CBTW-Workshop

NOVEMBER 7-9, 2012 DISNEY CONTEMPORARY HOTEL | ORLANDO

47th

annualBANK & CAPITAL MARKETSTAX INSTITUTE

47th

annualBANK & CAPITAL MARKETS TAX INSTITUTE

WWW.BANKTAXINSTITUTE.COM

Pre-Conference Workshop

18TH ANNUAL COMMUNITY BANK TAX WORKSHOPFantasia E/F November 7th, 8:30am – 5:00pm

47th ANNUAL BANK & CAPITAL MARKETS TAX INSTITUTE DISNEY CONTEMPORARY HOTEL

Speakers:

JOHN CEDERBERG

STEVEN CORRIE

JAMES GOELLER

Eighteenth AnnualCOMMUNITY BANK TAX WORKSHOP

Contemporary HotelOrlando, FloridaNovember 7, 2012

Faculty:

JOHN E. CEDERBERG

1248 O Street, Suite 760Lincoln, NE 68508Tel (402) 475-8155

[email protected]

JAMES D. GOELLER

Partner, Crowe Horwath, LLP575 Market Street, Suite 3300

San Francisco, California 94105Tel. (415) 946-7448

[email protected]

ADVISORY BOARD MEMBER

STEVEN W. CORRIESenior Vice President - Finance

Security National Bank601 Pierce Street

Sioux City, Iowa 51101Tel (712) 277-6640

[email protected]

Summit Business MediaContemporary Hotel, Orlando Florida

November 7, 2012

Disclaimer: This outline is intended for the general information of the attendees of theEighteenth Annual Community Bank Tax Workshop. It is not intended to provide tax advice.Attendees of the Workshop must perform their own research to confirm the effect of the topicsdiscussed herein to the facts and circumstances of their respective clients.

In accordance with professional regulations of tax practitioners encompassed in InternalRevenue Service Circular 230, any written tax advice contained in, forwarded with, or attachedto this material is neither written nor intended to be used by any person for the purpose ofavoiding penalties which may be imposed under the Internal Revenue Code or applicable state orlocal tax laws, and such advice may not be used for such purpose.

Table of Contents

I. 2011 - 2012 Developments Specifically Affecting Banks . . . . . . . . . . . . . . . . . . . . . 1A. Tax Changes Specifically Affecting Banks . . . . . . . . .. . . . . . . . . . . . . . . . . . 1B. Administrative Changes . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . 2

1. Fixed Asset Regulations 22. Other Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . 5

II. IRS Examination Issues . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 6A. Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 6

1. No Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . 102. Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . 13

B. Nonaccrual Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 14C. Pre-Foreclosure Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 21D. Foreclosure Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . 23E. OREO Holding Period Costs . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . 24F. Partial Charge-offs on Securities . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . 27

III. Examiner Ordered Restatements . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 32IV. Loans Restored to the Books . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 37V. The Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . 38VI. Loan Modifications - Reg. 1.1001-3 . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . 42VII. OREO - "In Substance Foreclosures" . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . 46VIII. TARP Transactions - Gain or Loss on Sale and Section 382 . . . . . . . . . . . . . . . . . . 48IX. S Corporations - Character of Income or Loss on Foreclosed Operating Assets . . . 54X. S Corps and Life Insurance . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 59XI. S Corps at a Stock Offering Cross-Roads . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . 61XII. Trust Preferred Securities - Deferred Interest Payments . . . . . . . . . . . . . . . . . . . . 64XIII. Prohibited Transactions by Self-Directed IRA Accounts . . . . . . . . . . . . . . . . . . . . . 68XIV. Taxable Acquisitions Using the Stock of the Acquirer . . . . . . . . . . . . . . . . . . . . . . 69XV. Asset Acquisitions - Failed Bank Assets; Section 338; QSub Purchases . . . . . . . . 74XVI. Maintaining a Valid S and QSub Election . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . 82XVII. Miscellaneous Accounting Methods . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 88

A. Section 448 Change to the Accrual Method . . . . . . . . .. . . . . . . . . . . . . . . . 88B. Change by S Corporations to the Cash Method . . . . . .. . . . . . . . . . . . . . . . . 88C. Prepaid Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . 90D. Deferred Loan Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . 91

Community Bank Tax Workshop Page 1 of 912012 Outline November 7, 2012

I. 2011 - 2012 Tax Changes Specifically Affecting Banks

A. Tax Changes Specifically Affecting Bank

1. There has been no new legislation affecting banks since the Small BusinessJobs Act of 2010, enacted September 27, 2010. Many of those provisionsexpired at the end of 2011 or are set to expire at the end of 2012.

2. There is no new material litigation specifically affecting banks since the CircuitCourt decision in Vainisi and the Tax Court decision in PSB Holdings, Inc.

B. Scheduled changes in existing law.

1. The S corporation built-in gains recognition period reverted to 10 years at thebeginning of 2012.

a. The built-in gains recognition period was 7 years for 2009 and 2010.

b. It was 5 years for taxable years beginning in 2011.

c. A Representative from Missouri has introduced a bill to make 5 yearspermanent, but it has not advanced.

d. The recognition period is determined by the closing date of the asset sale,not the definitive agreement date, or even the effective date.

2. Depreciation.

a. Bonus depreciation

(1) 100% from September 9, 2010 through December 31, 2011.(2) 50% during calendar year 2012(3) Expires under present law at December 31, 2012.

b. Section 179 first year depreciation.

(1) $500,000 for taxable years beginning in 2010 and 2011.

(a) The threshold of total additions for the phase-out of Section179 depreciation was $2 million for both years.

(2) $139,000 for 2012.

(a) The threshold of total additions for the phase-out is $560,000.


1 Sec. 179(d)(1).

2 Sec. 162(l)(4).

(3) The deduction is scheduled to revert to $25,000 for 2013.

(a) The threshold of total additions for the phase-out is scheduledto be $200,000.

c. Computer software is included in Section 179 property through 2012.1

d. Certain real estate was Section 179 property during 2010 and 2011, butthat provision was not extended to 2012. The most likely propertyapplicable to banks was qualified leasehold improvements described inSections 168(e)(6) and (k)(3).

3. The 2010 exclusion from self-employment income for self-employed healthinsurance costs was not extended to 2011 or 2012.2

C. The new fixed asset Regulations

1. Issued in December 2011 in Proposed and Temporary form. Effective for2012.

2. The Service’s third attempt to issue more detailed Regulations on capitalizationv. expensing of fixed asset related costs. The previous “editions” were only inProposed form, and have been withdrawn.

3. There are 250 pages of complex Regulations.

a. Only going to hit the high spots in this Workshop.

4. Adopting new capitalization and depreciation standards to conform to theRegulations is a change of accounting method.

a. The change is automatic.b. Most changes will require a Section 481(a) adjustment.c. Some specific changes use the cut-off method.

5. “New” concepts in the Regulations.

a. The “unit of property” concept.


(1) Probably has minimal effect on most personal property. Most banksprobably capitalize personal property now more or less on the unitof property basis.

(2) Most of the effect for banks is on buildings. The Regulationssomewhat codify the “component depreciation” concept but withspecified “units of property” rather than the consultants’ choice ofcomponents.

There are eight units of property in a building:

(a) The building structure; walls roof, et. al.

(b) Heating, air conditioning, and ventilation systems.

(c) Plumbing systems.

(d) Electrical systems.

(e) Gas distribution systems.

(f) Escalators and elevators.

(g) Fire protection and fire alarm systems.

(h) Security equipment.

If it doesn’t fit in units “ii” through “viii”, it is part of the buildingstructure; i.e. unit “i”.

b. Contrary to the component depreciation concept, all of the “units ofproperty” are depreciated over 39.5 years.

(1) Effectively, slowing up building depreciation significantly.

c. Disposition of a “building component.” A favorable change from thecurrent practice.

(1) Note the reference difference between a “building component” anda “unit of property.” The disposition rule applies to any materialbuilding component, such as a roof, interior walls, etc.

(2) Example, using the roof as a common replacement event:


(a) Under previous practice, the “acquired” roof that was on thebuilding when it was purchased was depreciated over 39.5years, regardless of how many times it was replaced duringthat period.

(b) New roofs were capitalized and also depreciated over 39.5years beginning in the replacement year.

(c) If the business owned the building long enough, it couldpossibly be depreciating three or four roofs.

(d) Under the disposition rule, the business deducts thedepreciated income tax basis of the old roof in the year that itis replaced and capitalizes the new roof. As a result, it only isdepreciating one roof at a time.

d. The Regulations obsolete the “Plan of Rehabilitation Doctrine.”

(1) Whether an expenditure is a repair expense or capitalized isdetermined by “unit of property,” not by whether it is part of alarger renovation of part or all of the building.

(2) Example - Expenditures on the HVAC system might be a repairexpense, even though it occurs during a renovation of the buildingfor which other expenses are capitalized.

e. Simplifying conventions (as if anything about these Regulations weresimply).

(1) The Regulations retain the concepts from the Section 263(a)Regulations that the wages of overhead employees and overheadexpenses are not capitalized.

(a) However, it is an election to allocate overhead costs toacquired assets and capitalize them if the taxpayer wishes.

(b) The election is separate for every project; not even required tobe consistent within the same tax year.

(2) The Regulations codify some di minimis scopes for capitalization,though the first one is so small as to be relatively useless.

(a) $100.00.


3 See Section 19.01(2) of Revenue Procedure 2011-14.

(b) 0.10% of gross revenue.

(c) 2.00% of book depreciation.

(3) There are “safe harbor” rules for “routine maintenance.”

6. The faculty have already encountered significant “push-back” from bankers tothe work, and cost, associated with conforming to the new Regulations.

a. Clients typically consider fixed assets immaterial.

b. The work should already be underway, but in most cases, there isn’t goingto be time after the first of the year to be ready for the tax returns,especially the S corporation returns that are timely filed.

D. Accrued Bonuses - Revenue Ruling 2011-29

1. An accrual basis taxpayer may deduct accrued bonuses in the year accrued,providing the liability for the total “bonus pool” is fixed and determinable.

a. It is not necessary for the “bonus pool” to be allocated by payee before theend of the year.

2. It is also not necessary for the employees in the “bonus pool” to be guaranteedreceiving a bonus if they are not employed when the bonus is paid. However,if the employees must be employed when the bonus is paid, then:

a. The total pool must be allocated among the employees who are paid.

b. If “forfeited” bonuses revert to the employer, then the entire pool is notdeductible until the bonuses are paid.

c. A change to adopt Revenue Ruling 2011-29 is a change of accountingmethod. It is automatic. The number is 133.3

E. Revenue Ruling 2012-1 - Prepaid expenses deductible by accrual method taxpayersunder Regulation Section 1.263(a)-4(f).

1. When the Section 263(a) Regulations were issued, many accrual methodtaxpayers viewed Section 1.263(a)-4(f) as an opportunity to accelerate thededuction for prepaid expenses.


2. Revenue Ruling 2012-1 is both a detailed analysis of the prepaid expenseswhich are deductible by accrual method taxpayers, and a discussion of twoprepaid expenses in particular:

a. Prepaid lease rents.

b. Prepaid service contracts.

3. Deductible prepaid expenses must be both “immaterial” to taxable income, andthe deduction must result in a “better batching of income and expense.

a. The Ruling looks to the principles of the recurring item exception inSection 461(h)(3)(A) to evaluate “materiality” and “matching.”

b. While, the Ruling states that GAAP accounting is not dispositive, it isclear from reading the conclusions that it is very influential.

(1) If the prepaid expense must be amortized for the future period forGAAP, then it must be either “material” to income or amortizationmust better match income and expense.

c. Conforming to the Ruling is an automatic change of accounting method -change # 161.

II. IRS Examination Issues - Where all of the action is this year.

A. "Conclusive Presumptions" that book charge-offs are worthless for tax purposes.

1. There are two “conclusive presumptions” in the income tax Regulations.

a. The historical presumption that has been used for more than 50 years bybanks that do not have a valid conformity election – Reg. 1.166-2(d)(1).

b. The Conformity Election, which was added to the Regulations in 1992 –1.166-2(d)(3).

2. What is a "Charge-Off" for tax purposes?

a. For partially worthless debt, Section 1.1 66(a)(2) indicates that financialinstitutions can deduct such losses, but that it should be accompanied bya "charge off or similar entry" in the books of the bank for the yeardeducted. Some controversy exists over what accounting entries need tobe made to meet this standard.


(1) The Tax Court, in Kentucky Rock Asphalt Co v Helburn stated that"if, before an income tax return is due, entries were made on thebooks showing the charge off, the provisions of the statute would bemet."

(2) In summary, an entry that removes the asset from the books shouldbe a “charge-off” for purposes of the deduction for partial orcomplete worthlessness of a loan or security.

b. There is a history of specific reserves in the thrift industry, and theService has consistently taken the position with thrifts that a specificreserve is a “charge-off.”

(1) If a loan is classified for regulatory purposes as having a "specificreserve" under FAS 114 at year end, and is subsequently charged offin the first two quarters of the following year, does this meet the"similar entry" of Reg 1.166(a)(2)?

(a) Regulation Section 1.166-2(d)(4)(ii) states:

“Charge-off . For banks regulated by the Office ofThrift Supervision, the term "charge-off" includes theestablishment of specific allowances for loan losses inthe amount of 100 percent of the portion of the debtclassified as loss.”

c. The IRS audit examination guide addresses "charge-offs" in Chapter 10,but there are few "bright line" criteria listed for the examining agents.

(1) One "bright line" requirement is that the loan must be classified lossfor the charge-off to be deductible.

(2) A second "bright line" requirement is a book charge-off.

(a) Most charge-offs, except for small, unsecured consumer debt,are really charge-offs for "partial worthlessness."

