WASHINGTON - Savings and loan executives and lawyers appealed Friday to the Internal Revenue Service to shelve a proposed rule that would curtail tax breaks on bad-debt reserves.

The rule proposed in January, would substantially reduce the tax benefit on reserves when thrifts convert to bank charters or diversify away from mortgage lending.

Thrifts See Squeeze

Testifying Friday at an IRS hearing, thrift representatives said the rule would not only discourage charter conversions but lock the institutions into mortgage lending at a time when the business is under intense competitive pressure.

"It's a squeeze play," Donald B. Susswein, an S&L lawyer with Thacher Proffitt & Wood, said after giving his testimony to a five-member panel of IRS officials.

"We ask that you reconsider," Abraham Ossip, corporate tax lawyer for the Dime Savings Bank of New York, told the panel on behalf of the Savings and Community Bankers of America.

Also testifying were representatives from Great Western Financial Corp. of Beverly Hills, Calif., the California League of Savings Institutions, and two accounting firms.

Sharon Galm, one of the IRS policy makers, declined to comment after the hearing. She said a decision on the regulation would be made this year. The rule has been in the works since 1989.

Savings and loans have been permitted to take deductions in excess of actual losses to cover expected deficits.

The proposed IRS regulation would affect thrifts that convert to a bank or that have less than 60% of their portfolios in residential loans.

An S&L with at least $500 million in assets that converts or diversifies would be able to deduct losses only when a debt becomes worthless.

Smaller thrifts could choose between that approach, known as the chargeoff method, or the bank method of averaging loan losses over six years.

The excess deductions were designed to help subsidize mortgage lending by S&Ls. As a result, S&Ls have reduced their tax payments and built sizable reserves.

Large commercial banks, on the other hand, were required by the Tax Reform Act of 1986 to "recapture" the recoveries on reserves that are added back into income.

Michael J. Palko, senior vice president of Great Western, said that converting to a bank - which his institution has considered - would cost it $200 million in taxes under the proposed rule.

Mr. Susswein said the rule contradicts Treasury policies aimed at modernizing the S&L industry.

"You have general policy that says banks and thrifts [should] become more alike," he said. "And you have tax policy that is no longer going to give you incentives to be in mortgages."

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