In the
United States Court of Appeals
For the Seventh Circuit
No. 09-3314
JEROME R. V AINISI and D ORIS L. V AINISI,
Petitioners-Appellants,
v.
C OMMISSIONER OF INTERNAL R EVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court.
Nos. 23699-06, 23701-06—Maurice B. Foley, Judge.
A RGUED F EBRUARY 23, 2010—D ECIDED M ARCH 17, 2010
Before B AUER, P OSNER, and SYKES, Circuit Judges.
P OSNER, Circuit Judge. 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 classi-
fied 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
2 No. 09-3314
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 obliga-
tions.” 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).
No. 09-3314 3
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 com-
pany’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[3]
(2009); Boris I. Bittker, Meade Emory & William P. Streng,
Federal Income Taxation of Corporations and Shareholders:
Forms ¶¶ 6.07[2], [7] (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
4 No. 09-3314
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 deduc-
tion 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[2][b], p. 209 (2008), and would thus
imply the zero percent rule applicable to tax-exempt
No. 09-3314 5
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 non-
tax-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 im-
mediately 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
6 No. 09-3314
above. “Under Present Law, S Corporations compute their
taxable income as an individual, and therefore the provi-
sion [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 corpora-
tions 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
No. 09-3314 7
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 sub-
sidiary 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 provi-
sions 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 ex-
pense, 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 to
benefits from the special banking rules that were intended
only for banks. Internal Revenue Service, “Subchapter
S Banks—Sections 1362 and 265,” Notice 97-5, 1997-1 C.B.
352 (Jan. 13, 1997); Harvey, supra, at 58; Harris et al., supra,
at 1506.
To enable the Treasury to eliminate such unintended
consequences of the 1996 amendment, Congress the
following year, at the urging of the IRS, amended 26
8 No. 09-3314
U.S.C. § 1361 to provide, in subsection (b)(3)(A), that
“except as provided in regulations prescribed by the
[Treasury], . . . a corporation which is a QSub shall not be
treated as a separate corporation,” that is, separate from
its S corporation parent. This “except” clause empowered
the Treasury to promulgate regulations that would
ensure that the special banking rules are applied to
QSubs at the corporate level, that is, before their assets
and liabilities and revenues and expenses disappear
into the assets and liabilities and revenues and expenses
of, in this case, the Vainisis as the owners of the S corpora-
tion that owns the QSub bank.
Three years later the Treasury promulgated such a
regulation. It provides that “if an S corporation is a bank,
or if an S corporation makes a valid QSub election for
a subsidiary that is a bank”—as the Vainisis did—“any
special rules applicable to banks under the Internal Reve-
nue Code continue to apply separately to the bank
parent or bank subsidiary.” 26 C.F.R. § 1.1361-4(a)(3). In
other words, the special bank rules—including sections
291(a)(3) and 291(e)(1)(B), which allow a bank that has
qualified tax-exempt obligations to deduct from its
taxable income only 80 percent of the interest on the
money it borrowed to buy the bonds—must be applied to
an S corporation bank or QSub bank before the bank’s
revenues and expenses are allowed to flow through
to the S corporation’s shareholders for tax purposes.
But we know from section 1363(b)(4) that section 291,
including therefore the 80 percent provision, applies to
an S corporation only if it had been a C corporation
No. 09-3314 9
within the three years preceding the taxable year in
question. The Vainisis’ S corporation had not been; and
section 291, by its terms, does not apply to such
S corporations. The government doesn’t want the Vainisis
to be allowed this break just because the three-
year waiting period has expired. So, noting that their
bank is not an S corporation but a QSub, the government
argues that section 1363(b)(4) does not apply to the
bank because the section does not mention QSubs.
If section 291 does not apply of its own force to
S corporations and QSubs, the government’s interpreta-
tion would exempt all QSubs, even those owned by
subchapter S corporations that converted from being
C corporations in the three years before the taxable year
in issue, from the 80 percent rule of sections 291(a)(3)
and (e)(1)(B). Suppose a bank that was a C corporation
decided it wanted to be an S corporation tomorrow, not
three years hence. It would form an S corporation
holding company and convert the bank to a QSub. The
holding company, not being a bank, would not be
subject to the 80 percent rule and under the govern-
ment’s interpretation neither would the bank be, because
it would be not a subchapter S corporation but a QSub.
That would be contrary to the general principle that a
QSub is to be disregarded for tax purposes—that it
merges with its S corporation parent.
To close the loophole that its interpretation creates, the
government further argues that the “except as pro-
vided in regulations” clause in section 1361(b)(3)(A)
authorized the Treasury Department to apply section 291
to S corporations or QSubs that are banks even if they
10 No. 09-3314
were not C corporations in any of the three previous years.
The government argues that because section 291, and the
amendment to it that created the 80 percent rule (for
remember that originally it was an 85 percent rule),
entered the Internal Revenue Code before banks could be
subchapter S corporations or QSubs, Congress never
intended section 1363(b)(4) to prevent the application of
section 291 to banks, and so should be taken to have
authorized the Treasury to rescind that application by
regulation, as Congress’s delegate.
