A recent decision provides banks with a reduced compensation hit stemming from excess employee stock options withheld for tax purposes, at least in the short term.

The Financial Accounting Standards Board’s Emerging Issues Task Force, which deals with the most urgent accounting issues, came to a cheaper conclusion than its parent board on the question of what to do when a company has withheld more than the minimum required number of stock option shares for tax purposes.

The EITF decided in a recent meeting that cost associated with only the excess number of shares should be expensed.

FASB had decided earlier in its work on an interpretation of Opinion 25 that compensation costs related to the entire award had to be recognized.

An exposure draft of the interpretation was released last week. If that proposal is adopted, it will govern the accounting. But until then, the EITF’s looser conclusion goes.

The board also decided that the effective date of the provision affecting excess tax withholding would apply to options granted after Dec. 31, 2009.

"The delayed effective date is to allow banks to modify their plans, to not allow excess withholding," said Lailani Moody, senior manager, assurance services, of Grant Thornton.

"There’s a big difference in terms of costs between the EITF version and FASB’s version," Moody said. She added the EITF’s decision could affect options for some time, because although it only pertains to options granted for the end of this year, those options might not be exercised for several more years.

A rush of banks is scurrying to set up tax shelters they think may be in danger under the proposed federal budget.

Real Estate Investment Trusts (REITs) are under fire in the federal budget proposal for the second year in a row, as the Clinton Administration tries to help states collect taxes from wily banks that have found a dodge.

While the biggest banks in the country have already jumped on the bandwagon, many of the rest are also looking to do so, according to accountants who have noticed a recent flurry of activity. Stephe Lawson, president and CEO of $1 billion-asset Cape Cod Bank and Trust Company, said he decided to make the change after hearing positive things from a peer group, and the obvious: a tax savings of six figures.

Bankers put a portion of their loan portfolio into a state-chartered REIT their company wholly owns, converting interest income into dividend income. In many states, REIT dividends are taxed little or not at all, to eliminate double taxation of corporations.

In this year’s budget proposal, the Obama Administration is seeking to limit one company’s ownership of a REIT to 50%, making it harder for banks to use it as a tax shelter. Perhaps the reason the proposal has not received much public attention is that the big banks have already taken advantage of the structure, which most likely would be grandfathered if the bill passed. Another reason is that the proposal is not among the 16 corporate tax shelters Clinton officially declared fair game–it raises no tax revenue at the federal level. It merely helps out states, some of whom have been hit hard by the loss of tax revenue from banks.

Capitol Hill watchers consider the measure’s passage a 50-50 shot at best. A few pointed to the fact that this is the second round for the proposal.

"This is not something unknown to states and it is not something the states could not change in their own laws. There is no need for federal legislation," said Chuck Wheeler, a partner at KPMG Peat Marwick. KPMG is widely credited with inventing the strategy and pushing it hard to banks whenever applicable oeven in some states where it was unclear it would work.

For example, in Massachusetts there is a 95% dividend deduction. But, the law was only clarified so that banks were certain the strategy would work at the beginning of this year. The big players have already set up REITs, but community banks, which were waiting for the law to become clearer, are just now getting to the task.

Explaining the benefit, Andrew Wilson, the tax partner in charge of Grant Thornton’s Boston office, said that if a Massachusetts bank has $100 million of loans, with an average interest income of 7%, and has a REIT, it would pay tax on around $350,000 in dividends through the REIT, rather than the much higher tax on the $7 million of interest income.

He said the strategy could still work, even if the proposed provision passed–which many observers consider a 50-50 shot at best–but it would be tricky. He said to get around the 50% ownership limit, three banks would have to be brought together. He noted that most competitors would probably not want to do business together–even to save a load of cash.

A recent decision by a tax court that could officially eliminate banks’ ability to write off what have been common merger and acquisition costs was already taken into account by bankers in the merger between Fleet Financial Group and BankBoston Corp., a source at one of the banks said.

The tax court’s ruling said that Davenport Bank & Trust Co. could not deduct due diligence fees to outside agencies for work on the bank’s merger with Norwest, following a 1992 Supreme Court decision striking down a chemical company’s tax write-off of advisory fees. But even more controversial, the court ruled the bank could not write off salaries paid to in-house executives during the time they worked on the merger.

Although many in the banking industry do not like the ruling–calling it "bad law"o a source at one of the banks in last week’s big merger said it was the logical outgrowth of the Supreme Court case. "I would not characterize it as a new law; it is not inconsistent with the current trend. It maybe took it one layer of expense further than (the 1992 Supreme Court case)."

The source said that although the Davenport case is not yet precedent, the trend it represents was taken into consideration when plotting the merger. "Appropriate consideration was given to that issue in calculating the effective tax rate of the combined entity," the source said.

Banks are chafing under 23 proposed tax increases contained in President Clinton’s budget for the year 2010, including a much despised provision that eliminates certain deductions for corporate-owned life insurance.

So far the top item worrying banks is the proposed repeal of the exception under the corporate-owned life insurance (COLI) pro-ration rules for contracts covering employees, officers, and directors. This would prevent businesses from funding deductible interest expenses with tax-exempt or taxdeferred inside buildup on life insurance and annuity contracts. The plan would raise $1.9 billion over five years.

