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S corporation banks score big win in Seventh Circuit

March 18, 2010

Sometimes the tax code means just what it says.

So said the Seventh Circuit Court of Appeals yesterday in a decision that's welcome news for hundreds of S corporation banks. They overturned a Tax Court decision that disallowed interest deductions to S corporation banks holding municipal bonds -- primarily Midwestern community banks.

The tax law has two provisions that disallow deductions for banks holding municipal bonds. One rule, Section 265, disallows all interest deductions attributable to purchases of "non-qualified" municipal bonds purchased after August 7, 1986. Another rule, Sec. 291, disallows 20% of the interest expense attributable even to "bank-qualified" bonds not subject to the Sec. 265 disallowance. In both cases the amount of the interest expense disallowance is determined by the ratio of the bank's investment in muni bonds to their total assets.

Another Section of the Code, Section 1363(b)(4), seems to exempt S corporations from the 20% disallowance on "bank-qualified" bonds -- known among bankers as the "20% TEFRA" disallowance -- after three years of S corporation status.

(b) Computation of corporation’s taxable income The taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that—
(4) section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.

Bankers long assumed that this means what it says: that after three years of being an S corproation, the Section 291 20% disallowance goes away. The IRS had other ideas. They said that the rules allowing them to write regulations for S corporation banks enabled them to apply Section 291 to all S corporation banks, and last year they got the Tax Court to go along.

The IRS had less luck convincing the Seventh Circuit, and Judge Posner:

The government argues that because section 291, and the amendment to it that created the 80 percent rule (for remember that originally it was an 85 percent rule), entered the Internal Revenue Code before banks could be subchapter S corporations or QSubs, Congress never intended section 1363(b)(4) to prevent the application of section 291 to banks, and so should be taken to have authorized the Treasury to rescind that application by regulation, as Congress's delegate.
But section 1361(b)(3)(A) doesn't say or hint that.

It's good news for bankers, and for those who think the tax law should mean what it says. Still, the IRS may not be done. They can still litigate the issue in other circuits; the Eighth Circuit, which includes Iowa, is a likely venue because it has so many S corporation banks. They shouldn't, because the Seventh Circuit has it right, but we should know in two or three months.

What should taxpayers do now? Banks that have been S corporations for more than three years should feel free to ignore the Section 291 "20% TEFRA" disallowance; if they are not in the Seventh Circuit, they should disclose that they are doing so to protect themselves from potential IRS penalty assessments. Shareholders of S corporation banks that have been filing returns under the now-overturned Tax Court decision should file refund claims on Form 1040-X. The statute of limitations for non-extended 2006 returns expires April 15, 2010; you can wait until after tax season for later years.

Banks that filed prior-year returns under the now-overturned Tax Court decision should file amended returns and give modified K-1s to their shareholders so they claim refunds on amended 1040s. This is especially urgent for any banks that filed 2006 returns with the Section 291 20% TEFRA disallowance, to help their shareholders file amended 2006 returns before the statute expires next month. All S corporation banks should contact their shareholders as soon as possible to let them know whether they filed their 2006 returns taking the 20% TEFRA disallowance that the Seventh Circuit overturned yesterday. No S corporation returns prepared for 2006 by Roth & Company will need to be amended as a result of this decision.

Taxpayers who don't receive amended K-1s for 2006 showing the correct amount of S corporation bank income might need to file a protective refund claim to preserve their 2006 refund rights.

What should the IRS do? They should comply with the tax law as enacted and tear up their proposed regulations requiring long-time S corporations to apply Sec. 291.

Cite: Vainisi, CA-7, No. 09-3314

Prior Coverage:

BANKING ORGANIZATIONS COME OUT AGAINST IRS 'TEFRA' REGULATION PROPOSAL

Tax Court rules for IRS in S corporation bank TEFRA disallowance

Tags: Judge Posner.S corporations.TEFRA disallowance.