UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-K

(Mark One)

x          ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008

or

o           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                          to                                        

Commission File Number:  33-96358

KENTUCKY BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:  (859)987-1795

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No x

Indicate by check mark if the registrant is not required to file reports to Section 13 or Section 15(d) of the Exchange Act. Yes o  No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

Aggregate market value of voting stock held by non-affiliates as of June 30, 2008 was approximately $60.0 million.  For purposes of this calculation, it is assumed that the Bank’s Trust Department, directors, executive officers and beneficial owners of more than 5% of the registrant’s outstanding voting stock are affiliates.

Number of shares of Common Stock outstanding as of March 5, 2009:  2,745,729.

PART I

Item 1.  Business

General

Kentucky Bancshares, Inc. (“Company” or “Kentucky”) is a bank holding company headquartered in Paris, Kentucky.  The Company was organized in 1981 and is registered under the Bank Holding Company Act of 1956, as amended (“BHCA”) and the Home Owners Loan Act of 1933, as amended (“HOLA”).

The Company conducts its business in the Commonwealth of Kentucky through one banking subsidiary, Kentucky Bank.

Kentucky Bank is a commercial bank and trust company organized under the laws of Kentucky.  Kentucky Bank has its main office in Paris (Bourbon County), with additional offices in Paris, Cynthiana (Harrison County), Georgetown (Scott County), Morehead (Rowan County), Nicholasville (Jessamine County), North Middletown (Bourbon County), Sandy Hook (Elliott County), Versailles (Woodford County), Wilmore (Jessamine County) and Winchester (Clark County).  The deposits of Kentucky Bank are insured up to prescribed limits by the Deposit Insurance Fund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”).

On July 7, 2006, Kentucky Bank acquired Peoples Bancorp of Sandy Hook, Inc. and its subsidiary bank, Peoples Bank, with offices in Sandy Hook and Morehead, Kentucky.

The Company had total assets of $679 million, total deposits of $521 million and stockholders’ equity of $57 million as of December 31, 2008.  The Company’s principal executive office is located at 339 Main Street, Paris, Kentucky  40361, and the telephone number at that address is (859) 987-1795.

Business Strategy

The Company’s current business strategy is to operate a well-capitalized, profitable and independent community bank with a significant presence in Central and Eastern Kentucky.  Management believes the optimum way to grow the Company is by attracting new loan and deposit customers within its existing markets through it product offerings and customer service.  Management continues to consider opportunities for branch expansion and will also consider acquisition opportunities that help advance its strategic objectives.

Lending

Kentucky Bank is engaged in general full-service commercial and consumer banking.  A significant part of Kentucky Bank’s operating activities include originating loans, approximately 72% of which are secured by real estate at December 31, 2008.  Kentucky Bank makes commercial, agricultural and real estate loans to its commercial customers, with emphasis on small-to-medium-sized industrial, service and agricultural businesses.  It also makes residential mortgage, installment and other loans to its individual and other non-commercial customers.

Loan Rates:  Kentucky Bank offers variable and fixed rate loans.  Loan rates on variable rate loans generally adjust upward or downward based on changes in the loan’s index.  Rate adjustments on variable rate loans are made from 1 day to 5 years.  Variable rate loans may contain provisions that cap the amount of interest rate increases or decreases over the life of the loan.  In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate may contain provisions that limit annual increases at a maximum of 200 basis points.  There is usually no annual limit applied to loans secured by commercial real estate.

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Credit Risk:  Commercial lending and real estate construction lending, generally includes a higher degree of credit risk than other loans, such as residential mortgage loans.  Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements.  Collateral requirements vary to some degree among borrowers and depend on the borrower’s financial strength, the terms and amount of the loan, and collateral available to secure the loan.  Credit risk results from the decreased ability or willingness to pay by a borrower.  Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loans outstanding balance.  For construction loans, inaccurate initial estimates of a project’s costs and the property’s completed value could weaken the Company’s position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property.  Secured and unsecured consumer loans generally are made for automobiles, boats, and other motor vehicles.  In most cases loans are restricted to the subsidiaries’ general market area.

Other Products:  Kentucky Bank offers its customers a variety of other services, including checking, savings, money market accounts, certificates of deposits, safe deposit facilities, a credit card and other consumer-oriented financial services.  Kentucky Bank has Internet banking, including bill payment available to its customers at www.kybank.com.  Through its Wealth Management Department, Kentucky Bank provides brokerage services, annuities, life and long term care insurance, personal trust and agency services (including management agency services).

