Many banks, back to profitability after riding out the economic downturn, are returning to the tax-exempt bond markets and, in turn, generating tax-exempt interest income. While the Seventh Circuit's decision in Vainisi, 599 F.3d 567 (7th Cir. 2010), was favorable for S corporation banks investing in tax-exempt obligations, those banks nonetheless must pay close attention to the specific type of tax-exempt obligations they purchase if they expect to reap the benefits of that decision.
Background for Banks and the TEFRA Disallowance
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, added Sec. 291, which includes what is commonly known as the TEFRA disallowance. For banks, this disallowance initially provided for an add-back equal to 15% of the proportionate amount of a bank's interest expense associated with the purchase or carrying of all tax-exempt investments. In 1984, the disallowance was increased to 20%. Technically, Sec. 291 applies only to tax-exempt obligations purchased after Dec. 31, 1982, and before Aug. 8, 1986.
When Sec. 265, which prohibits interest deductions for indebtedness incurred to purchase tax-exempt investments, applies, it provides for the disallowance of 100% of the proportionate amount of a bank's interest expense associated with the purchase or carrying of tax-exempt obligations. However, Sec. 265 provides an exception for certain qualified tax-exempt obligations (often referred to as bank-qualified obligations) whereby the bank-qualified obligations are treated, for purposes of Secs. 265 and 291(e)(1)(B), as having been purchased on Aug. 7, 1986. As such, the 20% disallowance under Sec. 291 generally applies to bank-qualified obligations.
Application of the TEFRA Disallowance to S Corp. Banks
Sec. 1363(b)(4) provides that the TEFRA disallowance under Sec. 291 applies to S corporations only for the first three years after conversion from C corporation status. Thus, three years after converting to S corporation status, those banks no longer would be subject to the TEFRA disallowance. Note also that an S corporation bank that has been an S corporation since inception also is not subject to the TEFRA disallowance. Additionally, a bank's status as a qualified subchapter S subsidiary (QSub) of an S corporation holding company does not change the application of this rule.
In Vainisi, the IRS argued that Congress never intended Sec. 1363(b)(4) to prevent the application of Sec. 291 to QSub banks. In support, it pointed out that in 1984 when Congress added Sec. 1363(b)(4) to the Code, QSubs did not exist and banks were not permitted to be S corporations. The Tax Court agreed (Vainisi, 132 T.C. 1 (2009)).
In March 2010, the Seventh Circuit reversed the Tax Court's decision. It found no evidence that Congress did not intend Sec. 1363(b)(4) to prevent the application of Sec. 291 to S corporation banks that previously filed as C corporations. The relevant regulation, in fact, merely requires that special banking rules be applied to S corporation banks at the corporate level so that a bank's S corporation status will not "emasculate" the rules.
On Dec. 27, 2010, the IRS issued Action on Decision (AOD) 2010-06 regarding the Seventh Circuit's ruling in Vainisi. The AOD states that the IRS will not apply Sec. 291 to an S corporation bank unless the bank (or any predecessor) was a C corporation during the three immediately preceding tax years.
While the Vainisi decision is a win for S corporation banks, it also is crucial for S corporation banks to remember that the TEFRA disallowance exemption applies only when an S corporation bank invests in bank-qualified obligations. If they are not bank-qualified, under Sec. 265 the bank still will be subject to an interest expense disallowance equal to 100% of the proportionate amount of the bank's interest expense associated with the non-bank-qualified obligations.
Sec. 265(b)(3) defines a qualified tax-exempt obligation (a bank-qualified obligation) as a tax-exempt obligation issued after Aug. 7, 1986, by a qualified small issuer, which is not a private activity bond and that is designated by the issuer as such. "Qualified small issuer" refers to a state or local government unit that reasonably anticipates that the total amount of tax-exempt obligations (which could include bonds and loans) that will be issued during the calendar year will not exceed $10 million.
Special rules exempt some obligations, including certain refinancings, from the $10 million limitation. For obligations issued during 2009 and 2010, the $10 million limitation was temporarily increased to $30 million. In addition, for obligations issued during 2009 and 2010 that do not meet the requirements of a bank-qualified obligation, an S corporation bank (whether or not within the three-year window) nonetheless can treat these as bank-qualified obligations, but not in an amount in excess of 2% of the bank's average adjusted tax basis in its assets for the entire tax year.
Before Investing in Any Tax-Exempt Issuance
To avoid uncertainty over whether an obligation is bank-qualified, a bank can request a copy of the issuer's Form 8038-G, Information Return for Tax-Exempt Governmental Obligations, or Form 8038-GC, Information Return for Small Tax-Exempt Governmental Bond Issues, Leases, and Installment Sales. (Form 8038-GC is for issuances under $100,000, so those obligations almost always will be bank-qualified.) Filing one of the forms is mandatory for the issuer of tax-exempt obligations and generally is made available by the issuer to the investors of the issuance. It is good practice for a bank to obtain copies of these forms for the obligations they hold, since IRS agents could request their production during an audit. If a bank cannot provide the forms, the IRS potentially could disallow the interest income exclusion and treat the income as taxable instead.
The Vainisi ruling should not give S corporation banks a false sense of security. If banks do not take steps to make sure that they have purchased bank-qualified tax-exempt obligations, those bonds or loans may, in fact, not be bank-qualified and not fall under Sec. 291, leaving them unprotected by Sec. 1363(b)(4) and subject to the 100% interest expense disallowance under Sec. 265. As a result, the holders of the obligations may wind up with an unexpected tax liability and expense that would negate much of the value of the investment in the tax-exempt obligations.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.