S Corporations
In Vainisi, No. 09-3314 (7th Cir. 3/17/10), the Seventh Circuit reversed a Tax Court decision (132 T.C. 1 (2009)) in which the Tax Court held that the 20% interest expense reduction imposed by Sec. 291(a)(3) would apply to a qualified subchapter S subsidiary (QSub) bank even for its tax years following the third year after it converted from C corporation to S corporation status. The court found that there was “no ambiguity to disambiguate” in the plain language of Sec. 1363(b)(4) that applies the provisions of Sec. 291, including Secs. 291(a)(3) and (e)(1)(B), to S corporations only in the first three tax years after converting from being a C corporation.
Background
In 2003 and 2004, First Forest Park Corp. (First Forest) was a parent corporation (wholly owned by eligible S corporation shareholders Jerome and Doris Vainisi) that elected to be taxed as an S corporation effective January 1, 1997. At the same time, its wholly owned subsidiary, Forest Park National Bank and Trust Co. (Forest Park Bank), elected to be taxed as a QSub. During those two years, Forest Park Bank held qualified tax-exempt obligations (QTEOs) and reported deductions for the entire amount of its interest expense allocable to the QTEOs.
Although the interest expense related to QTEOs is a financial institution preference item subject to a 20% reduction, Forest Park Bank relied on the exception enumerated in Sec. 1363(b)(4) providing that “Section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.” On examination of the 2003 and 2004 tax years, the IRS issued a notice of deficiency to the Vainisis for both years, taking the position that Forest Park Bank’s interest expense was subject to the 20% reduction imposed by Sec. 291(a)(3).
In Tax Court, the IRS raised two principal arguments in support of its position. First, it noted that when Sec. 1361(b)(3) was added to the Code in 1996 to allow S corporations to treat wholly owned subsidiaries as QSubs, Congress did not amend Sec. 1363(b)(4) to include a reference to QSubs. Therefore, according to the IRS, Sec. 1363(b)(4) can apply only to S corporations and not to QSubs. Second, the IRS argued that a 1997 technical correction provision (Sec. 1361(b)(3)(A)) authorized Treasury to issue regulations for the purpose of treating a QSub bank as a separate entity from its S corporation parent and that the IRS had done so by issuing Regs. Sec. 1.1361-4(a)(3), which states:
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 deemed liquidation of any QSub . . . had not occurred.
In response, the Vainisis noted that the omission of any reference to QSubs in Sec. 1363(b)(4), and all other operative provisions of subchapter S such as Sec. 1374, was readily explained by the fact that as a result of the deemed liquidation of the QSub into its S corporation parent, the income and expenses of a QSub are taxed in the same manner as those of its S corporation parent. Therefore, any reference to QSubs in the subchapter S operative provisions would be superfluous. With respect to Regs. Sec. 1.1361-4(a)(3), the Vainisis argued that the regulation, consistent with the congressional authorization, was simply intended to treat a QSub bank as a separate entity for the purpose of initially applying the special bank tax rules, including Sec. 291(a)(3), to the QSub bank. After the appropriate calculations and characterizations required by the bank tax rules are made, the resulting items of income and deduction of the QSub bank are then taxed in the same manner as if they belonged directly to the S corporation parent. Accordingly, Sec. 291(a)(3) did not apply to the bank in the two years at issue.
Deciding in favor of the IRS, the Tax Court found that “Section 1363(b)(4) specifically references S corporations, but it does not mention QSubs or banks.” The Tax Court concluded that Congress could have added a reference to QSubs at any time but did not do so. Therefore, Sec. 1363(b)(4) applies only to S corporations and not to QSubs. On the second argument, the Tax Court held that Regs. Sec. 1.1361-4(a)(3) requires that the special bank tax rules, including Sec. 291(a)(3), must be applied separately to a QSub bank before the bank’s income and deductions can be treated as the income and deductions of the S corporation parent. Accordingly, the Tax Court concluded that a QSub bank is subject to the 20% reduction in Sec. 291(a)(3).
Seventh Circuit Reversal of Tax Court Decision
The Seventh Circuit reversed the Tax Court’s decision, finding that under Sec. 1363(b)(4), the Sec. 291(a)(3) interest deduction limitation applied only to S corporations (including S corporations for which a QSub election had been made) that had been C corporations within the preceding three years. Thus, the limitation did not apply to Forest Park Bank. In reversing the lower court’s decision, the court held that the IRS’s interpretation of the applicability of Sec. 291(a)(3) would improperly deprive certain S corporations, including Forest Park Bank, of the privileges that Congress gave to S corporations that do not fall into the three-year exception.
In response to the government’s argument that the 1997 regulatory authorization in Sec. 1361(b)(3)(A) should be taken as authorization for Treasury to rescind the application of Sec. 1363(b)(4) to QSub banks, the court noted that neither Sec. 1361(b)(3)(A) nor the regulations issued thereunder “say or hint” at that authorization. The regulation merely requires that the special banking rules be applied to banks that are S corporations or QSubs at the separate corporate level to avoid having the QSub status “emasculate the rules.” As for the argument that the regulatory authorization in the technical corrections bill was to deny banks all the privileges accorded by subchapter S, the court concluded that it needed to find evidence of that purpose, and it could not find such evidence in the statute that provided the regulatory authorization or in Regs. Sec. 1.1361-4(a)(3) itself.
The court concluded its opinion by noting that neither Congress by statute nor Treasury by regulation has taken appropriate action that would deny S corporation and QSub banks the ability to avoid the 20% reduction in Sec. 291(a)(3). Until they do, the court held that the exception in Sec. 1363(b)(4) stands.
Conclusion
As a result of the Vainisi decision, in the Seventh Circuit (i.e., Illinois, Indiana, and Wisconsin) Sec. 1363(b)(4) is applicable to QSubs as well as S corporations. The government has decided not to appeal the Seventh Circuit decision. However, it remains to be seen whether the IRS will take the same position it did in Vainisi in other circuits. In addition, as noted in the Vainisi opinion, it is uncertain at this time whether the IRS will finalize proposed regulations (REG-158677-05) that would subject both S corporations and QSub banks to Sec. 291(a)(3) regardless of how long they have had that status. However, in the Vainisi opinion the court appears to express some skepticism as to whether the proposed regulations would be considered a valid interpretation of Sec. 1363(b)(4).
Editor: Frank J. O’Connell Jr., CPA, Esq.
EditorNotes
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