Competition and Market Served

Competition:  The banking business is highly competitive.  Competition arises from a number of sources, including other bank holding companies and commercial banks, consumer finance companies, thrift institutions, other financial institutions and financial intermediaries.  In addition to commercial banks, savings and loan associations, savings banks and credit unions actively compete to provide a wide variety of banking services.  Mortgage banking firms, finance companies, insurance companies, brokerage companies, financial affiliates of industrial companies and government agencies provide additional competition for loans and for many other financial services.  Kentucky Bank also currently competes for interest-bearing funds with a number of other financial intermediaries, including brokerage firms and mutual funds, which offer a diverse range of investment alternatives.  Some of the Company’s competitors are not subject to the same degree of regulatory review and restrictions that apply to the Company and its subsidiary bank.  In addition, the Company must compete with much larger financial institutions that have greater financial resources than the Company.

Market Served.  The Company’s primary market areas consist of Bourbon, Clark, Elliott, Harrison, Jessamine, Rowan, Scott, Woodford and surrounding counties in Kentucky.

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Supervision and Regulation

Governing Regulatory Institutions:  As a bank holding company, the Company is subject to the regulation and supervision of the Federal Reserve Board.  The Company’s subsidiary is subject to supervision and regulation by applicable state and federal banking agencies, including the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Kentucky Office of Financial Institutions.  Kentucky Bank is also subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered.  In addition to the impact of regulation, Kentucky Bank is affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.

Laws Protecting Deposits:  There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy.  These obligations and restrictions are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event the depository institution becomes in danger of default or is in default.  For example, under a policy of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and commit resources to support such institutions in circumstances where it might not do so absent such policy.  In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default.

The federal banking agencies also have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institutions in question are “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized” or “critically undercapitalized”, as such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies.

Deposit Insurance:  The Company’s subsidiary bank is a member of the FDIC, and their deposits are insured by the FDIC’s Deposit Insurance Fund up to the amount permitted by law.  The Company’s subsidiary bank is thus subject to FDIC deposit insurance assessments.  The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.  Under the Federal Deposit Insurance Reform Act of 2005, which became law in 2006, the Company received a one-time assessment credit of $434 thousand that can be applied against future premiums, subject to certain limitations.  Based on the one-time assessment credit, the Company was not required to pay any deposit insurance premiums in 2006 and unused credits from 2006 resulted in the amount of deposit insurance premiums being zero 2007.  Lower credits remained to offset assessments for 2008, which was the primary factor in higher deposit insurance net assessments of $175 thousand.  Financing Corporation (“FICO”) assessment costs were $54 thousand for 2008.  FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 possessing assessment powers in addition to the FDIC.  The FDIC acts as a collection agent for FICO, whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.

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The Company’s participation in the FDIC’s Transaction Account Guarantee Program initiated during the fourth quarter of 2008 also contributed to an increase in deposit insurance premiums in the current period.  More information about this program can be found under the heading “Temporary Liquidity Guarantee Program” that follows.  During the fourth quarter of 2008 the FDIC increased the deposit insurance from generally $100 thousand for each separately insured depositor to $250 thousand effective until December 31, 2009.

In February 2009, the FDIC adopted a long-term deposit insurance fund (“DIF”) restoration plan as well as an additional emergency assessment for 2009.  The restoration plan increases base assessment rates for banks in all risk categories with the goal of raising the DIF reserve ratio from its current .40% to 1.15% within seven years. Banks in the best risk category, which include the Company’s subsidiary bank, will pay initial base rates ranging from 12 to 16 basis points of assessable deposits beginning April 1, 2009, up from the initial base rate range of 12 to 14 basis points.  Additionally, the FDIC approved an interim rule imposing a special emergency assessment to all financial institutions of 20 basis points of insured deposits as of June 30, 2009.  The interim rule is subject to a 30-day comment period and in early March 2009 a proposal was introduced in Congress to lower the special emergency assessment to 10 basis points from the initial 20 basis points.  The special emergency assessment is estimated to be $1.1 million for the Company as currently adopted under the 20 basis point rule and will be collected on September 30, 2009.  The amount of the special emergency assessment would decrease to $530 thousand if the 10 basis point scenario is adopted.  The FDIC is also permitted to impose an emergency special assessment after June 30, 2009 of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance.  The increase in assessments by the FDIC could have a material adverse effect on the Company’s earnings.

