QSub Bank's Tax-Exempt Bond Expense Deductible

Article excerpt

The Seventh Circuit Court of Appeals held that a bank organized as a qualified S corporation subsidiary (QSub) could deduct in full its interest paid to acquire tax-exempt bonds, reversing the Tax Court.

As a general rule, expenses related to producing tax-exempt income, including interest, are nondeductible. Therefore, IRC [section] 265(b) requires financial institutions to allocate such interest based on their average basis of tax-exempt bonds and other obligations as a proportion of their average basis of all assets. This formula exempts tax-exempt bonds purchased before Aug. 8, 1986, and "qualified tax-exempt obligations" purchased after that date. Qualified tax-exempt obligations are those issued by a "qualified small issuer"--generally, those issuing no more than $10 million in certain tax-exempt obligations in a calendar year (section 265(b)(3)(C)). Congress reduced the tax benefit that financial institutions receive on acquiring these qualified exempt bonds by enacting section 291(a)(3), which reduces the deductible interest by 20%.

Jerome Vainisi owned a holding company that owned a subsidiary that was a bank. In 1997 an S corporation election was made for the holding company, and a QSub election was made for the bank. The S corporation's tax returns for 2003 and 2004 claimed interest expense deductions for 100% of the interest incurred to acquire qualified tax-exempt bonds. The IRS applied section 291 (a)(3) and reduced the deduction by 20%. The IRS issued deficiency notices to Vainisi and his wife totaling more than $45,000, plus a $3,841 accuracy-related penalty for 2003. The Tax Court affirmed the government's posi tion, and the taxpayer appealed to the Seventh Circuit. (For JofA coverage of the Tax Court ruling, see "Tax Matters: Looking Through the QSub Election," May 09, page 67.)

The appellate court pointed out that 31% of federally insured banks are either S corporations or QSubs (citing an FDIC database at tinyurl. …