Section 481d of the Internal Revenue Code

Dear Assistant Secretary Kautter:

On behalf of its member banks, the American Bankers Association (ABA) and the Subchapter S Bank Association request the assistance of Treasury and the Internal Revenue Service (IRS) in addressing the operation of Section 481 generally, and specifically of Section 481(d) of the IRC, which is a new section that was added by the Tax Cuts and Jobs Act (TCJA). We understand that the issue has been discussed in various forums with members of both Treasury and the IRS. In addition, we are aware that a number of taxpayers, advisors, and trade associations either have or will be submitting letters similar to ours to ask for your assistance. In short, an unintended "glitch" may preclude banks operating in a Qualified Subchapter S Subsidiary (QSub) status from applying the intended favorable transition relief included in Section 481(d). Therefore, as outlined below, we are suggesting that guidance is necessary to address these concerns.

Industry Background

You may be aware that roughly one third of the banks in the U.S. have elected Subchapter S corporation status. Most (but not all) of these banks operate with a holding company parent that owns the stock of the bank. The parent holding company makes an election to be an S corporation pursuant to Section 1362 of the IRC. Pursuant to Section 1361, a wholly owned qualified subsidiary bank is treated as a QSub. As a result of the parent's election, the QSub is not treated as a separate corporation for tax purposes, and the S corporation election applies to the combines entity.

It is important to recognize that this deemed tax treatment is not allowed under banking regulations, as the holding company parent must be distinct from the bank. The bank is chartered and regulated under federal and state law and must be a separate legal entity. These requirements are critical in considering the need for regulatory guidance and the relief described below.

Issue Background

The TCJA included a significant reduction in the corporate tax rate and also provided meaningful tax relief for pass-through entities, such as S corporations, through a deduction for qualified business income pursuant to Section 199A. That said, Congress recognized that the significant decrease in the corporate rates could cause taxpayers operating as S corporations to convert to C corporation status.

One of the implications of changing from S corporation to C corporation status is the loss of the ability to use the cash method of accounting if the taxpayer's gross receipts exceed $25 million. In the normal circumstance, the termination would trigger a required change in accounting method to the accrual method. Pursuant to Section 481(a) and Revenue Procedure 2015-13, the cumulative impact of the accounting change would be spread out ratably over four years. In connection with the TCJA, Congress provided special relief to taxpayers required to make this change by enacting new Section 481(d). Section 481(d) allows a six year transition period for taxpayers making the change within two years of enactment of the legislation. The conference report outlined the change:

HOUSE BILL Under the provision, any section 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during the six-taxable year period beginning with the year of change. An eligible terminated S corporation is any C corporation which (1) is an S corporation the day before the enactment of this bill, (2) during the two year period beginning on the date of such enactment revokes its S corporation election under section 1362(a), and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment. Under the provision, in the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account shall be allocated to such distribution, and the distribution shall be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits. Effective date - The provision is effective upon enactment.
SENATE AMENDMENTThe Senate amendment generally is the same as the House bill, except that any increase in tax due to the section 481(a) adjustment, rather than the section 481(a) adjustment itself, is taken into account ratably during the six-taxable-year period beginning with the year of change. Effective date- The provision is effective for distributions after the date of enactment.
CONFERENCE AGREEMENT The conference agreement follows the House bill.

While this would appear to be important relief for member banks who convert to C corporation status, there appears to be an unintended “glitch” that may preclude banks operating in a QSub status from using the six year (or even the four year) spread.

Section 1361(b)(3)(C) states the following:
(C)Treatment of terminations of qualified subchapter S subsidiary status
(i) In general - For purposes of this title, if any corporation which was a qualified subchapter S subsidiary ceases to meet the requirements of subparagraph (B), such corporation shall be treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before such cessation from the S corporation in exchange for its stock.

At the time the S Bank holding company terminates its Subchapter S election, its QSub’s status will cease and the above statute will deem a new corporation for tax purposes to be formed. One of the consequences of the deemed new corporation is that it will not have any existing accounting methods in place. All the existing assets and liabilities of the QSub are deemed to be acquired by the deemed new corporation, including receivables and payables that have previously been reported for tax purposes on a cash basis. The operation of these provisions appears to be problematic. For Section 481 generally and for 481(d) to apply, a taxpayer would need to have existing accounting methods in place to change from. Since the statute above deems the former QSub to be a new corporation, there are no existing accounting methods, and all new accounting methods would need to be adopted.

As noted above, in the case of corporations with gross receipts over $25 million, the accrual method of accounting would be required. Further, any cash basis reporting that is “carried over” from the former QSub will be recognized in the year of receipt / payment in the deemed new corporation if the six (or four) year spread is not available.

Based on the operation of the statutes, a QSub bank (or other types of QSubs) would appear to be unable to use the six year transition period that was clearly intended by Congress.

It should be noted here that this is not an issue unique to the operation of Section 481(d). It is equally applicable to a former QSub that must use the overall accrual accounting method after its parent S corporation revokes the election but is not entitled to the six year transition period under Section 481(d) (perhaps because there has been an intervening change in shareholdings or because the S election is revoked after December 22, 2019) but would otherwise be entitled to a four year transition period pursuant to Revenue Procedure 2015-13.

The increased attention on the issue arises now because of the focus on revocations of S elections related to the changes in tax rates made by the TCJA. Accordingly, guidance should apply generally to positive Section 481(a) transition adjustments encountered by former QSubs as a result of the revocation of an S election by the parent S corporation.

Recommendation

It is clear the Congress intended taxpayers who are terminating their S corporation status to receive a transition period for required accounting method changes. We understand that there have been discussions in various forums in which government representatives have acknowledged this potential issue and have suggested that the issue potentially could be resolved by having some sort of liquidation of the QSub into its S Corporation parent prior to the termination. We are uncertain how this solution would apply, however, in that Section 1361(b)(3)(A) already indicates that the assets, liabilities, etc. of the QSub are already treated for tax purposes as part of the parent S corporation. We may not have a complete understanding of the government position here.

That said, in the banking industry, for regulatory purposes, the legal structure of the holding company and the subsidiary bank must be maintained as the two entities are subject to distinct regulatory regimes. Accordingly, for legal purposes, a legal liquidation of the bank into the holding company is not possible. The entities must remain legally separate as the S Corporation termination process occurs. Thus, the suggested solution noted above would not be available for QSub banks.

To allow for the relief under Section 481(a) and (d) to be applicable for QSubs generally and for banks specifically, we suggest that guidance be issued that deems, for Section 481 purposes only, that the assets and liabilities held in the QSub prior to the termination of the election be eligible for the intended relief.

We understand that some number of our members may have terminated their S corporation status, relying in good faith on the intent of Congress as set forth above. Accordingly, we ask that any guidance that is promulgated be made available to those taxpayers.

We very much appreciate your consideration of this issue. Please do not hesitate to contact us with any questions, comments, or concerns.

Sincerely,

American Bankers Association
John P. Kinsella
Vice President, Tax Policy
202-663-5317
[email protected]

Subchapter S Bank Association
Patrick J. Kennedy, Jr.
President
210-228-4431
[email protected]