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The IRS Upgrades Its View of Banks

Interest income is no longer inherently passive income, according to the Internal Revenue Service.
Robert Willens, CFO.com | US
March 7, 2011

Up until late last month, the Internal Revenue Service's view of a bank's primary business activity might have been characterized as clipping coupons from its bonds. Since banks' main source of income is interest (and interest was inherently a "passive" way of earning income), the IRS wrote off banks as mere holding or investing companies with no real business activities. On the evidence of a letter ruling released on February 25, that view has radically changed.

In the ruling, LTR 201108001, the IRS truly determined for perhaps the first time that a bank constitutes an operating company. While the IRS doesn't identify the parties it's referring to in such rulings, this appears to be the one that Washington Mutual Inc. requested from the IRS concerning the character of its loss resulting from the worthlessness of its stock in Washington Mutual Bank. One of the key questions in that case was whether the worthless stock held by Washington Mutual Inc. is eligible for ordinary loss treatment for the purposes of bankruptcy recovery.

In any event, the ruling means that certain owners of worthless securities can take an ordinary loss rather than a capital loss on such stock, and gain a good deal of flexibility in tax reporting as a result. That's because capital losses are much narrower than ordinary losses in terms of their ability to offset gains. While ordinary losses can be used to offset either capital gains or ordinary gains on a tax form, capital losses can be used to offset only capital gains.

In the past, just the mere fact that the bank had interest income would mean it wasn't an operating company. Now the IRS seems to be agreeing that it should look more critically at the question and determine whether the interest income was earned through active operating activities or merely through passive investment activities. This ruling stands for the proposition that interest income is not passive income when it's earned from the active conduct of a banking or financial business.

The case at hand involves a parent company, which we'll call ParentBank, and a subsidiary, SubBank. SubBank, which, according to the IRS, "provided a broad range of banking services," was seized by the Office of Thrift Supervision and placed into receivership of the Federal Deposit Insurance Co. The FDIC then sold SubBank's assets to another company, "BuyerBank." As a result of the seizure and the asset sale, ParentBank and a nonbanking subsidiary, "NonBank," filed for protection under Chapter 11 of the U.S. Bankruptcy Code.

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In the receivership sale, BuyerBank bought practically all of SubBank's assets and assumed all its deposits and other of its liabilities for cash in a taxable transaction. ParentBank reported a net loss on its consolidated income-tax return related to the receivership sale.

ParentBank had reported that more than 90% of SubBank's aggregate gross receipts for all taxable years had been from interest income on, and gains from the sale of, real estate loans (including mortgage-backed securities) and consumer loans; service charges, fees, and commissions; and other noninterest income from operations. All such gains qualified for ordinary income treatment under Section 582(c) of the Internal Revenue Code, according to the IRS.

The IRS concluded that SubBank's loss from the worthlessness of its S stock would be an ordinary loss, rather than a capital loss. In doing so, the service essentially ruled that Congress really didn't intend for such rulings to turn on a black-and-white decision. Instead, Congress intended that we analyze the activities that the company undertook to earn that interest income. If those activities are business activities, then the corporation should not be penalized for the interest income it has earned. Interest income, in short, is no longer inherently passive.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.




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