A similar $2.2 billion provision was offered last year, but heavy lobbying kept the provision out of any legislation. However, experts predicted that the tax would resurface this year.

Banks are also worried about the Treasury’s plan to repeal the taxfree conversions of companies when they switch from C-Corp status to S-Corp status under Section 1374. Under the Taxpayer Relief Act of 1997, banks are eligible to switch to S-Corp status if they meet all the requirements. However the tax might make it less likely for small community banks to convert. "This would put a real damper on conversions," said Donna Fisher of the American Bankers Association. "The window ought to be open a little longer before they close it."

The tax is expected to raise $212 million over the next five years and would go into effect on Jan.1, 2010 instead of the traditional chairman’s mark. The proposal would also apply to mergers between C-corporations and S- corporations after Dec. 31, 2009.

A further tax would also require that banks that use the cash method of accounting must accrue all interest, original interest discount and acquisition discount on short-term obligations, including loans made in the course of the banks business.

Fisher says the proposal attempts to get around a 1993 decision by the Court of Appeals for the Eighth Circuit that says banks do not have to accrue stated interest and original issue discount on short-terms loans. However the Clinton administration, according to Fisher, has ignored the ruling. The Treasury, in its explanation of the new taxes, said "it is inappropriate to treat short-term obligations originated by a bank differently than short-term obligations purchased by a bank. That tax is expected to raise $72 million next year with a total of $85 million over the next five years.

Banks also saw the return of a proposal designed to close what the Treasury sees as a loophole involving closely held real estate investment trusts (REITs). The proposal would impose an additional requirement for REIT qualification that no person can own stock of a REIT if they own 50% or more of the total combined voting power of all classes of voting stock or 50% and above of the total value of all shares of all classes of stock. The change is expected to raise $75 million over five years

Some bankers could see a jump in the fee they pay to their trade association if a Clinton budget proposal to ring up trade associations on investment income passes.

The proposed tax hike, estimated to raise $1.4 billion over five years, would probably cause the Independent Bankers Association of America to raise fees, according to Paul Merski, the group’s director of tax policy. He added that the tax hike would also jeopardize any reserves the group has set aside for fluctuations in membership and general economic conditions.

The outlook is not all gloom and doom, however.

"We haven’t raised our dues in the seven years we’ve been the ACB, and we don’t have any plans to do it," said Robert Schmermund, director of communications for America’s Community Bankers.

But that does not mean the proposed tax, expected to raise $1.4 billion over five years, would not be painful.

Jim O’Connor, the group’s tax counsel, said it would be very difficult to estimate the bite the tax would take from the coffers because any money not spent on public education, or preparing reports for Congress, or any of the other activities which traditionally earmark the organization for tax-exempt status goes into the group’s checking account to be used next year.

Bob Wallgren, executive director of operations and finance for the American Bankers Association, concurred, saying he would have to take a look at the group’s sources and uses of funds before deciding if a fee hike was in the offing.

O’Connor said that he did not think there would be a lot of sympathy in Congress for the revenue raiser, because it shows that Congress’s intentions "are being undercut." He added, "Obviously we don’t think Congress should push it through. That investment income should be taxed so long as we perform certain valuable public policy point-of-view functions makes no sense to us."

A bill that would bring tax relief for community banks and attempt to level the playing field between small banks and credit unions that failed last year is being reworked and should be reintroduced by mid-February.

The bill, called the Qualified Community Lender Bill, will be reintroduced by Rep. Tom Campbell, R-Calif., and will give community banks tax credits on a scale depending on their size. Because credit unions are tax exempt, legislation last year easing restrictions on their membership was seen as a danger to community banks.

Last year’s version of the bill, also introduced by Campbell, originally called for qualifying banks to pay no taxes on the first $250,000 of profit and 15% on the next $750,000–a break from the standard 34% corporate rate they ordinarily would have paid. The bank would pay the prevailing rate on any profits over $1 million.

Patrick Kennedy, partner at law firm Kennedy, Barris & Lundy, who is helping write the altered version of the bill, said the decision to make the savings come as a tax credit is common sense.

"In order to reduce the rates you have to go into the primary-rate schedules in the Internal Revenue Code. It’s more simple and focused to accomplish this through a tax credit. It won’t create a special tax rate for an industry," he said. He added that the savings for banks should work out to be the same as under the original bill.

To qualify, banks must have under $1 billion in assets and at least 60% of lending to the community, and have shareholders in the home state or a contiguous state.

Charles DeWitt, legislative director for Campbell, said the bill is in the final stages of preparation for introduction, including getting scored, or having the amount of money the Treasury will lose estimated to get a sense of the effect on the national revenue. Although Campbell feels strongly about the legislation, which has been pushed by several state banking associations, he will need to find some other piece of legislation to offset the loss from giving bankers tax credits. DeWitt said the bill would probably be referred to the House Ways and Means Committee, with perhaps some time in the Joint Tax Committee, which is the tax version of the Congressional Budget Office.