Industry Issue Resolution Pilot Program under
Notice 2000-65
Financial Services Issues
Contents | Introduction | I | II | III
Problem Loans - Bad Debt Charge-offs
Disputes between lenders and the IRS on the deductibility of bad debts often focus on
whether the debt was worthless in the year in which the deduction was claimed. As noted in
the Treasury study, "[a]n inherent difficulty in identifying the year of deduction is
that worthlessness often results from a gradual deterioration in the debtor’s
financial condition rather than an easily identifiable event." A taxpayer may claim a
deduction for financial, regulatory and/or tax purposes without discharging the
borrower’s obligation under the debt, thereby creating an additional complication of
possible recovery of the loss after the year in which the tax deduction is claimed. While
the taxpayer must evaluate these factors when the tax return is filed, the IRS examination
of that return often occurs several years later, with the benefit of hindsight.
Over many years the regulations under IRC section 166 have provided several different
mechanisms for banks or other regulated corporations to establish the evidence necessary
to support a bad debt deduction. In 1921, language was promulgated that is today contained
in regulation section 1.166-2(d)(i) that worthlessness was presumed where the charge-off
occurred "in obedience to the specific orders of [Federal or state supervisory]
authorities." In 1973, that language was expanded in regulation section
1.166-2(d)(ii) to include cases where the charge off was made in accordance with
established policies of such authorities and confirmed in writing upon the next
examination. In 1992, the bad debt conformity election was provided in regulation section
1.166-2(d)(3), under certain circumstances, for a conclusive presumption for banks to
claim deductions based on their regulatory charge-offs.
Each of these provisions was rooted in the need for banks to have a practical method
for claiming deductions for bad debts without having factual disputes about the deductions
on the basis of hindsight. More importantly, however, the 1991 Treasury study states,
"[i]t is unlikely that banks and other regulated institutions would exploit the
conservatism of the regulators to the serious detriment of the tax system." Based on
our experience working with bank clients, the proposition can be stated more directly -
the requirement that banks claim a charge-off for financial statement and regulatory
purposes serves as an effective discipline against inappropriate acceleration of tax
deductions for bad debts. In many cases, however, the IRS examination of bank bad debt
charge-offs starts with an apparent assumption that the banks are accelerating deductions
under section 166. The conclusive presumption of worthlessness under the conformity
election, which was intended to ease disputes over bad debts, is not working as well as it
should.
First, many bank taxpayers have not adopted the conformity election because of one
particular requirement in the regulations. Regulation section 1.166-2(d)(3)(ii)(A)(1)
provides that the conclusive presumption applies only if the debt was categorized as a
"loss asset" at the time of charge-off. As noted above, loans frequently
deteriorate over time and a loan can decline in classification standards between the
evaluation periods from a level above "loss asset" directly down to the level of
"charge-off" for regulatory purposes, without technically stopping at the loss
asset classification. Many banks have regulatory classification systems that do not
accommodate this artificial IRS requirement that a deteriorating loan stop at the loss
asset classification before being charged-off. This requirement effectively prevents many
banks from adopting a needed practical mechanism for establishing that their bad debts are
worthless for tax purposes. Banks that have adopted the conformity election, but claim
deductions for charge-offs that were not classified as loss assets, run the risk of having
the IRS revoke the election.3
Second, some of the banks that have adopted the conformity election have nonetheless
experienced IRS challenges to their bad debt deductions. Some of these challenges are
appropriate. Many, however, involve requests for information that are inconsistent with
the existence of the conformity election (e.g. valuation of collateral) or propose to
challenge the use of the conformity election on grounds not specified in the regulation.4 In far
too many cases, taxpayers find themselves once again facing a loan by loan evaluation of
charge-offs by the IRS.
We believe that the Service should revisit the issue of bank bad debt charge-offs
generally. Regardless of whether a bank taxpayer claims deductions under the traditional
standards of section 166 or whether it has adopted the conformity election, the IRS audit
guidelines should instruct IRS examiners that a book charge-off is a strong factor to
support the worthlessness of a bad debt for tax. IRS examinations of loan losses where no
conformity election has been made should focus on a sampling of larger loans, and rely on
the appropriate bank regulatory agency standard of delinquency time for charge-offs of
small dollar loans. Finally the Service should revise the conformity election by
eliminating the "loss account" requirement and redirecting the focus on the
initial field examination to the three bases cited in Chief Counsel Advice 200027036 as
grounds for IRS to revoke the conformity election. This would effectively expand the
availability and the usefulness of the conformity election for both the IRS and bank
taxpayers.
Contents | Introduction
| I | II | III |