Sec. 166 prop. regs. expand bad debt conformity for regulated entities

Editor: Rochelle Hodes, J.D., LL.M.

On Dec. 28, 2023, the IRS issued proposed regulations under Sec.  166 that would expand tax conformity with financial statement charge-offs of bad debts for certain regulated financial companies and members of regulated financial groups (REG-121010-17, 88 Fed.  Reg.  89636 (Dec. 28, 2023)). This is a welcome development because the current bad debt conformity options are outdated and restrictive. To address these concerns, the proposed regulations would create a new allowance charge-off method of accounting available to a wider group of entities and a broader class of debt obligations.

Background

Sec.  166 provides a bad debt deduction for any debt that becomes worthless during the tax year.  The timing of the deduction for regulated industries, particularly banking, has historically been a source of contention between taxpayers and the IRS. The requirements for determining worthlessness under Sec. 166 and those applied for determining charge-offs of worthless debts on the financial statements are similar. However, the determination of worthlessness often requires subjective judgment on matters such as the borrower’s financial condition, the value of collateral, and the potential cost and effectiveness of pursuing legal action.

Furthermore, there is an inherent dichotomy between the perspectives of financial regulatory agencies and the IRS with respect to bad debts (for purposes of this item, financial regulatory agencies are referred to as “regulator” or “regulatory agency”). A conservative approach to bad debt charge-offs by the regulatory agencies often translates into an aggressive approach to bad debt deductions in the eyes of the IRS. These factors can lead to disputes between taxpayers and the IRS when claiming bad debt deductions.

To provide relief, Regs. Sec. 1.166-2(d)(1) includes two safe harbors for banks and other regulated entities.  These safe harbors protect the bad debt deduction for (1) any debt charged off under specific regulatory agency orders, and (2) any debt charged off in accordance with the established policies of a regulator, provided the regulator offers written confirmation upon its subsequent examination that it would have ordered the charge-off.  However, scenarios where these safe harbors apply are not common, and frequent ordered charge-offs would likely carry more serious negative regulatory agency consequences for the taxpayer.

In 1993, the IRS published Regs. Sec. 1.166-2(d)(3) to provide an elective tax method of accounting that, if adopted, creates a conclusive presumption of worthlessness for all debts (e.g., loans) a bank classifies as “gloss assets” on the report filed with the bank’s regulatory agency. Under this method, the bank’s bad debt tax deduction is assured, but the bank must conform the timing and amount of its bad debt deductions to the timing and amount of loans so classified as loss assets.

To use this method, the bank must secure written confirmation from its primary federal regulator, referred to as the “express determination letter,” that the bank is properly applying the regulator’s loan loss classification standards during the year of the election and for each successive federal regulatory examination.  Failure to secure this letter will force the bank off the conformity method and result in the loss of its protections.  Rev. Rul. 2007-32 extends favorable treatment under the conformity method to accrued but uncollected interest income on nonperforming loans, allowing bad debt conformity treatment for uncollected interest that is prohibited from accruing on these loans for regulatory purposes.

However, despite its overall benefits, the conformity method has some drawbacks.  These include the fact that some banks cannot secure the express determination letter during troubled regulatory examination cycles, the rigidity of the timing rules, the limitation on the availability of the conformity election to certain affiliates, and the fact that the conformity protections generally do not apply to debt obligations other than loans.

Following the financial crisis of the late 2000s, the IRS Large Business and International Division (LB&I) issued two directives for auditing bad debt deductions of banks and insurance companies.

LB&I-04-0712-009, issued July 30, 2012, addresses bad debt deductions for partial worthlessness of loan-backed and structured debt securities held by regulated insurance companies for which the insurance company recorded an other-than-temporary impairment charge to earnings on its regulatory insurance statement.  Under the directive, agents will not challenge a bad debt deduction claimed by the insurance company for this type of partial worthlessness.

The second directive, LB&I-04-1014-008, issued on Oct. 24, 2014, applied to bad debt deductions of banks and certain related affiliates.  This directive was issued in response to concerns the banking industry raised about challenges in meeting the express determination letter requirement due to difficult regulatory examinations occurring at the height of the financial crisis.

LB&I-04-1014-008, which could only be adopted in tax years 2010 through 2014, instructed agents to accept bad debt deductions claimed by a bank for all loans charged off on financial statements filed with the SEC or classified as loss assets on the bank’s regulatory reports without the requirement to secure the express determination letter. The directive applied to debt securities held by a bank for which the bank recorded an other-than-temporary impairment charge on its public financial statements or regulatory reports and to bank-owned subsidiaries included on the bank’s consolidated regulatory reports.  The directive only applied to bad debts under the direct charge-off method of Sec. 166 and was unavailable to small banks deducting bad debts under Sec. 585.

The directive was not structured as a method of accounting, but rather, a cumulative-effect deduction was allowed in the year the directive was adopted to catch up prior bad debts that were not deducted under the directive’s conventions.  If the deduction claimed under the directive is audited, the taxpayer is required to provide a certification statement affirming adoption and adherence to the directive within 30 days of the agent’s request.

In 2013, the IRS issued Notice 2013-35 to request comments on the bad debt conformity regulations.  However, despite this outreach effort, it has been over 10 years since any formal final guidance has been published to update the bad debt conformity rules.

