Tax-exempt interest for financial institutions.

• Author: Tribbett, Debra L.

Tax-exempt interest has become an increasingly complex area, but remains a very important aspect of most financial institutions, tax planning and asset liability management. Some of the issues that must be considered include the effect of exempt earnings on a banks alternative minimum tax (AMT) position, structuring the deal, the penalty under die Tax Equity md Fiscal Responsibility Act of 1982 (TEFRA), and the effect of a constantly changing economic environment. In addition, qualified Sec. 501(c)(3) bonds and qualified enterprise zone facility bonds (EZ bonds) can provide opportunities to render much-needed services to die banks customers.

Tax-exempt financing decisions cannot be made without considering the effect of the AMT. For most financial institutions, tax-exempt interest is the largest component of the adjusted current earnings (ACE) adjustment, which in turn is the largest component of AMT Paying AMT for a period of one or two years is generally not a cause for great concern, since a carry-over is generated that cm be used in future years to offset regular tax liability. The concern is escalated, however, when a company is paying AMT on a regular basis and generating carry-overs that win lose most of their value by the time they are able to be used. So, how does a bank maximize the benefit of tax-exempt interest without becoming an AMT taxpayer? There are two ways of analyzing tax-exempt interest's effect on the AMT position. The first is a "new fund" concept. If new funds or currently nonearning assets are used, the following formula determines how much additional tax-exempt interest a bank can earn without incurring an AMT liability.

Example 1: If a banks regular tax liability is $400,000 and its AMT liability is $300,00 the bank could earn an additional $666,665 ($100,000 / 75% / 20%) in net tax-exempt interest before being subject to AMT.

While the above calculation requires new or nonearning assets to be used, the following formula calculates a "swap amount." The swap amount is the principal currently invested in amble securities that can be reinvested in tax-exempt securities without generating an AMT liability.

Example 2: Assume the same facts as in Example 1. With a $100,000 gap amount, and assuming a 4.5% tax-exempt rate and a 6% taxable rate, the swap amount is $6,600,660. The result is that $6,600,660 of taxable securities can be swapped for tax-exempt securities with no additional AMT liability.

After it has been...