The Sub S Bank Report – February 2010 (Volume 13, Issue 1)

The Federal Deposit Insurance Corporation (FDIC) has invoiced depository institutions for premiums related to the 3rd and 4th quarter 2009, as well as the premiums for all of 2010, 2011, and 2012.  The assessment was required to be paid before December 31, 2009.  Although the accounting treatment under Generally Accepted Accounting Principles (GAAP) is explained in the FDIC guidelines, the tax treatment of the prepayments is not as clear.

Generally, prepayments of certain expenses can be deducted for income tax purposes in the year paid even if the benefit of the prepayment extends beyond the end of the tax year.  Of course, you must meet certain requirements for the prepayment to be deducted, including a requirement that the benefit period can not exceed 12 months.  The income tax consequences of the prepaid assessment for the FDIC insurance depend on whether the benefit period exceeds 12 months.

In determining whether the benefit period extends beyond 12 months, the U.S. Department of the Treasury regulations provide that any renewals (based on the facts and circumstances of the contract) must be taken into account.  The separate designation of the amount of the premium for each period does not change the fact that the benefit provided by the FDIC is for the entire three years.  Since the FDIC assessment is for the entire three-year period the requirement that the benefit not extend beyond 12 months has not been met.

The amount that should be deducted for income tax purposes would be the same amount that would generally be deducted for GAAP purposes.  The only amount deductible in 2009 would be the amount of the prepaid assessment that applies to the 3rd and 4th quarter of 2009.  The 2010 income tax deduction would be the amount that would be deducted on the GAAP statements based on the portion of the prepayment that applies to each quarter in 2010.  This same concept would apply to 2011 and 2012.

It should be noted that this same rule applies to taxpayers using the cash basis method of accounting as well as those using the accrual basis method.

In discussions with Internal Revenue Service (IRS) representatives, they confirmed it is their position that prepayment of the FDIC insurance premiums for the periods 2010 through 2012 will not qualify for any accelerated deductions in 2009.  The IRS has not issued any formal guidance on this position, but is considering issuing written guidance to this effect.  Based on the guidance available today, it does not appear there is substantial authority to deduct the FDIC assessments related to 2010-2012 for income tax purposes.  Doing so could result in penalties to both the taxpayer and the tax return preparer.

Patrick Donehue and Jerry Isaacs  are Oklahoma City, Oklahoma, tax partners with BKD, LLP, one of the top 10 CPA and advisory firms in the United States, and members of BKD National Financial Services Group, serving more than 1,200 financial institutions nationwide with their audit, tax, regulatory compliance, strategic planning, loan review and risk management needs.  Contact the authors at pdonehue@bkd.com or jisaccs@bkd.com.

BKD, LLP is the top-tier U.S. CPA and advisory firm that delivers its experience and service with a deep understanding of your business, your needs and what it takes to improve your business performance.  To learn more, visit www.bkd.com. 

Shortly after the dawn of the New Year, the Internal Revenue Service (IRS) filed its brief in the TEFRA disallowance appeal, Jerome R. Vainisi, et al. v. Commissioner of Internal Revenue. As anticipated, the IRS raised no new issues before the Seventh Circuit Court of Appeals, relying instead on the same points they argued in the original case before the U.S. Tax Court. On February 2nd, the Vainisi Appellants responded with their reply brief.

The IRS’s brief argues that Sections 291(a)(3) and (e)(1)(B) of the Internal Revenue Code (IRC)—which requires the disallowance of 20% of banks’ deductions for interest expense attributable to qualified tax-exempt obligations (QTEOs)—apply to all banks regardless of whether they are organized as a C corporation, S corporation or a qualified Subchapter S subsidiary (QSub). The IRS relies on provisions in Section 1361(b)(3) of the IRC and on Treasury Regulation § 1.1361-4(a)(3) which provide that a QSub must apply certain “special bank rules” before the QSub’s items of income and deductions are merged with those of its parent corporation.

