The Sub S Bank Report – October 2009 (Volume 12, Issue 3)

On Tuesday, October 27, 2009, through their counsel, appellants Jerome and Doris Vainisi filed an opening brief in their appeal of the United States Tax Court’s ruling on the TEFRA disallowance case. The appeal, styled Jerome R. Vainisi, et al. v. Commissioner of Internal Revenue, was filed in the Seventh Circuit Court of Appeals in Chicago, Illinois. Debra Koenig, with the law firm of Godfrey & Kahn, S.C. is the lead attorney handling the appeal.

Back on January 15, 2009, Subchapter S banks were dealt a surprising blow when the U.S. Tax Court ruled in favor of the Internal Revenue Service in the TEFRA disallowance case styled Vainisi v. Commissioner of Internal Revenue. The case centered on whether a provision in the Internal Revenue Code (IRC) limits the applicability of the 20% TEFRA disallowance to only the first three taxable years after a bank elects Subchapter S. It was initially brought before the Court in November of 2006.

The TEFRA disallowance refers to a mandatory 20% reduction in the amount of a financial institution’s deductible interest expense attributable to its investments in qualified tax-exempt obligations (QTEOs). The IRC generally permits all financial institutions to take annual deductions on their interest expense attributable to holding QTEOs; however, Section 291 of the IRC stipulates that C corporations must reduce, or “disallow,” these deductions by 20% each year in which the entity claims any such deductions. This is known as the 20% TEFRA disallowance. Section 1363(b)(4) of the IRC extends the reach of Section 291 to S corporations as well, but it expressly provides that the 20% TEFRA disallowance applies only for the first three years after an institution elects Subchapter S.

In the original case, the Tax Court ultimately concluded that Section 1363(b)(4) did not in fact limit the applicability of the 20% TEFRA disallowance to only those first three years. Conversely, it held that the TEFRA disallowance applies in every year in which the institution claimed a deduction for its interest expense attributable to holding QTEOs. In other words, despite the language of Section 1363(b)(4), the 20% TEFRA disallowance applied to the Vainisi petitioners in the same manner as it applies to C corporations.

The Tax Court’s ruling was based largely on semantics. It reasoned that Section 1363(b)(4) specifically references S corporations—not QSub (qualified Subchapter S subsidiary) banks—and because in the Vainisi petitioners’ case, the QSub bank, not the parent S corporation holding company, owned the QTEOs, the 20% TEFRA disallowance applied in the same manner as for C corporations.

Oddly, the Tax Court impliedly suggested that had the petitioners’ corporate structure been different, so too may have been the result. The judge made a point to clarify that “the focus of [the Court’s] analysis is on the statutes and regulations relating to QSub banks” and not those relating to S corporation banks (i.e. stand-alone Subchapter S banks without parent bank holding companies). So in other words, had the petitioners been merely a stand-alone S corporation bank, the Tax Court may have found that the 20% TEFRA disallowance applied only for the first three years, rather than in every year.

The pending appeal before the Seventh Circuit will likely be the final opportunity for the Sub S bank community to challenge the IRS’s position on the 20% TEFRA disallowance. Fortunately, it is also our best opportunity to have the Tax  Court’s opinion reversed, due in part to its seemingly inconsistent ruling.

The appellants’ arguments are essentially twofold: (1) the plain language of the relevant statutes clearly support only one conclusion—that the 20% TEFRA disallowance should apply to S corporations only during the first three years after they elect Subchapter S status; and (2) the Tax Court’s analysis was fundamentally flawed because it  implicitly suggested that the 20% TEFRA  disallowance might apply differently for stand-alone S corporation banks than it does (according to the Tax Court) to QSub banks. Because the facts in the case were fully stipulated, the only issue before the Seventh Circuit is a question of law. Questions of law are subject to de novo review. In other words, the Seventh Circuit is not being asked to confirm or deny the accuracy of the Tax Court’s ruling; rather, it will draw its own conclusions based on the arguments presented before it.