Temporary Liquidity Guarantee Program (“TLGP”):  The TLGP consists of two separate programs implemented by the FDIC in October 2008.  This includes the Debt Guarantee Program (“DGP”) and the Transaction Account Guarantee Program (“TAGP”).  These programs were initially provided at no cost to participants during the first 30 days.  Eligible institutions that do not “opt out” of either of these programs become participants by default and will incur the fees assessed for taking part.

Under the DGP, the FDIC will guarantee senior unsecured debt issued on or after October 14, 2008 through June 30, 2009 up to certain limits by participating entities.  The FDIC will provide guarantee coverage for debt issued between those dates until the earlier of the maturity date of the debt or June 30, 2012.  The Company chose to opt out of the DGP.

Under the TAGP, the FDIC guarantees 100% of certain noninterest bearing transaction accounts up to any amount to participating FDIC insured institutions. The unlimited coverage is applicable until December 31, 2009.  The Company opted to participate in the TAGP; as such, it will incur an additional quarterly-assessed 10 basis point fee on balances in noninterest bearing transaction accounts exceeding the recently increased $250 thousand deposit limit that became effective on November 13, 2008.  The previous deposit insurance limit amount was $100 thousand.

Emergency Economic Stabilization Act of 2008 (“EESA”):  EESA was signed into law by the President on October 3, 2008 as a measure to stabilize and provide liquidity to the U.S. financial markets.  Under EESA, the Troubled Asset Relief Program (“TARP”) was created.  TARP granted the Treasury authority to, among other things, invest in financial institutions and purchase troubled assets in an aggregate amount up to $700 billion.

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In connection with TARP, the Capital Purchase Program (“CPP”) was launched on October 14, 2008.  Under the CPP, the Treasury announced a plan to use up to $250 billion of TARP funds to purchase equity stakes in certain eligible financial institutions, including the Company.  The Company was preliminarily approved for $13 million of equity capital in December 2008, and subsequently withdrew its application.

Consumer Regulations:  In addition to the laws and regulations discussed above, Kentucky Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks.  While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act, the Fair Housing Act and the Fair and Accurate Transactions Act, among others.  These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with clients when taking deposits or making loans. These laws also limit Kentucky Bank’s ability to share information with affiliated and unaffiliated entities.  The bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing business operations.

Dividend Restrictions:  There are various legal and regulatory limits on the extent to which the Company’s subsidiary bank may pay dividends or otherwise supply funds to the Company.  In addition, federal and state regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice.  Dividends paid by the subsidiary bank have provided substantially all of the Company’s operating funds, and this may reasonably be expected to continue for the foreseeable future.

Employees

At December 31, 2008, the number of full time equivalent employees of the Company was 214.

Nature of Company’s Business

The business of the Company is not seasonal.  The Company’s business does not depend upon a single customer, or a few customers, the loss of any one or more of which would have material adverse effect on the Company.  No material portion of the Company’s business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of any governmental entity.

Available Information

The Company files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission (“SEC”) pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934.  The public may read and copy any material the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC  20549 and may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC on its website at www.sec.gov.

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Item 1A.  Risk Factors

There are factors, many beyond our control, which may significantly change the results or expectations of the Company.  Some of these factors are described below in the sections titled financial risk, business risk and operational risk.  These risks are not totally independent of each other.  Some factors affect more than one type of risk.  These include regulatory, economic, and competitive environments.  As part of the annual audit plan, our internal risk management department meets with management to assess these risks throughout the Company.  Many risks are further addressed in other sections of this Form 10-K document.

Significant decline in general economic conditions, locally and nationally, will negatively affect the financial results of our banking operations.  Our success depends on general economic conditions both locally and nationally.  Economic conditions in the United States and abroad deteriorated significantly in the latter part of 2008.  The United States is currently in a recession.  The housing market is in decline reflected by falling home prices and increases in foreclosures.  Unemployment has increased.  These factors have affected the performance of mortgage loans and resulted in financial institutions, including government-sponsored entities, in making significant write-downs of asset values of mortgage-backed securities, credit default swaps and other derivative and cash securities.  Some financial institutions have failed.  Many financial institutions and institutional investors have tightened the availability of credit to borrowers and other financial institutions, which, in turn, results in more loan defaults and decreased business activity.  Consumer confidence regarding the economy is low and the financial markets reflect this lack of confidence.  Most of our customers are in the Central Kentucky area.  This recession has directly affected our customers.  Local economic conditions have affected the demand of customers for loans, the ability of some borrowers to repay these loans and the value of the collateral securing these loans.  As these factors affect the overall business climate, they can have and have had a significant effect on loan demand.  Loan growth is critical to our profitability.  We do not expect significant improvement in the economy in the near future, and future declines in the economy will likely make the credit market crisis worse.

