The Sub S Bank Report – June 2010 (Volume 13, Issue 2)

As you have likely heard by now, the Subchapter S bank community scored a tremendous victory in the TEFRA disallowance appeal, Vainisi v. Commissioner of Internal Revenue. On March 17, 2010, the Seventh Circuit Court of Appeals ruled in favor of the Vainisi Appellants—as well as the greater Subchapter S bank community—holding that the 20% TEFRA disallowance only applies to Subchapter S and qualified Subchapter S subsidiary (QSub) financial institutions for the first three taxable years after they elect Subchapter S tax status. The Seventh Circuit’s ruling reversed the U.S. Tax Court’s previous decision in favor of the IRS.

On Wednesday, June 14 the 90-day period within which the IRS could appeal the decision to the United States Supreme Court expired. Shortly before the expiration of the appeals period, we received notification that the IRS did not intend to pursue the appeal.

What does this mean for Sub S banks? Because the Seventh Circuit’s ruling reversed the Tax Court decision, it means that there is now no precedent that would suggest that any Sub S bank in the country should be required to apply the TEFRA disallowance after the initial three-year period has expired.

To recap, the TEFRA disallowance refers to a 20% reduction in the amount of a financial institution’s deductible interest expense attributable to its investments in qualified tax-exempt obligations (QTEOs). The Internal Revenue Code generally permits all financial institutions to take annual deductions on their interest expense attributable to holding QTEOs; however, Section 291 of the Code specifically requires C corporations to reduce—or “disallow”—these deductions by 20% each year in which the entity claims such a deduction. This limitation contained in Section 291 is known as the TEFRA disallowance.

The Vainisi Appeal centered on whether Section 291 also applies to S corporations in the same manner as it does to C corporations.

The IRS argued that it does. They claimed that Section 291 of the Code is a “special banking rule” that applies every year (as it does for C corporations). The Vainisi Appellants, on the other hand, asserted that Section 291 generally only applies to C corporations. And only through a provision in Subchapter S of the Code—Section 1363(b)(4) specifically—does the 20% TEFRA disallowance become applicable to S corporations; but even then, as the plain language of Section 1363(b)(4) instructs, only for the first three years after the entity elects Subchapter S status.

Throughout the appeal, the IRS continued to rely on the U.S. Tax Court’s earlier analysis that since Section 1363(b)(4) does not specifically reference QSubs (it only references S corporations), it is therefore not applicable in the Vainisi’s case. (Note: The Vainisis own stock in a Sub S holding company that owns a QSub bank, which, in turn, owns the QTEOs.) Illogically, the IRS’s and the Tax Court’s conclusions suggest that the TEFRA disallowance could apply differently to QSub banks than it would to stand-alone S corporation banks.

The Seventh Circuit was not persuaded by the IRS’s arguments and ultimately agreed with the Vainisi Appellants, choosing to focus on the plain language of Section 1363(b)(4). Recognizing the flaw inherent the IRS’s argument, the Court rhetorically asks “had Congress wanted banks to enjoy none of the benefits [of Subchapter S], why did it change its previous policy and allow banks to become S corporations?”

Congress (by statute) and the Treasury Department (by regulation) have so far not chosen to alter or interpret the manner in which the TEFRA disallowance applies to Subchapter S institutions. In late 2006, the Treasury Department did propose a regulation that would make all Sub S financial institutions subject to the TEFRA disallowance in the same manner as C corporations, but it has never been finalized. As the Court astutely recognizes in its opinion, bankers and practitioners alike have questioned the validity of a regulation that would directly contravene the plain language of Section 1363(b)(4).

At this point, three things could happen. One possibility is that the Treasury Department could choose either to finalize the 2006 proposed regulation, or issue a new regulation that would attempt to require Sub S banks to apply the TEFRA disallowance in the same manner as C corporations. However, whether the Treasury Department’s rule-making authority extends this far is an issue that remains in question. A second possibility is that Congress could pass legislation—possibly as part of the broader financial reform legislation—that would in effect amend the Code to treat S corporations and C corporations alike for purposes of the TEFRA disallowance. Or, both Congress and the Treasury Department could simply do nothing, in which case the Seventh Circuit’s decision in the Vainisi Appeal would remain the definitive interpretation of the law. For now at least, the Sub S bank community can bask in the glow of this hard-earned victory.

We at the Subchapter S Bank Association are very grateful to Ms. Debra Koenig and her associates at Godfrey & Kahn, S.C., whose hard work and dedication secured the victory in the Seventh Circuit. Most importantly, we would like to thank all of the Sub S banks around the country, as well as the Independent Bankers Association of Texas, the Community Bankers Associations of Iowa, Illinois and Wisconsin, the Council of Community Banking Associations, the Independent Community Bankers of America and the Wisconsin Bankers Association, who all so generously contributed to the Subchapter S Bank Association’s TEFRA fund. Without your support, this victory would not have been possible.

Mr. Toppin is the Executive Director of the Subchapter S Bank Association and a partner in the law firm of Kennedy, Toppin & Sutherland, LLP.

