For accrual-basis financial institutions, there has long been a debate on the taxability of interest for loans that are past due. This debate centers on the difference in treatment between federal banking and IRS rules. Bank regulatory guidance always requires that the interest on a loan that is more than 90 days past due may no longer be accrued into income, and the interest previously recognized into income must also be reversed. However, the IRS has long disagreed with this treatment and has required current recognition of income provided a reasonable expectation of payment exists. In May 2007, in an effort to both reaffirm and clarify its position on accrued but uncollected interest, the IRS issued Rev. Rul. 2007-32 and Rev. Proc. 2007-33.
Rev. Rul. 2007-32
Rev. Rul. 2007-32 provides guidance on a specific factual situation. The key issues addressed are: (1) the recognition of uncollected accrued interest, (2) the impact of the bad-debt conformity election on the recognition of uncollected interest, and (3) the treatment of any subsequent payments that the bank receives on the loan. In the ruling, X, a banking corporation, determines its taxable income using the accrual method of accounting and is a calendar-year taxpayer.
X is regulated by federal banking authorities and is required to comply with federal banking rules when preparing regulatory financial statements. Unless a loan is both well secured and in the process of collection, regulatory rules require that X suspend the recognition of uncollected accrued interest into income and reverse any previously recognized interest if certain factors are met. These factors include: (1) the loan is maintained on a cash basis because of deterioration in the borrower’s financial condition; (2) payment in full of principal or interest is not expected; and (3) payment of principal or interest has been in default for a period of 90 days or more. A loan meeting these criteria is referred to as a “nonaccrual loan receivable” in the ruling.
Generally, federal banking rules also require X to apply any payment received on a nonaccrual loan receivable as a reduction to its recorded investment in the loan, to the extent necessary to eliminate the doubt of uncollectibility. Thus any payment received by X on a nonaccrual loan receivable is treated as a reduction in the loan balance until the loan balance is reduced to an amount deemed to be fully collectible. Any amounts received that exceed the loan balance would then be recorded as interest income.
In the ruling, X classifies Loan A as a nonaccrual loan receivable for regulatory financial statement purposes on January 16, 2007, because an amount of principal or interest on the loan has become more than 90 days past due. X reasonably expects the borrower of Loan A to continue making some but not all payments on the loan. The uncollected accrued interest on Loan A on January 16, 2007, is $9,000, of which $8,000 is attributable to 2006 and $1,000 is attributable to 2007. For regulatory financial statement purposes, X recognized the $9,000 as income prior to January 17, 2007. An additional $23,000 of accrued interest becomes due on Loan A during the period January 17–December 31, 2007.
Under federal banking rules, on January 16, 2007, X is required to reverse the $9,000 of uncollected accrued interest that had previously been recognized. The $23,000 of accrued interest attributable to the period January 17–December 31, 2007, also is not permitted to be recognized as income on the regulatory financial statements.
On January 1, 2008, X receives a $31,000 payment on Loan A. This payment, for regulatory financial statement purposes, is treated as a recovery of principal rather than a recovery of accrued interest; X therefore does not recognize any of the $31,000 as interest income. Under the most recent examination by the federal banking authorities of X’s regulatory financial statements and lending practices, it is determined that X maintains and applies standards consistent with federal banking rules.
Recognizing interest income: When applying this particular factual situation to the issues outlined in the ruling, the first issue raised is whether the interest income no longer being recognized for regulatory financial statement purposes should also not be recognized for federal income tax purposes. Under Regs. Sec. 1.451-1(a), X is generally required to include accrued interest in gross income in the year that all the events have occurred that fix the right to receive such interest and the amount can be determined with reasonable accuracy. Under the all-events test, a taxpayer’s right to receive income becomes fixed on the earlier of the date that (1) payment is earned through performance; (2) payment is due; or (3) payment is actually received.
The ruling states that the rules established for regulatory financial statement purposes are not controlling for federal income tax purposes, citing Old Colony R.R. Co., 284 US 552 (1932). In that case, the interest income on a nonaccrual loan receivable was not permitted to be recognized as income for financial reporting purposes; however, the taxing authority prescribed the rules needed to determine the amount, if any, of interest related to the nonaccrual loan receivable that should be recognized for federal income tax purposes.
Rev. Rul. 80-361 states that when an income item is properly accrued and subsequently becomes uncollectible, the taxpayer’s remedy is through a bad-debt deduction under Sec. 166, rather than the reversal of such an accrual. This rule is also applicable when the item is accrued and becomes uncollectible during the same tax year.