(b) The Code is clear that partial charge-offs are not deductible inexcess of the amount charged off on the books.

(c) A working position has also evolved that wholly worthlessloans must also be charged-off the books to support adeduction.


(3) A third, less specific "bright line" requirement is that the burden ofproof is on the bank to document the reduced value of the debt.

(a) This is established through the support in the loan fileregarding the troubled loan, efforts to collect, the value ofcollateral, et. al.

d. From the perspective of challenging specific charge-offs, the followingquotes from the examining guide are instructive:

"Review the loan files for comments and notes by the loan officeron the possibility of subsequent events that could affect thecollectibility or recoveries in future years.

"Request the current status reports for several of the larger loans.Analyze the bad debt recoveries in subsequent years. A largerecovery and consistent future payments on a particular loan mayindicate that the loan should not have been written off during theexamination year.

"... However, it should be noted that the taxpayer is not bound bysubsequent events, such as recoveries or future events to determinea charge-off. Also, the IRS does not have to accept subsequentevents to determine if a debt is bad in the current year.

"An aggressive position can be taken on the charge-offs. It is thebank's responsibility to establish the worthlessness of the debt.Failure to properly document the reduced value of the debtprecludes the taxpayer from taking a deduction.

"a. The taxpayer must document the worthlessness of eachloan. The documentation for one loan does not permit the deductionfor any other loan. Each loan stands on its own merits andsubstantiation, or lack thereof.

"b. Failure by the taxpayer to provide a loan file can give riseto a complete disallowance of any deduction taken for that particularloan. Unusual facts and circumstances should be considered thatwould affect the availability of the loan file.

"c. It should be remembered that a loan officer's determinationas to the collection potential for a particular loan is self serving. ...His or her comments should not automatically be accepted withoutother substantiating evidence supporting their opinion. The facts


4 Echols v. Commissioner, 935 F.2d 703, 91-2 USTC 50,360, 5 CA (7/15/1991). See a discussion of the Echolsdecision beginning at page 24.

contained in the loan file should speak for themselves.

"d. ... many of the adjustments we [make are] based on thetaxpayer's failure to provide sufficient proof of worthlessness. Thetaxpayer was also unable to show that sufficient attempts were madeto collect the debt at the point in time of the charge-off. "

e. The industry can concur with much of what is said in the examinationguide, but several statements require some analysis.

(1) The tenor of the guide's commentary is misleading to examiningagents who are not well versed in banking. The most criticalfinancial ratio to banks is their Tier I capital, not their effectivecurrent income tax rate.

(a) To the extent that charge-offs reduce the reserve, and requirethe reserve to be replenished by a book provision for baddebts, the charge-off will represent at least a 65% charge toTier I capital for a C corporation bank.

(i) It may be higher for small banks that have a less than35% effective federal tax rate.

(ii) It will be 100% for S corporation and QSub banks.

(b) All C corporation banks of every size are required by thefederal and state regulators to account for income tax expenseon an accrual method. While charge-offs may affect thecurrent tax liability, only in rare instances will it effect incometax expense. Accordingly, most bankers no longer view thededuction for bad debts as a "tax shelter" as may have been thecase 20 to 30 years ago.

(c) Comments and notes by the loan officer on the possibility ofsubsequent events that could affect the collectibility orrecoveries needs to be read in the context of the Fifth Circuit'sdiscussion of worthlessness in Echols.4 The fact that futurecircumstances might result in some speculative recovery doesnot establish that the asset is not "virtually worthless" now.

(d) The implication of the comment that a loan officer's notations


in the loan file are "self-serving" is open to misinterpretation.Indeed, the officer's comments in the loan file may be "self-serving," but the loan officer's incentive is to make the loanappear as sound as possible, not the opposite.

3. No conformity Election - Examiner ordered charge-offs and Regulation Section1.166-2(d)(1).

a. The conclusive presumption in (d)(1)(I) is the “default” provision whichapplies to every bank which does not have a valid Conformity Election.

b. The threshold for the presumption in (d)(1) is a charge-off “in obedienceto the specific orders of such authorities,” which requires “proof” that theexaminers in fact ordered the charge-offs.

c. Banks, their tax advisers, and IRS examiners have long had questionsabout just how banks could prove to the IRS examiners that certain loansqualify for the conclusive presumption under (d)(1)(I) because all thebank has is the examination reports from the regulatory safety andsoundness examiners. Those reports, whether Federal or State, areconfidential. Access to those reports is very strictly limited, and IRSexaminers are not among the permitted users.

(1) Banks, CPAs, and IRS examiners have traditionally solved the“proof” problem by following an informal working protocol thatthere is nothing so confidential on the pages of the reports whichonly list the loss assets and charge-offs required by the examinersthat the bank cannot show those pages to the examiners.

(2) This year, some IRS examiners have begun to state, with the supportof the IRS Examination Division's national industry specialists, that:

(a) The bank regulators’ examination reports are confidential,

(b) IRS personnel are not on the list of permitted users of thereports, and

(c) It is illegal for the bank to show any part of the report to theexaminer unless the bank has written permission from theregulator to do so.

(d) Without the written permission, the IRS examiner will notlook at the examination report pages to support the bank’sclaim of the 1.166-2(d)(1) conclusive presumption of


worthlessness.

d. If the IRS examiner takes this attitude, the default conclusive presumptionin subsection (d)(1) is effectively voided.

(1) The IRS examiner takes the position that the bank must “prove” thatthe safety and soundness examiners have ordered the charge-offs.

(2) The only “proof” available to the bank is the examination report,which the IRS examiner cannot look at.

e. The IRS examiners are not uniform over the country.

(1) A CPA who spoke at a conference this summer reported that theonly states where the attendees reported the problem were inMichigan and Wisconsin. I have heard since that it has spread toMinnesota.

(2) In late summer, Mr. Cederberg conducted a survey of CPA firmswith community bank clients.

(a) Respondents in many parts of the country reported that IRSexaminers, considering the economic issues during therecessions, simply "assumed" that book charge-offs weredeductible.

(b) Numerous respondents also reported that examiners had stillused the "charge-off pages" of the safety and soundnessexamination reports.

f. What is the bank’s alternative?

(1) Mr. Cederberg has been told that the FDIC has refused in writing toeither (i) grant permission to show even the charge-off pages to theIRS examiners, or (ii) to provide a confirmation letter (eithercontemporaneous with the examination or later) regarding thecharge-offs that were ordered during the examination.

(2) Only one federal regulator, the Federal Reserve, has a policystatement permitting the field examiners to write a separate letterconfirming ordered charge-offs, or charge-offs which would havebeen ordered if the examination had occurred on the date of thecharge-off.


5 SR 92-39 Dated October 30, 1992.

"Since 1973, the Federal Reserve has been willing toprovide a state member bank with a "'confirmationletter,' upon the bank's request and in appropriatecircumstances. This procedure, which remains in effect,was set forth in SR-225, dated September 7, 1973."5

(3) Some state departments of banking have been willing to issue asimilar confirmation letter if asked.

(a) However, Mr. Cederberg has also been told by CPAs that theIRS examiners have rejected confirmation letters from thestate Departments of Banking because they were issued duringthe IRS’ examination, not contemporaneous with the statesafety and soundness examination.

g. Status:

(1) The ABA is working with the IRS Examination Division at theNational level in an attempt to develop a protocol to resolve thisissue. The most recent meeting was on October 11, 2012.

(2) Suggestions for the banks:

(a) Make the conformity election as soon as possible.

(b) State member banks should obtain the confirmation letter fromthe Federal Reserve examiners at the completion of theexamination.

(c) State nonmember banks, and state member banks for thatmatter, should ask their chief field examiner for theconfirmation letter at the conclusion of the examination,unless the bank has already done so, or the state has issuedguidance that it will not provide a confirmation letter.

(3) In the meantime, it appears that most IRS examiners who are takingthe hard line on examiner ordered charge-offs really want to reviewthe loan files and reach their own, independent position on howmuch of the charge-offs are deductible. Principal targets fordisallowance are:

(a) Estimated selling costs; the most uniform and material


adjustment.

(b) Examiner ordered reductions in the fair market value ofcollateral based on the age of the most recent appraisal whenthe property was foreclosed upon, or upon changes in theaverage real estate values in the community since the lastappraisal.

(c) Examiner ordered reductions in the fair market value ofcollateral “because it will be owned by a bank,” which seemsto be a somewhat localized issue in some of the places hardesthit by the real estate recession.

(d) However, Mr. Cederberg has heard reports of much moreextreme positions taken by individual examiners.

4. Charge-offs on the Conformity Method.

a. Banks on the conformity method don’t have the “proof” problem becausethe threshold for deductibility is not whether the regulatory safety andsoundness examiners approved or ordered the specific charge-off, butrather that the federal safety and soundness examiners found that the bankcharged off loans in compliance with regulatory standards and signed theExpress Determination Letter.

b. Respondents to Mr. Cederberg’s survey reported that by-and-large, theConformity Election has eliminated virtually all controversy over charge-offs.

(1) Respondents also said that the Conformity Election eliminated mostcontroversy over nonaccrual interest by accrual method banks.

c. However, what we all thought was “conformity” may not really beconformity after all.

(1) Similar to the comment that was made about the default conclusivepresumption, Mr. Cederberg is hearing isolated reports from CPAsthat some IRS examiners are saying that GAAP accounting has sodiverged from the IRS’ views on tax accounting for bad debts thatnot all book charge-offs are deductible.

(2) As discussed above, the targets appear to be:

(a) Estimated selling costs;


(b) Estimated decreases in the fair market value of collateral,either prior to foreclosure or at the foreclosure date, from themost recent appraisal.

(3) Nevertheless, the Examination Division nationally tells the ABAthat the Service wishes that every bank were on the ConformityMethod, and the Election appears to have had significantly reducedthe volume of proposed adjustments, examination time, andprofessional fees.

B. Nonaccrual Interest Income.

1. The lack of IRS examiner experience with bank, and banking terminology, iscosting banks a lot of representation time.

a. It appears that many examiners have never heard of Revenue Ruling2007-32 for banks with the Conformity Election.

b. Some examiners do not know that the accounting method in Rev. Rul.2007-32 is mandatory for banks with the Conformity Election. They askfor the bank's Form 3115 to "elect" Rev. Rul. 2007-32.

(1) There is nothing in all of Rev. Rul. 2007-32 that says that it is"elective" for banks with the Conformity Election.

c. Some examiners have never heard of Rev. Rul. 80-361, or erroneouslythink that it was obsoleted by Rev. Rul. 2007-32.

d. Some examiners, observing correctly that nonaccrued interest is adeduction for "partial worthlessness" of the loan, look for the "charged-off" that is a threshold requirement for the deduction of a partiallyworthless bad debt. There is no charge-off on the books, so the deductionfor partial worthlessness is not allowed.

(1) Revenue Ruling 2007-32 states specifically, "X's failure torecognize the $23,000 of accrued interest for regulatory financialstatement purposes is tantamount to recognizing the accrued interestas income and immediately charging off the uncollected accruedinterest receivable as a loss asset."

e. Some examiners do not realize that banks routinely “extend” and/ormodify loans in an effort to keep the borrower paying as long as possible,


but that the underlying loan and accrued interest is still not “reasonablyexpected” to be collected.

(1) The bank extended the maturity, or refinanced the loan; thereforethe accrued interest must be collectible and has to be recognized.

(2) In reality, the refinancing might be a "significant modification"which would support not only a loss on the loan principle, butcertainly the loss of any accrued interest.

f. Some examiners do not appear to know that Rev. Proc. 2007-33 is"elective" and attempt to impose it on banks without the conformityelection.

2. Banks without a Conformity Election - The historical arguments regardingwhether the accrued interest is worthless continue.

a. Respondents to the survey reported relatively good results unless the bankhas an openly hostile examiner.

b. The key is developing the facts about the nonaccrued interest early in theexamination and in detail.

(1) Once IRS examiners have a misunderstanding of a loan, it is verydifficult to correct the situation.

(a) Example - One of the respondents described a situation inwhich the bank personnel referred to a pool of loans as“refinanced,” which the IRS examiner interpreted to mean thatthey must by “collectible” and included the nonaccruedinterest in a proposed adjustment. It was a six figure amount.

(b) In fact, the loans were pooled and sold at a discount from theprincipal amount. The “bank” had refinanced itself, not theborrower!

c. Without the conformity election, income tax accounting for nonaccrualinterest is a "facts and circumstances" test subject to Revenue Ruling 80-361. Revenue Ruling 80-361 states in relevant part:

"Section 1.451-1(a) of the Income Tax Regulations providesthat under an accrual method of accounting, income isincludible in gross income when all events have occurred thatfix the right to receive such income and the amount thereof


can be determined with reasonable accuracy.

"... [T]he right to receive interest income becomes fixedratably over the period of the loan so long as all events haveaccrued to fix the right to receive income and the amountthereof can be fixed with reasonable accuracy.

"A fixed right to a determinable amount does not requireaccrual, however, if the income item is uncollectible when theright to receive the item arises. Jones Lumber Co. v.Commissioner, 404 F.2d 764 (6th Cir. 1968).

"When an income item is properly accrued and subsequentlybecomes uncollectible, a taxpayer's remedy is by way ofdeduction rather than through elimination of the accrual.Moreover, this rule is applicable even when the item isaccrued and becomes uncollectible during the same taxableyear. Spring City Foundry Co. v. Commissioner, 292 U.S. 182(1934), Ct.D. 829, XIII-1 C.B. 28 (1934). Also Atlantic CoastLine Railroad Co. v. Commissioner, 31 B.T.A. 730, 751(1934), acq., XIV-2 C.B. (1935)."

d. In summary: Revenue Ruling 80-361 would indicate that:

(1) Loans are properly nonaccrual when there is no reasonableexpectation of collecting the nonaccrued interest.

