S Corporations

Prop. Regs. for S Corp. Banking Deductions

When Congress passed the Small Business Job Protection Act of 1996, for the first time several banks and thrifts were allowed to elect S status; see Sec. 1361(b)(2)(A). Since then, the number of banks and thrifts opting for S status has steadily increased each year. As of March 31, 2005, a total of 2,237 banks and stock thrifts were S corporations.

On Aug. 24, 2006, Treasury released Prop. Regs. Sec. 1.1363-1. The purpose was to clarify two issues for financial institutions that operate as S corporations:

1. Sec. 1361(b) does not prevent otherwise eligible banks from electing S status; and

2. Sec. 291(a)(3)’s and (e)(1)(B)’s interest-deduction disallowance applies regardless of Sec. 1363(b)(4)’s language providing that Sec. 291 ceases to apply three years after a C-to-S conversion.

S Status

The first clarification amends Regs. Sec. 1.1363-1(b)(2) by removing any doubts that certain banks may elect S status. It appears the seed of confusion stemmed from Sec. 1363(b)’s language providing, “[t]he taxable income of an S corporation shall be computed in the same manner as in the case of an individual.” This “taxed as an individual” concept appears to clash with Sec. 581’s requirement that a bank must be a corporation for Federal tax purposes. Put simply, how can a bank be an S corporation if it is taxed as an individual, but must be taxed as a corporation to be a bank? The proposed regulations’ preamble answers this question by highlighting the explicit Congressional intent for certain banks to be able to elect S status. Considering such clear direction, Prop. Regs. Sec. 1.1363-1(b)(2) explicitly states that Sec. 1363(b) does not affect an S corporation’s status as a bank within the meaning of Sec. 581.

Interest Deduction Disallowance

The second clarification amends Regs. Sec. 1.1363-1(b)(2) to extend Sec. 291(a)(3)’s and (e)(1)(B)’s 20% interest-deduction disallowance on certain local government bonds issued after Aug. 7, 1986. To better comprehend Sec. 291 and its effect on S corporation banks, one must first understand Sec. 265. Sec. 265(a)(2) provides a general rule that no deduction is allowed for interest on debt incurred or continued to purchase or carry obligations, the interest on which is wholly exempt from Federal income taxes. The apparent Congressional motive for Sec. 265(a)(2) was to stop taxpayers from borrowing funds with tax-deductible interest and using them to invest in tax-exempt debt. (With such an arrangement, one could imagine a taxpayer generating after-tax gains via high-bracket deductions and tax-free interest payments.) This law became commonly known as the “TEFRA disallowance” (TEFRA is the acronym for the Tax Equity and Fiscal Responsibility Act of 1985, the law that created Sec. 265(a)(2)). Several years after the TEFRA, Congress enacted Sec. 265(b) (1), extending the TEFRA disallowance to financial institutions.

In 1984, Congress enacted Sec. 1363(b)(4). Its purpose was to prevent C corporations from converting to S status to avoid Sec. 291’s corporate preference tax. Like many C-to-S conversion laws aimed at gradually allowing a converted C corporation the benefits of S status, Sec. 1363(b)(4) provides that Sec. 291 applies to a newly converted S corporation for three years. Among Sec. 291’s many preference items, Sec. 291(a)(3) provides a 20% deduction disallowance for any “financial institution preference item.” Sec. 291(e)(1)(B) defines this as “certain obligations issued after August 7, 1986” and refers to Sec. 265(b)(3). Sec. 265(b)(3) provides for a partial exception to the TEFRA disallowance. Specifically, it allows for an 80% interest deduction for a “qualified tax-exempt obligation” acquired before Aug. 8, 1986 and, for purposes of Sec. 291(e)(1)(B), deems any qualified tax-exempt obligation acquired after Aug. 7, 1986 as if it were acquired on that date. Sec. 265(b)(3)(B)(i) provides that, to be a “qualified tax-exempt obligation,” the:

1. Obligation must be issued by a qualified small issuer;

2. Qualified small issuer must reasonably anticipate that it will not issue more than $10 million of tax-exempt obligations during a calendar year;

3. Obligation may not be a private activity bond (other than a qualified Sec. 501(c)(3) bond, as defined in Sec. 145); and

4. Issuer must specifically designate the bond as a qualified tax-exempt obligation.

Thus, if a financial institution has a qualified tax-exempt obligation that meets these four requirements, the interest expense deduction is subject to a 20% (instead of 100%) disallowance.

Intent: Prop. Regs. Sec. 1.1363-1 appears to stop those taxpayers that would interpret Sec. 1363(b)(4) to mean that Sec. 291 (and, thus, the 20% disallowance rule) only applies for three years after a C-to-S conversion. Under such an interpretation, a full deduction could be taken for interest on debt incurred to purchase or carry qualified tax-exempt obligations, the interest on which is wholly exempt from Federal income taxes. Prop. Regs. Sec. 1.1363-1(b)(2) clarifies that Sec. 291(a)(3)’s and (e)(1) (B)’s interest-deduction disallowance applies to financial institutions operating as S corporations, regardless of Sec. 1363(b)(4)’s language.

Effective Date

If finalized, the regulations would apply to corporate tax years beginning on or after Aug. 24, 2006. The preamble notes that no inference should be drawn from this effective date regarding prior tax years.

From Michael R. Gould, J.D., Washington, DC