If the tumultuous economy wasn’t enough to lose sleep over, then the U.S. Tax Court ruling in January 2009 for Subchapter S financial institutions regarding the TEFRA disallowance had many community banks in a permanent state of insomnia.  Fortunately, relief came in March of this year that finally set the record straight as the Seventh Circuit Court of Appeals reversed the January 2009 ruling in the TEFRA disallowance appeal, Vainisi v. Commissioner of Internal Revenue.  Since the interpretation of the TEFRA disallowance has been in limbo, Sub S banks were faced with two options with respect to the tax treatment of interest on bank qualified bonds:  1) Take the full deduction of interest and hope that the ruling would be reversed or, 2) deduct only 80% of the interest and prepare to file amended returns if the ruling is reversed for the amount of overstated taxable income.

Many Sub S banks chose the latter, and it is likely that shareholders will reap significant reductions in taxable income going back as far as late 2005, when the turmoil began.  Today, AAA 20 year bank qualified municipal bonds yield almost exactly what the average has been since 2004; approximately 4.38% according to Bloomberg’s 20 year BQ index. The tax benefits of the 100% interest exemption on bank qualified bonds following the 3 year period of the Subchapter S election compared to deducting 80% of the interest is shown below.  These calculations assume the same 6 year bank qualified average net yield of 4.38% and an average cost of funds for Sub S banks in the U.S. since 2005 of 2.35%.  The result is a 25 basis point difference over the past four to five years that could produce a substantial reduction in a shareholder’s tax liability.  Institutions affected by the Vainisi ruling are advised to contact their tax advisors to analyze the potential benefits of the more favorable interpretation of the TEFRA disallowance.

Given the prospect of higher tax rates, the implied demand for tax exempt income will be a significant factor in managing the bond portfolio.   There are also a number of stimulus programs that are set to expire this year with the potential to diminish future supply of BQ municipal bonds.  One of which, commonly referred to the “Safe Harbor” provision from the American Recovery and Reinvestment Act (ARRA), allow financial institutions to purchase non-bank qualified municipal bonds issued in 2009 and 2010 and deduct 80% of the interest in the same manner in which BQ issues are treated.  While the safe harbor provision limits such purchases to no more than 2% of the institution’s adjusted total assets and excludes refunding bonds, it has proven to be an excellent supplemental source for banks to satiate their appetite for tax exempt income beyond the scope of traditional BQ issues.  The small issuer provision of the ARRA that raised the issue limit from $10 million to $30 million was initially scheduled to expire this year but has been extended to 2011. This will limit the supply of tax exempt issues if legislation fails to extend or permanently implement the provision.  According to Bloomberg data, bank qualified issues only represent approximately 33% of all outstanding municipal bonds. 
During the process of developing an appropriate municipal investment strategy in today’s environment, banks are advised to always consider the following:

1. Underlying Credit
2. Liquidity
3. Regulatory and Economic Changes
4. Education and Due Diligence
5. Earnings

These five elements are essential to the community banker’s arsenal, analogous to the five stones in David’s sling used to defeat Goliath.   The Vainisi case victory is a lesson learned by the IRS given the tenacity of our community banks and a response to the policy of “Too Big to Fail”; community banks are “Too Strong to Give Up.”

After months of heated debate and last-minute changes, Congress passed and President Obama signed into law the Patient Protection and Affordable Care Act (Patient Protection Act) and the Health Care and Education Affordability Reconciliation Act of 2010 (Reconciliation Act).  Together, these two laws reform the health care system and affect virtually all taxpayers.  One significant tax change is a provision within the Reconciliation Act that, effective 2013, imposes a Medicare tax of 3.8 percent on the lesser of net investment income or the excess of an individual’s modified adjusted gross income (MAGI) beyond $200,000 for single filers ($250,000 for joint filers).  Investment income would include items such as interest, dividends, rents, royalties, gains on sales of certain property and ordinary income from passive activities.  Investment income is reduced by deductions properly allocated to such income investment interest expense and investment management fees.  With the information above in mind, flow-through income from entities such as S corporation banks will have additional tax consequences.  The tax consequences are different for individuals who are considered active versus passive.

Impact on Active Bank Shareholders
As discussed above, if a taxpayer’s MAGI exceeds the abovementioned limitation, an individual will pay the Medicare tax on the lesser of net investment income or the excess of MAGI beyond $200,000 for single filers ($250,000 for joint filers).  An individual’s income received from a flow-through entity such as an S corporation bank maintains the character of the flow-through entity.  For example, the income earned by the bank in the ordinary course of its trade or business, i.e., interest from loans and/or securities, will be taxed as ordinary income and not subject to the additional Medicare tax on the active shareholder’s individual tax return.  However, the investment income earned by the bank, i.e., dividends paid on stock owned by the bank, will be subject to Medicare tax.  This makes the proper characterization on flow-through bank tax returns much more important,

Impact on Passive Bank Shareholders
Code Section 469 is used to determine whether an individual is considered to materially participate in an activity.  If a taxpayer does not materially participate in a flow-through entity such as an S corporation bank, all of the income passed through from the bank will be subject to the additional Medicare tax regardless of the character.  Unlike the active shareholder, the ordinary income passed through from the bank would from the bank would not only be subject to an individual’s ordinary federal income tax rate (currently projected to be 39.6 percent in 2011), but also would be subject to the additional 3.8 percent Medicare tax.  Individuals must pay the tax on the lesser of net investment income or the excess of MAGI beyond $200,000 for single filers ($250,000 for joint filers).

