Bankers are hopeful that legislation will be passed this year to eliminate a tax penalty on the transfer of certain trust assets into mutual funds.

The reform, which could help banks move billions of dollars into proprietary mutual funds, was passed by the House of Representatives last month, as part of a grab-bag tax bill called the Tax Simplification and Technical Correction Act.

The reform itself is not controversial. But it is a small part of much larger bill, which experts said could have a hard time getting enacted, although an Amerian Bankers Association official said that passage by the fall is a possibility.

"To us, it would be terribly, terribly important," said Paul R. Gordon, a senior vice president and tax expert at U.S. Trust Co., in New York.

The issue concerns the capital gains taxes paid by pools of individual trust funds, called common trust funds, when converted into mutual funds.

A Damper on Conversions

The taxes are levied on all gains realized in these funds, and have put a damper on conversions that banks are eager to do to boost mutual fund assets.

Instead, most trust fund conversions have been for employee benefit trusts, including retirement funds, 401(k) and employee stock ownership plans, which because of their tax-deferred status, don't pay capital gains taxes during conversions.

The opportunity for conversions of common trust funds is enormous. At yearned 1992 there were 1,770 common trust funds, operated by 473 institutions, with a total of $136 billion of assets, according to the most recent data disclosed by regulators.

Combinations of the two types of funds could help banks cut administrative costs, and boost economies of scale.

Richard Stierwalt, chairman and chief executive of mutual fund administrator Concord Financial Group in New York, figures that if tax-free common trust fund conversions were allowed another 300 banks could gain the "critical mass" to make money on proprietary mutual funds.

Such conversions could also be attractive to investors. One reason is that mutual fund share prices are disclosed daily. Common trust funds share prices are disclosed lees frequently, often only once or twice a month.

Varying Approaches

Banks have taken different approaches the tax penalty.

Mr. Gordon said U.S. Trust, which operates 25 proprietary mutual funds, has held off on any common trust fund conversions, because doing so would trigger a tax panalty that could put the bank in violation of its fiduciary obligation.

By contrast, Comerica Inc., of Detroit, over the next three months is converting all of its income-oriented common trust funds into mutual funds, because these funds have had nominal appreciation, and are subject to little, if any, capital gains tax, said Michael Obloy, a vice president and senior trust counsel at Comerica's lead bank.

But beause of the tax penalty, Comerica is holding off on converting its growth-oriented common trust funds -- which have appreciated -- into mutual funds, he said. The bank hopes to proceed with these conversions early next year if the tax penalty is eliminated.

If history is any guide, the tax reform could have difficulty becoming law. The provision was included in tax legislation twice vetoed by President Bush in 1992, for reasons unrelated to the trust tax provision.

This year, the Senate has yet to take up the issue.

"This is not controversial," said James McLaughlin, a trust and securities specialist with the American Bankers Association in Washington. "But the problem is that we can't look at this one provision in a vacuum."

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