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IRS ISSUES CHALLENGE TO S CORPORATION BANK DEDUCTION

August 24, 2006

Hundreds of community banks have become S corporations since they were first allowed to do so in 1997. The ability to distribute dividends without a second level of tax has been a boon to the bank shareholders.

Many tax rules for banks were drafted before banks could be S corporations. The Treasury has apparently decided that Congress didn't do an adequate job when it changed the law, so now it's trying to rewrite the S corporation bank rules.

TEFRA DISALLOWANCE

In 1982 Congress restricted the deductibility of interest expense for banks with tax-exempt bond investments. `Code Section 291(a)(3) disallows the interest deduction for 20% of interest attributable to municipal bonds. This provision is called "TEFRA Disallowance," after the name of the 1982 tax bill.

Section 1363(b)(4), an S corporation provision enacted in 1984, provides that Section 291 ceases to apply to S corporations beginning with the fourth year after their S election. When Congress enacted the 1996 legislation allowing banks to become S corporations, it left this provision in place. As a result, banks routinely stopped computing the 20% TEFRA disallowance. (Another provision, which disallows 100% of interest deductions attributable to "non-qualified" municipal bonds, was not affected by S corporation elections).

In recent years the IRS apparently decided that Congress really didn't mean to write the S corporation rules that let the TEFRA disallowance lapse after three years. It has challenged a number of banks who have ignored this disallowance. Yesterday they raised the stakes by proposing new regulations that would apply the 20% TEFRA disallowance to S corporation banks even after three years have passed.

CAN THEY DO THAT?

We think the language of the statute is clear, and that the 20% TEFRA disallowance goes away three years after the S election takes effect. We also don't believe that Congress granted broad enough regulatory authority to override the statute (in contrast to the passive loss rules and consolidated returns, for example). We think the IRS is exceeding its authority here.

That said, taxpayers need to know how to deal with this issue. S corporations have three choices right now:

1. Continue to file returns ignoring the 20% TEFRA disallowance, or
2. Adopt the IRS position, starting either in 2006 or 2007, or
3. File amended returns adopting the IRS position for open past years and future years.

We believe the statute provides adequate authority to continue to ignore the TEFRA disallowance. If the regulations become final taxpayers who continue to ignore the disallowance will have to file a special disclosure form, Form 8275-R, to avoid penalties for their 2007 returns (due in 2008) if the IRS challenges the deductions and wins. Filing this form will go a long way towards ensuring a visit from the IRS

FIGHT THE POWER!

Roth & Company will file a comment protesting the new regulations. If Congress had wanted to impose TEFRA disallowance on S corporation banks, they have had plenty of chances to do so when they have enacted other S corporation bank legislation. It's not the Treasury's place to fix the statute.

The comment deadline is November 22. You can submit comments at www.irs.gov/regs or on paper to:

CC:PA:LPD:PR (REG-158677-05), Room 5203, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington DC 20044.

If you file on paper, they want a signed original and eight copies.

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