The road for the proper federal income tax treatment of banks as S corporations has not always been smooth. An example of a recent bump can be found in the United States Tax Court’s decision in Vainisi v. Commissioner. In Vainisi, the Tax Court reviewed whether the 20 percent reduction in the amount of interest expense incurred by a bank in carrying certain tax-exempt obligations should apply to a bank that is a qualified subchapter S subsidiary (“QSub”).
In general, IRC section 291(a)(3) indicates that a financial institution that incurs interest in carrying qualified tax-exempt obligations (“QTEOs”) must reduce its tax deduction for that interest expense by 20 percent (the “20 percent TEFRA disallowance”). However, IRC section 1363(b)(4) states that “[t]he taxable income of an S corporation is computed in the same manner as for an individual, except that section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the three immediately preceding taxable years.”
Prior to Vainisi, several S corporation banks that had converted from a C corporation had taken the position that based on the language of IRC section 1363(b)(4), the 20 percent TEFRA disallowance applied to them only for the first three years after becoming an S corporation or a QSub. Thereafter, the QSub was not subject to the TEFRA disallowance.
The petitioners in Vainisi were two individuals who owned 100 percent of an S corporation (“First Forest”) that held 100 percent of the stock of a QSub that qualified as a financial institution for purposes of IRC section 291 (the “Bank”). For taxable years 2003 and 2004, First Forest’s tax returns showed deductions for the full amount of the interest incurred on various QTEOs held by the Bank. The Internal Revenue Service contested these deductions and issued deficiency notices indicating that the interest expense deductions were subject to the 20 percent TEFRA disallowance.
The IRS argued that the interest deductions were subject to the 20 percent TEFRA disallowance because the QTEOs were held by the QSub Bank and not First Forest, the S corporation parent. This argument was based on the fact that the 20 percent TEFRA disallowance is a special banking rule that is applicable to all banks, regardless of their status as a C corporation, S corporation or QSub. The argument was supported by language in Treasury Regulation section 1.1361-4(a)(3) that indicates that if either an S corporation or a QSub is a bank, any special rules applicable to banks under the Internal Revenue Code continue to apply separately to both the S corporation and the QSub as if the deemed liquidation of the QSub had not occurred. The IRS argued that, based on the Treasury Regulation, the rules of IRC section 1363(b)(4) apply separately to S corporations that were former C corporations and QSubs that were former C corporations. Accordingly, as the language of IRC section 1363(b) (4) mentions only S corporations that were former C corporations and does not mention QSubs that were former C corporations, the position of the IRS was that IRC § 1363(b)(4) should not apply to QSub banks that were former C corporations.
Conversely, the petitioners claimed that under the language of IRC section 1363(b)(4), the 20 percent TEFRA disallowance 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 petitioners also argued that subsequent language in Treasury Regulation section 1.1361-4(a)(3) supported their position by carving out an exception from the language argued by the IRS. The second sentence of Treasury Regulation section 1.1361-4(a)(3) states that “[f]or any QSub that is a bank, however, all assets, liabilities, and items of income, deduction and credit of the QSub, as determined in accordance with the special bank rules, are treated as assets, liabilities, and items of income, deduction, and credit of the S corporation.” Because First Forest had been an S corporation for more than three years, and all of the assets, liabilities and items of income, deduction and credit of the QSub Bank were treated as those of First Forest, pursuant to Treasury Regulation section 1.1361-4(a)(3), the interest expense deductions for the QTEOs held by the Bank were not subject to the 20 percent TEFRA disallowance.
The Tax Court ruled in favor of the IRS and held that IRC section 1363(b)(4) did not apply to the Bank because the express language of IRC section 1363(b)(4) makes reference only to S corporations. Although QSubs did not exist in 1982 when IRC section 1363(b)(4) was enacted, the Tax Court reasoned that Congress could have, but did not, choose to amend that section. Accordingly, the Tax Court ruled that the Bank must calculate its own income and deductions subject to any applicable special bank rules, such as the 20 percent TEFRA disallowance, prior to passing through such income and loss to First Forest.
In reaching its decision, the Tax Court did not address whether IRC section 1363(b) (4) would apply to limit the application of the 20 percent TEFRA disallowance to just the first three years following an S election by an S corporation bank. In addition, the decision in Vainisi may still be amended. The petitioners in Vainisi have filed a motion for reconsideration with the United States Tax Court and a motion requesting that the entire Tax Court hear the case. The IRS will likely oppose these motions. There is no specific time limit in which the Tax Court must consider these motions. Thus, it is unclear how quickly there will be a decision about a rehearing. Schams v. Commissioner, a case with facts similar to Vainisi, has also been filed in the Tax Court; however, such case has been held in abeyance pending the outcome of the motions in Vainisi and any subsequent appeal to the United States Court of Appeals for the Seventh Circuit.
Although Vainisi stands for the specific rule that IRC section 1363(b)(4) applies to C corporations only for purposes of the 20 percent TEFRA disallowance, the case could have a broader (and perhaps unintended) impact. Because the case was based on the fact that the language of the statute did not contain a specific reference to QSubs and was thus inapplicable to QSubs, this same line of reasoning could be applied to other provisions of the Internal Revenue Code that specifically reference S corporations but not QSubs. Therefore, rather than representing a smoothing of the pavement, Vainisi could create new potholes and a new stretch of bad road ahead for the application of the S corporation rules to banks.