IRS rules against Texas limited banking association.

Under current law, banks are not permitted to elect to be treated as S corporations. At least one large accounting firm has heavily marketed a structure that it claimed would permit financial institutions operating in Texas to enjoy passthrough taxation for Federal income tax purposes. That structure is the Texas limited banking association (LBA).

In a recent letter ruling, however, the IRS National Office concluded that a Texas LBA would not be treated as a partnership for Federal tax purposes.

In Letter Ruling 9551032, the taxpayer was a one-bank holding company for a national bank. The taxpayer proposed to reorganize its national bank subsidiary under the Texas banking act as an LBA, with some of the bank's officers and directors becoming members of the LBA. The taxpayer, as part of the reorganization, was to make an election to become an S corporation.

The taxpayer requested a ruling that the LBA be treated as a partnership for Federal tax purposes. Such structure and treatment would have eliminated double taxation on the bank's income. Income would flow through the partnership to the S corporation, which would in turn flow through to its shareholders, where it would be taxed.

The taxpayer asserted that the LBA was not a corporation, but should rather be classified according to factors contained in Regs. Sec. 301.7701-2:

* Continuity of life.

* Centralization of management.

* Liability for corporate debts limited to corporate property.

* Free transferability of interests.

The presence or absence of these corporate characteristics must be taken into consideration in determining whether an organization is treated as a corporation. The taxpayer contended that the proposed LBA lacked the corporate characteristics of limited liability and free transferability of interests and so should be considered as a partnership.

The IRS ruled that the LBA was a corporation. Entities treated as corporations under state law are treated as corporations for Federal income tax purposes without regard to the corporate characteristics outlined in the regulations. The corporate characteristics are relevant only in classifying entities that are not corporations under state law.

The Service found that the Texas Banking Act specifically treated LBAs as corporations for a variety of purposes. The IRS also noted that the bank must be incorporated for purposes of obtaining Federal Deposit Insurance Corporation (FDIC) deposit insurance and that the bank's acting general counsel represented to the FDIC that the bank "should be considered to be incorporated under Texas law."

Implications

This ruling demonstrates that, short of legislative relief, banks cannot achieve a single level of taxation on their income. The Senate included in its 1995 tax legislation a provision permitting banks to elect S status. That provision did not, however, survive the House-Senate conference, and is therefore not part of the budget reconciliation bill Congress is currently negotiating with the Clinton Administration.