Tax Court Defines “Bank” for Bad-Debt Deduction Purposes

By Christine R. List, CPA, and Monica J. Schmidt, CPA
| 5/27/2016

support-img-lp-cftsi-article-3-bad-debt Generally, a taxpayer is allowed to deduct wholly worthless debts and securities as capital losses, which are limited to the amount of the taxpayer’s capital gains. Banks, however, can take an immediate ordinary loss deduction for wholly and partially worthless debt securities up to the amount charged off in the current year. In today’s economy, though, many different types of organizations provide a wide variety of financial services, which places greater emphasis on which taxpayers qualify as “banks.” The U.S. Tax Court recently weighed in on that question in a case that now has moved on to the Fifth Circuit Court of Appeals.

Case Background

MoneyGram International provides consumers and financial institutions with payment services that the Tax Court described as “affordable, reliable, and convenient.” Its business involves moving money through three main channels – money transfers, money orders, and payment processing services. In 2007, the company was the largest issuer of money orders in the United States.

In 2008, MoneyGram undertook a recapitalization that included writing down or off a substantial volume of partially or wholly worthless asset-backed securities to comply with state regulatory guidelines following the global financial turmoil. As a result of the recapitalization, the company reported substantial losses related to its asset-backed securities portfolio on its 2007 and 2008 federal income tax returns.

It claimed bad-debt deductions of about $524 million and $17 million in 2007 and 2008, respectively, based on the partial or complete worthlessness of “non-real-estate mortgage investment conduit” (non-REMIC) asset-backed securities. Treating the losses as capital losses wouldn’t generate any current tax benefit for MoneyGram because it had no capital gains net income in those tax years against which it could offset the losses.

The IRS agreed that the securities were “debts evidenced by a security” and therefore, if MoneyGram qualified as a bank under Section 581 of the Internal Revenue Code, it could claim bad-debt deductions rather than capital losses. Because it found that the company didn’t qualify as a bank under the provision, the IRS disallowed the deductions. MoneyGram appealed to the Tax Court.

The Tax Court’s Definition of “Bank”

According to the Tax Court, an organization qualifies as a bank under Section 581 only if it meets the following three criteria:

  1. It is a bank or trust company incorporated and doing business under federal or state law.
  2. A substantial part of its business consists of receiving deposits and making loans.
  3. It is subject to regulation by federal or state banking authorities.

The Tax Court’s Rationale

The court disallowed the ordinary losses after determining that MoneyGram did not satisfy any of Section 581’s requirements.

The court determined that MoneyGram isn’t a bank for purposes of the first requirement because the company doesn’t display the “essential characteristics of a bank.” The company, the court observed, doesn’t receive deposits from the general public or hold funds “repayable to the depositors on demand or at a fixed time.” Moreover, the company’s business doesn’t involve “the use of deposit funds for secured loans.” MoneyGram is not chartered or regulated as a bank; it is a money services business (MSB), and federal banking regulations specifically exclude MSBs from the definition of “bank.”

The Tax Court also found that receiving deposits and making loans don’t constitute “any meaningful part” of MoneyGram’s business. Instead, the business involves moving its customers’ money from point A to point B as quickly as possible. The funds it holds pending completion of that service aren’t placed with it for safekeeping or held for any significant period of time. Money order customers explicitly are told that they aren’t making deposits, and the funds appear on the company’s financial statements as “payment service obligations,” not “deposits.” Furthermore, MSBs legally are prohibited from receiving deposits.

As for making loans, the court said that for purposes of Section 581 a “loan” must be similar to a bank loan, which is memorialized by a loan instrument, is repayable with interest, and generally has a fixed, often lengthy repayment period. The court explained that the items MoneyGram characterized as “loans” consist primarily of amounts due to MoneyGram – classified as accounts receivable – that its agents hold temporarily under “delayed remittance agreements.”

Finally, MoneyGram isn’t regulated as a bank by the Federal Reserve Board or other federal regulators but as an MSB. It’s subject to regulations under Title 31 of the United States Code and regulations that cover “Money and Finance,” while banks are regulated under Title 12 of the US Code and regulations that cover “Banks and Banking.”

The Appeal

MoneyGram has filed an appeal with the Fifth Circuit Court. It argues that the IRS and Tax Court have erred by interpreting the definition of “bank” as narrower than Congress intended for purposes of claiming securities losses as ordinary losses. MoneyGram claims that Section 581 isn’t limited to federally registered banks and that the company satisfies the deposits and loans requirements.

Lesson Learned

Organizations that provide financial services should take heed of the current Tax Court interpretation of the definition of “bank” for the purposes of taking bad-debt deductions for worthless securities – although the definition ultimately might be overturned on appeal. Note, too, that state definitions and treatment of worthless securities might vary.

In This Issue

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Christine List
Monica Schmidt