The Tax Court denied a taxpayer’s claim that the interest expense deduction for IRC § 265 qualified tax-exempt obligations (QTEOs) held by a qualified subchapter S subsidiary (QSub) bank is exempt from IRC § 291(a)(3) financial institution preference item limitations.
Petitioners Jerome and Doris Vainisi together owned 100% of an S corporation that in turn owned 100% of a QSub. The QSub itself qualified as an IRC § 581 bank. The 2003 and 2004 S corporation tax returns listed deductions for the full amount of the interest expense incurred on various QTEOs held by the QSub. The IRS issued deficiency notices indicating that the interest expense deductions were subject to a 20% reduction for financial institution preference items under IRC § 291(a)(3). According to the IRS, the interest expense reduction was to be applied to the QSub, which held the QTEOs.
Under IRC § 1361(b)(3)(A), when a QSub election is made, the S corporation’s subsidiary ceases to exist as a separate corporation, and all of its assets, liabilities, credits and items of income and deductions are treated as those of the parent S corporation. This is commonly known as the disregarded entity rule.
The petitioners claimed that under IRC § 1363(b)(4), section 291 applies to an S corporation’s taxable income computation only if the S corporation was a C corporation for any of the three immediately preceding taxable years. The parent S corporation had elected subchapter S status on Jan. 1, 1997. Therefore, disregarding the QSub under section 1361(b)(3)(A), the taxpayers ignored the section 291(a)(3) interest expense reduction and included the full deduction for interest expense on the QSub’s QTEOs in the S corporation’s taxable income calculation.
The Tax Court held for the IRS, noting that Treas. Reg. § 1.1361-4(a)(3) indicates that “any special rules applicable to banks under the Internal Revenue Code continue to apply separately to the bank parent or bank subsidiary as if the deemed liquidation of any QSub … had not occurred.” In other words, the special financial institution preference item rule under IRC § 291(a)(3) would continue to apply separately to a QSub bank, and such QSub must calculate its own income and deductions subject to the special bank rules before such income and deductions are passed through to an S corporation parent. The fact that the Vainisis’ S corporation had not been a C corporation for more than three years was therefore irrelevant.
In light of the Tax Court’s ruling and because the QSub held the QTEOs, the interest expense was to be calculated at the QSub level subject to the 20% reduction under section 291(a)(3).
The decision illustrates the importance of a phrase commonly found throughout the IRC: “except as provided in regulations prescribed by the Secretary.” In this case, the regulations established an exception to the disregarded entity rule. Such an exception would not be apparent from a reading of the IRC without a supplemental reading of the concurrent regulations. Taxpayers should be aware that the QSub election does not necessarily give carte blanche to pass through all items of deduction from the QSub to its S corporation parent.
Vainisi v. Commissioner, 132 TC No. 1 (2009)
By Peter R. Matejcak, CPA, student, Loyola University Chicago School of Law.