IRS Bad Debt Directive – Practical Considerations
Tabitha Lamontagne, Tax Principal
In October of 2014, the IRS Large Business & International Division released Directive 04-1014-008 to its auditors instructing them not to challenge bad debt deductions of banks using the specific charge-off method, provided that the deductions do not exceed the loan charge-offs and debt securities impairment write downs reported by the bank to its regulators and/or on its SEC filings. In addition, it also instructs auditors not to challenge deductions of estimated selling costs included in the charge-offs reported in the bank’s Applicable Financial Statement (AFS) typically included when valuing OREO as it is taken in foreclosure. The Directive is not applicable to banks using the reserve method under IRC §585.
Adopting the Directive - With Adjustment
The Directive allows banks (on an entity-by-entity basis) to adopt its provisions by amending returns as early as the 2010 tax year, and up to tax years beginning in 2014, with a first year adjustment (which in oversimplified terms, adjusts the tax basis of the loans and debt securities to equal the book basis). Once elected, the method must be consistently applied going forward. Many community banks have been following the methods provided in the Directive, so an adjustment may not be needed to apply the provisions.
Adopting the Directive – No Adjustment; Conformity Election in Place
The Directive can provide protection to Banks already under the conformity election if an Express Determination Letter was not obtained from the regulators. In addition, it will cover the deduction for the estimated selling costs of OREO not covered by the conformity election.
Adopting the Directive – No Adjustment; No Conformity Election in Place
An adjustment to elect the Directive is likely not needed if the Bank has already been deducting charge-offs that match its AFS. Therefore if this is the case, the adoption of the Directive will only formally take place upon examination of the tax year.
Upon examination, if the Bank chooses to adopt the provisions under the Directive, it would do so by informing the examiner and providing a copy of a signed Certification Statement within 30 days. The statement must be signed by the individual authorized to execute the federal tax return. To mitigate the risk due to employee turnover between the time the tax return is filed and under examination, it is recommended to prepare the statement at the same time as the return filing and maintain the statement with the Bank’s copy of the return. A statement must be prepared and signed for each applicable entity within a consolidated tax return.
Note that if the Bank did not have a first-year adjustment, the only way to elect the Directive aside from complying each year is to provide a signed Certification Statement to the examiner within 30 days of the request. If the authorized individual responsible for filing the tax return is no longer with the Bank, you may miss out on the protections the Directive provides for the bad debt deductions for the applicable year(s).
It should also be noted that the Directive is not an official pronouncement of law, and cannot be cited or relied on as such.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.