The exercise of regulatory power may have negative impact on our results of operations and financial condition.  We are subject to extensive regulation, supervision and examination by federal and state banking authorities.  Any change in applicable regulations or federal or state legislation could have a substantial impact on our operations.  Additional legislation and regulations may be enacted or adopted in the future that could significantly affect our powers, authority and operations, which could have a material adverse effect on the financial condition and results of operations.  For example, in response to the economic downturn and financial crisis, the U.S. government has enacted legislation by passing the Emergency Economic Stabilization Act of 2008 followed by the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”).  These Acts have enabled the U.S. Treasury, the FDIC and the Federal Reserve Board to develop programs, such as the TARP Capital Purchase Program, the Financial Stability Plan and the foreclosure prevention program, to improve funding to consumers, increase interbank lending and reduce home foreclosures.  The U.S. government continues to closely evaluate the economy, the effect of its legislation and resulting programs and initiatives on the economy.  We expect that the U.S. government will continue to refine these programs and develop new programs.  We do not know whether these Acts and programs will positively affect the economy, help stabilize the financial markets and increase the availability of credit.  Our business, financial condition, results of operations, liquidity and access to capital and credit will likely be negatively affected if the economy worsens or the financial markets do not stabilize.

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We face vigorous competition from banks and other financial institutions.  This competition may reduce or limit our margins on banking services, reduce market share and adversely affect results of operations and financial condition.  A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services.  Additionally, we encounter competition from both de novo and smaller community banks entering the markets we are currently in.  We also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies.

Financial Risk

Financial risk components include, but are not limited to, credit risk, interest rate risk, market risk and liquidity risk.  We have adopted various policies to minimize potential adverse effects of interest rate, market and liquidity risks.  However, even with these policies in place, a change in interest rates could negatively impact our results of operations or financial position.

Defaults in the repayment of loans may negatively impact our business.  Credit risk is most closely associated with lending activities at financial institutions.  Credit risk is the risk to earnings and capital when a customer fails to meet the terms of any contract or otherwise fails to perform as agreed.  Credit risk arises from all activities where the Company is dependent on issuer, borrower, or counterparty performance, not just traditional lending activities.  For example, the investment security portfolio has inherent credit risk as do counterparties in derivative contracts.  Credit risk encompasses a broad range of financial institution activities and includes items reflected both on and off the balance sheet.

Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of its borrowers and the value of real estate and other assets serving as collateral for repayment of many of the loans.  In determining the size of the allowance for loan losses, management considers, among other factors, the Company’s loan loss experience and an evaluation of economic conditions.  If these assumptions prove to be incorrect, the current allowance may not be sufficient to cover future loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio.  Material additions to the Company’s allowance would materially decrease our net income.

Fluctuations in interest rates may negatively impact our banking business.  Interest rate risk focuses on the impact to earnings and capital arising from movements in interest rates.  Interest rate risk focuses on the value implications for accrual portfolios (e.g., held-to-maturity and available-for-sale portfolios) and includes the potential impact to the Company’s accrual earnings as well as the economic perspective of the market value of portfolio equity.  The interest rate risk is comprised of repricing risk, basis risk, yield curve risk and options risk.  Repricing risk represents the risk associated with the differences in timing of cash flows and rate changes with our products.  Basis risk represents the risk associated with changing rate relationships among varying yield curves.  Yield curve risk is associated with changing rate relationships over the maturity structure.  Options risk is associated with interest-related options, which are embedded in our products.

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Changes in market factors may negatively affect the value of our investment assets.  Market risk focuses on the impact to earnings and capital arising from changes in market factors (e.g., interest rates, market liquidity, volatilities, etc.) that affect the value of traded instruments.  Market risk includes items reflected both on and off the balance sheet.  Market risk focuses primarily on mark-to-market portfolios (e.g., accounts revalued for financial statement presentation), including trading accounts and certain derivatives.

