TEFRA Disallowance Reversed for Some Corporations

3/18/2010

By Mark Corey, CPA

In 1982, Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA), which, among other things, restricted the deduction of interest expense related to 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 TEFRA disallowance, as it is commonly known, was upheld in a 2009 Tax Court case where the Tax Court decided the TEFRA disallowance under code Section 291 applied to S corporations as well as C corporations. The taxpayers in the Tax Court case 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 corporations life. The tax court disagreed, and stated that taxpayers could only deduct 80% of their expenses related to tax exempt obligation income. The taxpayers appealed to the Seventh Circuit Court of Appeals and the Appeals Court heard oral arguments in the case, Vainisi v. Commissioner of Internal Revenue. Yesterday, 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.

If you would like to read the Appeals Court’s opinion, go to the court’s website at http://www.ca7.uscourts.gov/, select “Opinions” and type in the case number, 09-3314.