(2) All accrued interest is properly charged off to the reserve, ordeducted as a bad debt, in the year that it becomes uncollectible.There is no reversal against income.

(3) Subsequent payments are applied against principal as long as thereis no reasonable expectation of collecting the nonaccrued interest.

e. How does Revenue Ruling 80-361 compare to the financial reportingstandards for nonaccrual of interest?

(1) Collection of the principal and interest is not reasonably expectedshould support nonaccrual for tax purposes as well as bookpurposes.

(2) Having taken a partial charge-off should be strong evidence that thecollection of the interest is not reasonably expected.


(3) Collection of the interest should not be reasonably expected on acollateral dependent loan which is undercollateralized.

(4) Sufficient deterioration of the borrower’s financial condition alsoprobably supports nonaccrual for tax purposes because it creates theexpectation that principal and interest will not be collected in full.

(5) There is likely to be a legitimate issue from a tax perspective if theborrower is current on payments, and perhaps even if some of thepayments are late or the borrower is behind the agreed uponschedule.

(6) Merely being in default for 90 days may not support nonaccrual insome cases, but if the bank can show a history that little if any of theinterest is ever collected on loans that default for 90days or more,then collection of the interest should not be "reasonably expected."

f. The IRS's audit examination guide states that the key issue is whether theinterest is uncollectible or merely delinquent. Delinquent loans are notnecessarily nonaccrual. Uncollectible interest is not accrued.

g. The examination guide also offers the examining agents examples ofloans that should still be on accrual, some of which the industry would notconcur with.

(1) Loans placed on nonaccrual because of a lapse of time.

(a) We would probably concur if, historically, this bank hascollected accrued interest on loans of the same category whichhave been in default the suggested period, such as 90 days.

(b) However, the industry would not concur if the bank hashistorically collected little if any accrued interest on suchloans after they have been in default for the specified period.

(2) Loans with only partial charge-offs.

(a) The industry would not concur with this statement.

(3) The suggestion is that loans which have been only partially chargedoff should accrue interest on the remaining book amount.

(a) This is inconsistent with how partial charge-offs aredetermined, even for tax purposes. The bank charges off the


6 Echols v. Commissioner, 935 F.2d 703, 91-2 USTC 50,360, 5 CA (7/15/1991).

portion of the principal which is a "loss asset." The amountnot charged off is the amount which the bank reasonablyexpects to collect, which is all principal.

(b) After the partial charge-off, there is no reasonable expectationof collecting any interest in addition to the principal notcharged off.

(4) Loans with sporadic payments.

(a) Whether loans with sporadic payments should be on accrualfor tax purposes is a facts and circumstances determination,based on the source of the payments.

(b) If the borrower is in the process of liquidating assets, and ismaking payments from the proceeds of the asset sales, thenthere is a reasonable expectation of collecting interest only tothe extent that the realizable value of the assets, minus otherliabilities, exceeds the principal.

(c) If the borrower is making payments from positive cash flowfrom operations, but is "sporadic" because of "sporadic" cashflow, then perhaps the guide has a point.

(5) Loans that are current, but are to borrowers which are delinquent onother loans.

(a) The industry would concur with only if the sources ofpayments for the delinquent loans are different from thesources of payment of the "current loans."

(b) If the sources of payments are identical, then the loans cannotbe evaluated separately for the expectation of collecting theinterest.

h. Note that the Revenue Ruling refers to whether collection of the interestis "reasonably expected." This clearly is not a "bright line" test.

i. Banks may want to consider the 5th Circuit Decision in Echols v.Commissioner,6 regarding the extent to which the bank must concede tothe examining agent's judgment regarding whether the collection ofinterest can be "reasonably expected."


(1) The Circuit Court in Echols discussed in great detail when adeduction for worthlessness of an asset is allowed. In the contextrelevant to both the allowance of charge-offs of loan principal andthe nonaccrual of interest, the Court identified two elements:

(a) A factual determination – is the property virtually worthless?The factual determination is a threshold requirement for adeduction for worthlessness.

(b) A subjective determination – when did the taxpayer concludethat the property is virtually worthless to it? The subjectivedetermination is largely at the discretion of the taxpayer andthe Service is not allowed to substitute its subjective judgmentfor the taxpayers. The Echols court stated:

"As long ago as 1943, federal courts recognized that thetiming of a deduction based on worthlessness is largelywithin the discretion of the taxpayer, given objectiveindicia of absence of value."

(c) The lesson of Echols is that so long as the bank documentsthat there is no "reasonable expectation" of collecting thenonaccrued interest, an IRS examining agent should notattempt to substitute his/her judgment for the bank's regardingwhen the nonaccrual is allowed.

3. Banks with a Conformity Election

a. This may be the most important benefit to accrual method banks frommaking the conformity election. The Election appears from the survey tosolve most of the issues on nonaccrual interest.

b. The legitimate issue is the tax accounting for interim cash receipts onnonaccrual loans.

(1) Revenue Ruling 2007-32 states that interim cash receipts from theborrower must be recognized in income equal to the lesser of (i) theaccumulated, nonaccrued interest, or (ii) the cash received.

(2) Revenue Ruling 2007-32 also cites favorably Revenue Ruling 80-361 and the court decisions in European Am. Bank & Trust Co. andJones Lumber Co.


7 Mr. Guiliano is the IRS examination division Senior Counsel, Commercial & Foreign Banking Industry Counsel.

"A fixed right to a determinable amount does not requireaccrual, however, if the income is uncollectible when theright to receive the income item arises. Accrual ofincome is not required when a fixed right to receivearises if there is not a reasonable expectancy that theclaim will ever be paid." European Am. Bank & TrustCo. v. United States, 20 Cl. Ct. 594, 605 (1990)(footnotes omitted), aff'd per curiam, 940 F.2d 677 (Fed.Cir 1991); see also Jones Lumber Co. v. Commissioner,404 F.2d 764, 766 (6th Cir. 1968) (stating that "[t]heright to receive ... determines the accrual of incomeunless, at the time the right arises, there exists areasonable doubt as to its collectibility"); Koehring Co.v. United States, 421 F.2d 715, 721 (Ct. Cl. 1970)(stating that "a reasonable doubt as to the collectibilityof a debt is a sufficient reason to justify its nonaccrual asincome"); Rev. Rul. 80-361, 1980-2 C.B. 164 (citingJones Lumber Co., supra.)

(3) Whether interim cash receipts are included in income was explainedby Vince Guiliano,7 at the 2010 Bank Tax Institute as follows:

(a) The recognition of interim cash receipts in the Revenue Rulingaddresses the common situation in which the bank must placeperforming loans on nonaccrual status for regulatory purposes.It is not focused on "loan workouts," loan liquidations, orloans in foreclosure.

(b) If application of the interim cash receipt to the income taxbasis in the loan, i.e. loan principal, reduces the income taxbasis in the loan, and recognized accrued interest, to less thanthe reasonably projected remaining cash collections on theloan, then the cash receipt must be recognized in income asdescribed in Revenue Ruling 2007-32.

(c) If, however, application of the interim cash receipt to the loanreduces both the income tax basis in the loan and thereasonably projected future cash collections so that after thereceipt, the income tax basis in the loan and the projected cashcollections are approximately equal, then the cash receipt isnot included in income. Vince specifically stated that


8 This was also confirmed to Mr. Cederberg privately by Jeff Kammerman after the session at the same Institute.

9 See Chapter 6.

Revenue Ruling 80-361 applies.8

(d) The example used in the question was liquidating a dairy loan,resulting in cash from the auction of the cattle, followed sometime later by cash from the auction of the equipment, andfinally wound up with cash from the sale of the land andbuildings. In this example, Vince said that the cash proceedsfrom interim sales of collateral would not be "nonaccruedinterest income."

C. Pre-Foreclosure costs incurred by the borrower and paid by the lender.

1. It is relatively routine for borrowers in the process of foreclosure not to paynumerous expenses, among them real estate taxes, other assessments, utilitybills, mechanics liens, etc. The lender ends up paying the bills either before orafter the foreclosure.

a. If the lender believes that there will be interested buyers at the auction, thelender may pay the costs before the auction in order to offer the bidders“clear title.”

b. Otherwise, the lender is likely to wait until after the auction and theproperty is reduced to possession.

2. Both GAAP and regulatory accounting require that these payments be expensedfor financial reporting purposes as incurred.

3. Tax accounting for some reason has not received much attention over the years.

The Service has announced its position on these items in the “Market SegmentSpecialization Program” for the Commercial Banking Industry, but the MSSPdiscussion is largely without citations.9

a. Service’s Position - Pre-acquisition expenses incurred by the debtor andpaid by the lender before the change of ownership increase the bank’sincome tax basis in the loan. The MSSP states that, “The basis of the loanis further increased by other costs, such as back taxes, insurance, legalexpenses, and similar items paid by the bank for protecting the value ofthe property prior to the transfer of ownership to the bank.”


10 MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.

11 Estate of Schieffelin v. Commissioner [4 B.T.A. 137 (1941).

[underscoring in original but italics added]10 Accordingly:

(1) If the bank paid the costs before the transfer of ownership, then theamounts are added to the loan for purposes of determining whetherthere is a charge-off for a bad debt, and if so the amount.

(2) If the bank pays the costs after the transfer of ownership, then theyare added to the income tax basis in the property, further increasingthe basis over the fair market value of the property.

b. The Service’s position appears to be consistent with the Board of TaxAppeals decision in Estate of Schieffelin v. Commissioner,11 a very oldcase from 1941 and not involving a Bank. The taxpayer in the case wasan individual who owned two loans, each secured by different properties.Both loans defaulted and the decedent foreclosed, obtaining possession ofboth properties.

(1) In one case, the lender had paid real estate taxes on the propertybefore the foreclosure.

(2) In the other case she paid the real estate taxes and water bills afterthe foreclosure.

(3) The Board of Tax Appeals held for the taxpayer with respect totaxes paid before the foreclosure but for the Service with respect tothe taxes and utilities paid after the foreclosure.

(4) The Board cited Minnie M. Coward, 39 B.T.A. 1158 (affirmed as tothe point at issue, 110 Fed.(2d) 725) to say that it was well settledthat if the purchaser of real estate pays taxes thereon which haveaccrued prior to the date of purchase, such payments are anadditional cost of the property to the purchaser and are therefore notdeductible by him as his taxes. The Board also cited Lifson v.Commissioner, 98 Fed.(2d) 508, and Merchants Bank Building Co.v. Helvering, 84 Fed.(2d) 478.

D. Foreclosure Costs:

1. GAAP requires that foreclosure costs be expensed as incurred for financialreporting purposes.


12 MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.

2. Tax accounting - The Service’s position is that foreclosure costs must be addedto the income tax basis in the property.

a. The MSSP states that, “Legal costs and other similar expenses incurredin connection with the foreclosure proceedings increase the basis of theOREO property.” [underscoring in original]12

b. Under the MSSP, a formal foreclosure transaction proceeds in thefollowing steps:

(1) The amount by which the bank’s income tax basis in the loanexceeds the bid price, if any, is a bad debt allowable underRegulation Section 1.166-6.

(2) If the bank purchased the property at the foreclosure auction, thenthe difference between the fair market value of the property and thebid price is a gain or loss on the foreclosure.

(3) Finally, the bank’s income tax basis in the property is its fair marketvalue plus the foreclosure costs.

(4) The MSSP’s approach to foreclosure costs would always result inthe bank having an income tax basis in the property greater than itsfair market value equal to the foreclosure costs.

3. The MSSP appears in direct conflict with the Tax Court decision in CommunityBank v. Commissioner, 62 T.C. 503, 7/9/74.

a. The issue in Community Bank was really whether there was a burden ofproof on the Commissioner to sustain fair market values in excess of thebid price, resulting in the bank recognizing gain on the foreclosure.However, in reciting the facts of the case, the Court states:

“Petitioner, as authorized by section 1.166-6(a), Income TaxRegs., charged against its bad debt reserve an amount equal tothe difference between (1) the balance due under the note pluscosts of foreclosure and (2) the bid price of the propertyacquired.” [italics added]

Later in a discussion of each of the Service’s arguments to the Court, theCourt states again:


13 MSSP, Chapter 6, Examination Techniques, third paragraph of numbered paragraph 3.

“Respondent [i.e. the Service] alternatively argues thatpetitioner’s deduction for bad debts should reflect an amountequal to the difference between the balance due under thenotes plus costs of foreclosure and the fair market value(rather than the bid price) of the property acquired.” [italicsadded]

4. Normal banking practices also support adding the foreclosure costs to the note.

a. Virtually all loan agreements provide that the debtor owes the lenderreimbursement of all collection costs.

b. Since the foreclosure costs become a legal part of the note when incurred,it appears that they should be added to the basis in the note in determiningthe bad debt charge-off resulting from either the foreclosure or the transferof the property by deed in lieu of foreclosure.

E. OREO Holding Period Costs

1. Service’s Position - According to the MSSP:

a. If the property is operated or rented, then post-acquisition expenses, anddepreciation, are deductible.

b. If the property is held for sale, then post-acquisition expenses must beadded to the basis in the property.

c. The MSSP states in relevant part:

“After the bank takes possession of the property, no portion of theexpenses is currently deductible if the bank is holding the propertyfor resale or sale to customers. The OREO property is similar toinventory, and therefore, all expenses are considered to be part ofthe basis of the property. If, however, the bank is holding theproperty out for rent, normal maintenance expenses, includingdepreciation, are deductible by the bank when incurred.”13

d. The MSSP does not cite Section 263A, but that clearly is the Service’sbasis for capitalization. See FSA 1998-170, a Field Service Adviceinvolving a thrift in which the National Office liberally cites Section263A.