In their reply brief, the Vainisi Appellants clarify that Section 1363(b)(4) of the IRC is an exception to the general rule that S corporations compute taxable income in the same manner as individuals. It is this exception, argue the Appellants, that causes the TEFRA disallowance to apply at all to Sub S and QSub banks. In other words, absent Section 1363(b)(4), the TEFRA disallowance would only apply to C corp. banks.

The IRS also argues that the language of 1363(b)(4) does not extend to QSub banks because it does not expressly reference QSubs or banks, only S corporations. The Tax Court applied this same logic in reaching its earlier decision, suggesting that the 20% disallowance of Section 291 may apply differently to a QSub bank than it would to a stand-alone S corporation bank.

The Vanisi Appellants’ respond that there is no need for the statute to directly reference QSubs because QSubs are generally governed by S corporation rules. In fact, as the Appellants noted in their opening brief, there are in fact no bank rules whatsoever that apply only to QSub banks and not to S corporation banks.

The IRS attempts to negate this very basic premise, but ultimately fails to reconcile how Section 291—purportedly a “special bank rule” and thus applicable to all banks—can apply to QSub banks and S corporation banks in the same manner as it does to C corporation banks despite plain language in Section 1363(b)(4) that clearly states the contrary.

To further illustrate this point, the Vainisi Appellants’ reply brief notes that the Treasury Department has yet to finalize the regulation it proposed back in August of 2006 that would require Sub S financial institutions to apply the 20% TEFRA disallowance in the same manner as C corporations. The Appellants suggest that its hesitation may be due in part to the numerous comments it received opposing Treasury’s position. The Association proudly voiced its opposition to the proposed regulation at that time and again thanks all of those Sub S bankers who did so as well.

The IRS’s brief and the Vainisi Appellants’ reply brief may be viewed in full on the Association’s website at www.subsbanks.org.

Oral arguments have been scheduled for February 23rd at 10:00 a.m. CST. Based on this schedule, a final decision will likely be forthcoming in late summer.

The Subchapter S Bank Association once again would like to thank all of its members, associate members, as well as the Community Bankers Associations of Iowa, Illinois and Wisconsin, the Council of Community Banking Associations, the Independent Community Bankers of America, the Independent Bankers Association of Texas and the Wisconsin Bankers Association for supporting the Sub S TEFRA Defense Fund.

There is reason to believe that the regulatory agencies are prepared to increase their focus on interest rate risk in 2010. This is not surprising as we are about to begin the second year of an unprecedented interest rate environment and banks find themselves tempted to extend duration by a steep yield curve. The reality is that banks, trying to maintain margin, are facing a weak lending environment and therefore find themselves relying more heavily on the investment portfolio. As the Federal Reserve continues to hold the funds rate near-zero, longer-maturity bonds offer much better yield in relative terms. This, however, could be the wrong time to extend duration as evidenced by the behavior of past cycles. The yield curve typically steepens sharply at the trough in interest rates.

Though the exact timing cannot be known, the next big move in interest rates is likely to be upward and when that happens, the entire curve could shift higher putting downward pressure specifically on longer-maturity bond prices and those with excessive options risk. If history is any guide, this phase of the interest rate cycle corresponds with an improvement in economic conditions and a pickup in loan demand which soaks up any excess liquidity. Banks then find themselves owning longer-maturity bonds at relatively low yields (though the yields once seemed attractive) at precisely the time when they wish they had liquidity for reinvestment. This, most likely, is the future scenario that regulators are starting to worry about.

A new emphasis on interest rate risk would follow closely on the heels of recent interagency guidance on liquidity risk management. This past summer the regulatory authorities articulated guidelines on funding and liquidity which highlighted the importance of adequate levels of highly liquid marketable securities and a dynamic, forward-looking system for monitoring cash flow patterns under different interest rate scenarios. This would necessitate use of interest rate risk management techniques that utilize true cash flow analysis rather than simple call-report based reporting.

