The Seventh Circuit Court of Appeals held that a bank organized as a qualified S corporation subsidiary (QSub) could deduct in full its interest paid to acquire tax-exempt bonds, reversing the Tax Court.
As a general rule, expenses related to producing tax-exempt income, including interest, are nondeductible. Therefore, IRC § 265(b) requires financial institutions to allocate such interest based on their average basis of tax-exempt bonds and other obligations as a proportion of their average basis of all assets. This formula exempts tax-exempt bonds purchased before Aug. 8, 1986, and “qualified tax-exempt obligations” purchased after that date. Qualified tax-exempt obligations are those issued by a “qualified small issuer”—generally, those issuing no more than $10 million in certain tax-exempt obligations in a calendar year (section 265(b)(3)(C)). Congress reduced the tax benefit that financial institutions receive on acquiring these qualified exempt bonds by enacting section 291(a)(3), which reduces the deductible interest by 20%.
Jerome Vainisi owned a holding company that owned a subsidiary that was a bank. In 1997 an S corporation election was made for the holding company, and a QSub election was made for the bank. The S corporation’s tax returns for 2003 and 2004 claimed interest expense deductions for 100% of the interest incurred to acquire qualified tax-exempt bonds. The IRS applied section 291(a)(3) and reduced the deduction by 20%. The IRS issued deficiency notices to Vainisi and his wife totaling more than $45,000, plus a $3,841 accuracy-related penalty for 2003. The Tax Court affirmed the government’s position, and the taxpayer appealed to the Seventh Circuit. (For JofA coverage of the Tax Court ruling, see “Tax Matters: Looking Through the QSub Election,” May 09, page 67.)
The appellate court pointed out that 31% of federally insured banks are either S corporations or QSubs (citing an FDIC database at tinyurl.com/y9e8pak). The court overturned the Tax Court’s decision because, it said, the Code and regulations provide a nonambiguous rule. Section 1363(b)(4) provides that section 291 applies to S corporations only if they were originally a C corporation and then only for the three years following the S election. Treas. Reg. § 1.1361-4 provides that the special rules for banks apply to S corporations that are banks. But, the Seventh Circuit noted, the regulation does not overrule IRC § 1363.
The government argued that section 1363(b)(4) did not apply in this case because the bank was a QSub and not an S corporation. This would result in section 291’s never applying to QSub banks, the Seventh Circuit said. The government also argued that section 1361 authorized the Treasury Department to issue regulations that would apply section 291. But, the Seventh Circuit said, the Treasury Department has not yet issued such regulations in final form.
The result is—in the Seventh Circuit, at least—a bank that is an S corporation or a QSub may have a tax advantage over a bank that is a C corporation. This advantage may be eliminated if the Treasury finalizes proposed regulations issued in 2006 (Prop. Treas. Reg. § 1.1363-1, REG-158677-05) that state Code section 1363(b) “does not prevent the application to … an S corporation bank of any special rule applicable to banks under the Internal Revenue Code.”
Jerome R. Vainisi v. Commissioner, docket no. 09-3314 (7th Cir., 3/17/10)
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.
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