2. This has emerged as a National issue with the IRS.

a. Examining agents appear to have little if any discretion not to disallow thecurrent deduction for the costs incurred to hold non-income producingOREO until it is sold.

b. Mr. Cederberg has been told that Service personnel say there are at leastfour banks which have taken this issue to Appeals.

c. The three banks whom Mr. Cederberg knows about have all had theirappellate conferences, and have hit a "brick wall" on the subject. Appealshas been unwilling to offer any settlement.

d. One tax counsel has told the Mr. Cederberg that the IRS appears to be so“dug in” on the subject that there appears to be only a remote likelihoodof prevailing short of the Circuit Court of Appeals.

e. This same counsel suggested that because of the total silence of bothofficial guidance and legislative history on the application to OREO,courts is likely to defer to the “presumed correctness” of theCommissioner’s position.

f. Technically, the case does not seem to be “open and shut”.

(1) The definition of Section 263A property in Section 263A(b)(2),which reads in relevant part as follows:

“(b) Property to which section applies. Except as otherwiseprovided in this section, this section shall apply to ... (2)Property acquired for resale. (A) In general. Real or personalproperty described in section 1221(a)(1) which is acquired bythe taxpayer for resale.” [italics added]

(2) Section 1221(a)(1) reads in relevant part:

“(a) In general. For purposes of this subtitle, the term "capitalasset" means property held by the taxpayer (whether or notconnected with his trade or business), but does not include (1)stock in trade of the taxpayer or other property of a kind whichwould properly be included in the inventory of the taxpayer ifon hand at the close of the taxable year, or property held bythe taxpayer primarily for sale to customers in the ordinarycourse of his trade or business ... .” [italics added]


(3) Banks probably should not argue that OREO is not Section1221(a)(1) property because that is effectively their only gateway toan ordinary loss on disposition.

(4) However, Section 263A introduces an “intent” test in addition tobeing Section 1221(a)(1) property; i.e. that the property “is acquiredby the taxpayer for resale.” Bankers will argue with great passionthat the OREO is not acquired for resale but rather to collect theloan. Restated, the origin of the OREO is in the loan, not in buyingand selling real estate.

(5) However, whether any bank is willing to spend considerable sumslitigating that issue is yet to be seen.

3. This should not be a problem for Operating Properties, i.e. income producingproperties.

a. The IRS' examination manual states that banks may deduct the holdingperiod costs of "operating OREO," and may claim deprecation.

b. Current deductions are not controversial. Except for inexperienced agentswho haven't read the IRS' examination manual, I am not hearing aboutchallenges.

4. The most common "error" is not discovering that OREO is actually incomeproducing. Vacant residences are problematic, but development land inparticular offers numerous creative opportunities to realize some income duringthe holding period, and that should make the property "income producing" andnot subject to cost capitalization.

a. In several cases, banks have cash rented failed developments to localfarmers during the interim while they were trying to sell the property.

b. A bank rented vacant OREO to a contractor for use as its constructiontrailer and equipment during construction of an adjacent project.

c. In another case, a bank rented vacant OREO to the City for a similarpurpose.

d. In several cases, banks have turned vacant OREO into a short termparking lot and charged people to park there; usually without even pavingthe lot.

e. In one case, the OREO was close enough to the bank that the bank


14 Section 166(a)(2).

allowed its employees to park there for free. That made it “premises” andthe holding period expenses are currently deductible.

5. If holding period costs are capitalized, it is critical that the bank account for thecapitalized costs by property so that it can reverse the Schedule M-3 item as theproperty sells.

a. The faculty have heard from CPAs whose clients are by now on theirsecond round of “recession examinations” that if the expenses cannot betracked to specific OREO properties, IRS examining agents are allegingthat the capitalized expenses cannot be deducted until all of the OREO issold; or at least until all of the OREO owned during the year the expenseswere capitalized is sold.

(1) The theory is that deductions are a matter of legislative grace andmust be proved. If the bank can’t prove what property was subjectto capitalization, it isn’t entitled to a deduction.

b. Of course, if all of the OREO owned in that year has been sold, then thebank has a deductible “loss” under Section 165.

F. Partial Bad Debt Charge-offs on “Securities.”

1. Examining agents, usually those without a lot of experience examining banks,are challenging the deductions on at least two bases.

a. That the charge-offs are “partial bad debt deductions” and that partiallosses are not available except for loans. No loss is deductible until the“security” is either sold or wholly worthless.

b. That OTTI adjustments to “fair market value” are not deductible.

2. The confusion is compounded by most agents' inexperience with bankinvestments. Many of the mortgage investments are really investments inregular interests in real estate mortgage investment conduits ("REMICs")

a. The agents are not aware that REMIC regular interests have been held bythe Service itself to be “loans” as defined in Regulation Section 1.585-2(e)(2), not “securities.” Accordingly, partial charge-offs are allowedwhen a "debt" becomes recoverable only in part.14

(1) Section 860B(a) of the Code states in relevant part, “... a regular


interest in a REMIC ... (if not otherwise a debt instrument) shall betreated as a debt instrument." Note that the Code refers to a "debtinstrument", not to a "debt security."

(2) In technical advice memorandum 9423002, the Service held "Aregular interest in a REMIC is considered debt for purposes of theCode without regard to the actual form of the instrument. SeeSection 860B(a). Thus, the obligations are 'loans' within themeaning of Section 1.585-2(e)(2), without regard to the underlyingcollateral that secures the debt."

(3) In technical advice memorandum 200439041, the Service cited9423002 and stated, "Pursuant to § 860B(a), a regular interest in aREMIC is treated as a debt instrument for federal income taxpurposes. Therefore, a regular interest in a REMIC is a loan withinthe meaning of § 1.585-2. ..."

3. Pass-through securities. Even if the “security” is not a REMIC, if it is a pass-through mortgage backed security, it is also a “loan” for income tax purposes.

a. This issue was first addressed by the Service in Revenue Ruling 84-10,where the Service held that FNMA guaranteed mortgage pass-throughsecurities were investments in mortgages secured by real estate for realestate investment trusts and residential real estate mortgages forqualification as by thrifts under Section 7701. The trust certificates werein registered form, stated that they represented fractional undividedinterests in the mortgage loans, pool proceeds, and mortgaged propertyacquired by foreclosure.

b. TAM 9423002 also involved pass-through securities that were notREMICs. The “facts” were stated by the Service as follows:

“Most of the mortgage-backed securities were participationinterests issued and insured by the Federal National MortgageAssociation (FNMA), the Government National MortgageAssociation (GNMA) or the Federal Home Loan MortgageCorporation (FHLMC), but some of the mortgage-backedsecurities insured by those agencies were REMIC regularinterests as described in Sections 860A through 860G of theCode.”

c. The Service held that the pass-through investments were “loans” asdefined in Regulation Section 1.585-2(e)(2).


15 After the adoption of Section 585, and under the Proposed Regulations under Section 585, it was believed that“securities” were included in total loans but not eligible loans. I don’t have a paper copy of Treasury Decisions 7532and 7835 which accompanied the final Section 585 Regulations, but I distinctly recall that the definition of “loans” waschanged in the Final Regulation to exclude securities. This is the source of the December 31, 1976 effective date forthe exclusion of securities from the definition of loans. [Reg. 1.585-2(e)(2)(ii)(C)]

"LAW - ... Section 1.585-2(e)(2) of the Regulations definesthe term 'loan' (for purposes of Section 585) as 'debt' withinthe meaning of Section 166 and the related Regulations. Theterm specifically includes, in relevant part, a loan participationto the extent that the taxpayer bears a risk of loss. Section1.585-2(e)(2)(i)(c).”

4. The suggestion that securities are not subject to partial worthlessness is simplyan issue of inexperience with banks.

a. Section 582(a) provides that credit losses incurred by banks [as definedin Section 581] on securities [as defined in Section 165(g)(2)(C)] , areallowable under Section 166 as bad debt losses.

b. Having moved the bank’s credit loss from Section 165 to 166, the partialbad debt provision of Section 166(a) apply.

c. Reg. 1.585-1(a) specifically provides that bad debts on partially or whollyworthless debt securities are deducted under Section 166(a) by virtue ofits reference to Section 582(a) and the Section 582 Regulations.Accordingly, reading the Code and Regulation together, a deduction isallowed for a partially worthless debt security in the year during which itis determined that it became partially worthless equal to the lesser of (i)the "loss" of principal, and interest to the extent included in income by anaccrual basis taxpayer, or (ii) the amount charged off on the books.

d. Regulation Section 1.585-1(a) also clarifies at least three other practicalissues.

(1) Securities are not included in “total loans” for purposes ofcalculating the experience ratio. They are excluded from thedefinition of loans.15

(2) Bad debt losses on Securities are not included in “bad debts” forpurposes of calculating the experience loss percentage because they


16 The Regulation does not specifically illustrate the operation of the bad debt reserve under Section 585. However,the examples in Reg. 1.585-2 consistently refer to "bad debts charged to the reserve for losses on loans," clearly implyingthat only bad debts on loans are charged to the Section 585 reserve.

are not charged to the Section 585 reserve.16

(3) The bad debt deduction for partial or wholly worthless securities isnot required to have been charged to the Section 585 “reserve forlosses.” It is only required to have been “charged off,” which hasbeen held to mean that the asset was effectively removed from thebooks of the taxpayer.

5. The objection whether the OTTI represents a worthlessness loss or a marketvalue adjustment is fair to the extent that the OTTI adjustment either (i) reflectsa reduction of the book value of the security to "fair market value" less than itsreasonably expected cash flow, or (ii) future cash flows are discounted topresent value.

a. Unless the bank is a dealer in securities, and has adopted the mark-to-market method of accounting under Section 475, it is well settled that"fair market value" adjustments of securities, or most other assets for thatmatter, are not deductible.

b. Most OTTI charges for partially worthless securities do include somediscount of future cash flows to their present value. This portion of theOTTI is not a credit loss because the Bank has no income tax basis in thenet present value discount.

6. Post Charge-off Accounting.

a. What is the proper tax treatment if the financial prospects of a debtsecurity changes in a year after the Bank takes an OTTI charge.

(1) For example, assume a security with an income tax basis of $5million. At the end of Year 1, the projected cash collections are $4million, with a present value of $3 million. The Bank takes a $2million OTTI on the books, and deducts the $1 million credit loss onits income tax return.

(2) By the end of Year 2, the cash collection prospect has furtherdeteriorated. The bank has collected $500,000, but the totalremaining collections are projected to be only $3 million. Since thebook value is now $2.5 million after the collection, the bankdetermines that no further OTTI is required.


(3) Is the bank entitled to claim a $500,000 partial bad debt deductionin Year 2 [i.e. $4 million basis after the Year 1 deduction, less$500,000 cash collected, minus $3 million projected collections]?

(4) Yes. Reg. 1.166-3(a)(2)(ii) addresses this question in theaffirmative.

"If a taxpayer claims a deduction for a part of a debt forthe taxable year within which that part of the debt ischarged off and the deduction is disallowed for thattaxable year, then, in a case where the debt becomespartially worthless after the close of that taxable year, adeduction under section 166(a)(2) shall be allowed for asubsequent taxable year but not in excess of the amountcharged off in the prior taxable year plus any amountcharged off in the subsequent taxable year. In suchinstance, the charge-off in the prior taxable year shall, ifconsistently maintained as such, be sufficient to thatextent to meet the charge-off requirement of section166(a)(2) with respect to the subsequent taxable year."

b. Accounting for Cash Receipts and Income After a Partial WorthlessnessDeduction

(1) If a debt security is determined to be partially worthless as discussedabove, by definition the remaining income tax basis in the debtsecurity is equal to the reasonably projected cash collections by theBank. Accordingly, there is no reasonable expectation of collectingany "interest" on the security, and the security becomes a nonaccrualasset for income tax purposes.

(2) Revenue Ruling 80-361 addresses when an accrual basis taxpayeris not required to accrue interest on a debt.

"A fixed right to a determinable amount does not requireaccrual, however, if the income item is uncollectiblewhen the right to receive the item arises."

(3) Accordingly, after the partial charge-off, the security is a nonaccrualasset for income tax purposes, unless there is an improvement in thefinancial condition of the debtor that increases the reasonablyexpected cash collections. Absent that improvement, all collectionsare charged to principal until the Bank's income tax basis, as


reduced by deductions for partial worthlessness, is collected. Anyfurther collections are a "recovery" included in income up to theaccumulated bad debt deductions. Any further collections after thatare interest income.

c. What does the Bank do if projected cash collections are less than the totalprincipal and interest due on the security but greater than the Bank'sincome tax basis in the security.

(1) Revenue Ruling 80-361 would still apply to adjust the accrual rateto the new "reasonably expected" collection of interest.

(2) Any further contractual interest "is uncollectible when the right toreceive the item arises." Accordingly, the Bank should adjust itsinterest accrual to the rate that represents a constant yield on theprojected cash flow, and recognize the adjusted rate of interest intaxable income as it accrues.

III. Examiner Ordered Restatements.

A. If a bank is examined, the examiners conclude that the bank had not recognizedmaterial loan losses which they order the bank to recognize in a previous accountingperiod, when are the charge-offs tax deductible.

1. In the year that the bank is examined and physically records the charge-off?

2. Should the bank amend its income tax returns to recognize the losses in the twoprevious years?

B. If the bank has made the Conformity Election, then the Regulation Section 1.166-2(d)(3)(ii)(B) reads in relevant part:

“(B) Charge-off should have been made in earlier year. The conclusivepresumption that a debt is worthless in the year that it is charged off forregulatory purposes applies even if the bank's supervisory authoritydetermines in a subsequent year that the charge-off should have beenmade in an earlier year. ...”