To be sure, it remains our view that the general interest rate environment will be relatively benign through most of this year. Even Federal Reserve Chairman Bernanke continues to reiterate that the Fed expects rates to remain low for an “extended period of time.”. The economy faces severe headwinds in the form of a massive debt overhang which will constrain household balance sheets and act as a drag on economic growth. This should keep a lid on interest rates for the foreseeable future. Nonetheless, smart bank managers will look at it like a chess match where they must always be thinking at least two moves ahead. The decisions made today will determine performance in future months and years based on the rate environment that exists then. Examiners are said to be thinking ahead on interest rate risk and bankers would be wise to do the same. This requires that banks have access to a robust asset / liability management reporting system, and the necessary ALCO processes for proper and prudent execution of strategy.

The Baker Group is dedicated to helping community banks manage interest rate risk and investments as they face the challenges of a new year. A financial systems “checkup” and investment portfolio review is available to all members of the Subchapter Association. These days, a community bank portfolio manager must have the proper tools for extracting necessary information about the various risk/reward relationships embedded in the bonds that they buy. Managing an investment portfolio without such tools can result in underperformance and unpleasant surprises. We recommend a risk management approach that captures the most important analysis and gives a clear picture of risk and reward. Otherwise, investment managers may find that they are flying blind.

In 2009, the Subchapter S community saw a handful of bills proposed that were aimed at one aspect or another of Subchapter S reform. Some of the legislation, such as the temporary built-in gains tax relief, was quickly passed into law. Other reforms, for one reason or another, have yet to make it to the President’s desk. Many of the bills referred to in this article will continue to be a focus for the Subchapter S community in 2010 and possibly beyond.

S Corporation Modernization Act of 2009

•  The S Corporation Modernization Act of 2009 (S. 996) was introduced in the Senate on May 7, 2009 by Senator Blanche Lincoln (D-AR). It is designed to update some of the Internal Revenue Code (the “Code”) provisions that govern institutions organized under Subchapter S which are largely believed to be outdated.  This bill is a reintroduction of the S Corporation Modernization Act of 2008, which failed to be enacted as law in Congress’s last session.  S. 996 contains the following proposed revisions to the Code:

• Reduced Recognition Period for Built-In Gains: Institutions electing Subchapter S tax treatment are subject to a built-in gains tax on the disposition of assets that were owned by the institution while it was organized as a C corporation. In general, the recognition period on built-in gains is ten years from the date the institution made its S election. However, legislation contained in the American Recovery and Reinvestment Act of 2009 temporarily reduced the built-in gains recognition period down to seven years. The temporary reduction is set to expire in 2010. This proposed legislation would permanently reduce the recognition period down to only seven years.

• Repeal of Excessive Passive Investment Income as a Termination Event: The Code currently specifies that a Sub S institution’s S election will be terminated if the institution has accumulated earnings and profits for three consecutive taxable years and its passive investment income exceeds 25 percent of the institution’s gross receipts for each of those years. S. 996 proposes to repeal this section, effective for taxable years beginning after December 31, 2008.

• Modifications to Passive Income Rules: Presently, the Code subjects Sub S institutions to a corporate-level tax, at the highest corporate tax rate, on excessive net passive income if the institution has accumulated earnings and profits for a taxable year and passive investment income exceeding 25 percent of the institution’s gross receipts for that year. This legislation would increase the allowable percentage of passive investment income from the current 25 percent to 60 percent and would be effective for taxable years beginning after December 31, 2008.

• Expansion of Qualifying Beneficiaries of an Electing Small Business Trust: An electing small business trust, or ESBT, can be a valuable estate planning tool which allows certain trusts with multiple beneficiaries to qualify as a shareholder of a Sub S institution. One requirement of an ESBT is that all potential current beneficiaries must individually qualify as Sub S shareholders. Eligible Sub S shareholders in an ESBT generally include individuals, estates and certain charitable organizations. However, individual non-resident aliens do not presently qualify as potential beneficiaries. S. 996 would amend this section of the Code to permit non-resident alien individuals to qualify as potential current beneficiaries. This proposed revision would be effective as of January 1, 2009.

