Corporate Financing Companies: Treatment of Losses

By Matthew J. Mittman, CPA, Oak Brook, Ill.

Editor: Frank J. O’Connell Jr., CPA, Esq.

Gains & Losses

It is common for hedge funds and private-equity funds that are passthrough entities and have foreign or tax-exempt investors to form and use, or make a “check-the-box” election to be treated as, C corporation “blocker entities” for the origination and servicing of loans. Blocker entities are used to change the character of income or assets to achieve certain tax results. Financial blocker entities (fincos) are used as a mechanism to prevent funds from potentially being engaged in a U.S. trade or business. Absent fincos, interest earned on, and any fees generated from, the loans held by hedge funds and private-equity funds could be “effectively connected income” for foreign investors (Sec. 864(c)), subject to withholding by the funds under Sec. 1446, and “unrelated business taxable income” to tax-exempt investors under Sec. 512.

Amid the economic conditions of the past several years, loans held by many fincos have become fully or partially worthless. The federal income tax treatment of losses from debt instruments that have become wholly or partially worthless is determined by various tax provisions. The determination of the amount, timing, and character of these losses depends on a number of factors including whether the debt is a “security” as defined in Sec. 165(g)(2)(C) and whether the property is a capital or ordinary asset in the fincos’ hands. Aside from special rules or exceptions that apply to specific taxpayers such as banks and financial institutions, there are multiple considerations for fincos in determining the timing and treatment of debt instruments that have become wholly or partially worthless.


In general, under Sec. 166(a), taxpayers are permitted an ordinary bad debt deduction for any business debt that becomes partially or wholly worthless within the tax year. For taxpayers other than corporations, Sec. 166(a) does not apply to nonbusiness debt, which is only deductible when it becomes wholly (not partially) worthless and which is deductible by noncorporate taxpayers only as a short-term capital loss (Sec. 166(d)(1)). Additionally, under Sec. 166(e), a Sec. 166(a) bad debt deduction is not permitted if the debt is a “security” as defined in Sec. 165(g)(2)(C).

A “security” under Sec. 165(g)(2)(C) includes a bond, debenture, note, certificate, or other evidence of indebtedness, issued by a corporation, government, or political subdivision with interest coupons or in registered form. So, a debt issued by a corporation in registered form is a “security” under Sec. 165(g)(2)(C). As a result, the finco is not entitled to a deduction under Sec. 166(a) for a partially or wholly worthless debt. Instead, the finco can claim a Sec. 165(g) worthless security loss in the year the debt becomes wholly worthless. The character of the loss depends on whether the debt is a capital or noncapital asset (Regs. Sec. 1.165-5).

By definition under Sec. 165(g)(2)(C), debt issued by an individual, partnership, trust, or any other issuer that is not a corporation, government, or political subdivision is not a security, and the finco can claim a full or partial worthless ordinary bad debt deduction under Sec. 166(a). As a result, the entity type of the underlying issuer dictates the timing and character of the loss recognized by the finco rather than by reference to whether the lending transaction was entered into in the ordinary course of the finco’s trade or business or for investment purposes. Nonetheless, any loan that is a security and becomes wholly worthless can be deducted by the finco only under Sec. 165(g).

Capital or Ordinary Loss Under Sec. 165(g)

If a debt security becomes wholly worthless during a tax year and is a capital asset, the loss is treated as a loss from the sale or exchange of a capital asset on the last day of the tax year (Sec. 165(g)(1)). If the loan is not a capital asset in the hands of the finco, the loss is ordinary and recognized during the year it becomes wholly worthless under Sec. 165(a) (Regs. Sec. 1.165-5(b)). However, determining whether the loan is a capital or ordinary asset can be rather complicated.

In Arkansas Best Corp., 485 U.S. 212 (1988), the Supreme Court rejected the position it had adopted in Corn Products Refining Co., 350 U.S. 46 (1956), that “profits and losses arising from the everyday operation of a business [should] be considered as ordinary income or loss rather than capital gain or loss.” Applying Arkansas Best, a debt security is a capital asset unless it falls within one of the specific exceptions to capital treatment in the Code.

One exception to capital treatment applies for banks and financial institutions that make loans described in Sec. 582 or Sec. 591. Additionally, there are two other statutory exceptions for capital loss treatment under the mark-to-market rules: (1) for securities dealers under Sec. 475(a); and (2) for securities traders that make an election under Sec. 475(f) (see Thornton, “Deducting Losses on Worthless Investment Securities,” below). However, a finco is usually not a bank or financial institution or a securities dealer or trader.