1. The plain language of that sentence is that the conclusive presumption appliesin the year that the debt is charged-off “for regulatory purposes.”

a. If the examiners order the bank to recognize the charge-off in an earlieryear and to restate call reports, then the loss is charged-off “for regulatorypurposes” in the earlier year.


17. Treasury Decision 8396; 57 F.R. 6291-6296, February 24, 1992.

b. A bank on the conformity method does not appear to have much of achoice but to amend the income tax returns and claim the loss in theearlier year. That is the only year in which the loss will be reflected inregulatory financial statements.

c. The alternative is to wait until the loan is “wholly worthless” and thenclaim the loss under Section 165.

2. The Treasury Decision accompanying the final Regulation appears to suggesta different interpretation.17 The relevant paragraph “b” of the comment sectionstates in relevant part:

“b. Debts charged off in wrong year. Commentators also asked forguidance on the tax treatment of a debt that is charged off in oneyear, when a bank's supervisory authority subsequently determinesit should have been charged off in an earlier year. Thecommentators suggested that the debt should be presumed worthlessfor tax purposes in the year of the charge-off rather than in theearlier year, despite the after-the-fact determination by thesupervisory authority.

“It is consistent with the concept of a conclusive presumption thata bank be permitted to claim a tax deduction for a debt charge-offfor a year in which the bank satisfies the requirements of thepresumption, notwithstanding that its regulator subsequentlydetermines that the charge-off should have been made in an earlieryear. Accordingly, the final regulations provide that a charge-offqualifies for the presumption in the year of the charge-off, providedthe requirements of the Regulations are otherwise satisfied. Apattern of charge-offs in the wrong year, however, may result inrevocation of the bank's election.”

a. The Service certainly implies in the second paragraph that it is accedingto the commentators’ request that the charge-off qualifies for theconclusive presumption in the year that it was initially charged-off by thebank, notwithstanding the regulatory examiners’ subsequentdetermination.

b. Unfortunately, there are a number of problems with the implementationof the commentators’ request:


(1) The Treasury Decision is inconsistent with the plain wording of theRegulation.

(2) The wording of the second to last sentence of the second paragraphin the Treasury Decision is not consistent with the implication. Itdoesn’t use words like “in the year of the initial charge-off” or “inthe year charged-off by the bank.”

(3) Even more difficult is the reference to “provided the requirementsof the Regulations are otherwise satisfied.” Regulation Section1.166-2(d)(3)(ii)(A) and (A)(1) state in relevant part:

“(A) In general. If a bank satisfies the expressdetermination requirement of paragraph (d)(3)(iii)(D) ofthis section and elects to use the method of accountingunder this paragraph (d)(3) -- (1) Debts charged off, inwhole or in part, for regulatory purposes during ataxable year are conclusively presumed to have becomeworthless, or worthless only in part, as the case may be,during that year, but only if the charge-off results froma specific order of the bank's supervisory authority orcorresponds to the bank's classification of the debt, inwhole or in part, as a loss asset, as described inparagraph (d)(3)(ii)(C) of this section; ...” [italics added]

This citation from the Regulation appears to “otherwise require” thebad debt to be deducted in the year that the examiners determine theloss to have occurred.

C. If the bank has not made the Conformity Election, there is no similar reference inRegulation Section 1.1662-(d)(1) regarding examiner determinations that the charge-off should have been made in a prior year.

1. Subsection (d)(2) discussed the evidence of worthlessness in a later year if thebank does not claim the deduction in the year charged off the books.

2. Section 1.166-2(d)(1) states in relevant part, with the language extraneous tothis consideration deleted:

“If a bank ... which is subject to supervision by Federal authorities,or by State authorities maintaining substantially equivalentstandards, charges off a debt in whole or in part, ... In obedience tothe specific orders of such authorities, then the debt shall, to theextent charged off during the taxable year, be conclusively


presumed to have become worthless, or worthless only in part, asthe case may be, during such taxable year. But no such debt shall beso conclusively presumed to be worthless, or worthless only in part,as the case may be, if the amount so charged off is not claimed as adeduction by the taxpayer at the time of filing the return for thetaxable year in which the charge-off takes place.”

a. Two provisions of this paragraph create a significant conundrum.

(1) The first sentence states that if the bank makes a “charge-off” uponthe specific orders of the safety and soundness examiners, theconclusive presumption applies only to the year of the charge-off.

(a) However, it doesn’t indicate whether the charge-off is madewhen the examiners make their determination or when theexaminers determine that the loss occurred.

(b) If the examiners require amended call reports, the charge-offwill only appear in the regulatory books for the prior period.

(c) Accordingly, it would seem that the loss should be deductedin the prior period.

(2) The last sentence provides the conclusive presumption only if thetaxpayer claims a deduction “at the time of filing the return for thetaxable year in which the charge-off takes place.”

(a) In many, if not most, cases, the tax return will have alreadybeen filed when the safety and soundness examiners determinethat the regulatory reports must be restated.

(b) Does the last sentence refer to only the original return, or toany return for the year.

(3) Finally, subsection (d)(2) limits the deductibility of the charge-offin a “later year”, which in this case is likely to be the year of theexamination, then the deduction is allowed in that year only“...provided that the taxpayer produces sufficient evidence to showthat (i) The debt became wholly worthless in the later taxable year,or became recoverable only in part subsequent to the taxable year ofthe involuntary charge-off, as the case may be ...”

3. The bank which is not on the conformity method also has access to the ashowing that the loss factually occurred in the prior year.


a. The "proof" issue arises again because the Bank cannot show the IRSexaminer the regulatory examiners' order to recognize the losses or torestate the call reports.

b. However, the amended call reports are not confidential, and theworkpapers which develop the amount of the loss are probably notconfidential.

4. In summary, there doesn’t seem to be as clear guidance for banks that are noton the Conformity Method, but it still seems that the year determined by theexaminers that the loss occurred is the appropriate year to claim the deduction,particularly if the original return is still under extension when the examinersorder the amended call reports.

D. It is important who is requiring the restatement.

1. The Regulation refers only to the bank maintaining “loan loss classificationstandards that are consistent with the regulatory standards of that supervisoryauthority.”

2. There is no reference to GAAP.

3. Accordingly, a decision by the independent auditors to “opine” on restatedfinancial statements, or a recommendation by consultants that the loss occurredin the previous year, would not seem to be eligible for the conclusivepresumption under the conformity election.

4. The bank also fails the “conclusive presumption” of the conformity electionbecause the assets were not timely classified as loss assets in the earlier year.

a. When the examiners order losses recognized in the earlier period, the“loss” classification does not become an issue because “the charge-offresults from a specific order of the bank's supervisory authority” undersubsection (A)(2).

b. Furthermore, a conformity method bank may not establish that the lossesfactually occurred in the earlier years based upon all of the evidence in theloan files. A factual determination is not effective to allow a deductionon the conformity method because of the following statement fromsubsection (A)(2):

“A bad debt deduction for a debt that is subject to regulatoryloss classification standards is allowed for a taxable year only


to the extent that the debt is conclusively presumed to havebecome worthless under paragraph (d)(3)(ii)(A)(1) of thissection during that year.” [italics added].

This sentence seems to preclude a factual presentation that the lossoccurred in another period.

IV. Loans Restored to the Books

What is the tax implications of a charged-off loan which is restored to the books?

A. The IRS held in Revenue Ruling 80-180 that an unsecured loan to a bankruptcorporation, which was charged off at the direction of the examiners in 1974, but wasrebooked in 1976 based on a letter from the examiners reconsidering the priorcharge-off, was not a recovery in 1976 when it was rebooked. The Ruling states inrelevant part:

"Section 1.111-1 (a)(2) of the Regulations provides that recoveries resultfrom the receipt of amounts in respect of the previously deducted section111 items, such as from the collection or sale of a bad debt. For there tobe a recovery of a bad debt there must be a receipt of amounts attributableto such debt or an event inconsistent with the prior deduction. In thiscontext, an event is inconsistent with the prior deduction only if thetaxpayer's actual dealings with, as opposed to book entries with respect to,the item are inconsistent with such deduction. The mere expression ofdoubt does not constitute a receipt or an inconsistent event."

B. This Ruling was before the Conformity Election was added to the Regulations, butthe Ruling should apply equally to banks that have not made the conformity electionand those that have made the election.

1. The conformity election applies only to charge-offs. There is no reference in theRegulation to recoveries. Regulation Section 1.166-2(d)(3) states in relevantpart:

“Conformity election ... a bank ... may elect under this paragraph(d)(3) to use a method of accounting that establishes a conclusivepresumption of worthlessness for debts ... .”

2. Recoveries are described in Regulation Section 1.111-1(a)(2), which states inrelevant part:

“(2) Definition of "recovery". Recoveries result from the receipt ofamounts in respect of the previously deducted or credited section


18 Reg. 1.166-2(d)(3)(i) and Rev. Rul. 2001-59.

111 items, such as from the collection or sale of a bad debt, refundor credit of taxes paid, or cancellation of taxes accrued. Care shouldbe taken in the case of bad debts which were treated as only partiallyworthless in prior years to distinguish between the item described insection 111, that is, the part of such debt which was deducted, andthe part not previously deducted, which is not a section 111 item andis considered the first part collected. The collection of the part notdeducted is not considered a "recovery". ...” [italics added]

C. Accordingly, a bank does not recognize taxable income from a “recovery” until thereis “a receipt of amounts attributable to such debt or an event inconsistent with theprior deduction.”

V. The Conformity Election.18

Principal issues surrounding the conformity election.

A. The "Express Determination Letter."

1. The first Express Determination Letter is required for the last federalexamination before the first day of the year for which the election is made.

a. If the election is to be made with the 2012 return, the bank must have anExpress Determination Letter for the last federal examination date beforeJanuary 1, 2012; which could be as early as the second six months of 2010depending on the examination cycle.

2. The bank must obtain an Express Determination Letter for every federalexamination after the first letter.

a. Failure to obtain an EDL letter automatically revokes the conformityelection.

b. The bank should add a request for the EDL to the President's permanentchecklist for the initial examination interview with the federal examiners.This will assure that not only the first letter, but all subsequent letters, arerequested.

c. The federal regulators' examination manuals state that the field examinersshould not issue EDL letters after the examination is finished.

3. An issue which has emerged during the recession is that the regulators'examination manuals state that the EDL letter will not be issued if the bank has


not taken its charge-offs in accordance with regulatory standards, either bytaking the charge-offs too early or too late. We are experiencing automaticrevocations of conformity elections because the examiners have orderedsignificant additional charge-offs during the examination.

B. The election is made by including Form 3115 in a timely filed return. Commonquestions about the Forms 3115:

1. The Form 3115 is more directly controlled by Regulation Section1.166-2(d)(3)(C) than by Revenue Procedure 2011-14.

2. The Regulation requires that the words "ELECTION UNDER section1.166-2(d)(3)" be typed or legibly printed at the top of page 1 of the Form 3115.

a. The faculty has been told by a representative of the Service that thiscaption is still technically required because the Regulation has not beenrevised, despite the fact that after the Regulation was published, theService assigned the conformity election an automatic change number (6)so that the caption makes no particular sense.

3. In the space provided for “Other Changes of Method” the Regulation states thatthe preparer should insert “Election Under §1.166-2(d)(3).”

4. Regulation Section 1.166-2(d)(3)(C)(1) states in relevant part

"The ... Form 3115 must include ... a declaration that the expressdetermination requirement of paragraph (d)(3)(iii)(D) of this section issatisfied for the taxable year of the election). When a Form 3115 is used,the declaration must be made in the space provided on the form for "Otherchanges in method of accounting."

When the Regulation was adopted in 1992, the Form 3115, Schedule D,Miscellaneous Changes in Method of Accounting, Part V was captioned “OtherChanges in Method of Accounting.” That section no longer exists in the currentForm 3115. The faculty is told, however, that the declaration is still required,and should be made on a statement attached to the Form 3115.

5. There is no Section 481(a) adjustment.

6. In Part I, Line 1, insert "6" as the automatic change number.

7. Part II, Line 9a - This question asks about any change of accounting methodwithin the last five years, not just a prior conformity election.


19 Reg. 1.166-2(d)(3)(iii)(B).

8. Part II, Line 10 similarly asks about any request for a private letter ruling,change of accounting method, or request for technical advice.

9. The correct answer to Part II, Line 14 regarding consistency with financialreporting is "yes."

10. Part II, Line 16 regarding the request for a conference should be marked "yes,"Even though this is an automatic change and the prospect of needing aconference should be remote, if there is some problem, one wants the NationalOffice to contact the preparer, not just send a rejection letter.

11. Similarly, the faculty recommends that even though the change is automatic,that a power of attorney authorizing the Service to contact the preparer beattached to the Form. Again, any questions which the Service might have willbe expedited if they contact the preparer rather than the bank.

12. The correct answer to Part IV, Line 1 is "yes;" the change is made using thecut-off method.19

13. It is not clear whether a copy of the Form 3115 must be timely filed with theIRS National Office.

a. The copy requirement is in Revenue Procedure 2011-14.

b. There is no copy requirement in Regulation Section 1.166-2(d).

c. However, since the bank gets only one “free” opportunity to make theelection, the faculty suggests from an abundance of caution that a copy betimely filed with the National Office.

C. Documenting the loss classification of charged-off loans.

1. Revenue Ruling 2001-59 refers to a Board of Directors resolution authorizingthe Bank’s officers and employees to make partial or complete charge-offswhen loans are classified “loss” under the loss classification standards of theregulators is adequate under the Revenue Ruling to establish the presumptionthat the charge-offs are good charge-offs providing the bank obtains the expressdetermination letter.

