The balanced budget bill that President Clinton signed into law last week eliminated a big tax liability for thrifts that convert to subchapter S corporations.
Small banks and thrifts were permitted to become S corporations last summer, a structure that allows them to avoid corporate taxes by passing earnings directly to shareholders.
But the benefits of converting were put in doubt for thrifts last February when the Internal Revenue Service ruled they may have to pay taxes anyway because of conflicts between accounting rules for thrifts and S corporations.
After lobbying by America's Community Bankers, lawmakers agreed to resolve the discrepancies.
The trade group's tax counsel, James O'Connor, praised IRS officials for helping to draft the changes. "They worked with us to solve the problem."
Kathleen E. Marinangel, chairman and chief executive officer of McHenry (Ill.) Savings Bank, said her $105 million-asset institution will pursue conversion because of the fix.
"Without this correction, the problems would be extensive for thrifts that convert," she said. "We were going to have double taxation."
Last winter the IRS said thrifts that convert to S corporations would have to pay taxes on their bad-debt reserves when they paid dividends to shareholders.
Ms. Marinangel said her institution would have faced a $400,000 tax bill on bad-debt reserves of $1 million.
Under IRS rules, S corporations profits are not classified as earnings, but rather pooled in an "accumulated adjustment" account. Normally an S corporation would simply tap the account to pay dividends.
Thrifts, however, were subject to special accounting rules that require them to pay dividends out of their reserves before drawing off the accumulated adjustment account.
That would have hurt thrifts because many carry large bad-debt reserves that they have held tax-free on their books. If the reserves were tapped for dividends, thrifts would have had to pay back taxes, which would have defeated the reason for converting to an S corporation in the first place. The new law allows them to pay dividends from the account before draining reserves.
The legislation also directs the Treasury Department to draft rules for banks that are wholly owned subsidiaries of S corporations holding companies. The new rules are needed because S corporations were not allowed to own subsidiaries until last year.
