A recently released IRS Large Business and International (LB&I) division audit directive provides welcome relief for banks and bank subsidiaries by simplifying the IRS’ approach to auditing bad-debt deductions (any subsequent reference to “bank” should be considered a reference to a bank or a bank subsidiary). The directive may eliminate some of the controversy related to bad-debt deductions and offers banks the ability to amend prior-year returns to claim benefits. However, the binding nature of the directive will require careful analysis by banks prior to adoption. The directive does not apply to small banks that use the reserve method of accounting for loan losses under IRC Section 585.
Definitions of “bank,” “bank subsidiary,” “eligible debt,” “eligible debt securities,” and “applicable financial statement” are provided in the directive.
The directive provides the following guidance:
For banks using the general facts and circumstances method for bad debts, the IRS generally will not challenge a bad-debt deduction for eligible debt and eligible debt securities if the tax deduction is the same as the amount on the bank’s applicable financial statement for either:
- Credit-related impairment portion of the bank’s charge-off of eligible debt
- Credit-related impairment portion of the bank’s charge-off of eligible debt securities
For bad debts taken as a result of specific orders of federal or state banking regulators, or in accordance with the established policies of those regulators under Treasury Regulations Section 1.166-2(d)(1), the IRS will not challenge a bank’s bad-debt deduction for eligible debt and eligible debt securities if the deduction is the sum of both of the following:
- The amount of the credit-related impairment portion of the bank’s charge-off of eligible debt and the amount of the credit-related impairment portion of the bank’s charge-off of eligible debt securities as reported on its applicable financial statement
- The portion of the charge-off of eligible debt and the eligible debt securities in excess of the credit-related impairment that was taken as a result of a specific order or written confirmation (as described in Treasury Regulations Section 1.166-2(d)(1)) by a bank regulator as reported on its applicable financial statement
If a bank made a proper conformity election under Treasury Regulations Section 1.166-2(d)(3), the IRS will not challenge the bad-debt deduction even if the bank has not satisfied the express determination requirement.
The directive also allows the inclusion of estimated selling costs related to foreclosed property in computing the bad-debt deduction under any of the methods described here.
The provisions of the directive may be applied no earlier than the 2010 taxable year and no later than a taxable year that begins in 2014. Amended returns must be filed to adopt the provisions of the directive to prior tax years. Once a bank applies the directive, it must follow the methods outlined in the directive in all subsequent years. For example, if a bank desires to adopt the provisions of the directive for its 2011 tax year, it also will need to amend its 2012 and 2013 returns to apply the principles of the directive.
The directive appears to allow the changes without requiring the filing of Form 3115, “Application for Change in Accounting Method.” The directive also provides the mechanics of computing the adjustment to taxable income in the initial and subsequent years to which the directive is applied.
Upon examination, banks will be required to sign a statement certifying compliance with the requirements of the directive for each taxable year under audit.