A three-judge panel for the U.S. Court of Appeals for the Seventh Circuit has over-ruled a Jan. 15, 2009 Tax Court ruling regarding the tax treatment of qualified tax-exempt obligations held by subchapter S banks. The ruling is good news for subchapter S banks. About a third of the banks across the country have subchapter S incorporation status. Read the decision here, issued March 17.

Jerome and Doris Vainisi, owners of the First Forest Park Corp., in Forest Park, Ill., were the petitioners. The holding company owns First Park National Bank and Trust Co., in Forest Park. The bank owned qualified tax exempt obligations that generated more than $600,000 in income in 2003 and 2004. When computing their interest expense deduction for their federal income tax returns for those years, the bank did not take a TEFRA disallowance because it had obtained subchapter S status more than three years earlier. The IRS cried foul, saying the bank should have taken a disallowance.

Prior to the IRS determination and its Tax Court ruling, it was widely believed that subchapter S banks did not need to take a disallowance if they had been a sub S bank for three years or more. The Tax Court Judge, Maurice Foley, ruled that since the provision in the tax code regarding the TEFRA disallowance does not make reference to S corporations or S subsidiaries, they need to take the disallowance.

The Vainisis appealed the Tax Court ruling and now the Appeals Court has overturned the decision to the previous, generally-held interpretation of the tax code. In the Appeals Court case, argued Feb. 23 in Chicago, the U.S. government argued that Congress did not intend for bank holding company subsidiaries with sub S status to enjoy this tax advantage.

“We cannot rewrite statutes and regulations merely because we think they imperfectly express congressional intent or wise social policy,” circuit judges Richard Posner, Diane Sykes and William Bauer write in their ruling.

“Of course, unless abrogated, the privilege conferred by section 1363(b)(4) will perpetuate a competitive advantage enjoyed by S or QSub banks that have never been C corporations or that converted from C to S earlier rather than later. Later converters — not to mention all existing C corporation banks — may be gnashing their teeth in fury at the additional interest deduction that many of their S or QSub bank competitors can take. But the difference in treatment, and whatever consequences flow from it, are built into section 1363(b)(4),” the judges write.

“The regulation was promulgated a decade ago and the Treasury Department has thus had ample time in which to decide whether the favored treatment of S and QSub banks is a bad idea. The Internal Revenue Service thinks it is a bad idea, the Tax Court thinks it a bad idea, but the institutions authorized to correct the favored treatment of these banks — Congress by statute, and the Treasury Department, as Congress’s delegate, by regulation — have thus far left it intact. True, the Treasury has proposed to subject all subchapter S banks, no matter now long they have enjoyed that status, to section 291… But the proposal has been in limbo for years … Unless and until such a regulation is adopted or the statute amended, the distinction stands, and exempts the Vainisis from section 291. The judgment of the Tax Court is therefore reversed.”