“... under the resolution adopted by [the Bank’s] board of directors, [theBank’s] officers and employees are authorized to charge-off loans (orportions thereof) only if the charge-offs are required under applicable loan


loss standards issued by [the Bank’s] supervisory authority. Under thesecircumstances, [the Bank’s] charge-offs of certain loans (or loan portions)are sufficient to demonstrate classification of those loans (or loanportions) as loss assets under standards issued by [the Bank’s] supervisoryauthority.”

2. This resolution is not required for a valid election, but it should solve thequestion whether loans were classified "loss" when they were charged off.

3. From an abundance of caution, the faculty encourages conformity banks toadopted a Rev. Rul. 2001-59 resolution.

D. The Conformity Election can be revoked by including Form 3115 in a timely filedreturn.

E. The election is automatically revoked for failing to conform to the requirements forthe election.

1. The most common issue is failure to obtain the Express Determination Letterfrom the federal examiners at an examination.

2. The second most common issue is an election that was technically invalid whenit was made.

a. The faculty has been told by IRS personnel that if an election isattempted, but is invalid [for example, the Express Determination Letterwas not obtained for the correct examination], the bank will be treated ashaving made the election, which was then immediately revoked.

F. The bank has only once try in the lifetime of the bank to make the conformity electionautomatically and without a user fee.

1. If a previous election has been revoked, a new election can only be made withIRS consent pursuant to the normal procedures for requesting a change ofaccounting method.

2. That bank cannot ever make the election without filing the Form 3115 with theNational Office and paying the user fee for a change of accounting method;currently $7,000.

a. There is no "five year" period as there is for many other changes ofaccounting method.

G. Should the bank ask for the Express Determination Letter even if it does not know


whether it will make the conformity election, or if its election was revoked becausea letter was not obtained at some interim federal examination?

1. There is no tax issue with obtaining the Express Determination Letter as amatter of course without making the conformity election if the field examinerwill give it.

2. Reports differ on whether an EDL is helpful during an IRS examination if thebank has not made the Conformity Election.

a. IRS national examination division specialists are adamant that withouthaving filed the Form 3115, the EDL isn’t “worth the paper it is printedon.”

(1) That is probably technically correct.

(2) They seem annoyed with calls from examining agents inquiringabout EDLs without the election.

b. Practitioners tell the faculty that the EDL has been helpful during IRSexaminations even without the formal election.

VI. Loan Modifications - Reg. § 1.1001-3

Last year’s outline included a relatively long and technical outline of the loan modificationRegulations. It had been some time since we gave much attention to modifications, andwith the recession, we believed that a refresher course would be appropriate.

This year we are spending so much more time on IRS examination issues that we decidedto forgo a repeat of the modification discussion, except to respond to questions and to liftup the special deemed charge-off for modified loans that have been subject to a charge-off.

Anyone who would like a copy of the modification outline should provide their card andwe will e-mail you a copy.

A. Regulation Section 1.166-3(a)(3) provides a special “deemed charge-off” rule forsignificantly modified loans that have been the subject of a partial charge-off priorto the modification.

B. The deemed charge-off is equal to the lesser of:

1. The gain recognized on the modification; or

2. The amount by which the tax basis of the modified debt exceeds the greater of:


20 The only requirements for the deemed charge-off are that a deduction for partial worthless was allowed undersubparagraph (a)(1) of the Regulation and that a charge-off was made on the books as required in subparagraph (a)(2).Those two subparagraphs apply equally to banks with and without the conformity election.

a. The fair market value of the modified debt, or

b. The amount of the modified debt recorded on the taxpayer's books andrecords.

C. The deemed charge-off rule of Regulation Section 1.166-3 applies to both bankswhich have made the conformity election and those which have not.20

D. Example - Facts

Assume the same facts as in the modification example except that the originalprincipal amount was paid down to $350,000 instead of $250,000.

The bank has recorded a $100,000 charge-off, reducing the book value to $250,000,and put the loan on nonaccrual, so the accrued interest of $18,750 has not beenincluded in interest income.

The terms of the modified loan are (i) the borrower will pay the accrued interestimmediately, (ii) the principal amount will be $300,000, and (iii) the interest rate willbe 4.5%, and (iv) the borrower will make 16 equal semi-annual installments ofprincipal and interest of $22,535 each.

The following table illustrates the income tax accounting for the modification:


21 Note that the fair market value includes the nonaccrued interest that will now be collected.

22 The tax basis in the modified debt includes the tax gain of $68,750.

23 The book value includes the nonaccrued interest which will be collected at closing on the modification, and becomesfor an “instant” accrued interest receivable.

Issue price of the “new” modified note:

Accrued interest $ 18,750

The issue price is the stated principal 300000$318,750

Income tax basis in “old” note:

Unpaid principal balance $350,000

Partial charge-off -100000

Accrued interest $ 0 250000

Gain on the modification $ 68,750

Deemed charge-off is the lesser of:

(i) Gain recognized on modification; or $ 68,750

(ii) The greater of:

(a) Tax basis of the modified debt over its FMV

Fair market value of modified note21 $318,750

Tax basis in the modified debt22 318750

Excess tax basis, or $ 0

(b) Tax basis in the modified debt over book value

Tax basis in the modified debt $318,750

Book value of the modified debt23 268750

Excess tax basis $ 50,000

Deemed charge-off - lesser of (i) or greater of (ii)(a) or(ii)(b)

$ 50,000

E. For income tax purposes the bank:


1. Will recognize a gain on the modification of $68,750.

2. Will recognize a charge-off of $50,000 [the deemed charge-off].

3. Interest income will be recognized at 4.5% of $300,000, the stated principalamount of the modified debt, declining as payments are made.

4. Will recognize the $50,000 recovery of the deemed charge-off after the$250,000 tax basis in principal is collected.

F. For financial reporting purposes the bank:

1. Will recognize $18,750 interest income at the modification date for thecollection of nonaccrual interest;

2. Will recognize interest at 4.50% on $250,000 original book balance of the loan,declining as payments are made over the balance of the loan.

3. Will recognize:

a. The $50,000 recovery of the prior charge-off as principal paymentsexceed the $250,000 book value of the modified loan;

b. The $19,704 difference in interest income on the stated principal balanceof $300,000 and interest income on the book value of $250,000 after theprincipal is recovered in full.

G. Schedule M-3 adjustments:

1. There will be three Schedule M-3 adjustments in the year of the modification:

a. Increasing book income by the $68,750 gain on modification of the loan.

b. Decreasing book interest income by the $18,750 of nonaccrued interestthat will be recognized on the books.

c. Increasing book charge-offs by the $50,000 deemed charge-off.

d. Note, the net effect of the adjustments in the modification year is zero.

2. There will be adjustments increasing book interest income every year for theterm of the modified loan by the difference between 4.5% interest on the bookvalue of the loan and 4.5% on the stated principal amount of the modified loan.


3. The recovery of the $50,000 deemed charge off will be the same for book andtax purposes.

4. There will be adjustments reducing book interest income by the "recognition"of the nonaccrued interest on the $50,000 difference between the book valueand stated principal amount of the modified loan; i.e. to reverse the adjustmentsin "b".

5. Book and taxable income will exactly equal over the eight years - $110,560.

VII. OREO - “In-substance foreclosure.”

A. The lender obtains complete control over the collateral, but not ownership.

1. The basic requirement of an "in-substance" foreclosure is that the lender gainscomplete control of the management and marketing of the collateral asset.

2. Examples of "in-substance foreclosures":

a. The collateral is in a single-asset subsidiary corporation of the borrower.After a default on the loan, the governing documents of the subsidiaryempower the lender to select all of the officers and directors of thesubsidiary, giving the lender full power to manage and market thecollateral without taking ownership.

b. The collateral is in a single-asset, single member, manager managed LLC.Upon default on the loan, the lender becomes the sole manager of theLLC. Again, the lender gains full power to manage and market thecollateral without taking ownership.

c. A co-operative borrower and the lender negotiate an agreement by whichthe collateral is transferred to a newly organized, single member, managermanaged LLC. The single member is the borrower. The manager is thelender.

(1) The transfer to the LLC has no tax significance because the LLC isa disregarded entity, and the transfer is a disregarded transaction fortax purposes.

(2) The articles of organization of the LLC make the lender the solemanager of the LLC.

(3) As in the other two scenarios, the lender gains full power to manageand market the collateral without taking ownership.


B. Financial accounting for an "in-substance foreclosure."

1. An in-substance foreclosure is accounted for as an acquisition of the collateral,exactly like an actual foreclosure.

a. The loan is moved to OREO.

b. Loss, but not gain is recognized on the books as in a foreclosure.

C. Income tax accounting for in-substance foreclosures.

1. “In-substance foreclosure” is a regulatory and GAAP only concept. There is notax transaction.

2. No gain or loss is recognized for tax purposes when the lender gains control ofthe collateral and moves the loan to OREO.

3. The post foreclosure income and expenses are income and expenses of the“owner,” i.e. the borrower, not the lender.

4. To the extent that the lender advances the expenses, they are an extension of theloan, which can then be charged-off as a bad debt for tax purposes.

a. The fact that they are expensed for book purposes should count as a"charge-off." The asset has been removed from the books. Accordingly,

(1) Bank that have made the conformity election will have a bookcharge-off to which the tax charge-off "conforms."

(2) Banks that have not made the conformity election would also havemade the charge-off to qualify for a partially worthless deduction.

5. Since the loan is still outstanding, write-downs of the value of the collateralduring the holding period should be deductible "charge-offs" of the loan forincome tax purposes.

6. Gain or loss on “sale” of collateral is the borrower’s gain or loss included in theborrower's return.

7. The lender has either a charge-off or recovery equal to the difference between(i) the "collection" from the net proceeds of the sale and (ii) the income taxbasis in the loan.


VIII.TARP Transactions – Gain or Loss on Sale and Section 382

A. Gain or Loss on Redemption of TARP securities.

1. C Corps - The TARP securities are preferred stock.

a. The costs associated with obtaining the funds are stock issue costs and arenondeductible.

b. The dividends are nondeductible.

c. The warrants exercised by the government are additional stock and thepremium to redeem them is nondeductible.

d. For book purposes, the warrant to are being recorded as an allocation ofearnings over the five years to expected redemption.Debit Retained earnings $xxx.xxxCredit Preferred Stock $xxx,xxx

e. Accordingly, C corporations recognize no gain or loss on redemptionthrough the income statement.

(1) If there is a gain, it probably goes to paid in capital for bookpurposes because the government paid more for the preferred stockthan it was redeemed for.

(2) Any preferred dividends in arrears would also be an equityadjustment.

f. The same approach applies for tax purposes. Gain or loss on redemptionsshould not affect current or accumulated earnings and profits.

2. S Corporations - The S Corp TARP securities are debt.

a. The costs associated with obtaining the funds are debt acquisition costs,and are capitalized and amortized over the maturity of the debt.

b. The interest is deductible.

c. If the TARP securities are issued by the bank, rather than the BHC, theinterest expense is included in interest expense for purposes of the Section265(b) and Section 291(e) TEFRA disallowances.

d. If the TARP securities are issued by the BHC, then the interest is not


24 See Section 1272, Reg. 1.1272-1 and Section 1273.

25 Section 163(e).

26 See Section 1272, Reg. 1.1272-1 and Section 1273.

27 Reg. 1.1273-1(d). The discount is about 4.76% [ 0.05 divided by the stated principal at maturity of 1.05 = 4.76%].This is easily less than 7.5% [0.25% per year times 30 years].

included in the 265(b) and 291(e) disallowance calculations.

e. The Senior Warrant Subordinated Securities, equal to 5% of the TARPdebt, cause the TARP debt to be OID obligations.

(1) OID is recognized over the maturity of the debt.24 The unamortizedbalance is deducted when the TARP debt is prepaid.

(2) The issuer deducts OID over the same period as it is recognized bythe holder.25

f. The material question is what is the maturity of the TARP debt?

(1) The conventional wisdom was that the term of the TARP debt forincome tax purposes is its legal maturity, which is 30 years.26

(a) If this is correct, the OID is de minimis because it is less than0.25% multiplied by the years to maturity,27 and the OID isdeducted over 30 years on the straight-line method.

(b) The debt acquisition costs are also amortized over 30 yearsusing the straight line method.

(c) If the securities are prepaid within five years as expected, thenthe unamortized balances of the OID and the debt acquisitioncosts are deducted in the year prepaid.

(2) Upon further review, Regulation Section 1.1272-1(c)(5) shouldapply.

(a) Paragraph (c) of the Regulation addresses the yield andmaturity of obligations which are subject to contingencies.

“(c) Yield and maturity of certain debt instrumentssubject to contingencies.


28 Subparagraph (c)(2) is a payment schedule that is significantly more likely than not to occur and subparagraph (c)(3)is mandatory sinking fund provisions. Neither is applicable to the TARP obligations because (i) the thirty year paymentschedule is unlikely to occur, and (ii) there are no sinking fund provisions.

(1) Applicability. This paragraph (c) provides rulesto determine the yield and maturity of certain debtinstruments that provide for an alternative paymentschedule (or schedules) applicable upon the occurrenceof a contingency (or contingencies). This paragraph (c)applies, however, only if the timing and amounts of thepayments that comprise each payment schedule areknown as of the issue date and the debt instrument issubject to paragraph (c)(2), (3), or (5) of this section.”[italics added]

(b) The amounts of each payment during the entire 30 year life ofthe debt are known at issue and all of the payment dates areknown at issue, so paragraph (c) appears to apply to the TARPdebt.

(c) Paragraph (c) of the Regulation provides a “deemed” maturitydate for obligations that are the subject of that paragraph. Forthose obligations, the Regulation overrides the more generallanguage of Sections 1272 and 1273 and Regulation Section1.1272-1, which refer to OID calculations to the “statedmaturity” of the obligation.

