdens.”
Regulators seemingly could provide many regulatory relief elements addressed by this measure
by using their existing authority for paperwork reduction and similar streamlining. The
Regulatory Flexibility Act of 1980 and subsequent laws require all federal regulatory agencies to ³
consider the economic impact of their rules on small entities. In particular, the Economic Growth
and Regulatory Paperwork Reduction Act of 1996 requires that federal financial regulatory
agencies identify outdated, unnecessary, or unduly burdensome statutory or regulatory
requirements. The agencies must then eliminate unnecessary regulations to the appropriate extent.
The regulator of many community banks, the Federal Deposit Insurance Corporation (FDIC), has ⁴
been coordinating this effort. Thus, some proposals in this measure might not require legislative
authorization, since the growth of the financial economy, with the emergence of trillion-dollar
banking companies, has led many observers to characterize banks of up to $1 billion in assets be ⁵
considered as “small” in industry context. As an example of regulatory rather than legislative
change under way, the federal banking regulators granted these “intermediate small banks” some ⁶
Community Reinvestment Act compliance relief in 2005. Proponents of this measure, and even
more comprehensive statutory regulatory relief for financial businesses, however, believe that
legislation is a better mechanism to gain the changes they desire.

The Communities First Act is also a fiscal measure, as the bill contains a series of tax provisions.
Some of these provisions are generally applicable to a broad range of taxpayers, some are focused
on community banks, and others apply to subchapter S corporations. All of them seemingly
would require statutory changes to the Internal Revenue Code of 1986.
Its generally applicable provisions are more significant, in potential cost, than its focused
provisions. Perhaps the most important, at least from a revenue cost perspective, is the repeal of
the alternative minimum tax for individuals, which has been estimated to cost $842 billion over ⁷
FY2008-FY2017. A second general provision would permanently extend current Section 179
expensing for small businesses. Another provision would allow the deferral of tax on interest
earned on certificates of deposit (CDs) held by individuals until the CD matures, and lowering the
top rate of tax on such interest to the capital gains tax rate (currently 15%). Basically this

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provision applies to CDs with a maturity of a year or more. The fourth general provision permits
Roth IRA accounts for children under the age of 25. A fifth provision would allow interest on
agricultural loans, and home loans in rural areas (defined by the Secretary of Agriculture) with
population of less than 2,500 to be excluded from income. The bill also includes an increase in
the cap for certain small issue private activity bonds from $10 million to $30 million, where there ⁸
is a limited amount of associated capital expenditures. Finally, the bill allows certain banks and
similar financial institutions to elect to be taxed as partnerships rather than corporations, a
treatment that is generally beneficial because partnerships pay only the individual level tax, while
corporations pay a corporate tax and their shareholders then pay taxes on dividends and capital
gains at the individual level.
The measure contains provisions more narrowly focused on community banks and holding
companies. For banks with assets of $5 billion or less, the bill would allow a credit for 20% of tax
liability for corporations (up to $250,000) and an exclusion of 20% of income for subchapter S
(small corporations that elect to be taxed as partnerships), up to $1,250,000. It would increase
these percentages to 50% and double the ceilings for qualified banks in distressed areas. Banks
with less than $5 billion in assets would not have to pay alternative minimum tax.
The measure also contains provisions focused on subchapter S corporations. It would increase the
S Corporation shareholder limit from 100 to 150 and change the treatment of bad debt reserves
for S Corporations that convert from C Corporations. The measure would also allow S
Corporation banks to issue preferred class stock and exclude the bank’s qualifying directors’
shares from counting toward their shareholder limit.
While the Independent Community Bankers of America has said that it supports this bill which,
they believe, would provide regulatory relief for community banks and tax reform to small
businesses, individuals, and community banks, the scope of some of the bill’s tax provisions is, ⁹
however, quite broad, and extends beyond reducing the taxes of these banks. The repeal of the
individual alternative minimum tax and the interest provision could be particularly costly. As
mentioned above, repealing the AMT is estimated to cost $842 billion over FY2008-FY2017. In
addition, the interest provision would provide a powerful incentive to shift interest-earning assets
into CDs eligible for preferential taxation. In 2003, $127 billion of interest was reported on tax
returns. In addition, some receipts reported as dividends reflect interest earned through mutual
funds. The revenue loss resulting from a large shift of this interest into eligible CDs could be in
the billions of dollars.
Under the proposal, the tax on many types of investments financed by debt would become
negative (i.e., a subsidy rather than a tax.) For example, on agricultural loans, the farmer could
deduct the interest, which offsets any tax on the return this filer pays, leading to a zero effective
tax rate at the individual farmer level. The deduction of interest is entirely appropriate in an
income tax system. However, the tax is probably already negative at the farmer level because it is
nominal interest that is deductible (that is, debt finance is somewhat subsidized due to inflation)
and because the owner has deducted some investment on a farm when incurred. (Overall, the firm
level tax on debt financed investment tends to be negative during inflationary periods, and it is
more negative for those businesses with significant tax benefits.) In addition, however, the bank

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could exclude the interest received, but deduct any interest paid to depositors in the bank. Thus, at
the bank level (ignoring any yield spread) there is a subsidy (negative tax) provided at the current
tax rate. Allowing the bank to deduct interest payments is appropriate, but only if the interest
received is taxable. Finally, the one level at which some tax might be collected is at the individual
level, but here, the tax is deferred and the rate reduced.
The provisions with cliffs (a benefit allowed only for firms under a certain size) could create
powerful disincentives for growth around the cliff. The measure phases out most tax benefits
aimed at small businesses as their size becomes larger.

Additional proponents of tax provisions may include certain communities, farmers,
manufacturers, investment bankers offering municipal bonds, and recipients and issuers of
deposit interest on CDs. Additional supporters of banking relief proposals are likely to include
federal and, especially, state supervisors of banks smaller than the cliff sizes of the measure, plus
industry trade associations whose membership includes banks of all sizes and “holding
companies” owning them. Opponents may include credit unions, which are not pleased with this
measure because banks would get tax benefits while continuing to attack tax benefits of credit
unions.
The Department of the Treasury may object to the measure’s bank-related tax breaks, since it has
often opposed many tax relief proposals for bankers and their customers. The measure would
alter the tax climate for economic sectors beyond banking, and could thus face additional
objections from those not benefitted and those—including the Treasury—concerned over
nonbank-related revenue losses.
Similar legislation was introduced in the 109^th Congress and hearings were held by the House
Financial Institutions Subcommittee on May 19 and June 9, 2005, and by the Senate Banking
Committee on June 21, 2005, that explored banking regulatory relief.
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