Our inability to maintain appropriate levels of liquidity may have a negative impact on our results of operations and financial condition.  Liquidity risk focuses on the impact to earnings and capital resulting from our inability to meet our obligations as they become due in the normal course of business without incurring significant losses.  It also includes the management of unplanned decreases or changes in funding sources as well as managing changes in market conditions, which could affect the ability to liquidate assets in the normal course of business without incurring significant losses.  Liquidity risk includes items both on and off the balance sheet.

Business Risk

Business risk is composed mainly of legal (compliance) risk, strategic risk and reputation risk.

Our results of operations and financial condition are susceptible to legal or compliance risks.  Legal or compliance risk is the risk to earnings or capital arising from the impact of unenforceable contracts, lawsuits, adverse judgments, violations or nonconformance with laws, rules, regulations, prescribed practices, or ethical standards.  The risk also arises in situations where laws or rules governing certain products or activities of our customers may be ambiguous or untested.  This risk is not limited to the traditional thinking that legal/compliance risk is only associated with consumer protection laws.  It includes the exposure to litigation from all aspects of both traditional and nontraditional financial institution activities.

Incorrect strategic decisions may have a negative impact on our results of operations and financial condition.  Strategic risk is the risk to earnings and capital arising from adverse business decisions or improper implementation of those decisions.  Strategic risk focuses on more than an analysis of the written strategic plan.  Its focus is on how plans, systems and implementation affect franchise value.  It also incorporates how management analyzes external factors that affect the Company’s strategic direction.

Adverse publicity may have a negative impact on our business.  Reputation risk is the risk to earnings and capital arising from negative public opinion.  This affects the ability to establish new relationships or services or to continue servicing existing relationships.  Examiners will assess reputation risk by recognizing the potential effect the public’s opinion could have on our franchise value.

Operational Risk

An inability to process transactions may have a negative impact on our business.  Operational risk is present on a daily basis through our processing of transactions and is pervasive in all products and services provided to our customers.  It can be defined as the impact to earnings and capital from problems encountered in processing transactions.  Operational risk is a function of internal controls, operating processes, management information systems, and employee integrity.

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Item 1B.      Unresolved Staff Comments

None.

Item 2.         Properties

The main banking office of Kentucky Bank is located at 401 Main Street, Paris, Kentucky 40361.  The principal office of Kentucky Bancshares, Inc. is located at 339 Main Street, Paris, KY 40631.  In addition, Kentucky Bank serves customer needs at 14 other locations.  All locations offer a full range of banking services.  Kentucky Bank owns all of the properties at which it conducts its business.  The Company owns approximately 118,000 square feet of office space.

Note 5 to the Company’s consolidated financial statements included in this report contains additional information relating to amounts invested in premises and equipment.

Item 3.         Legal Proceedings

The Company and its subsidiary are from time to time involved in routine legal proceedings occurring in the ordinary course of business that, in the aggregate, management believes will not have a material impact on the Company’s financial condition and results of operation.

Item 4.         Submission of Matters to a Vote of Security Holders

Not Applicable.

PART II

Item 5.         Market for Common Equity and Related Stockholder Matters

There is no established public trading market for the Company’s Common Stock.  The Company’s Common Stock is not listed on any national securities exchange nor is it quoted on the NASDAQ system.  However, it is traded on the OTC Bulletin Board under the symbol “KTYB.OB”.  Trading in the Common Stock has been infrequent, with retail brokerage firms making the market.  The following table sets forth the high and low closing sales prices of the Common Stock from the OTC Bulletin Board and the dividends declared thereon, for the periods indicated below:

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Note 16 to the Company’s consolidated financial statements included in this report contains additional information relating to amounts available to be paid as dividends.

As of December 31, 2008 the Company had 2,745,729 shares of Common Stock outstanding and approximately 559 holders of record of its Common Stock.

The table below lists issuer purchases of equity securities.

On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program.  The Company is authorized to purchase up to 100,000 shares of its outstanding common stock.  On November 11, 2002, the Board of Directors approved and authorized the Company’s repurchase of an additional 100,000 shares.  On May 20, 2008, the Board of Directors approved and authorized an additional 100,000 shares.  Shares will be purchased from time to time in the open market depending on market prices and other considerations.  Through December 31, 2008, 258,001 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on December 22, 2008.

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Performance Graph

The information included under the caption “Performance Graph” in this Item 5 of this Form 10-K is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C under the Securities Exchange Act of 1934 or to the liabilities of Section 18 of the Securities Exchange Act of 1934, and will not be deemed to be incorporated by reference into any filings we make under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference into such a filing.

