Compliance Bulletin

Tax Ruling Jeopardizes Deductions By Bank Subsidiary of S Corp
August 17, 2009

A U.S. Tax Court ruled that a bank that is a qualified subsidiary of a subchapter S corporation (QSub) is not entitled to a full deduction of expenses related to qualified tax-exempt obligations such as municipal bonds (QTEOs). The plaintiffs in Vainisi v. IRS are the shareholders of First Forrest Park Corp. 

(“First Forrest”), which was established in 1973 as a C corporation and then made an election to become a subchapter S corporation in 1997. First Forrest in turn is the sole shareholder of Forest Park National Bank and Trust Co. (the Bank).

The IRS had challenged the bank’s deductions made in 2003 and 2004 against interest income relating to certain debt instruments that were QTEOs. In plaintiffs’ consolidated federal income tax returns which included the Bank, the full amount of interest expenses relating to the Bank’s QTEOs was deducted. The IRS’s notice of deficiency was based on I.R.C. Section 291(a)(3), which reduces the interest expense deductions relating to the QTEOs by 20% if the filer is a financial institution. [1]

Plaintiffs claim that their taxable income should be treated under I.R.C. 1363(b)(4) [2]. Under I.R.C. Section 1361, an S corporation is a pass-through entity and its items of income and expenses pass through to, and are reported by, their shareholders. [3]

The tax court in this case noted that the potential discrepancy between Section 291(a)(3) on the one hand (reducing a financial institution’s QTEO deductions by 20%) and Sections 1361(b)(3) and 1363(b)(3) on the other (which ignore the S corporation as a separate entity) was addressed by the Treasury in the tax regulations in 2000 in 27 CFR 1-1361-4(a)(3). That section states:

(3) Treatment of banks.–(i) In general.–If an S corporation is a bank, or if an S corporation makes a valid QSub election for a subsidiary that is a bank, 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 [subchapter S election] had not occurred (except as other published guidance may apply section 265(b) and section 291(a)(3) and (e)(1)(B) not only to the bank parent or bank subsidiary but also to any QSub deemed to have liquidated under paragraph (a)(2) of this section). For 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. . . .

Therefore, the court held, the special bank rules (including Section 291) continue to apply separately to each QSub that is a bank.

Plaintiffs noted that Section 1363(b)(4), which sets forth the computation of an S corporation’s taxable income, provides that Section 291 applies if the S corporation was a C corporation for any of the 3 immediately preceding taxable years (see footnote 2 above). In 2003 and 2004 First Forest had been an S corporation for more than 3 years (i.e., since 1997). Thus, Section 291 does not apply to the Bank. According to an August 10, 2009 American Banker article, banks that operate as S corporations historically have deducted the entire expense. “When a bank switched from a C Corp to an S Corp, it was widely believed that the deduction would be limited to 20% for only the first three years.” The tax court held that the status of First Forrest is irrelevant as Section 1363(b)(4) is not applicable to the Bank, which is the subsidiary of First Forrest and the holder of the QTEO investments [4].

The court also cited the House Budget Committee and Senate Finance Committee reports relating to the enactment of the technical correction to 1-1361-4(a)(3):

The technical correction provides that the Secretary of the Treasury may provide, by regulations, instances where the separate corporate existence of a qualified subchapter S subsidiary may be taken into account for purposes of the Code. Thus, if an S corporation owns 100 percent of the stock of a bank (as defined in sec. 581) and elects to treat the bank as a qualified subchapter S subsidiary, it is expected that Treasury regulations would treat the bank as a separate legal entity for purposes of those Code provisions that apply specifically to banks (e.g., sec. 582).

As a result of this decision, the owners of banks that are S corporations may be liable for back taxes on municipal bond investments. The banks themselves would not be directly liable for the money, but many subchapter S banks have agreements to reimburse their owners for tax mistakes. The ruling was finalized on July 13.

  1. I.R.C. Section 1363(b)(4): Computation of corporation’s taxable income. The taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that -****(4) section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.
  2. I.R.C. Section 291(a)(3): Certain financial institution preference items. The amount allowable as a deduction under this chapter (determined without regard to this section) with respect to any financial institution preference item shall be reduced by 20 percent.
  3. I.R.C. Section 1361(b)(3): Treatment of certain wholly owned subsidiaries. (A) In general Except as provided in regulations prescribed by the Secretary, for purposes of this title—(i) a corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation, and (ii) all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S corporation.
  4. In footnote 3 to the court’s decision, the court declined to decide whether Section 1363(b)(4) precludes the application of Section 291(a)(3) to S corporation banks.

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