QSubs included in definition of S Corp. for purposes of Sec. 291(a) (3).

• Author: O'Connell, Frank J., Jr.

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, raking 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...