The following graph compares the change in the cumulative total stockholder return on our common stock with the cumulative total return of the SIC Code 6022 State Commercial Banks <$100 million and the Russell Microcap Index from 2004 through 2008.  This comparison assumes $100 invested on December 31, 2003 in (a) our common stock, (b) SIC Code 6022 State Commercial Banks <$100 million, and (c) the Russell Microcap Index.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among Kentucky Bankshares Inc.,  The Russell MicroCap Index

And SIC Code 6022 State Commercial Banks <$100mil

*$100 invested on 12/31/03 in stock & index-including reinvestment of dividends.

Fiscal year ending December 31.

Copyright ©2009 Dow Jones & Co. All rights reserved.

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Item 6.         Selected Financial Data

The following selected financial data should be read in conjunction with the Company’s Consolidated Financial Statements and the accompanying notes presented elsewhere herein.

(1)          Tax equivalent

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Item 7.         Management’s Discussion and Analysis

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and accompanying notes included as Exhibit 13.  When necessary, reclassifications have been made to prior years’ data throughout the following discussion and analysis for purposes of comparability with 2008 data.

Critical Accounting Policies

The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.  Significant accounting policies are listed in Note 1 in the “Notes to Consolidated Financial Statements”.  Critical accounting and reporting policies include accounting for loans and the allowance for loan losses.  Different assumptions in the application of these policies could result in material changes in the consolidated financial position or consolidated results of operations.

Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses.  Interest on loans is recognized on the accrual basis, except for those loans on the nonaccrual status.  Interest income received on such loans is accounted for on the cash basis or cost recovery method.  The allowance for loan losses is a valuation allowance for probable incurred credit losses.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  The accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management.

Forward-Looking Statements

This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.  Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to:  economic conditions (both generally and more specifically in the markets, including the tobacco market, in which the Company and its bank operate); competition for the Company’s customers from other providers of financial and mortgage services; government legislation, regulation and monetary policy (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; and other risks detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.  The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

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Overview

Net income for the year ended December 31, 2008 was $3.7 million, or $1.34 per common share compared to $6.6 million, or $2.31 for 2007 and $6.5 million, or $2.35 for 2006.  Earnings per share assuming dilution were $1.33, $2.30 and $2.34 for 2008, 2007 and 2006, respectively.  For 2008, net income decreased $2.9 million, or 43.6%.  Net interest income decreased $415 thousand, the loan loss provision increased $2.7 million, total other income increased $418 thousand, while total other expenses increased $1.9 million.  In July 2006, the Company purchased Peoples Bancorp of Sandy Hook, Inc. (Peoples Bancorp) and its subsidiary, Peoples Bank (Peoples) of Sandy Hook, to strengthen its business and grow its customer base.

For 2007, net income increased $100 thousand, or 1.5%.  Net interest income increased $1.3 million, the loan loss provision increased $525 thousand, total other income increased $700 thousand, while total other expenses increased $1.4 million.

Return on average equity was 6.5% in 2008 compared to 11.6% in 2007 and 12.8% in 2006.  Return on average assets was 0.58% in 2008 compared to 1.04% in 2007 and 1.09% in 2006.

Non-performing loans as a percentage of loans (including held for sale) were 1.73%, 1.57% and 0.59% as of December 31, 2008, 2007 and 2006, respectively.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income, the Company’s largest source of revenue, on a tax equivalent basis increased from $19.5 million in 2006 to $20.9 million in 2007 and decreased to $19.8 million in 2008.  The taxable equivalent adjustment (nontaxable interest income on state and municipal obligations net of the related non-deductible portion of interest expense) is based on our Federal income tax rate of 34%.

Average earning assets and interest bearing liabilities both increased from 2007 to 2008.  Average earning assets increased $7 million, or 1%.  Investment securities increased $23 million primarily due to lower level of loan demand.  Loans decreased $14 million as a result of the slower demand during 2008.  Average interest bearing liabilities increased $5 million, or 1% during this same period.  This change was primarily from the increase in FHLB advances.  The Company continues to actively pursue quality loans and fund these primarily with deposits and FHLB advances.

After peaking in 2006, bank prime rates have been decreasing.  Bank prime rates decreased 100 basis points in 2007, and another 400 basis points in 2008.  As a result of this, the tax equivalent yield on earning assets decreased from 6.80% in 2007 to 6.07% in 2008.

