Responding to industry appeals, the Internal Revenue Service said banks will be allowed to use a corporate structure that passes profits to shareholders tax free.

In guidance issued Dec. 20, the IRS said interest earnings will not be counted as "passive income." Rules prohibit so-called S corporations from earning more than 25% of their income from passive investments.

The IRS decision is a "positive step," said John R. Ziegelbauer, a tax partner at the Washington office of the accounting firm Grant Thornton. "This was a potential deal-breaker for banks. All banks do, really, is have a lot of interest income."

Congress gave banks the right to convert to S corporations in August when it passed the Small Business Job Protection Act. Investors prefer S corporations because income is taxed only at the personal level. Normally, companies pay corporate taxes and investors then pay taxes on dividends.

Because an S corporation may have only 75 shareholders, the provision is expected to be used overwhelmingly by small banks.

According to a study by the accounting firm Grant Thornton, more than 700 community banks are "likely" to convert to S corporation in 1997 and another 1,120 are expected to change in 1998 or later.

The IRS spelled out a variety of assets considered part of the "ordinary course" of banking that won't count toward the passive income cap. They include:

*Loans, participations, and real estate mortgage investment conduit securities (Remics) owned by the bank. Even loans not originated by the bank will be exempt from the cap.

*Capital required by government entities such as the Federal Reserve and Federal Home Loan banks.

*Assets held to qualify as a depository for federal taxes or state funds.

*Investments held to satisfy "reasonable liquidity needs."

The IRS guidance does not have the same binding authority as official regulations, but will assist banks that want to take the S corporation structure.

Karen Thomas, director of regulatory affairs for the Independent Bankers Association of America, said the agency should have gone further. If the agency doesn't define "reasonable liquidity," many banks may violate the 25% cap, she said.

The IBAA argued that 65% of a bank's investment revenue should be exempt from the passive-income limit.

"We wanted a safe harbor rather than have every bank trying to justify what amounted to 'reasonable liquidity,"' she said.

Breaking with previous rules, the IRS also said companies with more traditional corporate structures may convert to S corporations on Jan. 1.

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