The IRS has issued proposed regulations under Section 166 that provide rules for presuming the worthlessness of debt in certain circumstances for banks and other regulated corporations. The proposed regulations would amend existing regulations under Treas. Reg. Sec. 1.166-2(d) and would apply to a regulated financial company, including certain banks and insurance companies.
Section 166(a)(1) permits a deduction for any debt that becomes worthless within a taxable year. Section 166(a)(2) provides that the Secretary may allow a deduction for debt when it is partially worthless to the extent such debt is charged off within the taxable year. The existing regulations do not define “worthless.” However, whether a debt has become worthless within a taxable year is determined by examining all evidence, including objective circumstances such as the value of the collateral and the financial condition of the debtor.
Two alternative rules under Treas. Reg. Secs. 1.166-2(d)(1) and (3) provide banks and other regulated corporations with a conclusive presumption that a debt is worthless.
The first alternative rule under Treas. Reg. Sec. 1.166-2(d)(1) provides that a bank or other regulated corporation subject to supervision by certain federal or state authorities (an “other corporation”), may conclusively presume under the “Specific Order Method” that a debt is worthless or partially worthless during a taxable year when:
- Such debt is charged off in whole or in part, and
- Such charge-off is either: (a) in obedience to a specific order from such authorities; or (b) in accordance with established policies of such authorities and upon their first audit, such authorities confirm in writing that the charge-off would have been subject to specific orders if the audit occurred on the date of the charge-off.
The second alternative rule under Treas. Reg. Sec. 1.166-2(d)(3) provides that banks can elect the “Book Conformity Method,” which provides that loans are conclusively presumed worthless to the extent charged-off during a taxable year if a bank regulator issues an express determination letter stating that such bank maintains and applies standards that are consistent with the bank regulator.
Since the existing regulations have been issued, there were significant changes to the regulatory standards and relevant accounting rules for loan charge-offs. In 2013, the IRS issued Notice 2013-35 requesting public comments related to existing regulations under Treas. Reg. Sec. 1.166-2(d). Commenters responded that the conclusive presumption regulations were outdated and contained requirements for a bad debt deduction that taxpayers could no longer satisfy. Guidance on the conclusive presumption of worthlessness for bad debts was based on recent Priority Guidance Plans from the IRS.
The proposed regulations permit a “regulated financial company” or a member of a “regulated financial group” to use a charge-off method as defined in the proposed regulations (the “Allowance Charge-off Method”) to conclusively presume a debt has become worthless or partially worthless. The IRS stated that they believe regulated financial companies and regulated financial groups described in the proposed regulations are subject to regulatory and accounting standards for charge-offs that are sufficiently similar to the federal income tax standards for Section 166.
The term “regulated financial company” is defined to include:
- Bank-holding companies that are domestic corporations
- Covered savings and loan holding companies
- National banks
- Certain banks that are members of the Federal Reserve System
- Regulated insurance companies
- The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)
- Other regulated entities.
Under the proposed regulations, a regulated financial company does not include credit unions, U.S. branches of foreign banks and non-banks that are “systematically important financial institutions.” A “regulated financial group” is defined as one or more chains of corporations connected through stock ownership with a common parent that meet certain requirements.
Generally, the Allowance Charge-Off Method would apply when a debt is charged off from the allowance for credit losses and recorded on applicable financial statements in accordance with U.S. GAAP. For a regulated insurance company, the Allowance Charge-Off Method would apply when a debt is charged off pursuant to an accounting entry or set of accounting entries that reduce the debt’s carrying value and result in a realized loss or charge on financial statements prepared in accordance with standards set forth by certain insurance regulators.
The proposed regulations are effective upon the publication of final regulations, but taxpayers may choose to apply the rules for taxable years ending on or after Dec. 28, 2023.
Change in method of accounting
The proposed regulations explicitly provide that a taxpayer’s change to the Allowance Charge-off Method constitutes a change in method of accounting because it would determine the timing of the bad debt deduction. Accordingly, the proposed regulations further provide that a change to the Allowance Charge-off Method would require the taxpayer to secure consent from the Commissioner before using the proposed method on an entity-by-entity basis. The proposed regulations also provide that a change to the Allowance Charge-off Method would require a Section 481(a) adjustment, whereas the current regulations require the accounting method change to be made on a cutoff basis.
The preamble states that those regulated financial companies, or members of regulated financial groups, that do not presently use or change to the Allowance Charge-off Method will not be entitled to a conclusive presumption of worthlessness and would generally be required to use the specific charge-off method.
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