I have an AVI file where the subtitles are on the movie, not in the black areas (i would just black it out). Is there a tool, method or filter to use to remove before I encode to KVCD.

No.

I found a VirtualDub filter called "MSU Subtitle&Logo Remover" but have not tried it out yet, just wondering if anyone has used this or ever tried to remove subs before.

All logoremover I tried do great job but they all distort a little the picture of the zone where the logo is supposed to be (that is normal after all).
I never see any filter removing subtitles but I fear artefacts on the screen will be lot more dirturbing than for a simple (small) logo. But let try and tell us.

I don't think it will work unless the subs are very opaque. The filter doesn't know what has been underneath the subs if they are solid.