The next step in the appeals process is for the Internal Revenue Service to file its reply brief, which is due 30 days after the appellants’ opening brief was filed. The appellants will then have 14 days in which to file a reply brief. Oral arguments will then be heard, which will then be followed by the Court’s decision. In all likelihood, a decision will not be rendered until late Spring or early Summer 2010.

We would like to thank Ms. Koenig and her firm for their efforts in preparing and arguing this critical appeal. In addition, the Subchapter S Bank Association owes a sincere debt of gratitude to all of the banks and state associations that have generously contributed to the TEFRA Legal Fund, thus making this appeal possible.

The Association will continue to closely monitor this case as it progresses through the appellate process. Any updates will promptly be reported in future editions of the Sub S Bank Report and on our website at www.subsbanks.org.

On Wednesday, October 28, Subchapter S Bank Association Executive Director Bruce E. Toppin, III issued a comment on behalf of the Association on the FDIC’s proposal for banks to prepay multiple years worth of assessments to restore liquidity to the Deposit Insurance Fund. 

The full text of Mr. Toppin’s comments to the FDIC board appear below.  The Sub S Bank Association will continue to provide updates as the FDIC releases additional information.

Dear Mr. Feldman:

On behalf of the Subchapter S Bank Association and the almost 2,500 banks that have elected to be taxed as S corporations, thank you for the opportunity to comment on the Board’s proposal to restore liquidity to the Deposit Insurance Fund by collecting a multi-year prepaid insurance assessment.

Upon hearing of the Board’s proposal, we began consulting with a number of accounting firms in an effort to ascertain the potential impact this assessment might have on Subchapter S banks, due to their unique tax treatment. Our question was simply: Will Subchapter S banks be allowed to deduct this prepaid multi-year assessment incrementally over the life of the assessment? In response, we received no clear consensus on the answer to this question; however, everyone with whom we spoke agreed that current tax rules would without question preclude Sub S banks from deducting the full amount of the assessment in 2009.

In this current economic environment, which has unquestionably taken a heavy toll on the financial services industry, one principle has become resoundingly clear: Capital is king. To that end, so too is the preservation of capital. We therefore submit that the tax treatment of the Board’s proposal should be such that the capital impact of the assessment is minimized for all financial institutions, including those organized as S corporations.

We would first ask the Board to provide clarity as to the tax treatment of the proposed assessment under existing tax laws. Particularly, will Subchapter S banks be permitted to incrementally deduct the expense over the life of the assessment, much in the same manner as their C corporation counterparts? At a minimum, we feel that such tax treatment would be appropriate.

Second, in the interest of capital preservation, we believe Subchapter S institutions should be afforded the opportunity to choose to deduct the entire amount of the prepaid assessment in 2009 if doing so would minimize the impact the assessment would have on the bank’s capital resources.

Our primary concern is the impact this multi-year prepaid assessment could potentially have on banks’ capital levels if it can only be deducted incrementally over the life of the assessment. While a number of Subchapter S institutions would undoubtedly prefer this tax treatment (i.e. institutions whose taxable earnings may have suffered as of late) and should be allowed to deduct the expense accordingly, we respectfully submit that there are also a significant number of Sub S institutions for whom it would be substantially more beneficial were they able to deduct the entire amount of the assessment in the taxable year in which it was paid. Doing so would, in effect, reduce the taxable earnings of these institutions in the current year, thus reducing the amount of dividends they would be required to pay out to their shareholders to cover the shareholders’ tax liabilities. This would allow these institutions to maintain a higher level of capital in the current year, when it likely will be needed most.

As to the second point, we recognize that this proposed tax treatment is not presently allowed under current tax rules. However, there is strong precedent for amending federal tax laws in order to soften the impact those laws would otherwise have on banks. In particular, provisions in the Emergency Economic Stabilization Act of 2008 amended certain sections of the Tax Code to change the treatment of the sale of preferred stock issued by the Federal National Mortgage Corporation (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) from capital gains or losses to ordinary gains or losses. It is without question that such measures should be reserved only for times of severe economic distress, but given the alarming number of bank failures that have occurred over the preceding 18 months, such measures appear warranted at this time.

