Appeal from the United States Tax Court. Nos. 23699-06, 23701-06-Maurice B. Foley, Judge.
The opinion of the court was delivered by: Posner, Circuit Judge
Before BAUER, POSNER, and SYKES, Circuit Judges.
This appeal from the Tax Court presents an important question concerning the taxation of banks that either (1) are subchapter S corporations or (2) are wholly owned by such corporations and are classified as "qualified subchapter S subsidiaries" ("QSubs"), as is permissible unless they're in one of the categories of "ineligible corporations." 26 U.S.C. §§ 1361(b)(2), (3). Thirty-one percent of all federally insured banks are either subchapter S corporations or QSubs (by number, not deposits-these banks are mainly small community banks). Federal Deposit Insurance Corporation, Institution Directory, www2.fdic.gov/IDASP/main.asp?formname=inst (under "Specialized Categories (FAQ)" drop-down menu) (visited Feb. 24, 2010). The question is whether they can deduct all or merely part of the interest expense that they incur to purchase certain tax-exempt bonds.
The Vainisis own a holding company that in turn owns all the stock of First Forest Park National Bank and Trust Company. Until 1997, both the holding company and the bank were conventional corporations, which in tax-speak are called "C" corporations. But that year the holding company became an S corporation and the bank became a QSub. In 2003 and 2004 the bank earned tax-free interest income on what are called "qualified tax-exempt obligations." 26 U.S.C. § 265(b)(3)(B). The Vainisis deducted from their taxable income the entire interest expense that their QSub bank had incurred in borrowing money with which to buy those obligations. The Tax Court held that the Vainisis were entitled to deduct only 80 percent of that expense; its decision has received a good deal of critical commentary. See Carol Kulish Harvey, "The Application of Section 291 to Subchapter S Banks-A Look at the Vainisi Decision," 22(6) J. Taxation & Regulation of Financial Institutions 47 (2009); Kristin Hill & Kevin Anderson, "Computing S Corporation Taxable Income: Unraveling the Mysteries of Section 1363(b)," 11(4) Business Entities 32, 39-41 (2009); Deanna Walton Harris, Paul F. Kugler & Richard H. Manfreda, "IRS Succeeds with an Unexpected Argument Regarding a QSub Bank," 122 Tax Notes 1505 (2009).
Subchapter S allows an eligible corporation to be taxed much as if it were a partnership of its shareholders, see 26 U.S.C. §§ 1361 et seq.; S. Rep. 640, 97th Cong., 2d Sess. 2 (1982); Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 6.11, pp. 6-78 to 6-79 (7th ed. 2006)-that is, at the individual rather than the enterprise level. Unlike a C corporation, a partnership is not a taxpayer for purposes of federal income tax. Instead the partnership's income is deemed income of the partners and taxed to them as if they were sole proprietors. 26 U.S.C. § 703. And so with a sub-chapter S corporation: when the Vainisis converted their holding company to an S corporation, the holding company's income became income to the Vainisis, to be reported by them on their personal tax returns. In other words, it passed through to the Vainisis without being taxed at the company level.
As a QSub, the bank owned by the holding company was also disregarded for tax purposes-its income passed all the way through to the Vainisis without being taxed until it reached them. 26 U.S.C. § 1361(b)(3)(A); see Harvey, supra, at 47 n. 1, 50-51; James S. Eustice & Joel D. Kuntz, Federal Income Taxation of S Corporations ¶ 3.07 (2009); Boris I. Bittker, Meade Emory & William P. Streng, Federal Income Taxation of Corporations and Shareholders: Forms ¶¶ 6.07,  (2009). It was as if the Vainisis owned bank assets outright.
Interest that a financial institution (including a bank, 26 U.S.C. §§ 291(e)(1)(B)(i), 265(b)(5), 581, 585(a)(2)) pays on a loan that it uses to purchase a tax-exempt bond or other tax-exempt obligation (but to simplify exposition we'll generally refer to such obligations as bonds) is generally not deductible from taxable income if the bond had been bought by a financial institution after August 7, 1986, but is deductible if it was bought on or before that date. 26 U.S.C. §§ 265(a), (b)(1), (2). Some of the Vainisis' bank assets, however, consisted of a subset of tax-exempt obligations called "qualified tax exempt obligations." 26 U.S.C. § 265(b)(3)(B) (emphasis added). These are tax-exempt bonds that, although bought after August 7, 1986, are treated, if they satisfy certain additional criteria, as if they had been acquired on that date. This allows the taxpayer to deduct interest on the money borrowed to buy them-but not all the interest; sections 291(a)(3) and 291(e)(1)(B) of the Code reduce the permitted deduction by 20 percent, and thus allow only 80 percent of the interest to be deducted. We'll call this the "80 percent rule."