• Expansion of S Corporation Eligible Shareholders to Include IRAs: Presently, Section 1361(c)(2)(A)(vi) provides a limited exception allowing an IRA (including a Roth IRA) to qualify as a shareholder of a Sub S institution, but only on stock held by the IRA on or before October 22, 2004. This proposed legislation would generally permit any IRA to invest in stock of a Sub S institution, as well as allow existing IRA shareholders to make additional investments in Sub S stock, provided that the IRA itself meets the requirements of a Sub S shareholder. This amendment would be effective as of January 1, 2009.

• Allowance of Deduction for Charitable Contributions for Electing Small Business Trusts: Under the Code, any earnings from S corporation stock held by an ESBT are taxed at the highest marginal tax rate, so deductions can play an important role in the amount of tax an ESBT may be required to pay. S. 996 proposes to allow an ESBT to deduct charitable contributions and apply the limitations on charitable contributions imposed on individuals to ESBTs as well.

• Making Existing Rule Regarding Basis Adjustment to Stock for Charitable Contributions: This amendment would make permanent an existing rule that was set to expire on December 31, 2007.  The rule provides that the decrease in the basis of each shareholder’s stock by reason of charitable contribution will be equal to the shareholder’s pro rata share of the property basis.  This is the only new provision added to the 2009 version of the bill.

The S Corporation Modernization Act of 2009 has been referred to the Senate Committee on Finance. A companion bill to S. 996, H.R. 2910, was introduced in the House by Rep. Ronald Kind [D-WI] and four co-sponsors on June 21, 2009 and presently resides in the House Committee on Ways and Means.

S Corporation ESOP Promotion and Expansion Act of 2009
H.R. 3586 was introduced on September 16, 2009 by Representative Ronald Kind [D-WI] and eleven other co-sponsors. 

This bill proposes to (i) extend to all domestic corporations, including Subchapter S corporations, provision allowing deferral of tax on gain from the sale of employer stock to an S corporation-sponsored ESOP; (ii) allow a tax deduction for interest incurred on loans to S corporation-sponsored ESOPs for the purchase of employer stock; (iii) transfer liability for payment of estate tax on transfers of employer stock to an S corporation-sponsored ESOP from the estate executor to the ESOP; and (iv) allow an estate tax deduction for 50 percent of the proceeds from the sale of employer stock to an S corporation-sponsored ESOP. In addition, the bill would require the establishment of the S Corporation Employee Ownership Assistance Office to foster increased employee ownership of S corporations.

The bill was initially referred to the House Committee on Ways and Means and, as of November 16, 2009, resides in the House Education and Labor Subcommittee on Health, Employment, Labor, and Pensions.

S Corporation Inventory Contribution Act of 2009Representative Phil Hare [D-IL], along with co-sponsor Danny Davis [D-IL], introduced H.R. 4069, titled the S Corporation Inventory Contribution Act of 2009, to the House on November 26, 2009.  The Act proposes to extend tax deductions from charitable contributions of inventory to S corporations and consequently increase non-profit organizations’ access to goods.  This provision allows S corporations to deduct up to twice the donated asset’s basis (but not more than retail value). The bill also includes a provision to limit the amount of such deductions for corporations other than C corporations to 10 percent of their aggregate net income.  The bill was referred to the House Committee on Ways and Means. 

Senator Roland Burris [D-IL] presented companion legislation (S. 2841) to the Senate on December 7, 2009.  This bill currently resides in the Senate Committee on Finance.

Small Business Tax Relief Act of 2009On June 25, 2009, Sen. Charles Grassley [R-IA] introduced S. 1381, titled the Small Business Tax Relief Act of 2009.  The Act contains several provisions aimed at reducing tax burden on small businesses, including a reduction in the built-in gains recognition period from ten to five years.

Other notable features include a reduction in graduated tax for corporations with taxable incomes of less than $10 million and an exemption in income attributable to business tax credits from alternative minimum tax.  The bill has been referred to the Senate Committee on Finance.