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Financial institutions electing S status face unresolved issues.

With the signing of the Small Business Job Protection Act of 1996 (SBJPA), banks and thrift institutions (as defined in Sec. 581) were granted the opportunity to elect S status for tax years beginning after 1996. Financial institutions had historically been prohibited from taking advantage of the favorable tax treatment available to small business corporations over the years, numerous Code sections have been drafted with this prohibition in mind. Some of these sections are now in need of amendment and are open to a variety of interpretations when read in conjunction with the revisions to Sec. 1361 that permit banks to make an S election. Although the IRS has offered temporary guidance in some of these areas, others remain unresolved, in spite of the fact that some eligible banks have already made 1997 S elections.

Prior to the SBJPA, banks were prohibited from making an S election by Sec. 1361(b)(2)(B). Historically,financial institutions to which the reserve method of accounting for bad debts of Sec. 585 applied (or would apply were it not for the restriction on the use of this method by small banks) and thrift institutions to which the special bad debt reserve method of Sec. 593 applied were not eligible. Thus, any financial institution was prohibited from electing S status because Secs. 585 and 593 would encompass all such institutions if the small bank restriction of Sec. 585 was not applicable.

The new legislation amends Sec. 1361(b)(2) to redefine an ineligible financial institution as one that actually uses the reserve method of accounting for bad debts provided in Sec. 585. Sec. 593 is no longer mentioned because it was repealed; Sec. 585 now applies to eligible thrift institutions that previously kept a reserve for bad debts under Sec. 593. The amendment is effective for tax years beginning after 1996. Thus, beginning with the 1997 tax year, any financial institution can make an S election provided that it does not actually use the bad debt reserve method of Sec. 585 and meets the other S eligibility requirements.

Passive Investment Income

Perhaps the most obvious oversight in the new law was the failure to adopt revisions to Sec. 1362(d)(3) to coincide with the availability of S status to banks. Sec. 1362 (d) (3) provides that a taxpayer's S status is automatically revoked if more than 25% of its gross receipts for three consecutive years is comprised of passive investment income and the corporation has sub chapter C earnings and profits (E&P) at the close of each of those tax years. This section is particularly troublesome for banks; typically, they derive a large portion of their income from the investment of deposited funds and most do have accumulated E&P (AE&P), because they were required to be taxed as C corporations prior to 1997.

Sec. 1362(d)(3)(C)(iii) provides an exception to the definition of passive investment income for interest received "directly from the active and regular conduct of a lending or finance business (as defined in section 542(d)(1))." However, this section was drafted prior to the SBJPA change and was obviously intended to cater to finance companies rather than to financial institutions, which typically hold large investment portfolios. Likewise, Regs. Sec. 1.1362-2(c)(5)(iii) (B) provides that interest income and gain with respect to loans originated in a lending or financing business are not considered passive investment income, but expressly denies such treatment for interest earned on the investment of idle funds in short-term securities.

Thus, even though a bank's interest income from lending activities would generally not be considered passive investment income, the classification of its income from investments remains unresolved in the Code or regulations. The Joint Committee on Taxation's Explanation of the SBJPA indicates that income earned by a bank in the ordinary course of its banking business is not intended to be treated as passive investment income, but this is the extent of the congressional guidance on the issue.

On Dec. 23, 1996, the Service issued Notice 97-5 in an effort to provide guidance to banks making a 1997 S election. This guidance was necessary in light of the fact that the deadline for filing the 1997 S corporation election (Mar. 17, 1997) was rapidly approaching and several significant financial institution issues remained unresolved. The passive investment income issue was addressed in the notice.

The IRS stated that income from the following sources would be treated as income "directly derived from the active and regular conduct of a banking business," and thus not treated as passive investment income under Sec. 1362(d)(3):

* All loans and real estate mortgage investment conduit regular interests owned (or considered to be owned) by the bank, regardless of whether the loan originated in the bank's business. For this purpose, securities described in Sec. 165(g)(2)(C) are not considered loans.