(d) Subparagraph (c)(5) addresses the treatment of certain options.

“Treatment of certain options. Notwithstandingparagraphs (c)(2) and (3)28 of this section, the rules ofthis paragraph (c)(5) determine the yield and maturity ofa debt instrument that provides the holder or issuer withan unconditional option or options, exercisable on one ormore dates during the term of the debt instrument, that,if exercised, require payments to be made on the debtinstrument under an alternative payment schedule orschedules (e.g., an option to extend or an option to calla debt instrument at a fixed premium). Under thisparagraph (c)(5), an issuer is deemed to exercise or notexercise an option or combination of options in amanner that minimizes the yield on the debt instrument,and a holder is deemed to exercise or not exercise anoption or combination of options in a manner that


29 There are a number of examples in paragraph (j) of the Regulation. None of them are directly on point with the TARPsecurities, but the following scenario is consistent with the context of the examples.

30 The yield is so high at the end of the first year because the 5% warrant obligation would all be included in the firstyear’s yield.

31 9.19% total yield, minus the 7.7% stated interest.

maximizes the yield on the debt instrument. If both theissuer and the holder have options, the rules of thisparagraph (c)(5) are applied to the options in the orderthat they may be exercised.” [italics added] 29

(e) The issuer, in this case the Bank, has an unconditional optionto call and prepay the TARP obligation at any time.

(f) The holder, in this case the Treasury Department, has no putor call options.

(g) Accordingly, subparagraph (c)(5) should apply.

(3) If paragraph (c) and subparagraph (c)(5) apply, then the maturity ofthe TARP obligation is the date that results in the minimum cost tothe bank.

(4) As one would expect, the lowest yield to the holder of the TARPdebt is for a call at the end of five years.

(5) The annual yields, compounded quarterly, if the TARP obligationis prepaid at the end of the following years are:

1st Year 13.15% 30

4th Year 9.43%5th Year 9.19%6th Year 9.80%30th Year 11.74%

(6) Accordingly, the maturity of the TARP securities should be fiveyears.

(a) The TARP obligation is a five year debt instrument.(b) The issue price is 100.(c) The redemption price at maturity of 105.(d) The 7.7% interest is qualified stated interest, and(e) The OID is 1.49%. 31


(f) The OID is not di minimis; 1.49% divided by 5 years is0.298% per year, which is greater than 0.25%.

(7) Accordingly, the OID should be deducted over five years at theannual rate of 1.49% compounded quarterly.

(8) The debt acquisition costs would also be amortized over 5 years, buton the straight-line method.

(9) Any unamortized balance would be deducted in the year that thesecurities are prepaid.

3. If the S corporation TARP securities are redeemed at a discount, the Scorporation will recognize taxable gain from discharge of debt income for thediscount.

B. Risks of ownership changes under Section 382.

1. All stock issuances, and significant transactions in stock, of a “loss corporation”(a corporation at a loss or with carryforward NOL or tax credit carryforwards)should review their status under section 382 before issuing securities.

2. The following transactions most commonly contribute to or result in anownership change.

a. A merger, stock purchase or other corporate acquisition.

b. A significant capital infusion (over a 36 month period).

c. A large-block stock purchase (over a 36 month period).

3. For purposes of measuring whether the ownership of 5% shareholders increasesby more than 50 percentage points, all greater than 5% shareholders areaggregated and viewed as a single shareholder, but different groups and sub-groups are segregated based upon discrete transactions and events.

4. The more capital that is raised, the more the Bank needs to be aware of:

a. The 5% owners; and

b. How many shares can be issued to a greater than 5% shareholder; and

c. How many shares can be issued to a group of greater than 5%


shareholders before there would be a Section 382 problem.

5. Issuers would also need to be aware of whether any prior offerings would betreated as subject to the “anti-stuffing” provisions with respect to valuation ofthe entity.

a. With valuations of bank stocks at low values, and the long-term tax-exempt rates at historic rates, a Section 382 change could decrease thebank’s capital (as a result of the loss of the value of deferred tax assets)by an amount is excess of the capital raise.

C. Status of TARP for Section 382.

1. The Emergency Economic Stabilization Act of 2008 ( P.L. 110-343) authorizedthe Treasury Secretary to establish the Troubled Asset Relief Program (TARP)and the guidance issued since then has included:

a. Notice 2008-76;b. Notice 2008-84; and c. Notices 2009-14, 2009-38, and 2010-2

2. In general, stock acquired by Treasury will not be considered to have triggeredany of the Section 382 loss limitation rules.

a. Preferred stock will be treated as Code Sec. 1504(a)(4) stock, and it willnot be treated as stock for purposes of Code Sec. 382 while held by theTreasury or by other holders.

(1) Exception - Preferred stock will be treated as stock for purposes ofdetermining the old loss corporation's value under Code Sec.382(e)(1).

b. Any warrant to purchase stock acquired by the Treasury pursuant to thePublic CPP, TARP TIP, and TARP Auto will be treated as an option (notas stock) and will not be deemed exercised under Reg. §1.382-4(d)(2)while held by the Treasury.

3. TARP Qualities

a. TARP is issued as Section 1504(a)(4) preferred stock.

b. General, non-public entities do not have the common stock warrants.

c. Common stock warrants, if sold by Treasury, will generally create a


testing date.

D. Deals and the Impact on Section 382.

1. Institution buys back the TARP – not an equity shift.

2. If the TARP is sold (and the Treasury retains the Warrants, or no Warrants wereever issued), the TARP would retain its Section 1504(a)(4) preferred stockclassification, and thus would not result in an equity shift for Section 382.

3. Designated buyers – If the designated buyer wants to execute a transaction inwhich the TARP shares are purchased, and exchanged for common shares, orpreferred stock with traditional conversation features, an ownership couldresult.

4. Doing a deal will be more adverse than similar stock issuances.

a. No cash would be added to the institution, so the issuance would not beentitled to the favorable provisions accorded in the ‘cash issuanceexception.’

5. The “Cash Issuance Exception” - Stock issued solely for cash is excluded fromthe segregation rules up to an amount equal to one-half of the stock held bysmall shareholders before the new issue.

a. The exception, when calculated, cannot exceed: Total stock issued minusstock owned by 5% shareholders immediately following the issuance.

b. If a loss corporation issues stock solely for cash, a fraction of that stockis considered as acquired by the existing public group(s). This fraction isdetermined under the following formula:

(1) Stock owned by public group before Stock x 50% =

(2) New Issuance / Total stock owned by all public groups beforeissuance.

IX. S Corporations - Character of Income or Losses on Foreclosed Operating Assets

A. The question is whether the net loss, or income if any, of an S corporation onforeclosed operating assets is "passive income or loss," even to the activeshareholders. There are really two questions:

1. If an S corporation bank forecloses on a real estate loan and either (i) takes


possession of the property subject to the existing leases or (ii) rents the propertyduring the holding period until it can be sold, is the foreclosed real estate a“rental activity” that must be separately disclosed on Schedule K, Line 2 ofForm 1120-S and Form 8825, and income or loss from a passive activity?

2. A similar question arises if an S corporation bank leases out part of its premises,either headquarters building or branch building, to one or more tenants.

3. If an S corporation bank forecloses on an operating business, such as arestaurant, bar, hotel, etc. and operates the business until it can be sold, is theoperating business a passive activity to the shareholders, including the activeshareholders of the bank?

B. Operating Foreclosed Real Estate

1. The rental and passive activity issue has a number of tax implications:

a. If the rental of the foreclosed collateral is a real estate rental activity, it isalso a passive activity for all of the shareholders.

(1) That may not be a material issue for the shareholders who do notactively participate in the banking business because, as long as thebank itself is profitable, the passive income from the bankingactivity will exceed the passive loss from the rental.

(2) However, it is material to the shareholders who actively participatebecause their allocated shares of income from the banking businesswill not be passive income. Unless they individually have otherpassive income, they are likely to be disallowed their share of theloss as an excess passive activity loss.

b. If the rental of foreclosed collateral is a real estate rental activity, does thebank have one passive activity, renting foreclosed collateral, or is eachproperty a passive activity?

(1) If the bank has only one passive activity, when is that activity“disposed of” for purposes of allowing the deduction ofaccumulated excess passive losses under Section 469(g)?

(2) If the bank deducts operating expenses and depreciation offoreclosed property that is rented, does the bank risk changing thecharacter of its gain or loss from ordinary to capital?

c. Regulation Section 1.469-1T(e) defines a passive activity, a rental


32 Reg. 1.469-9(h).

33 The instructions to Form 8825 appear to be clear that rental properties must be separately listed by property. Line 1to the Form states, "Show the type and address of each property." The instructions to the Form include the followingexample where more than one property are a single passive activity.

"If there are more than eight properties, attach additional Forms 8825."The number of columns to be used for reporting income and expenses on this form may differ from the number

activity, and the exceptions to a rental activity. The Regulation is longand complex, but the major problem fitting within one of the exceptionsto a passive rental activity is the requirement that gross rental income forthe entire tax year be less than 2% of the lesser of the fair market value orincome tax basis in the rented property.

d. Mr. Cederberg discussed the issue orally with an attorney in the NationalOffice of the IRS, and was told that, while the bank's issue is sympathetic,except for the 2% exception, he believes that the income and expensefrom the operating OREO is probably passive rental income and expense.

e. In summary:

(1) If the gross income on a property is less than the 2% threshold, thenthe property is not a rental activity and is not a passive activity. Itwould be reported on Page 1 of the Form 1120-S return.

(2) If the gross income on a property is greater than the 2% threshold,then the property is a rental activity, is a passive activity, would bereported on Form 8825 and Line 2 of Schedule K, and is a passiveactivity.

(3) Whether the 2% threshold is met is determined on a property-by-property basis.

2. Should the bank make the election in Regulation Section 1.469-9(g)(1) to groupall foreclosed rental properties as a single passive activity?

“(1) In general. A qualifying taxpayer may make an election to treat allof the taxpayer's interests in rental real estate as a single rental real estateactivity.”

a. The election is made by the S corporation.32

b. It may be tempting to make this election, especially if the practitionerconcludes that it would then be permissible to group all of the rentalproperties in one column on Form 882533 and avoid the compliance issue


of rental real estate activities the partnership or S corporation has for purposes of the passive activitylimitations. For example, a partnership owns two apartment buildings, each located in a different city. Forpurposes of the passive activity limitations, the partnership grouped both buildings into a single activity.Although the partnership has only one rental real estate activity for purposes of the passive activity limitations,it must report the income and deductions for each building in separate columns."

of completing that form property-by-property.

(1) If the gross income on some operating properties is less than 2% ofvalue, making the single activity election may include thoseproperties in passive rental income when they might not otherwisebe included.

(2) Suspended excess passive losses may not be allowable underSection 469(g) until all of the foreclosed properties that are groupedas a single activity are sold.

C. Operating Foreclosed Businesses

1. The foreclosed business probably becomes a passive activity for all of the bankshareholders for a different reason.

a. In most cases, the bank employees will not operate the business directly.The bank will retain someone experienced in operating that kind ofbusiness to operate it for the bank; perhaps even in hopes that the operatorwill eventually also be the purchaser.

2. Three questions arise in the S corporation context.

a. First, has the S corporation bank "leased" the business to the operator, oris the bank operating the business?

(1) Leasing the business is not uncommon. The answer turns on whohas the opportunity for gain and risk of loss from operations.

(2) If the bank collects rents from the operator, and the opportunitiesand risks of operations are with the operator, except perhaps forsome percentage rents, then the bank has leased the business, andthe previous section on rental activities would apply equally to theforeclosed business.

(3) If on the other hand, the bank is operating the business with a hiredmanager, and the bank has the risk of loss, then this section applies.


34 There is no provision in most state laws for a partnership to have a sole partner.

35 Unless, of course the bank took control in an "in substance foreclosure," in which case the borrower still owns theentity, and the business operations, for income tax purposes.

36 I expect that in most cases, the bank will want to make the QSub election, despite the passive loss implicationsdiscussed below. In most cases, the business is not likely to be operating profitably or it would not have become subjectto foreclosure. The accumulated net operating loss carried forward by a C corporation is not likely to be very valuableto the eventual buyer because of the limitations under Section 382 after two changes of control in less than three years.Even as passive losses, the net losses will usually be materially more valuable to the bank's shareholders.

b. Second, if the bank is operating the business, how does the income or lossof the business pass through to the bank's return? In most cases the bankwill have acquired the entity operating the business, and the operatingbusiness will not be a division of the bank.

(1) If the entity was a partnership, or more likely a limited liabilitycompany taxed as a partnership, and the bank acquired all of thepartnership or LLC interests in foreclosure, then

(a) If the entity was an LLC, the LLC became a disregarded entitywhen the bank became the sole owner, and the operations willpass through to the return of the S corporation bank.

(b) If the entity was a partnership, then the partnership dissolvedwhen the bank became the sole owner,34 the business becamea division of the bank, and the operations will pass through tothe return of the S corporation bank.

(2) If the entity was a C corporation, an S corporation, or an LLC whichhad made the election to be taxed as a C or an S corporation, thenthe entity became a C corporation subsidiary of the bank when thebank took control.35 Unless the bank makes a timely QSub electionfor the new subsidiary, the entity will file its own, separate Ccorporation return, and the income and expenses will not passthrough to the bank's S corporation return.36

c. Third, is the operating business a separate passive activity to theshareholders of the S corporation?

(1) Section 469(c) states in relevant part:.

"(c) Passive activity defined. For purposes of this section (1)In general. The term "passive activity" means any activity(A) which involves the conduct of any trade or business, and


(B) in which the taxpayer does not materially participate."

(2) There are a number of criteria for determining whether theshareholder "materially participates" in a trade or business, but themost common test is whether the shareholder devotes at least 500hours of work to the business.

