TEFRA Tax Disallowance

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We’ve been seeing more activity with community banks purchasing non-bank qualified bonds.  It’s important to remember the tax consequences of purchasing these bonds.  For both S Corps and C Corps, the TEFRA penalty applies.  The penalty results in an interest expense disallowance equal to 100% of the proportionate amount of the bank’s interest expense associated with the non-bank-qualified obligations. For qualified bonds, there is no penalty after a bank has been an S Corp for 3 years and it is a 20% disallowance for C Corps.

We’ve started to get questions about ways to circumvent the penalty by either purchasing the securities in the bank holding company or a related subsidiary, or transferring or distributing the securities from the bank to the holding company or related subsidiary.  As a general rule, the TEFRA penalty only applies to BANKS, so it wouldn’t apply to the holding company or a bank subsidiary. That being said, there may be other unintended consequences. 

  • Given the current rate environment, transferring these assets to another entity could create a realized loss that may not be deductible for tax purposes.
  • The characteristics of the bond may change from being an ordinary asset to a capital asset, thus resulting in capital gains or losses rather than ordinary if the bond is sold. This could impact the tax rate, the use of the loss and impacts on NIIT tax and 199A deductions.
  • If the entity uses financed dollars to purchase the investments, Section 265(a) would apply, thus creating a larger disallowance of interest expense.

If you are interested in exploring this further, please contact your Pinion advisor, and we can walk through both the tax and accounting implications.

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