Tax impact on bank-qualified and non-bank-qualified securities
As more financial institutions invest in non-bank-qualified securities, it’s important to understand how they are different from bank-qualified securities.
The first difference is in taxes. The non-bank-qualified securities are being included with the bank-qualified securities to calculate the disallowed interest expense. Two separate calculations need to be done to determine the tax impact for each group of tax-exempt securities and the interest expense that is disallowed.
Generally, interest expense attributable to carrying tax-exempt securities is not deductible. The nondeductible amount varies depending on whether the tax-exempt security is bank qualified (20% disallowance) or non-bank qualified (100% disallowance).
Under IRC Section 291(e), 20% of the interest expense deduction allocable to bank-qualified securities is disallowed for financial institutions. Under IRC Section 265(b), 100% of the interest expense deduction allocable to non-bank-qualified tax-exempt securities is disallowed for financial institutions. The initial limitation was created from the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, with changes under the Tax Reform Act of 1986 and additional changes with the 2009 Recovery Act.
A bank-qualified tax-exempt obligation is a tax-exempt obligation that:
- Is issued after August 7, 1986, by a qualified small issuer
- Is not a private activity bond
- Is designated by the issuer as qualifying for the exception
A qualified small issuer is one that issues less than $10 million in total debt during the calendar year.
For the TEFRA limitation:
- Financial institutions that are C corporations are subject to the TEFRA limitation for both bank-qualified and non-bank-qualified securities.
- Financial institutions that are S corporations are subject to the TEFRA limitation for non-bank-qualified securities and only the first three years of electing S-corporation status for bank-qualified securities.
- Financial institutions that are S corporations from inception are not subject to the TEFRA limitation on bank-qualified securities.
To calculate the interest disallowance, using your tax basis, take the average tax-exempt assets, divided by the average total assets, multiplied by the total interest expense. Bank-qualified securities will then be multiplied by 20% to determine the disallowed interest expense.
|
|
Bank qualified |
Non-bank qualified |
|
Average tax-exempt assets |
$8,000,000 |
$8,000,000 |
|
Average total assets |
880,000,000 |
880,000,000 |
|
Total interest expense |
5,500,000 |
5,500,000 |
|
Disallowed interest (initial) |
50,000 |
50,000 |
|
20% bank qualified |
10,000 |
- |
|
Total disallowed interest |
$10,000 |
$50,000 |
The financial institutions have indicated they do plan to invest in more non-bank-qualified securities.
As the portfolio of non-bank-qualified securities grows, the disallowed interest will increase, assuming other factors stay consistent. Also note, the TEFRA limitation is a permanent difference.
Another thing to consider is that the 2009 Recovery Act provides that non-bank-qualified tax-exempt securities issued in 2009 or 2010 are not taken into account in determining the pro rata portion of interest incurred by financial institutions that are disallowed. This exception applies for up to 2% of the average assets of the financial institution (i.e., a bank with $100 million in assets could have $2 million in securities excluded from the 100% disallowance rule).
The portion of any obligation not taken into account under this new law is treated as acquired on August 7, 1986, which results in it being treated as a financial institution preference item under Section 291(e); therefore, the interest deduction allowable for interest incurred to carry that item is reduced similarly to bank-qualified tax-exempt securities.
How Wipfli can help
Our financial services team provides proactive and specialized tax services. Learn more about how we can help you with tax planning, compliance and audit assistance on our web page.