Proposed regulations

On Dec. 28, 2023, the IRS issued Prop. Regs. Sec. 1.166-2(d), which would replace the bad debt conformity method for banks with a broader method that would apply to a wider base of regulated entities.  The proposed regulations provide a conclusive presumption of worthlessness for any debt charged off by a qualified taxpayer under a prescribed bad debt charge-off method used for financial or regulatory reporting, referred to as the “allowance charge-off method.” Thus, the proposed regulations would remove the existing bank safe harbors under Regs. Sec. 1.166-2(d)(1).

The proposed conclusive presumption of worthlessness is only available to certain regulated financial companies and members of certain regulated financial groups.  The term “regulated financial company” is defined in Prop. Regs. Sec. 1.166-2(d)(4)(ii) and includes banks, thrifts and insured depository institutions, bank and thrift holding companies, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp., and regulated insurance companies.  The term “regulated financial group” is defined in Prop. Regs. Sec. 1.166-2(d) (4) (iii) and generally includes chains of corporations connected through stock ownership under a common parent under the rules of Sec. 1504(a) (2) (i.e., at least 80% direct or indirect ownership of the total voting power and value of the includible corporation’s stock).  However, regulated investment companies and real estate investment trusts are specifically excluded from these definitions and are not eligible for the conclusive presumption of worthlessness.

The allowance charge-off method, as defined in Prop. Regs. Sec. 1.166-2(d)(1)(i), is a financial accounting convention used in the preparation of an “applicable financial statement” under which wholly or partially worthless debts are charged off from the allowance for credit losses under GAAP in the period they are determined to become worthless.

Under Prop. Regs. Sec. 1.166-2(d) (4) (ix), the term “applicable financial statement” includes a financial statement prepared in accordance with GAAP that is required to be filed with the SEC; a financial statement required to be provided to a bank regulator; an insurance company financial statement prepared in accordance with GAAP that is given to creditors for purposes of making lending decisions, given to shareholders for investment decision purposes, or provided for other substantial nontax purposes; and an insurance company financial statement prepared in accordance with the standards set forth by the National Association of Insurance Commissioners (NAIC) and filed with insurance regulatory authorities.

Prop.  Regs.  Sec.  1.166-2(d)(4)(i) defines the term “charge-off” as an accounting entry on the applicable financial statement that directly reduces the debt at the time it is determined to be wholly or partially worthless.  In the case of regulated insurance company financial statements prepared in accordance with NAIC regulatory accounting requirements, the term “charge-off” has the same definition, except the offset to the debt reduction is recorded as a charge to the statement of operations (and not recorded as an unrealized loss).

The scope of the proposed conclusive presumption of worthlessness is broader than the existing bank bad debt conformity method and is less restrictive.  It incorporates many of the provisions from LB&I-04-0712-009 and LB&I-04-1014-008. For example, no express determination letter is required; certain bad debt losses on debt securities are covered (e.g., banks would be permitted to apply the conformity protection to debt securities deducted under Sec. 166 by way of Sec. 582(a)); and the rules can be applied by affiliates of a regulated bank or regulated insurance company under common control.

Unlike the existing conformity method, the allowance charge-off method does not require the taxpayer to adhere to the timing of the financial statement charge-off.  Prop.  Regs.  Sec.  1.  166-2(d)(3) permits claiming the bad debt deduction for a wholly or partially worthless debt in a later year.  For a wholly worthless debt required under Sec. 166(a)(1) to be deducted in the year total worthlessness is achieved, this means the timing of the financial statement charge-off is incorrect and the facts and circumstances support total worthlessness in the later year.  For a partially worthless debt charged off on the financial statements, Sec. 166(a)(2) offers the taxpayer a choice: claim the bad debt deduction for the partial charge-off currently or forgo the current deduction in favor of deducting it in a later year when the debt further deteriorates or becomes totally worthless.  Prop.  Regs. Sec. 1.166-2(d)(3) accommodates this elective deduction deferral for partial charge-offs.

Under Prop.  Regs. Sec. 1.166-2(d) (2) , the allowance charge-off method is a tax method of accounting, and changing to this method will require the IRS’s consent on an entity-by-entity basis.  As such, entities must file Form 3115, Application for Change in Accounting Method, to change to this new method.

According to Prop. Regs. Sec. 1. 166-2(d)(5), the new method and the changes will apply on a cut-off basis to charge-offs occurring in tax years ending on or after the date the regulations are finalized.  However, qualifying regulated financial entities can choose to apply the new method and the changes made under the proposed regulations to charge-offs occurring in tax years ending on or after Dec. 28, 2023.

The IRS issued Rev. Proc. 2024-30 to provide most regulated financial companies with the ability to adopt the allowance charge-off method under the automatic accounting method change procedures for tax years ending on or after Dec. 28, 2023.  This pronouncement reiterates that the change is to be made on a cut-off basis with no Sec. 481(a) adjustment. For those taxpayers currently on the existing bank bad debt conformity method, adopting the allowance charge-off method will be treated as a revocation of that existing method.  The only exception to the automatic change procedure is for small banks currently using the Sec.  585 bad debt reserve method; those banks must seek approval under the advance consent procedures for adoption of the allowance charge-off method.

A benefit for regulated financial entities

The proposed regulations would replace the existing bank bad debt conformity method and will become the exclusive conformity method available to banks, insurance companies, and certain of their affiliates. The proposed conformity method is more expansive and less restrictive than existing conformity provisions, and many regulated financial entities will benefit from these changes.  Also, elimination of the need to rely on nonbinding IRS examination directives provides taxpayers with increased certainty.  Although the regulations are only proposed, taxpayers can elect to apply the allowance charge-off method to bad debt charge-offs occurring in tax years ending on or after Dec. 28, 2023.

Editor notes

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.