Income tax considerations for fintechs with a bank or trust charter

| 6/10/2021
Income tax considerations for fintechs with a bank or trust charter

Recently, a wave of fintech companies have applied with state banking agencies or the Office of the Comptroller of the Currency (OCC) to obtain bank or trust charters or simply acquire an existing bank for the charter. Receipt of a charter does not necessarily mean that the entity will be treated as a bank for federal income tax purposes. In many cases, fintech companies might not meet the definition of a bank for federal or state income tax purposes, which can lead to unexpected tax consequences.

Definition of bank for federal income tax purposes
Under IRC Section 581, a bank is defined as an entity that meets three distinct requirements: 1) It must be “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 and discounts.” 3) It must be “subject by law to supervision and examination” by federal or state authorities having supervision over banking institutions.

Obtaining a bank charter generally will meet the first, and by default, the third requirements of the definition of a bank under IRC Section 581. The income tax distinction generally arises for the second requirement of the definition. For instance, in MoneyGram International Inc. v. Commissioner, the U.S. Court of Appeals for the 5th Circuit affirmed the Tax Court’s holding that MoneyGram is not a bank for federal income tax purposes because customers do not give it money for safekeeping; therefore, it failed to meet the second requirement of the IRC Section 581 definition. In the fintech industry, many companies that seek a bank or trust charter do not engage in gathering deposits in order to fund their operations but instead seek outside financing. As a result, these companies likely do not meet the “substantial part” test and therefore are not banks under IRC Section 581.

Federal tax benefits of being a bank
What is special about being classified as a bank for federal income tax purposes? In general, banks are taxed in the same manner as other corporations. However, one of the biggest benefits of being a bank for federal income tax purposes is that under IRC Section 582(c)(1) gains and losses from the sale or exchange of bonds, debentures, notes or certificates, or other evidences of indebtedness are treated as ordinary gains and losses. Because the ordinary trade or business of a bank is to issue debt, and a bank is limited to the types of securities it can hold, for liquidity purposes it is important for a bank to be able to exit debt security positions without the negative consequences of a capital loss for income tax purposes, which might not currently be deductible and could expire unused.

For fintech companies that do not meet the definition of a bank for federal income tax purposes, capital gain or loss treatment can be a trap for the unwary. It is important for such companies to be aware of the potential tax implications of selling debt securities at a capital loss, which can be offset only by capital gains. This scenario could be an issue for a fintech company if it cannot generate sufficient offsetting capital gains.

In addition to sales of securities, the IRC Section 582(c) provisions can affect loan losses. Fintech companies that originate loans might be considered dealers subject to mark-to-market treatment on loans held for sale to customers under IRC Section 475. If the loans are not considered inventory subject to mark-to-market treatment, they are simply portfolio assets. Nonbank lenders will need to consider both the timing and character of gains and losses upon the sale of these assets. Currently, no statutory provision specifically allows for debt assets held for investment – which are exempted from mark-to-market treatment under IRC Section 475(b)(1)(A) – to be treated as other than a capital asset for businesses that are not banks as defined in IRC Section 581. Thus, for fintech companies that are not banks for federal income tax purposes to consider losses on loans or debt instruments as ordinary assets, those assets must either be considered inventory under IRC Section 475 or meet one of the exceptions to being treated as a capital asset under IRC Section 1221.

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State tax considerations
While the federal treatment is complex, the myriad rules applied by the states is dizzying. States such as Georgia, Nebraska, Virginia, and Michigan have altogether different taxing regimes for financial institutions. States such as California and Tennessee have different income tax rates and apportionment factor rules for financial institutions. As if that wasn’t enough, each state also has different definitions of bank, financial institution, and similar terms. Therefore, fintech companies with a bank or trust charter need to consider the impact of state income and franchise taxes in their business plans.

Tread carefully
The income tax issues facing fintech companies are increasingly complex and heavily dependent on each institution’s facts and circumstances. Obtaining a bank or trust charter from a state regulatory agency or the OCC does not necessarily equate to being treated as a bank from a federal or state income tax perspective. Fintech companies pursuing or considering a bank or trust charter should consult with their tax adviser to understand the federal and state income tax implications of their business.

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Tiffany Richardson
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Cody Lewis