WASHINGTON - Dealing a blow to some thrifts, the Internal Revenue Service plans to review the tax liability associated with a popular procedure used by mutual savings and loans to raise capital.

Thrift lawyers and accountants said the review will indefinitely delay use of the technique, which allows depositor-owned thrifts to sell minority stakes to the public.

What's more, an unfavorable IRS ruling could significantly boost the tax bills or reduce the capital levels of the 15 thrifts that Converted to public ownership using this technique over the past two years.

Auditor Piqued IRS Interest

The issue first arose last December when KPMG Peat Marwick asked the IRS to confirm that thrifts converting to public ownership through the creation of mutual holding companies would not lose a tax break associated with so-called base-year reserve levels.

Last week, the IRS informed thrift lawyers and accountants that it planned a much broader review of how to treat bad-debt reserves - the main tax break for S&Ls - in such transactions.

"It is not a good development," said Raymond J. Gustini, a Washington-based partner who specializes in financial institutions at Kelley, Drye & Warren, a New York law firm.

"People were hoping that the meeting at the IRS would answer - not raise - questions."

After the December request for an opinion, a dozen S&Ls put their conversion plans on hold, awaiting a signal from the IRS. The larger-scale IRS review is likely to halt those deals and any others until the IRS makes a final decision, thrift accountants and lawyers said.

Liberty Savings Bank in Liberty, Mo., had completed its $5 million stock offering one week before the IRS met on the issue. Although the deal was oversubscribed, it has not closed because of the pending review.

"That threw a monkey wrench in the works," said Michael A. Gilmore, Liberty's chief financial officer. "That's definitely a potential tax liability to us of about $1.4 million."

Liberty, which has $100 million in assets, must rescind the offer, disclose the potential consequences to its would-be stockholders, and hope they are still interested in buying. It also must again ask the OTS for approval to let the deal go forward.

Some Deals Completed

Other thrifts have already completed the conversion to mutual holding companies. They include the $363 million-asset Guaranty Bank in Milwaukee, $1 billion-asset Home Savings Bank in Hollywood, Fla., and $944 million-asset First Federal Savings Bank of Colorado, Lakewood.

Malcolm "Bud" Collier, First Federal's chairman, said an adverse IRS decision could force the thrift to adjust its capital downward by $4 million.

How much of a hit - in taxes or in capital levels - thrifts would take if the IRS reaches an unfavorable decision changes depending on how much each institution has in its bad-debt reserves.

Stock conversions using mutual holding company structures have been permitted since 1991. While not as common as standard mutual-to-stock conversions, they have grown in popularity because they allow management to retain control after the transaction.

In mutual holding company conversions, the ownership of a depositor-owned saving and loan is split. The larger piece, providing majority control for the thrift's management, is retained by depositors. The smaller piece is broken into shares and sold to the public.

Even if the IRS review is favorable for thrifts - and the agency has given no indication of which way it is leaning - it comes at a bad time.

S&Ls that want to raise capital by going public are more likely to do so in the current strong market for thrift stocks.

"We are still in limbo," said Charles H. Meacham chairmand and president of Commonwealth Federal Savings Bank in Valley Forge, Pa. With several million dollars at stake, the $1.2 billion-asset thrift is "hesitant to go forward" with its planned conversion.

The complicated tax issue revolves around the key tax shelter for savings and loans.

Since 1986, thrifts have been allowed annually to set aside 8% of taxable income in a tax-free account called a bad-debt reserve. A component of that account - called a base-year reserve - contains the reserves the thrift had built up over the previous years.

For most mutual thrifts, base-year reserves account for a significant part of bad-debt reserves.

Carryover Allowed

In a 1981 private-letter ruling, the IRS had said that thrifts that converted to mutual holding companies could carry over their bad debt reserves tax-free to the new company.

But the IRS had never addressed whether the base-year reserve also could be carried over tax-free. Peat Marwick asked for a ruling because of a recent change in accounting rules for deferred tax assets.

Some experts expect the OTS to put a hold on all deals in the pipeline, reasoning that a thrift's board of directors should consider doing standard mutual-to-stock conversions instead.

The OTS will "take into account" the tax consequences of the IRS ruling when it occurs, said Carolyn B. Lieberman, the agency's acting chief counsel She said the OTS will consider "what the financial impact will be on a particular institution" that wants to transform into a mutual holding company.

IRS assistant chief counsel James Malloy declined elaborate on last week's meeting. "We're aware of the issue, we're working on it, and we've made no decision," he said.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.