Municipal bonds have been federally tax-exempt for more than 100 years as a means of encouraging investment in local infrastructure and supporting communities. Then in 1982, the Tax Equity and Fiscal Responsibility Act limited the amount of tax-exempt income earned on muni investments by community banks. The law’s intent was to prevent banks from “double-dipping,” defined as earning tax-exempt income on munis as well as a deductible business expense for interest paid on deposits funding these investments.

The cost of TEFRA is a function of two factors: a bank’s cost of funds and the federal tax rate. During the pandemic, the Federal Reserve cut interest rates to near zero, considerably reducing the cost of funds. With the Fed subsequently raising rates to combat inflation, the cost of TEFRA has become more pronounced for banks with large muni portfolios.

Investments in small, bank-qualified municipal issuers – municipalities that issue no more than $10 million in a calendar year – allow banks to deduct 80% of the interest expense related to the bonds from their taxable income. By contrast, municipalities issuing more than $10 million annually are classified as general-market muni issuers, for which banks do not receive any interest expense deduction. In 1982, bank-qualified munis accounted for nearly 40% of total annual municipal bond issuance; today, they make up less than 4% of the market.

Banks have an opportunity to curb the negative earnings impact of TEFRA by forming a bank-owned investment subsidiary. An investment sub allows a bank to consolidate the management of its investment portfolio while continuing to utilize their existing portfolio manager or transition to the investment officers managing the subsidiary. The investment subsidiary also delivers greater purchasing power for portfolio services such as buying or selling of securities, custody and bond accounting. In 2007, a community bank prevailed in the tax court case PSB Investments vs. the IRS, and this ruling has been the basis for banks around the country to establish investment subsidiaries and realize the many benefits of the structure, including saving on TEFRA costs.

Historically, community banks only purchase bank-qualified munis. Since 2007, many banks have considered forming investment subsidiaries and building portfolios of general-market munis, which make up 96% of all municipal bond issuance. With this greater supply, general-market munis offer meaningfully higher yields compared to bank-qualified munis. KeyState works with community and regional banks to structure and manage investment subsidiary structures, allowing them to access the general-market municipal bond market, earn higher yields and reduce their TEFRA costs. Serving over 140 community banks across the country, KeyState helps banks implement and manage investment subsidiaries, solar tax credit investments and captive insurance companies. These innovative structures provide our community-bank customers with meaningful increases to their annual earnings.

KeyState is not a tax advisor. Please consult your bank’s tax advisor before proceeding with any strategy.