This article was written by Jack Johnson, Manager, Tax.
Treasury recently issued Proposed Regulations which provide guidance as to whether a loan is presumed conclusively to be worthless for federal income tax purposes under §166. These proposed rules present both opportunities and pitfalls for banks and leave many key questions unanswered. Whether a bank should take advantage of these Proposed Regulations depends upon a number of factors that are discussed below.
For purposes of deducting bad debts, banks presently may use a number of different approaches:
- Facts and circumstances – Under this approach, there is no conclusive presumption of worthlessness. The IRS is free to challenge the bad debt deduction on audit, including challenging the value of loan collateral. Under this approach, a bank may claim a deduction for partial worthlessness of a loan in the current tax year or may defer the partial worthlessness deduction to a future tax year. Loans that become wholly worthless in a tax year must be charged off in that tax year.
- Banks with average adjusted basis of assets of $500 million or less are allowed a bad debt deduction for an addition to the reserve for loan losses which cannot exceed the amount determined under the Experience Method as provided in IRC §585. This essentially places a cap on the tax bad debt deduction.
- Under the more common of two alternate conclusive presumptions of worthlessness, a bank (but not a subsidiary nonbank entity) may claim a bad debt deduction for loans wholly or partially charged off under what is commonly referred to as a conformity method election if the bank’s federal or state regulator issues an express determination letter that the bank uses loan classification standards that are consistent with the regulator’s standards. In this case, the deduction for total or partial worthlessness must be claimed in the same tax year as the loan is charged off for regulatory purposes. Some larger banks utilize this approach to minimize uncertainty over their tax bad debt deduction for financial reporting purposes.
- Under a 2014 IRS Industry Directive, IRS examiners were directed not to dispute a bank’s deduction for wholly or partially charged off bad debts where the bank has used the third approach above, even if the bank has not obtained the required regulatory determination letter. While this Industry Directive was only allowed to be elected by banks in connection with filing the federal income tax return for the 2014 tax year, under its terms banks are required to follow the Industry Directive going forward until otherwise directed. This regulatory relief extended to certain non-bank entities as well.
The Proposed Regulations – The Allowance Charge-off Method
The Proposed Regulations update existing Regulations to generally permit banks (and some, but not all other nonbank related entities) to conclusively presume that charge-offs made in accordance with GAAP satisfy the requirements for bad debt deductions under §166 (the Allowance Charge-off Method).
The Proposed Regulations require that “The debt is charged off from the allowance for credit losses in accordance with GAAP and recorded in the period in which the debt is deemed uncollectible on the applicable financial statement.” This requirement may be problematic, since banks may record credit related impairment on loans in ways other than as a direct charge-off to the allowance for credit losses (i.e.- a credit mark against loans where purchase accounting is required, etc.).
Additionally, the Proposed Regulations define “charge-off” to mean an accounting entry that reduces the basis of the debt in connection with the debt being recorded in whole or in part as a “loss asset.” The term loss asset was a historical regulatory concept as opposed to a GAAP concept.
Finally, the Proposed Regulations would not apply to bank owned Real Estate Investment Trusts (“REIT’s”), which are commonly used by banks for real estate loans. A bank adopting the Allowance Charge-off Method would thus not obtain conclusive presumption of worthlessness for charge-offs of loans in its REIT.
The Proposed Regulations note that the proposed Allowance Charge-off Method is a method of accounting requiring IRS consent. This would typically require the taxpayer to file Form 3115 with the Internal Revenue Service National Office. It is possible, but not a given, that the IRS may, when finalizing the Proposed Regulations, allow taxpayers to elect the Allowance Charge Off Method by attaching an election to their applicable tax returns or otherwise making the method change automatic, thus not requiring IRS National Office consent.
Effective Date
The new Allowance Charge Off Method Proposed Regulations will become effective upon publication of Final Regulations in the Federal Register, but taxpayers may adopt the Proposed Regulations in tax years ending after December 28, 2023 – thus calendar year taxpayers may adopt the regulations for their 2023 returns.
Reasons To Adopt the Allowance Charge-off Method
Banks adopting the Allowance Charge-off Method will be deemed to meet the conclusive presumption of worthlessness for bad debts and thus would not be subject to IRS challenge on audit that loans are not wholly or partially worthless. The Allowance Charge-off Method also provides an adopting Bank with a measure of certainty with regard to the timing of the deductibility of its bad debts, which may be helpful for purposes of the Bank’s financial statements. Finally, Banks adopting the Allowance Charge-off Method should not face exposure (at the Bank entity level) with regard to potential IRS adjustments for non-accrual loan interest, since any non-accrued interest is deemed to be charged off under the Allowance Charge-off Method.
Reasons Not to Adopt the Allowance Charge-off Method
One reason NOT to adopt this new method of accounting for tax bad debts is if the Bank is planning an acquisition and the Target Bank may possibly have net unrealized built-in losses on its loans (“NUBIL”). An acquiring Bank not on the Allowance Charge-off Method can defer partial charge-offs to a future tax year and avoid post-merger charge-offs being treated as recognized built-in losses (“RBILS”) that are treated similarly to net operating losses and are subject to limitation under IRC §382.
Additionally, Banks with substantial loans in REITs would not, as the Proposed Regulations are currently drafted, be able to have the conclusive presumption of worthlessness apply to charge-off of REIT loans.
Banks that are concerned with the definitions of charge-off and loss asset in the Proposed Regulations, or that have substantial loans in REITs, may want to defer deciding whether to adopt the Proposed Regulations until they are finalized, in order to see if the Final Regulations are more favorable with regard to these issues.
Finally, Banks using the Experience Method of IRC §585 to calculate their tax bad debt deduction should generally be allowed a deduction sufficient to bring their tax bad debt reserve up to the base year amount.
Note that the Allowance Charge-off Method outlined in these proposed regulations is not available to “Ineligible Companies” such as credit unions and US branches of foreign banks.
This article is only meant to be an overview of some of the considerations involved in deciding whether to utilize the Allowance Charge-off Method. We would be glad to discuss this matter further with you at your convenience.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