* Assets required to be held to conduct a banking business (i.e., Federal Reserve Bank stock, Federal Home Loan Bank stock, Federal Agricultural Mortgage Bank stock or participation certificates issued by a Federal Intermediate Credit Bank that represent nonvoting stock in the bank).

* Assets pledged to a third party to secure deposits or business for the bank (such as assets pledged to qualify as a depository for Federal taxes or state funds).

* Investment assets (other than assets specified in the preceding paragraphs) held by the bank to satisfy reasonable liquidity needs (including funds needed to meet anticipated loan demands).

While this guidance offers banks a safe harbor with respect to the classification of income from certain types of investments, the final category of investments--those held to satisfy reasonable liquidity needs--is overly subjective and does not provide any assurance that a particular bank's determination of the level of investments held to satisfy its reasonable liquidity needs will be acceptable to the IRS.

Furthermore, many banks engage in equipment leasing transactions with their customers as an alternative to a standard financing arrangement Although these leasing transactions are no less a part of a bank's active and ongoing business operations than its lending activities, the income from these leasing transactions might not be excepted from the passive income rule of Sec. 1362(d)(3), because it is arguably not a part of the bank's lending or finance business and is not specifically excepted in Notice 97-5.

Notice 97-5 is an important first step by the Service in providing immediate guidance to financial institutions making 1997 S elections. However, it is not likely to be the final word on the classification of passive income for purposes of Sec. 1362(d)(3). Until further guidance is issued, banks must proceed with caution in determining their optimum mix of investment securities, so as not to jeopardize the S election.

Bank-Specific Code Provisions

Although an S corporation is not permisted to have a corporate shareholder, the SBJPA permits a wholly owned subsidiary of an S corporation parent to make a qualified subchapter S subsidiary (QSSS) election if certain requirements are met. This election permits the subsidiary to be treated as part of the parent S corporation for tax purposes. To achieve this result, Sec. 1361 (b)(3)(A) maintains that the electing subsidiary will not be treated as a separate corporation, and all assets, liabilities, income and deductions of the subsidiary shall be treated as items of the S corporation parent. In Notice 97-4, the IRS issued additional guidance indicating that a tax-free Sec. 332 liquidation of the subsidiary would be deemed to occur on its filing of a QSSS election.

However, the Code contains numerous sections that apply exclusively to financial institutions (as defined in Sec. 581), including: (1) Sec. 265(b), providing a specific interest expense allocation formula to be used by financial institutions to determine the portion of their nondeductible interest expense incurred to carry exempt obligations; (2) Sec. 582(a), providing liberalized bad debt deduction rules to banks for worthless securities; (3) Sec. 582(c), providing ordinary gain or loss treatment on the sale or exchange of bonds, loans or other evidences of indebtedness; and (4) Secs. 6050H and 6050P, requiring banks to file certain information returns.

Neither the Code nor the regulations indicate how these bank-specific provisions are to apply to the combined entity if a bank holding company makes an S election and the bank subsidiary makes a corresponding QSSS election. Notice 97-5 offers some temporary guidance by indicating that "the special provisions of the Code that apply to banks should apply only to the specific state-law entity that qualifies as a bank under section 581 of the Code." This rule effectively prohibits taxpayers from applying the bank-specific provisigns to the parent company and from circumventing the bank provisions by applying nonbank provisions to the bank.

While the guidance issued in Notice 97-5 appears to be rather simple, taxpayers are likely to experience difficulties in its application; the guidance is rather vague, especially in light of the fact that the bank's separate existence is to be ignored for purposes of applying all other Code sections. Numerous technical corrections will be necessary to make this guidance workable. The notice indicates that "Treasury intends to work with Congress on appropriate technical corrections to the Act to clarify the tax treatment of banks affiliated with nonbanks." At this writing, such technical corrections are pending. However, until these corrections are passed and IRS regulations are issued, taxpayers are left on their own to interpret this general guidance and apply it to complex situations. Further, the notice anticipates that any such corrections will be effective retroactively to the date of the new legislation.