The principle that informs this statutory mosaic, though it is fully implemented only for tax-exempt bonds that are not qualified tax-exempt obligations acquired after August 7, 1986, is that expenses incurred in generating tax-exempt income should not be tax deductible. This is a general principle of income taxation, Denman v. Slayton, 282 U.S. 514 (1931); Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420, 422 (7th Cir. 1968); Levitt v. United States, 517 F.2d 1339, 1343 (8th Cir. 1975); Joshua D. Rosenberg & Dominic L. Daher, The Law of Federal Income Taxation § 4.19[b], p. 209 (2008), and would thus imply the zero percent rule applicable to tax-exempt bonds acquired after August 7, 1986, that are not qualified tax-exempt obligations, rather than the 80 percent rule.
An example will illustrate the underlying principle. Suppose a taxpayer who has income of $10,000 from nontax-exempt bonds borrows money and uses it to buy tax-exempt bonds and pays interest of $10,000 on the loan. His income from the second set of bonds is by definition tax exempt. If from the $10,000 in income that he obtains from his non-exempt bonds he can deduct the interest he paid to obtain the money that he used to buy the tax-exempt bonds, then he pays no tax on his income from the non-exempt bonds either. Denman v. Slayton, supra, 282 U.S. at 519-20. That is the abuse to which the 80 percent rule is a partial response.
Section 291, the source of the rule, is made applicable to S corporations by section 1363(b)(4), which states that "the taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that § 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years." Section 291 lays down rules relating to corporate preference items. Since S corporations are taxed at the individual rather than the corporate level, this suggests, and the legislative history of section 1363(b)(4) further suggests, that the rules in section 291-including the rule limiting deduction of interest on loans used to acquire qualified tax-exempt obligations-are inapplicable to S corporations in the absence of express statement, such as the "except that . . ." statement which one finds in section 1363(b)(4), quoted above. "Under Present Law, S Corporations compute their taxable income as an individual, and therefore the provision [section 291] relating to corporate preference items does not apply to an S corporation." H.R. Rep. 432(II), 98th Cong., 2d Sess. 1644 (1984). Thus, for firms that have been S corporations for at least three years and so escape the "except" clause, the zero percent rule and the 80 percent rule are replaced by a 100 percent rule: all the interest expense incurred in acquiring qualified tax-exempt obligations is deductible. Section 291 simply isn't applicable to such S corporations.
The three-year waiting period prevents a C corporation from avoiding section 291 by opportunistically switching back and forth between C and S status. Only corporations that really want to be S corporations, as shown by their having adhered to that status for at least three years, are allowed to avoid the burdens that section 291 imposes on C corporations. See H.R. Rep. 432(II), supra, at 1644. The Vainisis' subchapter S holding company and QSub bank are such S entities; the earlier of the two taxable years at issue in this case-2003-was six years after the Vainisis' holding company converted from C to S corporate status.
Section 291 had been enacted in 1982, though at first it permitted the deduction of 85 percent of the interest on loans used to buy tax-exempt bonds. The percentage was reduced to 80 percent in 1984. That was the same year that subsection (b)(4) of section 1363-the key statute in this case-which states, to repeat, that "the taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that § 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years"-was added to the tax code.
It was not until 1996 that section 1361 was amended to allow an S corporation to treat a wholly owned subsidiary as a QSub and to allow a bank to become an S corporation or (as in this case) a QSub. This change in the law worried the Internal Revenue Service. It feared that a subchapter S bank might not be subject to provisions of the Internal Revenue Code that impose special rules on banks-including the 80 percent rule in section 291, along with rules relating for example to the sale of bonds and other debt, the determination of interest expense, and the exemption of insolvent banks from federal income tax. 26 U.S.C. §§ 582(c), 1277(c), 7507. A subchapter S bank might be held not to qualify as a bank subject to the special banking rules just because it owned a nonbank QSub; a QSub bank owned by a nonbank subchapter S parent might be held not to be a bank for purposes of those rules; and alternatively which-ever entity was the nonbank might be held entitled ...