Another exception to the capital asset treatment applies under Sec. 165(g)(3) if the corporate issuer is affiliated with the domestic corporate holder. A corporation will be treated as affiliated if (1) the corporate holder directly owns stock in the corporate issuer and meets the requirements of Sec. 1504(a)(2); and (2) more than 90% of the aggregate of its gross receipts for all tax years is from sources other than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of stocks and securities. A finco of a hedge fund and private-equity fund generally does not meet the Sec. 165(g)(3)(A) affiliation requirements with the corporate obligor.

The only other exceptions to capital treatment are for specific types of assets in Sec. 1221, which generally defines capital assets as everything other than those assets specifically enumerated in Sec. 1221. The primary exception that might apply to a finco is under Sec. 1221(a)(4), which states that a capital asset does not include receivables and notes acquired in the ordinary course of a trade or business for services rendered. In Burbank Liquidating Corp., 39 T.C. 999 (1963), the Tax Court held that loans originated in the ordinary course of the taxpayer’s savings and loan business were considered ordinary assets under Sec. 1221(a)(4). The decision was based on the premise that the “business of a savings and loan company could properly be described as ‘rendering the service’ of making loans” (39 T.C. at 1009–10). Practitioners should consider the applicability of this case when determining whether the finco acquires notes for services rendered.

Even though the IRS had a history of acquiescing to Burbank and has cited the case in a number of rulings that applied ordinary treatment to loans originated by a variety of lenders, Treasury issued Prop. Regs. Sec. 1.1221-1(e)(1) in August 2006 (REG-109367-06) that would have reversed the holdings in Burbank (see Thornton, “Prop. Regs. Create Capital Gains and Losses for Non-Bank Lenders,” 38 The Tax Adviser 503 (September 2007)). A short time after, the IRS withdrew the proposed regulations in Announcement 2008-41. The IRS stated in the announcement, “[it] will not challenge return reporting positions of taxpayers under section 1221(a)(4) that apply existing law, including Burbank Liquidating . . .” Accordingly, the holdings in Burbank can arguably be available to a finco on a particular set of facts resulting in ordinary loss treatment for the wholly worthless debt security.

Registered Form

A debt is in “registered form” if: (1) the obligation is registered as to both principal and interest and transfer of the obligation can only happen with the surrender of the old instrument and either the reissuance or issuance of a new instrument by the issuer of the old instrument to the new holder; (2) the right to the principal of, and interest on, the obligation may be transferred only through a book-entry system maintained by the issuer (or its agent); or (3) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and may be transferred through both of the preceding methods (Regs. Sec. 5f.103-1(c)(1)). Under Regs. Sec. 5f.103-1(c)(2), an obligation is considered transferable through a book-entry system if the ownership of an interest in the obligation is required to be reflected in a book entry, whether or not physical securities are issued. For purposes of Regs. Sec. 5f.103-1(c)(2), a book entry is a record of ownership that identifies the owner of an interest on the obligation. Inasmuch as debt instruments commonly include a clause restricting transferability and a book-entry system is typically used by a finco, most debt instruments held by a finco will be in registered form.

Under Rev. Rul. 73-101, it appears that a corporation’s obligation that is issued in registered form can be unregistered for purposes of claiming a full or partial worthlessness deduction under Sec. 166(a). Unregistration occurred under the revenue ruling when the registration language was actually removed from the face of the debentures and the underlying loan contracts. Rev. Rul. 73-101 appears to provide a planning opportunity for fincos; however, advisers of the finco and corporate obligor need to consider the potential issues related to unregistered obligations, such as Sec. 163(f), which disallows the deduction for interest on certain obligations not in registered form.


If a finco has a loan issued by a corporate entity that is in registered form, the loan is a security under Sec. 165(g)(2)(C) and the finco is generally entitled to a loss under Sec. 165(a) in the year the debt security becomes wholly worthless. The resulting loss is treated as a loss from the sale or exchange of a capital asset occurring on the last day of the tax year under Sec. 165(g)(1). If the finco can properly apply the findings of Burbank, the loss will be ordinary and recognized during the year it becomes wholly worthless under Sec. 165(a) (Regs. Sec. 1.165-5(b)). If the note is issued by a noncorporate, nongovernmental entity, and it is a business bad debt for a noncorporate holder, the loan is not a security under Sec. 165(g)(2)(C), and the loss is ordinary and recognized during the year it becomes partially or wholly worthless under Sec. 166(a). Accordingly, the type of the issuing entity determines when the finco recognizes a full or partial worthless deduction, its character, and the timing. If the loan is issued by a corporation in registered form, it appears that the loan could be unregistered for purposes of qualifying for a full or partial worthlessness deduction under Sec. 166(a) (Rev. Rul. 73-101). However, practitioners need to be aware of other potential implications of a corporate obligor’s issuing an unregistered note.


Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.

For additional information about these items, contact Mr. O’Connell at 630-574-1619 or .

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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