Stock Held by Bank Directors

The Office of the Comptroller of the Currency (OCC) requires directors of national banks to own a minimal amount of stock in the bank for fiduciary purposes. This stock, referred to as "director stock," is sometimes subject to various restrictions and limitations not generally applicable to the bank's other outstanding stock.

Sec. 1361(b)(1)(D) prohibits a corporation with more than one class of stock outstanding from qualifying for S status. For this purpose, differences in voting rights between classes of stock are permitted, as long as the stock does not confer different economic rights. As a result, national banks must be particularly mindful of the differences between their director stock and their other outstanding stock, so that they do not jeopardize an S election.

Identifying and correcting potential issues in advance of making an S election is a worthwhile exercise when faced with the alternative. Likewise, this may also be a potential problem for national bank holding companies that wish to make a QSSS election, as such an election is only possible if all of a bank's outstanding stock is owned directly by the holding company.

It is unclear whether Treasury will issue any guidance in this area. To date, the IRS has made no mention of any anticipated guidance on director stock: issues. As a result, taxpayers must address this issue themselves, paying close attention to the various stock requirements of S corporations and QSSSs.

Distributions by Thrift Institutions

Thrift institutions face a unique uncertainty resulting from the SBJPA provisigns allowing such institutions to elect S status. This uncertainty concerns distributions to shareholders and results from two seemingly conflicting Code sections, both of which now apply to thrifts.

Sec. 593(e) has historically governed the treatment of distributions by a thrift to its shareholders. This section provides that a distribution to shareholders, other than a distribution in redemption or in complete or partial liquidation, is deemed to be made from the following sources in the following order:

* First out of E&P accumulated after Dec. 31,1951, to the extent thereof;

* Then out of the remaining accumulated bad debt reserves for qualifying and nonqualifying loans and the supplemental reserve, to the extent thereof; and

* Then out of such other accounts as may be proper.

Although most of Sec. 593 (relating to the special bad debt reserve method available to thrift institutions) was repealed effective for tax years beginning after 1995, Sec. 593(e) was preserved and continues to apply to thrift distributions.

However, if a thrift makes an S election, Sec. 1368 would arguably apply to its distributions of earnings accumulated after the effective date of the election. Specifically, under Sec. 1368(c), a distribution to shareholders by an S corporation with AE&P would be treated as coming first out of the accumulated adjustments account (AAA) to the extent thereof. Distributions from this account are not currently taxable to the S shareholders, but instead reduce their stock basis. This is because the AAA represents the S corporation's cumulative earnings, net of previous distributions, that have already been taxed to the S shareholders. Absent such treatment, the primary benefit of S status, avoiding double taxation, cannot be accomplished. Once the AAA has been exhausted, incremental distributions are deemed to be made from the corporation's AE&P and are taxable to the shareholders as dividends.

It is not clear from a reading of Secs 593(e) and 1368(c) which section controls in determining the source of a thrift distribution and, consequently, the treatment of the distribution to the shareholders. Technical corrections are pending that provide that Sec. 1368(c) would supersede Sec. 593(e) for purposes of determining the source of the distribution, thus allowing thrifts to make tax-free distributions to their shareholders.


The S corporation and financial institution provisions of the Code have existed for quite some time. Both sets of provisions, as well as many others, have been developed over the years with the understanding that financial institutions could not elect S status. Therefore, it is not surprising that, with S status now available to these institutions, numerous inconsistencies result, some of which pose practical problems in applying the S corporation rules to banks. Although the IRS has provided guidance in some of these areas, others remain open to interpretation at a time when some banks are proceeding with S elections. These issues acre likely to be the topics of future laws, IRS pronouncements and judicial proceedings.

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Author:Thornton, David A.
Publication:The Tax Adviser
Date:Sep 1, 1997
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