Considering the projected increase in individual tax rates and the Medicare tax change, a bank may want to consider an independent analysis to confirm it is still advantageous to operate as an S corporation, especially if the majority of the ownership is passive.  Please consult with your tax advisor to determine the implications of the Medicare tax on your bank and/or individual tax return.

The Medicare tax will become effective for taxable years beginning January 1, 2013.

Brian Mall, a manager with BKD, LLP, specializes in tax consulting with financial institutions and companies in the construction, manufacturing and service sectors. 

In today’s challenging economic environment, Subchapter S bankers are looking for alternative ways to maintain shareholder value despite lower earnings.  One such opportunity is the reduction of shareholders’ tax burdens through engineered cost segregation. Cost segregation is a process by which personal property assets are separated out from real property assets for the purpose of depreciating those personal property assets at a more accelerated rate than the real property to which they are attached.  The result is that a Sub S bank is able to increase its depreciation expense, which, in turn, lowers its shareholders’ tax liability. The tax savings created by cost segregation generate an average of $70,000 in income tax benefits per million dollars in building cost. 

Cost segregation can be applied retroactively on buildings built, purchased, or improved since 1987.  These savings can be applied to the current tax year without amending the returns.

How Did Cost Segregation Come About?Cost segregation came about in 1997 with the landmark tax court case Hospital Corporation of America (HCA) vs. IRS.  Prior to the HCA case, buildings were required to be depreciated over 39 years.  With the favorable HCA decision, qualified building components can now be depreciated over five, seven, and fifteen years.  The result of is that a bank is able to increase its depreciation expense, thus reducing its shareholders’ tax liability.  In the case of Subchapter S banks—which typically make regular cash distributions to cover their shareholders’ tax liabilities—the reduced tax burden allows the bank to make smaller distributions to cover those tax payments.

What Does the IRS Say About Cost Segregation?
The IRS says, “As a practical matter, cost segregation studies should be applied by taxpayers.”  Yet despite the IRS’s recommendation of its application, most taxpayers have never heard of cost segregation.  If the cost segregation study is performed by a qualified cost segregation firm, as directed by the IRS, the filing of the cost segregation depreciation is no more aggressive than straight line depreciation.  In fact the IRS recognizes cost segregation as the proper way to report depreciation.

I Don't Own the Building, but Paid for Leasehold Improvements.  Can I Have a Cost Segregation Study?
Yes.  Cost segregation can be done on leasehold improvements as well.  It is not a requirement that the bank own the building in order to apply cost segregation.

What Is Involved in a Cost Segregation Study?
A cost segregation study segregates out all the construction costs that can be depreciated over five, seven, and fifteen and thirty-nine year periods.  A typical study involves a site visit by the contracted cost segregation firm as well as examination (if available) of architectural plans, appraisals, and cost details.

What Percentage of My Building's Construction Costs Can Be Reclassified?

According to a June 2009 article published by the Texas Society of CPAs, 25-43% of a bank's construction costs can be reclassified from 39 year depreciation schedule to a five, seven, or fifteen year depreciation schedule.

What are some of the Components that Can Be Reclassified to five, seven, and fifteen year Depreciation?
A partial list of components typically seen in a bank cost segregation study includes:

Five year: Cabinets and millwork, communication/electrical equipment, drive-up windows, wall finishing, glass window walls, interior partitions, ATM canopies

Seven year:  Pneumatic tube systems, projection screens

Fifteen year: Site preparation and drainage, sidewalks and curbs, landscaping and exterior signage

Who Qualifies for a Cost Segregation Study?
Any commercial property that has been purchased, constructed, or has had leasehold improvements since January 1, 1987 may qualify for cost segregation.

How Does Cost Segregation Work on Existing Properties?The IRS allows taxpayers to go back as far as January 1, 1987 and report in the current tax year depreciation they were entitled to take in past years.  The result of this catch up depreciation is a significant income tax benefit to the Sub S bank's shareholders.

Do the Taxpayers Have to Amend Their Returns to Apply Cost Segregation?
The taxpayer does not have to amend returns to apply the results of a cost segregation study.  The bank’s CPA files a 3115 change of accounting form along with the bank’s tax return. (It is prudent to note also that the bank’s CPA plays an important role in the cost segregation process by implementing the findings of the cost segregation study.)  The shareholder then reports the increased depreciation from previous years (and the current year) on its next tax return.

David DeLamar is a senior consultant for a prominent national cost segregation service provider. He can be reached by phone at (806) 773-6382 or by email at   daviddelamar@suddenlink.net.