IRS provides boost to trust-preferred securities.

In Letter Ruling (TAM) 9910046, the IRS reduced some of the uncertainty surrounding the tax treatment of trust-preferred securities, which are generally treated as equity for financial and regulatory reporting purposes and as debt for tax purposes. In general, the TAM provides a useful analysis for supporting the debt treatment of trust-preferred securities. Since the release of this letter ruling, many banks have decided to raise capital using trust-preferred stock.

Trust-Preferred Stock Structure

Typically, a bank or bank holding company forms a business trust that owns all the trust's common equity and at least 3% of the trust's total equity. The trust then issues the preferred securities to third-party investors. Simultaneously, the bank or holding company issues subordinated debt to the trust in exchange for the proceeds of the preferred issue.

The cash, now in the hands of the financial institution, can be used in a number of ways, including funding internal growth, cash acquisitions, investments or capital restructuring. For regulatory purposes, trust-preferred stock can count for up to 25% tier 1 capital. Interest payments made to the trust are tax deductible.

Letter Ruling 9910046 was issued shortly after the IRS settled a case with Enron Corp. involving securities similar to trust-preferred securities (referred to as monthly income preferred securities (MIPS)).

Enron Corp. treated these securities as debt for tax purposes and equity for financial reporting purposes. The Service argued that, in determining whether the securities were debt or equity, it was important how the securities were treated for nonbook purposes.

The IRS also questioned whether the relationship of the parties to the arrangement exercised equity-like control, exerting undue influence on a lender that the parent controlled. The Service eventually settled with Enron and allowed the loans issued in connection with the preferred securities to be treated as debt.

In the letter ruling, the IRS applied the factors in Notice 94-47, as well as other factors enumerated in case law, to the loans made to the corporation. It concluded that the loans were, in fact, debt for Federal income tax purposes. These factors included whether:

* An unconditional promise exists on the issuer's part to repay the principal at a fixed maturity date;

* Holders of the instruments possess enforcement rights;

* Instruments give the holders rights to participate in management;

* Rights of the holders of the instruments are subordinate to the rights of other general creditors;

* The issuer is thinly capitalized;

* There is identity between the holders of the instruments and stockholders of the issuer;

* A label is placed on the instruments; and

* Instruments are intended as debt or equity for nontax purposes.

Applying these same factors to the preferred securities, the Service determined that, had the corporation issued the preferred securities directly, they would have been debt for Federal income tax purposes.

MIPS are very similar to the trust-preferred securities used today by many banks. Regulatory agencies treat trust-preferred securities much the same as the rating agencies treated MIPS in Enron.

An IRS victory in Enron could have led to successful challenges of the many bank trust-preferred securities issued during the past few years. Letter Ruling 9910046 and the Enron settlement provide banks with an important analysis that they can use to defend the debt treatment of trust-preferred stock.

FROM JOHN ZIEGELBAUER, CPA, WASHINGTON, DC