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May 22, 2013 The Tax Lawyer

The Seventh Circuit Addresses the Application of Section 291(a)(3) to S Corporation and QSub Banks: Vainisi v. Commissioner

Vol. 66, No. 2 - Winter 2013

Katherine Thompson

Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.


    Approximately 30% of banks in the United States that are insured by the Federal Deposit Insurance Company have elected to organize as S corporations rather than as C corporations. Organizing as an S corporation in general eliminates the corporate-level income tax on the income generated by the banking business, instead passing income and gain—and deductions and tax credits—through to the shareholders who include such items on their individual income tax returns. Community banks are large purchasers of tax-exempt obligations. Section 291, which provides rules for the special treatment of certain corporate tax preference items, includes in section 291(a)(3) a limitation on the deductibility of a C corporation bank’s interest expense attributable to the holding of a “financial institution preference item,” defined in section 291(e). As explained in greater detail below, section 291(a)(3) permits a C corporation bank to deduct only 80% of such interest. While section 291 clearly applies to C corporation banks, it has been unclear whether section 291(a)(3) applies to S corporation banks and wholly-owned subsidiaries of S corporations that the S corporations elect to treat as “qualified subchapter S subsidiaries” pursuant to section 1361(b)(3).

    The lack of clarity stems from the interactions of sections 1361(b)(3), 1363(b)(4), and 291(a)(3). Section 1361(b)(3)(A) provides that a qualified subchapter S subsidiary (QSub) is disregarded as a separate corporation, and that all of the assets, liabilities, and items of income, deduction, and credits of the QSub are treated as belonging to the S corporation.6 Section 1363(b) (4) provides that the 80% interest deduction limitation imposed by section 291(a)(3) applies to an S corporation in a taxable year “if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.” Section 1363(b)(4) does not refer specifically to QSubs, thus raising the question of whether the three-year period in that section applies if an S corporation that has not been a C corporation in more than three taxable years has a QSub that generated interest deductions potentially subject to the section 291(a)(3) limitation. In Vainisi, both First Forest Park Corporation (Forest Park) and its subsidiary, Forest Park National Bank and Trust Co. (Bank) had C corporation histories, but First Forest had elected S status and immediately elected to have the Bank become a QSub more than three taxable years before the Service questioned the interest deductions generated by the Bank.

    The Seventh Circuit Court of Appeals decided in Vainisi v. Commissioner that the 80% deduction of interest allowable for qualified tax-exempt obligations (QTEOs) from section 291(a)(3) is inapplicable to an S corporation that was not a C corporation in the preceding three years, as per section 1363(b)(4). The holding also applies to QSubs—wholly owned subsidiaries that a parent S corporation has elected to treat as a QSub under section 1361(b)(3)(B). The Tax Court held that the limitation on the interest deduction imposed by section 291(a)(3) applied to deductions generated by a QSub bank and reported by the parent S corporation, although the S corporation had not been a C corporation in any of its immediately preceding three taxable years. The Seventh Circuit Court of Appeals reversed the Tax Court, concluding that, because both the S corporation and its QSub had ceased to be C corporations more than three taxable years before the year in question, section 1363(b)(4) prevented section 291(a)(3) from applying. Accordingly, the decision grants qualifying S corporation banks and QSub banks an advantage by permitting them to reduce their federal income tax liabilities by claiming a deduction that is impermissible to C corporation and non-qualifying S corporation banks. Furthermore, because “community banks, many of which have elected S corporation or QSub status, are large purchasers of [] tax-exempt obligations, the Vainisi decision has farreaching impact.”Although the Seventh Circuit’s decision is binding only in that circuit, the court’s approach to statutory interpretation is persuasive and deserves consideration in other circuits.

    This Note argues that the Seventh Circuit’s conclusion was correct because it was in accordance with the clear and unambiguous language of the Code, even though it results in favorable treatment of qualifying S corporation banks and QSub banks. Part II of this Note examines the structure of the law regarding S corporations and QSub banks. Part III explains the Vainisi decisions by both the Tax Court and by Judge Posner in the Seventh Circuit. Part IV argues that the Seventh Circuit correctly reversed the Tax Court’s decision, finding that section 1363(b)(4) precludes the application of section 291 to S corporations and QSub banks if the parent had existed as an S corporation for more than the three immediately preceding years. Part V concludes that if Congress disagrees with the Seventh Circuit’s analysis, an amendment to section 1363(b)(4) would be required to address the issue.

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