Because X reasonably expects the borrower of Loan A to continue to make some, but not all, of the payments, X has a reasonable expectation to receive payment. The payment made by the Loan A borrower of $31,000 in 2008 demonstrates this reasonable expectation. The “no reasonable expectancy of payment” exception to the general accrual rule (as described in Koehring Co., 421 F2d 715 (Ct. Cl. 1970)) does not apply.
Consequently, under the facts described above, X is required to recognize the $8,000 of uncollected accrued interest as income in X’s 2006 tax year for federal income tax purposes. X also is required to recognize the $24,000 of uncollected accrued interest in X’s 2007 tax year. This position simply reaffirms the historical IRS position and does not represent a change.
Recognizing uncollected interest: The second issue in the ruling addresses how the bad-debt-conformity method of accounting affects the recognition of uncollected interest. This method of accounting is described in Regs. Sec. 1.166-2(d). If a bank that is subject to supervision by federal authorities charges off a debt in whole or in part either in obedience to the specific order of such authorities or in accordance with established policies of such authorities, to the extent that the debt is charged off during the year, it will be presumed to have also become worthless during the tax year. On the first review of the bank subsequent to the charge-off, the federal authorities must also confirm in writing that the charge-off would have been subject to such orders if the review had been made on the date of the charge-off.
In connection with the most recent examination of X’s regulatory financial statements, X’s supervisory authorities have determined that X maintains and applies standards consistent with federal banking rules. Under Rev. Proc. 92-84, this satisfies the written requirement supporting the charge-off and under Regs. Sec. 1.1662(d)(3)(iii)(D) is known as the express determination requirement.
As stated above, on January 16, 2007, X reversed the recognition of the $9,000 of pre-January 17, 2007, uncollected accrued interest as interest income on Loan A for regulatory financial statement purposes. This reversal removes the interest receivable from X’s books and records for regulatory financial statement purposes and constitutes a 2007 charge-off of the interest receivable as a loss asset for purposes of Regs. Sec. 1.166-2(d)(3)(ii)(C). As discussed earlier, X also will treat the $9,000 as taxable interest income ($8,000 in 2006 and $1,000 in 2007) due to the reasonable expectation of payment.
For regulatory purposes,
X did not recognize as income any of the $23,000 of
accrued interest attributable to the period January 17–
December 31, 2007. Under these circumstances, and due to
X’s conformity election for tax purposes, X will
treat the interest income of $23,000, for federal income tax
purposes, as being fully recognized into 2007 taxable income,
followed by an immediate charge-off of the uncollected accrued
interest receivable as a loss asset.
Payments for nonaccrual loan receivable: The final issue raised in the ruling is the treatment of payments made by the borrower for a loan that is considered a nonaccrual loan receivable. Under Regs. Sec. 1.446-2(e), in general, each payment made on a loan is treated as a payment of interest, to the extent of any accrued interest uncollected on the date the payment becomes due. The interest inclusion applies to all payments made on a loan, regardless of whether or not the taxpayer previously recognized uncollected accrued interest for federal income tax purposes. In addition, the interest characterization would apply to a payment on a loan for which the uncollected accrued interest was previously recognized as income for federal income tax purposes and subsequently deducted as a worthless bad debt under the taxpayer’s method of accounting.
As indicated above, in the case of X, the $31,000 payment made by the Loan A borrower on January 1, 2008, will be treated as a payment of principal for regulatory financial reporting purposes. However, for federal income tax purposes, X is required to characterize any payment received on Loan A as a payment of interest to the extent there is uncollected accrued interest outstanding on Loan A.
Prior to the receipt of the $31,000 payment on January 1, 2008, the uncollected accrued interest on Loan A is $32,000. Therefore, X is required to characterize the payment on Loan A as a payment of interest for federal income tax purposes. The characterization of the payment as interest would be the same regardless of whether (1) X had not yet recognized the $32,000 of uncollected accrued interest on Loan A as income under its method of accounting for federal income tax purposes; (2) X had recognized the $32,000 of uncollected accrued interest on Loan A as income for federal income tax purposes but subsequently deducted the interest receivable as a bad debt under Sec. 166; or (3) X used a bad-debt-conformity method of accounting.
