Prop. Regs. for S Corp. banking deductions.

• Author: Gould, Michael R.

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 stares; 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 See. 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...