IRS Withdraws Proposed Regulation Disallowing Tax Exempt Interest Expense

11/23/2011

By Mark Corey, CPA, JD

On October 26, 2011, the IRS formally withdrew a controversial proposed regulation that attempted to disallow 20% of a bank's tax exempt interest deduction in certain cases.

The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) restricted the deduction of interest expense related to qualified tax exempt obligation income. Code section 291 requires corporations to reduce their interest expense by 20% related to qualified tax exempt obligation income for every year they claimed this income. This is the TEFRA disallowance. In 2006 the IRS proposed regulation §1.1363-1, which stated that the 20% TEFRA disallowance applied to S and C corporations for every year they had qualified tax exempt interest income. In 2009, the IRS convinced the Tax Court using this theory to disallow 20% of the taxpayer's interest expense deduction (Vainisi v. Commissioner). Vainisi had argued that section 1363(b)(4) on its face stated that taxpayers did not have to calculate the TEFRA disallowance after the third year of their S corporation's life. The Appeals Court reversed the Tax Court and ruled that the TEFRA disallowance only applies to S Corporations and their wholly owned subsidiary Q-Subs for the first three years after their S election (assuming they were a C corporation at some point before they made the S election).

After losing the Vainisi case appeal, the IRS' Office of Chief Counsel issued an Action on Decision where they acquiesced to the appeals court decision. In furtherance of that decision not to litigate the position in the proposed regulation, the IRS formally withdrew the proposed regulation that led to the Vainisi case.

It appears that S corporation banks can continue to deduct 100% of their tax exempt interest expense related to qualified tax exempt interest income after their third year of S corporation existence, or for all years if they were never a C corporation.