Nearly 1,500 small, privately held banks around the country could have to pay tens of millions of dollars combined in back taxes if a court ruling stands.

These banks, which are taxed under the rules of Subchapter S of the Internal Revenue Code, would not be directly on the hook for the money. This is because profits at S Corps, which can have no more than 100 shareholders each, are taxed only at the shareholder level, instead of both at the shareholder and corporate levels, as C Corps are. But most Subchapter S banks have agreements to reimburse their owners for tax mistakes.

"This is an issue we think affects almost every Subchapter S bank in the country," said Debra Koenig, a lawyer at Godfrey & Kahn SC in Milwaukee, who will lead an appeal of the ruling. "It is a test case for all Subchapter S banks."

Aside from potentially having to eat the tax bill, explaining the situation to shareholders will be "an administrative nightmare" for banks, Koenig said. She will be representing Jerome R. Vainisi and Doris L. Vainisi, the owners of First Forest Park Corp. in Illinois, in the suit against the Internal Revenue Service. "It is difficult for the banks because they have to communicate to the shareholders. … It is a very difficult issue, and it is hard to explain."

Near the beginning of this year, Judge Maurice B. Foley ruled in favor of the IRS in the United States Tax Court. The decision, if not overturned, could make the owners of Subchapter S banks liable for three years of back taxes on municipal bond investments. The ruling was finalized July 13.

The Vainisis have 90 days from that date to appeal. Koenig said they intend to do so.

According to data compiled by Baker Group LP, an Oklahoma City firm that advises community banks, the hit for any given Subchapter S bank could range from $6 to almost $300,000, depending on the institution's portfolio.

The total S Corp banks nationwide would have owed if the tax ruling were in effect was $21.6 million for 2008 alone, Baker Group said. The statute of limitations for overdue taxes is three years.

A spokeswoman for the IRS said it could not discuss the matter.

Whereas C Corps can deduct 20% of the interest expense on liabilities used to fund investments in municipal bonds, S Corps historically have deducted the entire expense. When a bank switched from a C Corp to an S Corp, it was widely believed that the deduction would be limited to 20% for only the first three years. This belief was based on an interpretation of a section in the Tax Equity and Fiscal Responsibility Act.

But the IRS argues that a "countervailing provision" in another section of the law applies to Subchapter S banks, meaning they, too, can deduct only 20% of their interest expense.

First Forest Park changed from a C Corp to a S Corp in 1997. Guy Giannini, First Forest Park's chief financial officer, said he was surprised in 2006 when an IRS audit of the $179 million-asset bank found that its shareholders owed $10,000.

"I think we were doing what every other S Corp in the country was doing," he said. "The only issue they found was the TEFRA disallowance. We thought, 'Oh, the auditor doesn't know what is going on.' " The Vainisis took the IRS to court.

Giannini said he learned after talking with colleagues at a bankers' convention that several other S Corps had been audited without the same result, leading him to believe his bank was picked because it was so small and unlikely to fight over the amount of money involved.

The Independent Community Bankers of America, Community Bankers of Wisconsin and other banking associations helped pay the Vainisis' legal fees as it became clear the IRS was not going to budge on its position.

Because so many banks are affected, the Subchapter S Bank Association in San Antonio has decided to raise money for legal fees to appeal the decision, said Bruce E. Toppin 3rd, the trade group's executive director.

"From our perspective, for Subchapter S banks this is an extremely important appeal," he said. "We have realized this is the last chance for Subchapter S banks to appeal this decision. It is unlikely that any future appeal to the tax court would have a different result. … We feel this was wrongly decided, and we want to get this decision turned around."

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