On Oct. 24, 2014, the Internal Revenue Service (IRS) issued a directive (LB&I I-04-1014-008) regarding bad debt deductions related to eligible debt and eligible debt securities. The directive provides large business and international (LB&I) examiners with guidance on deductions for bad debts taken under Internal Revenue Code (IRC) §166. The goal of the directive is to provide administrative relief to examiners and taxpayers by accepting the charged-off amounts, including any related estimated selling costs, reported by banks and bank subsidiaries as reported for generally accepted accounting principles (GAAP) and regulatory purposes.
Currently, a bank can use four methods a bank to determine its bad debt deduction.
- The general facts and circumstances test, including the value of any collateral and the financial condition of the borrower
- The conclusive presumption rule, under which worthlessness is presumed to occur in the same year that a bank charges off a debt pursuant to federal or state bank regulatory rules and established policies, or pursuant to a specific order by a bank regulator
- The conformity election, under which worthlessness is conclusively presumed if a bank’s regulator makes an express determination that the bank maintains and applies loan loss classification standards consistent with regulatory standards through the issuance of an annual express determination letter
- The small bank (banks with less than $500 million in assets) experience or reserve method of accounting for loan losses under IRC § 585 (the directive specifically states it does not apply to this method of deducting bad debts)
IRS directive summary
If the bank or bank subsidiary presents a signed certification statement (as discussed below), examiners are directed not to challenge bad debt deductions in amounts equal to charge-offs of eligible debt and eligible debt securities reported on applicable financial statements in the following situations:
- The amount is the same as the credit-related impairment portion of its charge-off
- The bank or bank subsidiary fails to present a specific order by bank regulators or confirmation in writing under the conclusive presumption rule (not restricted to the credit-related portion of the bad debt if certified in the statement that the charge-off was pursuant to a specific order or written confirmation)
- If a proper conformity election was made regardless of whether the annual express determination letter requirement was satisfied
- If estimated selling costs are included in the charge-off
The post-deduction tax basis of the eligible debt or eligible debt securities may not be less than the post-charge-off carrying value on the applicable financial statements.
A bank or bank subsidiary may apply this directive no earlier than its 2010 tax year and no later than a tax year that begins in 2014 either on amended or originally filed returns. Once a bank chooses to apply the directive, it must continue to do so going forward. If a bank is currently under examination, the examiners and taxpayer may decide if it is appropriate to change the amount of bad debt being deducted for the open tax years under examination or to allow amended returns to be consistent with this directive.
If the taxpayer has claimed a bad debt deduction in accordance with the directive, the taxpayer must sign and complete the Certification Statement (as included with the Directive) and present it to an examiner within 30 days of the request by the examiner. The certification must be signed by an individual who is authorized to execute the taxpayer's federal income tax return for the taxable year under audit.
It is important to note that the Directive is administrative guidance and is not considered authority. Therefore, it cannot be used, cited, or relied on as such.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.