S Corporations Lose in Fight Over TEFRA Adjustment

The Tax Court recently ruled that the 20 percent reduction in interest expense for qualified tax-exempt obligations under Code Sec. 291(a)(3) applied to qualified Subchapter S subsidiary banks (QSubs).

Generally, banks are not allowed an interest expense deduction for the portion of the expense allocable to investments in tax-exempt obligations. However, banks are allowed to deduct 80 percent of the interest allocable to “qualified tax-exempt obligations.” Qualified tax-exempt obligations are obligations issued after December 31, 1982, and before August 8, 1986 (most issuances after Aug. 8, 1986, are treated as if there were issued on that date).

The 1996 Small Business Protection Act allowed banks to elect to be treated as S corporations and for bank subsidiaries to be treated as qualified Subchapter S subsidiaries (QSubs). This election treats the subsidiary bank as a “disregarded entity” for tax purposes by including all of the bank’s activity with the holding companies. In January 2000, the IRS issued regulations that stated that if an S corporation is a bank or a QSub, then any special banking provisions within the code continue to apply separately to the bank or QSub.

The court upheld the validated regulation drafted by the IRS: S corporation banks or QSub banks should be calculating the amount of non-deductible interest expense allocated to investments in tax-exempt securities.

The taxpayers, in this case, have not indicated whether or not they will appeal this decision. Consideration should be given to amending prior year returns where interest expenses related to these investment securities were fully deducted.