We strongly urge the Board to consider these issues. We are confident that the Board will seek equity for all banks in making its final ruling on this issue, including those that have elected Subchapter S taxation. Thank you for considering our concerns and for the opportunity to submit this comment.

Recently a number of Sub S bankers and shareholders have expressed concern about the provisions in the Internal Revenue Code (IRC) relating to “members of a family” and how they fit within the limitation that S corporations have no more than 100 shareholders.

Section 1361(b)(1) of the IRC defines a “small business corporation” as, among other things, a domestic corporation that does not have more than 100 shareholders. In the twelve-plus years that financial institutions have been eligible to elect Subchapter S, this particular provision has seen its share of amendments. Prior to enactment of the legislation allowing financial institutions to elect Subchapter S, the number of permissible shareholders for an S corporation was 35. Through passage of the Small Business Protection Act of 1996, this number was increased to 75. It was subsequently increased again to 100 in 2004 through passage of the American Jobs Creation Act of 2004. (In 2007, legislation was proposed through the Communities First Act which would once again increase the shareholder limit up to 150, but the bill was never passed.)

In addition to raising the number of permissible shareholders from 75 to 100, the American Jobs Creation Act also introduced the term “members of a family” to the world of Subchapter S taxation. The 2004 legislation had the effect of treating individual shareholders (including their spouses or former spouses) who were “members of a family” as a single shareholder for Subchapter S purposes. Which shareholders qualified as members of a family was determined by counting backwards up to six generations from the youngest generation of shareholders, as of a specified date, to determine what is called a “common ancestor.” All of those shareholders who were lineal descendants of this common ancestor qualified as members of a family.

The result of this legislation was twofold: 1) it gave shareholders of existing Sub S institutions the ability to pass along their shares to younger generations without concern for increasing the bank’s shareholder count; and 2) it allowed a number of institutions, which could not otherwise qualify to elect Subchapter S because of their large shareholder numbers, to condense their shareholder numbers so that they were eligible to elect Subchapter S.

Without question, the 2004 legislation (which was slightly amended again in 2005) took great strides towards alleviating Sub S banks’ concerns over shareholder number limits. Yet as shareholders continue to pass their shares along from generation to generation, Sub S banks have begun asking the question: What happens when we get past six generations? According to section 1361(c)(1) of the IRC, the answer is nothing. There exists a common misconception among the Sub S bank community that the IRC provisions relating to members of a family limit the number of generations that can qualify as members of a family to only six. Fortunately, this is not in fact the case.

Section 1361(c)(1)(A)(ii) of the IRC states that all members of a family shall be treated as one shareholder for purposes of the 100 shareholder limit. The term “members of a family” is defined as “a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant.”

The six generation rule only relates to the individual who is to be treated as the common ancestor and only applies on what is called “the applicable date.”

An individual can only be a common ancestor if, on the applicable date, the individual is not more than six generations removed from the youngest generation of shareholders who would be members of the family. (It is also worth noting that the IRC does not specify that this common ancestor even needs to have been a shareholder of the Sub S institution.) The applicable date for purposes of determining the common ancestor is the later of: 1) the date of the bank’s S election; 2) the earliest date that an individual who is purporting to be a member of a family holds stock in the S corporation; or 3) October 22, 2004. Once that common ancestor is determined as of the applicable date, it will never change.

The result of all of this is that, while on the applicable date, only up to six generations of lineal descendants are eligible to qualify as members of a family, as future generations (generations seven, eight, nine, etc.) of lineal descendants come into being, they too (along with their spouses or former spouses) are able to qualify as members of the family. In other words, once a common ancestor has been determined, the members of a family can continue to grow past the initial six generations and all will be treated as a single shareholder for purposes of the 100 shareholder limit.