S Corporation Bank Highlights
By Mariann Krieger
Community Bank Advisor, 2007 Winter

TEFRA Issue — Proposed Regulations

The IRS has issued proposed regulations regarding the TEFRA disallowance (interest expense disallowance related to carrying tax-exempt investments) as it relates to S Corporation banks. These proposed regulations would clarify the IRS’s position that the TEFRA disallowance continues after the third S Corporation year. This proposed regulation, if issued as is in final form, would become effective in 2007.

Because these proposed regulations do not have the effect of law, an S Corporation bank may continue to not apply the TEFRA disallowance rules to its 2006 federal income tax return. When purchasing qualified tax-exempt obligations in 2007, however, a bank may want to consider evaluating tax-equivalent yields as though the TEFRA disallowance applies.

Methods of Accounting

If an S Corporation bank is currently using certain methods of accounting for tax purposes, an opportunity may exist to request to change such accounting methods for tax purposes. In many cases, these changes create a deferral of income and therefore, a deferral of tax.

Changes in accounting methods are requested by filing a Form 3115 — Application for Change in Accounting Method. Some change-in-method requests are considered non-automatic changes, which means that IRS approval must be granted before the method change may be implemented.

Thus far, our S Corporation bank clients who have applied for accounting method changes have been granted IRS permission to change. If you are an S Corporation bank, we would welcome an opportunity to discuss this issue further.

Death of a Shareholder

Upon the death of a shareholder, the S Corporation stock owned by such shareholder can continue to be held by the shareholder’s estate, but only for a period of time not to exceed two years. If the stock is transferred to the shareholder’s beneficiaries, the bank will want to make sure that those beneficiaries are qualified S Corporation shareholders and that the total number of shareholders does not exceed 100.

If the stock is transferred to a trust for the benefit of the shareholder’s beneficiaries, the trust must be a qualified S Corporation trust or an electing small business trust. In both cases, certain language is required to be in the trust document and the trust is required to make certain elections within certain time frames.

If these transactions are not handled properly, the S election as made by the bank will be terminated. There are provisions within the current federal tax code that allow for reinstatement of an S election in certain circumstances. These are known as the “inadvertent termination” rules; however, to invoke these rules, a private letter ruling request must be filed with the IRS, which is a lengthy, involved, and somewhat expensive process.

It is imperative for an S Corporation bank to monitor shareholder transactions and events on a continuous basis. We welcome an opportunity to consult with you on any shareholder issues or questions you might have.

Conformity Election

The conformity election is described on the next page in greater detail. As described, if done appropriately, the conformity election can provide protection to the bank’s tax bad-debt deductions upon audit by the IRS. This is especially important for an S Corporation bank to consider, as any IRS audit adjustments to the S Corporation tax return would require adjustment to all the shareholder returns.