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New Tax Strategy Can Eliminate 10.5% Mass Financial Institution Excise Tax By Jeffrey P. Hart, Esq

Wednesday, October 16, 2002 - By: Jeffrey P. Hart

By Jeffrey P. Hart, Esq.

A tax ruling was just released in Massachusetts that accepts an innovative tax strategy that can eliminate the 10.5% financial institution excise tax now imposed on many mortgage companies. A few years ago, tax legislation was passed which broadened the category of entities falling within the definition of a "financial institution." Many mortgage companies fell under this new definition. Unfortunately, this created a double tax for mortgage companies that had elected to be taxed as "S Corporations" for federal and state income tax purposes. (S corporations, a common form of organization for closely-held businesses, pay no corporate tax but instead pass their taxable income through to the shareholders to be recognized by them on their personal income tax returns.) Beginning in 1999, financial institutions that had elected to be S Corporations became subject to the 10.5% excise tax at the company level and the company's shareholders were also subject to the 5.85% income tax on all of the company's income. A double-tax trap had been created. Clever accountants reacted to this trap by advising the owners of S corporation-financial institutions to take large year-end bonuses to reduce or eliminate taxable income at the corporate level. This helped with the double tax problem by reducing the company's taxable income, but the bonuses were themselves subject to a 2.9% social security/medicare payroll tax. Calculating the proper bonus also required the company's accountant to accurately estimate the company's projected profit before December 31st. If the accountant's estimates were off, the company still had to pay the 10.5% tax on the shortfall. The year-end bonus was also subject to the risk of it being classified as "unreasonable compensation" and disallowed as a tax deduction by the IRS. Finally, the large bonuses that reduced or eliminated the taxable income also reduced or eliminated the company's year end profit reported on its financial statements, possibly raising concerns with the company's bank or with state regulators.

The new planning technique can eliminate virtually all of these headaches. No excise tax. No Medicare tax. No scrambling at year end to zero out the company's taxable income. No reporting of reduced or zero profits on the year-end financial statements.

The steps required to meet the conditions of the ruling involve the organization of a new parent company entity as a Massachusetts Business Trust ("New Trust"), an entity not commonly used to transact business in Massachusetts. New Trust would elect to be treated as an S corporation for Federal income tax purposes. After creating New Trust, the shareholders of the financial institution would then transfer their corporate stock into New Trust in exchange for shares of stock representing the beneficial interest of New Trust. Subsequently, New Trust would make an election to treat the financial institution as a "qualified subchapter S subsidiary." Assuming a valid business purpose for the plan, the federal tax law will recognize this transaction as a tax-free reorganization. For corporate law purposes, the mortgage company continues to operate just as before. The company's employees and customers won't even notice the change. New Trust, now the parent company of the financial institution, would be required to file a number of federal forms with the IRS to create the proper tax reporting structure. Under some very complicated federal tax rules, the results of this plan should be as follows:

1. The financial institution's taxable income will be treated as earned directly by New Trust; and

2. Neither New Trust nor the financial institution will be subject to the excise tax imposed on financial institutions or be required to file a financial institution excise tax return.

It is important to realize that a private letter ruling issued by the Massachusetts DOR can be officially relied on only by the specific taxpayer who requested the ruling. However, a letter ruling does reflect the DOR's current thinking and such rulings are often used as guidance by other taxpayers. There is one final benefit: since the technique, if properly executed, is considered a reorganization for federal tax purposes, the benefits will be retroactive to the beginning of the tax year, allowing the entire year's profit to qualify for the tax savings. Though the strategy is complicated, financial institutions can take comfort in the fact the Massachusetts DOR just last week issued the ruling accepting the plan.

Jeffrey P. Hart is a senior member of the Boston law firm of Tarlow, Breed, Hart & Rodgers, P.C. Mr. Hart requested the DOR letter ruling referenced in the article. Note: This article is for informational purposes only and does not constitute legal advice. The application of specific laws and legal principles will vary according to individual circumstances. Any information contained in this article should not be acted upon without seeking professional counsel from an experienced attorney.