Municipal interest is exempt from federal income tax except for interest received from a "larger issuer" by a commercial bank. Which statement best describes this exception?

• A. It remains tax-exempt
• B. It becomes taxable
• C. It is deductible
• D. It is subject to AMT

Answer: (B)

The key idea is that municipal bond interest is generally exempt from federal income tax to support public financing, but there’s a specific exception for commercial banks. When a bank receives interest from a municipal bond issued by a “larger issuer,” that interest is no longer tax-exempt. Instead, the bank must include it in its gross income and pay federal income tax on it as ordinary income.

This exception exists to prevent banks from retaining the tax benefits of municipal bonds when the issuer is sizeable, which could distort tax treatment for large-scale municipal activity. So, the correct interpretation is that the interest becomes taxable to the bank. It isn’t treated as a deduction, and the usual AMT considerations don’t apply in the sense of keeping it tax-exempt; the practical result is tax at the regular federal rate on that interest.