Thrifts may have a tough time saving taxes by converting to S Corporations.

In July, Congress permitted banks and thrifts with fewer than 75 owners to become S corporations, allowing them to avoid corporate taxes by passing earnings directly to shareholders.

But the Internal Revenue Service, in a Feb. 20 ruling implementing the law, said thrifts converting to S corporations may have to pay taxes anyway.

The problem is created by conflicts between accounting rules for thrifts and S corporations.

Under IRS rules, S corporation profits are not classified as earnings, but rather pooled in an "accumulated adjustment" account.

Normally, an S corporation would simply tap the accumulated adjustment account to pay dividends to its owners. Thrifts, however, are subject to special accounting rules that prevent them from directly drawing from an accumulated adjustment account.

Instead, the rules require thrifts to first pay dividends out of their reserve accounts. Other accounts may be used only after reserves have been exhausted.

That hurts thrifts, because many carry large bad-debt reserves that they have held tax-free on their books. If those reserves were tapped for dividends, thrifts would have to pay back taxes-which defeats the reason for converting to an S corporation in the first place.

What's worse, a Clinton administration budget proposal would tax all bad-debt reserves immediately after a thrift becomes an S corporation.

The liability is a nasty surprise because Congress voted in August to free thrifts from back taxes owed on bad-debt reserves made before 1988.

"Switching to an S corporation may be very beneficial for some institutions," said James O'Connor, tax counsel for America's Community Bankers. "But thrifts have to make the decision with their eyes open, knowing that there are some significant unresolved issues."

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.