ARTICLE
20 October 2004

New Federal Tax Legislation Favorably Affects S Corporations

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Goodwin Procter LLP

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On October 11, 2004, Congress passed a significant federal tax bill, the American Jobs Creation Act of 2004 ("AJCA"), which President Bush is expected to sign into law prior to the end of the year. Although AJCA was originally designed to end a U.S. tax credit for exported goods that had been determined to violate international trade agreements, the bill addresses many other areas of federal tax law.
United States Tax

On October 11, 2004, Congress passed a significant federal tax bill, the American Jobs Creation Act of 2004 ("AJCA"), which President Bush is expected to sign into law prior to the end of the year. Although AJCA was originally designed to end a U.S. tax credit for exported goods that had been determined to violate international trade agreements, the bill addresses many other areas of federal tax law.

Among the changes are several that affect financial services S corporations. For example, under current law, an S corporation is subject to corporate-level tax on its excess net passive income if it has gross receipts of which more than 25% consist of "passive investment income," as well as left over earnings and profits from a predecessor C corporation at the end of the taxable year, and it may be disqualified as an S corporation if this happens in three consecutive taxable years. For this purpose, passive investment income generally includes gross receipts derived from interest, dividends, royalties, rents, annuities, and sales or exchanges of stock or securities (to the extent of gains), unless such income is derived directly from certain activities such as the active and regular conduct of a lending or finance business. Under AJCA, for taxable years beginning after December 31, 2004, S corporations that are banks (as defined in section 581 of the Internal Revenue Code of 1986, as amended (the "Code")), bank holding companies or financial holding companies (both as defined in the Bank Holding Company Act of 1956, as amended) may exclude interest income and, with respect to assets required to be held by the bank or holding company (such as stock in the Federal Reserve Bank or the Federal Home Loan Bank), dividends from passive investment income.

In addition, among other S corporation changes, (1) the number of permitted shareholders of an S corporation will be increased from 75 to 100, (2) an S corporation may elect to have all members of a family related within six generations treated as one shareholder for purposes of the 100-shareholder test, and (3) an IRA that holds stock of a bank S corporation (but not a bank holding company or financial holding company S corporation) at the date of enactment of AJCA (despite the fact that current rules prohibit an IRA from owning S corporation stock) will now be a permitted shareholder of such stock, with the beneficiary of the IRA being treated as the shareholder.

New Federal Tax Legislation Has Substantial Impact on Non-Qualified Deferred Compensation Arrangements

The AJCA also would add a new section to the Code ("Section 409A") that will have a substantial impact on most non-qualified deferred compensation arrangements. It does not apply to certain tax-qualified retirement plans (e.g., 401(k) plans are excepted from the new law). The changes imposed on deferred compensation arrangements are significant and affect, among other things, the timing of deferral elections, the permissibility, timing and election of various distribution alternatives, and the availability of certain funding methods such as foreign rabbi trusts. Section 409A generally will become effective January 1, 2005, and in some circumstances will apply to deferred compensation earned before that date. The consequences of failing to comply with the new requirements are significant and include the immediate or early taxation of the deferred compensation and, in some cases an additional 20% penalty tax, as well as interest. Goodwin Procter has prepared a detailed Client Alert on this topic, that includes Q&A’s. A copy of the Client Alert was forwarded to you under separate cover.

FDIC Adopts Revised Guidelines for Appeals of Material Supervisory Determinations and of Deposit Insurance Assessment Determinations

The FDIC released revised Guidelines for Appeals of Material Supervisory Determinations to the Supervision Appeals Review Committee, (the "SARC"), an independent FDIC committee established under the Reigle Community Development and Regulatory Improvement Act of 1994. These guidelines describe the types of FDIC supervisory determinations eligible for SARC review and outline the appeal process. Determinations subject to appeal to the SARC include CAMELS, CRA, trust and EDP ratings, classifications of loans and certain other supervisory determinations. Decisions to take prompt corrective action, impose formal or informal enforcements actions or certain other designated matters are not subject to SARC review. The burden of proof, in all cases, is with the appealing insured depository institution. The FDIC also released updated Guidelines for Appeals of Deposit Insurance Assessment Determinations. Appeals of a financial institution’s assessment risk classification and/or assessment payment calculation are made to the Assessment Appeals Committee ("AAC") of the FDIC. Under the revised guidelines, the membership of the AAC is reduced from seven to five voting members and the AAC will review an appeal and issue a written decision, generally within 60 days.

OCIE Director Provides Update on SEC Examination Program

In a speech made at the Financial Services Institute’s Public Policy Day, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations ("OCIE"), provided an overview of OCIE’s use of risk-based targeting in its examination process. This process has driven OCIE’s in-depth investigation of a variety of discrete issues across a number of industry participants since its introduction in 2003. Ms. Richards listed the issues underlying a number of risk targeted examinations currently underway, including (a) undisclosed payments associated with (i) securities lending transactions, (ii) brokerage commissions or (iii) the selection of service providers, (b) payments by funds to consultants or 401(k) plan sponsors without adequate disclosure of the conflicts created, (c) allocation of securities among client accounts, (d) soft dollar practices, (e) pricing practices of mutual funds that hold difficult-to-price securities and (f) the use of customer trading information or other non-public information by employees of broker-dealers, funds, advisers and other types of entities. She noted that in these types of narrow inquiries OCIE staff is likely to make significant requests for records and documents, including internal communication such as e-mails, and that while OCIE will work with firms on the timeframes for producing documents, OCIE will expect prompt production of relevant information. She observed that for investment advisers and investment companies, OCIE will conduct regular examinations of high-risk firms, i.e., those with significant investors' assets under management, less-than-robust internal controls or other high risk characteristics, while all other firms may be examined for cause (e.g., based on a tip or complaint), pursuant to a risk targeted examination or randomly. Ms. Richards also briefly reviewed the factors OCIE considers in deciding whether to refer examination findings to the Division of Enforcement, including (1) evidence of fraud, (2) harm to investors, (3) a firm’s conduct in bringing improper conduct to OCIE’s attention and taking remedial action, (4) whether another regulator should more appropriately address the issue, (5) whether findings deal with an emerging type of wrongdoing that the SEC wants to highlight, (6) profit from improper conduct and (7) inadequate supervisory procedures.

Other Items of Note

FASB Votes to Delay Public Company Stock Option Expensing Rules

The Financial Accounting Standards Board ("FASB") voted to allow public companies to delay until the first period after June 15, 2005 when they will be required to count stock-based compensation as a cost against earnings. The FASB also provided a number of alternatives for companies wishing to expense options prior to the June 15, 2005 date.

Federal Banking Agencies Provide Consumer Information on Overdraft and Bounced Check Fees

The four federal banking agencies jointly published a document for consumers entitled "Protecting Yourself from Overdraft and Bounced Check Fees." The publication is available at http://www.occ.treas.gov/ftp/release/2004-95a.pdf.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. (c) 2004 Goodwin Procter LLP. All rights reserved.

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