The volume rate analysis for 2008 that follows indicates that $4.0 million of the decrease in interest income is attributable to the decrease in rates, while the change in volume contributed to a decrease of $53 thousand in interest income.  The rate decrease also caused a decrease in the cost of interest bearing liabilities.  The average rate of these liabilities decreased from 3.94% in 2007 to 3.15% in 2008.  Based on the volume rate analysis that follows, the lower level of interest rates contributed to a decrease of $3.8 million to interest expense, while the change in volume was responsible for a $104 thousand increase in interest expense.  As a result, the 2008 net interest income increase is attributed to decreases in rates.

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The volume rate analysis that follows, during 2007, indicates that $2.0 million of the increase in interest income is attributable to the change in volume, while the higher level of rates contributed to an increase of $1.6 million in interest income.  This higher level of rates also caused an increase in the cost of interest bearing liabilities.  The average rate of these liabilities increased from 3.62% in 2006 to 3.94% in 2007.  In addition, the change in volume contributed to an increase of $915 thousand in interest expense, while the higher level of rates was responsible for a $1.4 million increase in interest expense.  As a result, the 2007 net interest income increase is primarily attributed to increases in volume.

In addition to the negative impact on net interest income that may result from the decreasing rate environment that began in 2007 and continued into 2008, competitive pressures on interest rates will continue and are likely to result in continued downward pressure on net interest margins.

The accompanying analysis of changes in net interest income in the following table shows the relationships of the volume and rate portions of these changes in 2008 and 2007.  Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.

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Average Consolidated Balance Sheets and Net Interest Analysis  (dollars in thousands)

(1)                  Averages computed at amortized cost.

(2)                  Includes loans on a nonaccrual status and loans held for sale.

(3)                  Tax equivalent difference represents the nontaxable interest income on state and municipal securities net of the related non-deductible portion of interest expense.

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Noninterest Income and Expenses

Noninterest income was $8.4 million in 2008 compared to $7.9 million in 2007 and $7.2 million in 2006.  In 2008, increases in securities gains and other income were offset by decreases in service charges and loan service fee income.  In 2007, increasing service charges and increasing gain on sale of mortgage loans account for the majority of the increase.

Securities gains were $658 thousand in 2008, $37 thousand in 2007 and $34 thousand in 2006.  These are primarily attributable to declining interest rates and the related inverse relationship of interest rates and market values.  Some securities gains were taken in 2008 and used to offset addition to the loan loss reserve and costs related to the pension plan termination.

Gains on loans sold were $411 thousand, $432 thousand and $290 thousand in 2008, 2007 and 2006, respectively.  Loans held for sale are generally sold after closing to the Federal Home Loan Mortgage Corporation.  During 2008, the loan service fee income decreased $187 thousand ($213 thousand write down of mortgage servicing rights), compared to an increase of $25 thousand in 2007.  Proceeds from the sale of loans were $19 million, $16 million and $17 million in 2008, 2007 and 2006, respectively.  The volume of loan originations is inverse to rate changes.  The volume of loan originations during 2008 was $19 million, comparable to $16 million in 2007, and $17 million in 2006.

Other noninterest income excluding security net gains and gain on sale of mortgage loans was $7.3 million in 2008, $7.5 million in 2007 and $6.9 million in 2006.  Service charge income, and more particularly overdraft income, is the largest contributor to these numbers.  Overdraft income was $4.3 million in 2008, $4.6 million in 2007 and $4.1 million in 2006.  The decrease in 2008 is primarily attributable to the slower economy, while the increase in 2007 is primarily attributable to the Peoples acquisition in July 2006.  Other income was $1.1 million in 2006, $1.4 million in 2007 and $1.6 million in 2008.  The increase in 2008 is primarily attributable to a $153 thousand increase in interchange income, and the increase in 2007 is primarily attributable to a $200 thousand increase in interchange income and a $137 thousand increase in brokerage income.