But section 1361(b)(3)(A) doesn’t say or hint that. And
neither does the regulation, which merely requires that
the special banking rules be applied to banks that are
S corporations or QSubs at the corporate level so that a
bank’s S corporation status will not emasculate the
rules. A bank is a bank is a bank, whether it is an S or a
C corporation.
The regulation gives two examples of how it is meant
to apply. 26 C.F.R. § 1.1361-4(a)(3)(ii). One actually in-
volves interest on tax-exempt bonds (the zero deduc-
tion provision—section 265(b)). But nothing in either
example suggests that section 1363(b)(4) is to be over-
ridden with regard to banks.
Missing from the government’s analysis is recognition
that the only S corporations to which section 291, the
source of the special banking rule at issue in this case (the
80 percent rule), applies are S corporations that were
C corporations in one of the three immediately preceding
years. Nothing in the regulation suggests a purpose to
change that rule.
No. 09-3314 11
The government’s interpretation would deprive certain
S corporations, including the Vainisis’ bank, of the privi-
leges that Congress gave S corporations that don’t fall
into the recency exception (the exception for corpora-
tions that were C corporations at some time in the pre-
ceding three years)—deprive without basis in the
language of the regulation or of its authorizing statute.
The privileges may be anomalous or even unintended,
since section 1363(b)(4) was enacted before banks were
allowed to be S corporations or QSubs. But we cannot
rewrite statutes and regulations merely because we think
they imperfectly express congressional intent or wise
social policy. Even if the “except” clause in the 1997
statute authorized the Treasury to repeal the provision
that immunizes S banks from section 291, we need
at least hints in the text of either the regulation or the
authorizing statute that that is what the regulation
does, and we can’t find any.
Of course, unless abrogated, the privilege conferred
by section 1363(b)(4) will perpetuate a competitive ad-
vantage enjoyed by S or QSub banks that have never
been C corporations or that converted from C to S earlier
rather than later. Later converters—not to mention
all existing C corporation banks (the majority of all
banks)—may be gnashing their teeth in fury at the addi-
tional interest deduction that many of their S or QSub
bank competitors can take. But the difference in treat-
ment, and whatever consequences flow from it, are built
into section 1363(b)(4).
The government suggests, finally, that the regulation
may be an attempt to clarify an ambiguity in sections 291
12 No. 09-3314
and 1363(b)(4) rather than to rewrite the latter section
to treat all S corporation banks as if they had been
created within the preceding three years so that none of
them would be entitled to the interest deduction. When
those sections were enacted, all banks were C corpora-
tions and therefore subject to section 291. So Congress
may have assumed, if it thought about the matter (of
which there’s no evidence, however), that sections 291(a)(3)
and (e)(1)(B) would apply to all banks even if at a later
date some banks were allowed to become S corporations.
If this is right, it implies that the purpose of section
1363(b)(4) was merely to apply the other parts of section
291—the parts that don’t concern banks—to S corpora-
tions unless they had converted from C to S more than
three years before the taxable years in question.
The problem with the argument is that there is no
ambiguity to disambiguate. What the government really
is saying is that the regulation corrects a mis-
take—that Congress never wanted banks to have all the
privileges that subchapter S confers, including freeing a
bank such as the Vainisis’ from section 291. But we
need some evidence that the purpose of the regulation
was to correct this mistake (if it was a mistake), and we
cannot find any such evidence either in the statute that
authorized the regulation or in the regulation itself.
It’s not as if it would be an absurdity to assume that
subchapter S banks receive the same immunity from that
section as other subchapter S corporations. Had Congress
wanted banks to enjoy none of the benefits that the tax
laws confer on such corporations, why did it change its
previous policy and allow banks to become S corporations?
No. 09-3314 13
The regulation was promulgated a decade ago and
the Treasury Department has thus had ample time in
which to decide whether the favored treatment of S and
QSub banks is a bad idea. The Internal Revenue Service
thinks it a bad idea, the Tax Court thinks it a bad idea,
but the institutions authorized to correct the favored
treatment of these banks—Congress by statute, and the
Treasury Department (we are assuming without de-
ciding), as Congress’s delegate, by regulation—have thus
far left it intact. True, the Treasury has proposed to subject
all subchapter S banks, no matter how long they have
enjoyed that status, to section 291, with its 80 percent rule.
“Proposed Subchapter S Bank Regulations,” 71 Fed. Reg.
50007 (Aug. 24, 2006). But the proposal has been in limbo
for years, its validity questioned on the ground that it
contradicts section 1363(b)(4). “Comments of the American
Bar Association Section of Taxation on Proposed Regula-
tions Under Section 1363(b),” Nov. 30, 2006, www.abanet.
org/tax/pubpolicy/2006/113006scorpbankcomments.pdf
(visited Feb. 27, 2010); Harvey, supra, at 53; see also Hill &
Anderson, supra, at 41; Harris et al., supra, at 1507. Unless
and until such a regulation is adopted (assuming that it
would be a valid interpretation of section 1363(b)(4)) or
the statute amended, the distinction stands, and exempts
the Vainisis from section 291. The judgment of the
Tax Court is therefore
R EVERSED.
3-17-10