7th Circuit Reverses Tax Court in Vainisi –

Subchapter S and Q Sub Banks Following Notice 97-5 with Respect to Expenses Relating to Tax Exempt Income
Should Consider Filing Refund Claims

On March 17, 2010, the U.S. Court of Appeals, Seventh Circuit, reversed the U.S. Tax Court’s decision in Vainisi v. Commissioner, 132 T.C. No. 1 (2009), which held that a sub-S corporation that is a bank (or in this case a bank holding company that owned a bank that had made a qualified S subsidiary or “Q-sub” election) is required, under the provisions of Section 291 of the Internal Revenue Code of 1986, as amended, (the “Code”), to increase the amount of its taxable income by 20-percent of the amount of the bank’s interest expense that is considered attributable to certain qualified tax exempt-obligations that are owned by the sub-S bank, despite the plain language of Code Section 1363(b)(4), which provides 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.” The bank in the Vainisi case had been a Q-sub for longer than 3 years.

The 7th Circuit’s decision is not surprising in that the IRS’ position in the Vainisi case was clearly contrary to the plain language in the Code. The IRS, through the issuance of its Notice 97-5 and with the help of Treasury through the issuance of regulations, attempted to backstop its position by relying on, as authority for its position to disallow a portion of the Q-sub bank’s interest expense, a grant of authority from Congress in a technical corrections bill for Treasury to issue regulations prescribing rules under Code Section 1361(b)(3)(A) (not Code Section 1363(b)(4)) as to when special rules in other sections of the Code will continue to be applicable to banks that make a sub-S or Q-sub election.

The decision in the Vainisi case is well-reasoned and is solid support for a sub-S or Q-sub bank and its shareholders (regardless of whether they reside in the 7th Circuit) to file amended returns and/or claims for refunds with respect to past returns if the sub-S or Q-sub bank followed the IRS’ position in Notice 97-5 and the Treasury regulations, and reduced their deduction for interest expense by 20% of such expense attributable to certain tax-exempt obligations owned by the bank, even though the sub-S or Q-sub bank had not been a C corporation during any of the 3 immediately preceding taxable years. The decision also provides ample support for claiming a full deduction for interest expense attributable to certain tax-exempt obligations owned by the sub-S or Q-sub bank in future taxable periods as well, at least until such time as the Code is amended by Congress to provide otherwise.

We would be happy to assist any clients with the filing of amended returns and/or claims for refund. Generally, a claim for refund must be filed within three (3) years from the time the return was filed or within two (2) years from the time the tax was paid, whichever period expires later.