Noninterest expense increased $1.9 million in 2008 to $20.0 million, and increased $1.4 million in 2007 to $18.1 million from $16.7 million in 2006.  The increases in salaries and benefits from $9.6 million in 2006 to $10.6 million in 2007 and to $11.1 million in 2008 are attributable to normal salary and benefit increases, and in 2006 and 2007 to the Peoples acquisition.  Bonus compensation was $481 thousand lower in 2008 compared to 2007 and $38 thousand higher in 2007 compared to 2006.  The 2008 decrease is mainly a result of a decline in net income, while the 2007 increase is from higher compensation (the percentage payout of base salaries was lower in 2007 versus 2006).  Occupancy expense increased $240 thousand in 2007 to $2.6 million and increased $178 thousand, or 7% in 2008 to $2.7 million.  The largest expense, depreciation, increased $85 thousand to $1.0 million in 2007, and increased $113 thousand to $1.1 million in 2008.  Other noninterest expense increased from $4.7 million in 2006 to $5.0 million in 2007 and increased to $6.2 million in 2008.  Additional pension plan costs due to its December 31, 2008 termination were $563 thousand in 2008.  FDIC insurance increased $196 thousand in 2008 compared to 2007.  Legal and professional fees increased $140 thousand from 2007 to 2008, mainly from additional loan collection efforts.  Check card processing fees increased $114 thousand from 2007 to 2008.   Amortization of core deposits related to the Peoples acquisition was $169 thousand in 2008, compared to $175 thousand in 2007.  See Note 6 in the notes to consolidated financial statements included as Exhibit 13 for more detail of the goodwill and intangible assets.

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The following table is a summary of noninterest income and expense for the three-year period indicated.

Income Taxes

The Company had income tax expense of $684 thousand in 2008 and $2.4 million in 2007 and $2.5 million in 2006.  This represents an effective income tax rate of 15.6% in 2008, 26.7% in 2007 and 27.6% in 2006.  The difference between the effective tax rate and the statutory federal rate of 34% is primarily due to tax exempt income on certain investment securities and loans.

Balance Sheet Review

Assets grew from $631 million at December 31, 2007 to $679 million at December 31, 2008.  Securities increased $25 million and loans increased $7 million in 2008.  Deposits grew $35 million and FHLB borrowings increased $13 million.  The gain in deposits of 7% is primarily from normal growth and the addition of public money.  Assets at year-end 2007 totaled $631 million compared to $630 million in 2006.  Loan decline was $27 million in 2007.  Deposits grew $17 million and FHLB borrowings decreased $16 million.  The gain in deposits of 4% is primarily from normal growth.  See Note 15 in the notes to consolidated financial statements included as Exhibit 13 for additional information on the business combination.

Loans

Total loans (including loans held for sale) were $424 million at December 31, 2008 compared to $417 million at the end of 2007 and $444 million in 2006.  The slight increase in 2008 is mainly attributable to normal loan demand.  Loans declined in 2007, following growth in 2006.  The decline in 2007 is primarily attributable to the softening economy.  As of the end of 2008 and compared to the prior year-end, commercial loans decreased $1.4 million, real estate construction loans decreased $9.4 million, real estate mortgage loans (including loans held for sale) increased $16.3 million and installment loans increased $2.2 million.  As of the end of 2007 and compared to the prior year-end, commercial loans decreased $6.4 million, real estate construction loans decreased $2.9 million, real estate mortgage loans (including loans held for sale) decreased $19.6 million, agricultural loans increased $1.1 million and installment loans increased $.9 million.

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As of December 31, 2008, the real estate mortgage portfolio comprised 68% of total loans compared to 65% in 2007.  Of this, 1-4 family residential property represented 54% in 2008 and 62% in 2007.  Agricultural loans comprised 19% in 2008 and 19% in 2007 of the loan portfolio.  Approximately 73% of the agricultural loans are secured by real estate in 2008 compared to 72% in 2007.  The remainder of the agricultural portfolio is used to purchase livestock, equipment and other capital improvements and for general operation of the farm.  Generally, a secured interest is obtained in the capital assets, equipment, livestock or crops.  Automobile loans account for 29% in 2008 and 36% in 2007 of the consumer loan portfolio, while the purpose of the remainder of this portfolio is used by customers for purchasing retail goods, home improvement or other personal reasons.  The commercial loan portfolio is mainly for capital outlays and business operation.  Collateral is requested depending on the creditworthiness of the borrower.  Unsecured loans are made to individuals or companies mainly based on the creditworthiness of the customer.  Approximately 7% of the loan portfolio is unsecured.  Management is not aware of any significant concentrations that may cause future material risks, which may result in significant problems with future income and capital requirements.

The following table represents a summary of the Company’s loan portfolio by category for each of the last five years.  There is no concentration of loans (greater than 5% of the loan portfolio) in any industry.  The Company has no foreign loans or highly leveraged transactions in its loan portfolio.

Loans Outstanding