A U.S. Tax Court ruling issued earlier this year draws into question the ability of “QSub banks” to fully deduct interest expenses related to financing tax-exempt bond investments. If the Tax Court ruling is not overturned on appeal, thousands of shareholders of S corporations may owe millions of dollars in back taxes attributable to interest deductions taken by their S corporation’s wholly owned “QSub bank.”

A “QSub bank” is a bank that is a wholly-owned subsidiary of an S corporation and a bank for which a QSub election has been made. An S corporation is a corporation for which a “S” election has been made, resulting in the corporation being disregarded for federal income tax purposes. Instead, the federal income tax attributes of the an “S” corporation are reported by the shareholders in the S corporation. This contrasts with the treatment of a “C” corporation which is a taxpayer for federal income tax purposes. Many the holding companies of many community banks have found it desirable to elect “S” status.

In general, a QSub is a disregarded entity that is not considered as a separate entity for tax purposes from its S corporation owner, although in the case at issue the Tax Court ruled that the QSub must be considered a separate entity for purposes of the interest deduction rules discussed below, a treatment analogous to the treatment of a C corporation subsidiary .

Section 291 of the Internal Revenue Code requires that tax deductions taken by banks for “interest on debt to carry tax-exempt obligations” (primarily municipal bonds) be reduced by 20%. This provision has been interpreted to require C corporation banks to reduce such interest deductions by 20%. Banks that are S corporations or QSubs, however, have historically deducted their entire interest expense based on a belief that another Internal Revenue Code provision, Section 1363(b)(4), limited the application of the Section 291 deduction limitation to only those S corporation banks that had been C corporations in the previous three years.

The Tax Court disagreed, holding that Treasury Regulations state that “any special rules applicable to banks,” such as Section 291, “continue to apply separately to each QSub that is a bank” as if the QSub election were not in effect. Any QSub deductions are directly reportable on the S corporation’s tax return. Because S corporations are pass-through entities for federal income tax purposes, any additional tax, interest, or penalties resulting from disallowed QSub deductions would be owed by the S corporation’s shareholders.

At least for now, the Tax Court ruling does not negatively impact the amount of interest expenses deductible by S corporation banks, only QSub banks owned by S corporations. The Tax Court case is Vainisi v. Commissioner, 132 T.C. 1 (2009).