Financial institutions electing S status face unresolved issues.

• Author: Thornton, David A.

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 Sec. 593 is no longer mentioned because it was repealed; Sec. 585 now applies to eligible thrift institutions that previously kept a reserve for bad debts under Sec. 593.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...