On Tuesday, February 23, 2009, oral arguments were heard before the Seventh Circuit Court of Appeals in the TEFRA disallowance appeal styled Jerome R. Vainisi, et al. v. Commissioner of Internal Revenue. The Appellants are seeking a reversal of the U.S. Tax Court's January 2009 decision that the 20% TEFRA disallowance applies to Subchapter S financial institutions in the same manner as to C corporations. 

The TEFRA disallowance refers to a 20% reduction in the amount of a financial institution's deductible interest expense attributable to its investments in qualified tax-exempt obligations (QTEOs). The Internal Revenue Code (the Code) generally permits all financial institutions to take annual deductions on their interest expense attributable to holding QTEOs; however, Section 291 of the Code stipulates that C corporations must reduce or "disallow" these deductions by 20% each year in which the entity claims such a deduction. This limitation contained in Section 291 is known as the TEFRA disallowance.

The Vainisi Appeal centers on whether Section 1363(b)(4) of the Code serves to limit the applicability of the 20% TEFRA disallowance to Subchapter S banks and their wholly-owned subsidiaries (QSubs) to only the first three years after they elect to be taxed under Subchapter S. The Appellants argue that it does.

The Vainisi Appellants, represented by Debra Koenig, a partner with the law firm of Godfrey & Kahn, P.C., argue that Section 291 of the Code in general only applies to C corporations. Only through Section 1363(b)(4) does the TEFRA disallowance extend to S corporations, but even then, it applies only for the first three taxable years after a bank elects Subchapter S.

The IRS, on the other hand, contends that Section 291 of the Code is a "special banking rule" that applies every year (as it does for C corporations) in spite of the plan language of Section 1363(b)(4) to the contrary. The IRS relies on the Tax Court's earlier ruling that because Section 1363(b)(4) does not specifically reference QSubs, it is therefore not applicable. Illogically, this suggests that the TEFRA disallowance could potentially apply differently to a QSub bank than it would to a stand-alone S corporation bank.

Throughout the oral arguments, the Seventh Circuit appeared to agree with the Vainisi Appellants' arguments, even referring at one point to the IRS's arguments as "ridiculous conclusions." The Court gave very little deference to the lower Tax Court's seemingly incongruous opinion, focusing instead on the plain language of Section 1363(b)(4), which states that after three years the TEFRA disallowance should no longer apply to S corporation and QSub banks. Ms. Koenig indicated that her assessment of the strength of the Vainisi Appellants' case remains strong and expressed her confidence that the taxpayers would ultimately prevail.

It is anticipated that the Seventh Circuit's ruling will likely be in late-summer 2010, but could come as early as May. The parties' oral arguments may be heard in their entirety on the Seventh Circuit's website at http://www.ca7.uscourts.gov/fdocs/docs.fwx. The case number is 09-3314.

The Subchapter S Bank Association, in partnership with the Community Bankers Associations of Iowa, Illinois and Wisconsin, the Council of Community Banking Associations, The Independent Community Bankers of America, the Independent Bankers Association of Texas and the Wisconsin Bankers Association, funded the appeal.  The Association continues to accept contributions to the appeal fund from financial institutions.  A contribution form is available by following this link.