Bank's Mutual Fund Losses Were Not Ordinary Losses.

In 1990 and 1991, Bank C purchased shares in several mutual funds that invested in government bonds; these funds went down in value. On its returns, C claimed these losses as ordinary losses under Sec. 582(c) (deductible fully against its income), rather than as capital losses (which could only be netted against its capital gains). The IRS challenged this treatment, and the District Court (opinion Hood, J.) holds for the Service.

During the tax periods at issue, Sec. 582(c)(1) read:

[T]he sale or exchange of a bond, debenture, note, or certificate or other evidence of indebtedness shall not be considered a sale or exchange of a capital asset. For purposes of the preceding sentence, any regular or residual interest in a REMIC shall be treated as evidence of indebtedness.

This provision allows banks to treat certain losses and gains on specific types of investments as ordinary. C asserts that its mutual fund losses fall under the category of "evidence of indebtedness" and should be treated as ordinary.

For an instrument to fall within the "evidence of indebtedness" category, it must have the essential characteristics of debt instruments, such as the repayment of principal. Although the mutual funds in this case were invested in guaranteed U.S. debt securities, the funds themselves gave no assurances that the investor would ever receive a return of principal.

Even though the bonds owned by C's mutual funds promise to pay the principal (with interest) back to the fund, the mutual funds make no such guarantee to C. This shows that the mutual fund is a separate entity from the investor, and that the mutual fund, not the investor, is the owner of the bonds. The fund also does not promise a fixed yield, unlike a bond. In a nutshell, shares of mutual funds do not have the characteristics of debt instruments and, hence, they do not fall within the "evidence of indebtedness" category.

C also argues that the court should look to the substance of the transaction, not the form. The problem, however, is that this is not a sham transaction. The "substance over form" argument is applicable only when a transaction is tax-motivated. If economic forces drive a transaction, the taxpayer is bound by the transaction's form.

In this case, C had legitimate economic reasons for choosing to purchase mutual funds. For example, C wished to obtain a diverse investment portfolio without having to purchase each security individually. By not having to purchase each security individually, it was able to save on procurement expenses. Because C's mutual fund transactions were based on legitimate economic reasons, the court must not ignore the form of the transaction.

Moreover, C's transaction is no different from a sole proprietor who incorporates his wholly owned business to reduce his personal liability. The substance of his business after incorporation is no different than if it were unincorporated; in essence, he is still the only owner. The fact is, however, the different forms result in vastly different tax consequences.

COMMUNITY TRUST BANCORP, INC., DC KY, 6/28/99