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IRS Loosens Rules on Worthless Debt Deductions for Banks
On October 27, 2014, the IRS’s Large Business and International Division issued a directive that loan charge-off amounts reported on financial statements by banks and bank subsidiaries will generally be treated as sufficient evidence that a debt is worthless. The IRS examiners will therefore not challenge worthless debt deductions claimed by banks and regulated bank affiliates.
“This directive confirms our long-standing belief that regulatory or GAAP charge-offs meet the ‘sufficient evidence of worthlessness test’ for tax purposes,” says Brad Mattson, a financial institutions manger at CliftonLarsonAllen.
The directive does not apply to small banks (C corporations with less than $500 million in assets) that use the reserve method of accounting for loan losses. However, it applies to all other banks, even those that have not elected to use the conformity method of accounting to determine when a debt becomes worthless. Until further guidance from the IRS, a community bank no longer needs to make this conformity election, and the banks that have already made the election are not required to request an express determination from the regulators each time they have an exam.
“This change is great news for community banks that are currently under audit and also relieves the burden of future audits for banks that have not made the conformity election,” notes Mattson.
Effect on OREO property
Additionally, the directive permits charge-offs related to estimated selling costs for other real estate owned (OREO) property in the following section:
In addition, do not challenge the inclusion in the Bank or Bank Subsidiary’s bad debt deduction for Eligible Debt of estimated selling costs to the extent such estimated selling costs are included in the Charge-off reported in the Bank or Bank Subsidiary’s Applicable Financial Statement.
These had previously been capitalized to the property’s basis for tax purposes and ultimately deducted when the property was sold. This change may offer an opportunity for your bank to take a tax deduction for prior capitalized costs on properties that remain unsold. This can be done by either filing amended returns for open years or taking a cumulative one-time deduction in the current year.
Banks may apply this directive in tax years beginning in 2010 through 2014. Once a bank chooses to apply the directive, it must apply it consistently each year.