In summary, the ruling reaffirms the IRS’s position requiring current recognition of uncollected but accrued interest income if a reasonable expectation of payment exists, despite conflicting regulatory financial reporting rules. However, if X makes the bad-debt-conformity election, the accrued interest receivable related to Loan A is considered worthless for purposes of Sec. 166 in the year the amount is charged off for regulatory financial statement purposes. Therefore, for federal income tax purposes, X is allowed a worthless bad debt deduction for the amount of uncollected accrued interest written off for regulatory financial statement purposes. X is required to characterize subsequent payments received as a payment of interest for federal income tax purposes and not a reduction to the loan principal balance.
Rev. Proc. 2007-33 Safe Harbor
Rev. Proc. 2007-33 describes the procedures, effective for tax years ending on or after May 21, 2007, in which a taxpayer may change its method of accounting for uncollected interest to elect a safe-harbor method of accounting. It applies to a “bank” as defined in Regs. Sec. 1.166-2(d)(4)(i) that meets the following qualifications: (1) it uses an accrual method of accounting to determine its taxable income for federal income tax purposes; (2) it is subject to supervision by federal authorities or by state authorities maintaining substantially equivalent standards; and (3) it has uncollected interest, other than interest such as original issue discount, which is considered to have a reasonable expectation of payment.
When using the safe-harbor method, a bank determines for each tax year the amount of uncollected interest for which it has a reasonable expectancy of payment. To compute this amount, the total accrued (as determined under Regs. Sec. 1.446-2) but uncollected interest for the year is multiplied by the bank’s recovery percentage for that year. The recovery percentage is calculated by dividing the total payments that the bank received on loans (including principal and interest) during the five tax years immediately preceding the tax year by the total amounts that were due and payable to the bank on loans during the same five tax years. The calculation of the recovery percentage is limited to 100% and must be calculated to at least four decimal places.
The recovery percentage calculation must also
consider the impact of any acquisitions and dispositions. When a
bank acquires the major portion of a trade or business of another
person (predecessor) or the major portion of a separate unit of a
trade or business of a predecessor, the recovery percentage
calculation must in-
clude the data from the predecessor’s
preceding tax years attributable to the portion of the trade or
business acquired. Similarly, when a bank disposes of a major
portion of a trade or business or the major portion of a separate
unit of a trade or business, the recovery percentage must exclude
the data from the bank’s preceding tax years attributable to the
disposed portion of the trade or business.
Example: Bank X is a calendar-year taxpayer that uses the accrual method of accounting. For 2007, X’s accrued but uncollected interest is $51,600. The total amount of payments received and the total amount of payments due on all loans during the preceding five tax years were $73,048,313 and $74,900,705, respectively. To determine the portion of the accrued but uncollected interest for which there is a reasonable expectancy of payment, the recovery percentage for 2007 must first be calculated. This is determined by dividing $73,048,313 (total payments received during the preceding five tax years) by $74,900,705 (total payments due and payable during those years). This calculation yields a recovery percentage of 97.5269%. This percentage is then multiplied by $51,600, X’s total accrued but uncollected interest for the 2007 tax year, resulting in $50,323.88 of uncollected interest that X has a reasonable expectancy of payment. Therefore, for the 2007 tax year, $50,323.88 of interest is included in X’s federal taxable income, and $1,276.12 is excluded from X’s federal taxable income.
To use the safe-harbor method, a bank is required to change its accounting method relating to the treatment of uncollected interest income. A bank with six or more years of collection experience will follow the automatic change-in-accounting-methods provisions as described in Rev. Proc. 2002-9, except that the limitations of Section 4.02 of that revenue procedure do not apply to a bank that makes the change for either its first or second tax year ending on or after December 31, 2006. A bank with fewer than six years of collection experience will follow the regular consent procedures as described in Rev. Proc. 97-27 (as modified by Rev. Proc. 2002-19, as modified by Rev. Proc. 2002-54). However, the limitations of Sections 4.02(2)–4.02(6) of Rev. Proc. 97-27 do not apply to a bank that makes the change for either its first or second tax year ending on or after December 31, 2006. To the extent that a bank changes its accounting method, a Sec. 481 adjustment will be required.
By filing an application for change in accounting method to elect the safe-harbor method, the uncertainty surrounding the taxability of interest income on certain loans is removed. However, Rev. Proc. 2007-33 does not address the appropriate treatment of payments received in future years. The IRS is requesting comments to address this issue as well as any other comments.
EditorsNotes
Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.
Unless otherwise noted, contributors are independent members of Crowe Chizek.
If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.