3. It is unlikely that, unless a particular shareholder has experience in operating theforeclosed business, that any shareholder will qualify as an active participantin that business.

X. S Corps and Life Insurance

A. Recording investment in an insurance contract.

1. Section 1001(a) provides gain from sale or disposition of property is the excessof the amount realized over the adjusted basis of the property.

2. For C Corps basis is defined by Sections 1011 through 1023.

3. In the case of S Corps add in the adjustments from Section 1367.

B. Basis before the transaction.

1. For determining gain or loss when a contract is surrendered, the aggregateamount of the consideration paid for the insurance contract minus the aggregateamount received under the contract (that is excludable from gross income) is thebasis of the contract.

2. Under Rev. Rul. 2009-13 upon surrender of the policy, income is recognized tothe extent the amount received is in excess of the investment in the contract.

a. Investment in the contract (above) is all amounts invested less theamounts received that are not taxable.

b. However, the basis in the contract is different. Basis is the investment inthe contract reduced by the portion of the premiums that are consideredto have paid for the ‘cost’ of the insurance that has been consumedthrough the date of the transaction.

c. Gain or loss on sale of a policy is the difference between the amountrealized and the basis in the contract.

C. Surrender is governed by Section 72 and sale of a contract is governed by Section


1001.

1. Meaning for S Corps with prior C Corp E&P Life insurance is accounted forin the AAA account

2. Basis is adjusted under Section 1367 except for income and expenses that areexempt from tax.

3. In Section 1367(a)(2)(D) shareholders basis is reduced by “any expense of thecorporation not deductible in computing taxable income and not properlychargeable to capital.”

4. Using the same analysis that we use in determining the AAA account and theOAA the insurance premium would not reduce the AAA account – likelychargeable to the OAA. The cost of insurance reduces the basis of the policybut not the investment in the policy.

D. Example of Disposition

1. Premiums of $10,000 are paid each year for 5 years. The cost of insurance eachyear is $1,500 and the basis is $8,500.

2. At the end of the 5th year the basis of the contract is $42,500 and the investmentin the contract is $50,000.

3. The policy is disposed of for $55,000 at the end of 5 years. The net gain is$5,000.

E. Surrender of the policy

1. The surrender of the policy would result in income of $5,000, equal to theproceeds in excess of the investment in the contract. If the cost of the insuranceis charged to the OAA, the net impact of the transaction would be a reductionin the AAA of $2,500. The OAA is decreased by $7,500 during the holdingperiod.

2. The cost of the insurance during the term of the policy reduces the shareholders’investment of the S Corp under Section 1367.

a. With a gain of $5,000 and a cost of insurance the $7,500, the shareholders'basis is decreased by $2,500.

(1) The basis is increased by the gain on surrender.


F. Sale of the Policy

1. In a sale of the policy, the basis is measured by the investment in the policy, sothe gain would be $12,500.

a. Basis in the S Corp stock is decreased by the cost of insurance ($7,500)and the net impact on S Corp shareholder basis is $5,000.

G. If the policy is held to ‘maturity’ by death of the insured.

1. Death benefits (net of related expenses) under Section 1368(e)(1)(a) wouldmean that neither the gain nor the cost of insurance would impact theshareholders’ basis.

XI. S Corps at a Stock Offering Cross-Roads – Undoing the S Election for Tier 1 CapitalThis may not be a recommended strategy but it bears consideration if the bank is short ofcapital..

A. In general, S Corps do not record deferred taxes on their financial statements.

1. As a “pass-through” entity, the deferred tax "asset" that most C corporationbanks have recorded, unless it is "reserved" because of recession era losses, isthe shareholders' asset, not the company's.

2. However, shareholders typically look to the corporation for distribution at leastequal to their "current" income tax liabilities associated with the companyearnings.

B. Financial Statement Capital - When the bank elected to become an S corporation, itwas required to eliminate its deferred tax asset or liability. Since most banks have adeferred tax asset due to the loan loss reserve, this was most likely accomplishedthrough a charge to expense.

1. If the bank were to terminate the S election, the deferred tax asset would bere-established, thus creating a one-time increase in book income and capital.

a. The effect is similar to that of an equivalent stock offering, except that:

(1) The company would not incur the costs of a stock offering;

(2) The shareholders would not incur the dilution associated with thevaluation "discount" that would likely be associated with a stockoffering of a potentially "undercapitalized" bank;


(3) There would be no dilution of the existing shareholders; and

(4) If Section 382 is a consideration, it would not affect a potentialchange date.

2. In addition, as the bank grows, the deferred tax asset is likely to grow also.

a. As long as the corporation remains an S corporation, the annual increasein the "deferred tax asset" is likely to be distributed, thereby decreasingbook capital by a growing amount each year.

C. The Tier 1 Capital benefit might be staged.

1. GAAP does not really look at the timing of the realization of a deferred taxasset, as long as it is more likely than not that the benefit will be realized.

2. The Call Report Tier 1 Capital calculation, allows recognition subject tolimitations.

a. The deferred tax asset must be recognized for GAAP to be benefited.

b. Test 1: The first limit is that the deferred tax asset cannot exceed 10% ofTier 1 Capital before the deferred tax asset.

c. Test 2:

(1) Determine the amount of taxes that could be realized as a result ofall of the temporary differences reversing on the report date (thecarryback amount).

(2) The amount of the deferred tax assets dependent on future earnings- Forecast the tax on the next 12 months of earnings.

(3) Forecast of pre-tax items and permanent differences ; plus

(4) Tax planning strategies that are reasonable and practical (and in theopinion of many regulators, that you expect to implement in the next12 months).

d. Add Test 1 (the carryback potential) and Test 2 (forecasted earnings) butthe sum cannot exceed the total deferred tax asset for GAAP.

e. The maximum amount of the deferred tax asset that can be benefited forTier 1 capital is the lesser of Test 1 or Test 2.


(1) This is a severe limitation on an S corporation converting to a Ccorporation because in the first year as a C corporation, thecompany will no carryback potential, and in the second year only alimited carryback potential.

f. Basel 3 appears to eliminate the use of the 12 months of forecastedincome.

(1) Companies converting from S to C status after the effective date ofBasel 3 will have even more difficulty initially benefitting deferredtax assets in Tier 1 capital.

D. Other Issues to consider whether to continue the S election. (A small sampling of theIssues to consider.)

1. Income Tax Rates on Shareholders.

a. Individual tax rates on dividends from C corporations could possiblyincrease, especially for high income shareholders, from 15% to over43.4%, including the AFA tax on unearned income.

b. On the other hand, the maximum federal tax rates on S corporationearnings passed through to "passive" shareholders may also increase from34% to 43.4%; an increase of 28%.

(1) Active shareholders may be subject to the excess AFA tax on the Scorporation earnings, but if there are a significant number orpercentage of passive shareholders, they will look to the companyto make distributions reflecting the 43.4% rate.

(2) That will affect capital because if the 43.4% is distributed to thepassive shareholders, the identical rate must be distributed to allshareholders.

2. Shareholder Reporting

a. As the concept of “economic nexus” continues to have a life of its own(including the concept introduced by California as ‘factor nexus’), moreS Corp shareholders will be required to file in more states and theirindividual returns may become more complex than they are willing tomanage, unless the company is willing to absorb the cost of the filingcompliance, which has its own tax reporting difficulties.


37 Reg. 1.1272-1(c)(2).

38 As discussed again below, Section 163(e) allows the issuer a deduction for original issue discount parallel to theamount recognized by the holder.

b. Estimated taxes will also present a problem consistent with the annualfilings discussed above.

c. More states are requiring withholding on earnings distributed tonon-residents.

3. C Corporations have the advantage of being able to raise capital by issuingmultiple classes of equity instruments.

a. One of the legislative objectives of the Independent Community Bankersof America in their "Communities First" act is to allow S corporations toissue preferred shares and treat the preferred dividends paid as a priorallocation of earnings.

4. C Corporations may sell stock to ineligible shareholders.

XII. Trust Preferred Securities - Deferred Interest Payments.

A. Trust preferred securities could have been OID obligations when issued, but theprospectuses which the faculty has reviewed have all treated the TPS as not havingOID.

1. The issuer's ability to defer interest payments could have resulted in OID status.

2. The determining factor is whether the likelihood of deferring interest was"remote" or the deferral of interest is not "significantly more likely than not tooccur."37 Regulation Section 11275-2(h) states in relevant part:

"(h) Remote and incidental contingencies. (1) In general. Thisparagraph (h) applies to a debt instrument if one or more paymentson the instrument are subject to either a remote or incidentalcontingency. Whether a contingency is remote or incidental isdetermined as of the issue date of the debt instrument, including anydate there is a deemed reissuance of the debt instrument underparagraph (h)(6)(ii) or (j) of this section or section 1.1272-1(c)(6).Except as otherwise provided, the treatment of the contingencyunder this paragraph (h) applies for all purposes of sections 163(e)38


39 Section 163(e)(5) relates to high yield obligations that are not an issue with trust preferred securities.

(other than sections 163(e)(5)39) and 1271 through 1275 and theRegulations thereunder. For purposes of this paragraph (h), thepossibility of impairment of a payment by insolvency, default, orsimilar circumstances is not a contingency.

"(2) Remote contingencies. A contingency is remote if thereis a remote likelihood either that the contingency will occur or thatthe contingency will not occur. If there is a remote likelihood thatthe contingency will occur, it is assumed that the contingency willnot occur. If there is a remote likelihood that the contingency willnot occur, it is assumed that the contingency will occur."

a. The prospectuses have concluded that deferral of the interest was"remote."

b. The significant due diligence done by the investment bankers who puttogether the trust preferred issues, and the financial standards imposed onthe issuing banks, probably support the position that the publicly issuedtrust preferreds, whether single bank issues or pools, were not OIDobligations.

c. Private issues used to raise capital for a bank that was incurringsignificant losses could be OID obligations from the date of issue.

B. When interest is first deferred, then the trust preferred security becomes an OIDobligation. Regulation Section 1.1275-2((h)(6) states in relevant part:

"(6) Subsequent adjustments. (i) Applicability. This paragraph (h)(6) appliesto a debt instrument when there is a change in circumstances. For purposes ofthe preceding sentence, there is a change in circumstances if -

"(A) A remote contingency actually occurs or does not occur, contrary tothe assumption made in paragraph (h)(2) of this section;

"(B) A payment subject to an incidental contingency described inparagraph (h)(3)(i) of this section becomes fixed in an amount that is notinsignificant relative to the total expected amount of the remaining paymentson the debt instrument; or

"(C) A payment subject to an incidental contingency described inparagraph (h)(3)(ii) of this section becomes fixed such that the differencebetween the assumed payment date and the due date of the payment is not


insignificant.

"(ii) In general. If a change in circumstances occurs, solely for purposes ofsections 1272 and 1273, the debt instrument is treated as retired and thenreissued on the date of the change in circumstances for an amount equal to theinstrument's adjusted issue price on that date."

1. This is not a modification of the debt obligation under Regulation Section1.1001-3. No gain or loss is recognized.

a. The "reissued" language is limited solely to Section 1272 and 1273.

b. Implementing a "remote" provision of the obligation is not a"modification" of the obligation because the deferral was in the originaldocument.

C. The practical effect is that the accrued interest expense becomes OID rather thanstated interest.

1. If the trust preferred security has become an OID obligation, then the OID isdeductible by both an accrual basis issuer and a cash basis issuer as it accrues.

a. Section 163(e) allows the issuer a deduction for OID equal to theaggregate daily portions of the original issue discount during the taxableyear. This amount is equal to the amount included in the taxable incomeof the holders.

(1) There is no restriction on the deduction based on the issuer's overallmethod of accounting.

(2) Both accrual basis and cash basis issuers would deduct the sameamount of OID as it accrues, even though it is not paid.

2. Similarly, the holders of trust preferred securities recognize OID income,whether on the accrual or cash method, for deferred interest that has not beenreceived

3. What if the OID is uncollectible?

a. The rulings on nonaccrual of interest do not apply because OID cannot beplaced on "nonaccrual."

b. Regulation Section 1.1272-1(g) states that OID is added to the income taxbasis in the obligation itself.


c. Uncollectible OID is not a separate asset like accrued interest receivable.Rather, it becomes part of the income tax basis in the obligation.

d. Accordingly, uncollectible OID should be "charged-off" and deducted asa bad debt under Section 166(a)(2) and (b).

(1) It is necessary for the holder to both recognize the OID on the booksas income and an addition to the OID security, and charge the OIDoff to the reserve for loan and lease losses on the books.

(a) Recognition is the step that includes the OID in the basis ofthe obligation.

(b) The charge-off is the step that allows for a deduction for thepartial worthlessness of a debt.

(2) If the holder has made the conformity election, this approach willcreate the "charge-off" to which its bad debt deduction can"conform."

(3) Even if the holder has not made the conformity election, the partialbad debt deduction is only allowed under Section 166(a)(2) to theextent of "the part charged off within the taxable year."

D. Does a Trust Preferred Security cease to be an OID obligation when the interest isbrought current?

1. No. Once the Trust Preferred Security has become an OID obligation, itremains an OID obligation until it is retired.

a. The Trust Preferred did not become an OID obligation because theinterest was deferred, but rather because the deferral was no longer a"remote contingency." Once the interest has been deferred, the likelihoodof a deferral is no longer "remote."

b. The Trust Preferred changed from an non-OID obligation to an OIDobligation because it is deemed by Regulation Section 1.1275-2((h)(6)(ii)to have been redeemed and reissued when there was a change incircumstances. Again, the "change in circumstances" was not the deferralof the interest, but rather the remote contingency actually occurringcontrary to the assumption made when the obligation was issued. Payingthe interest currently was not a remote contingency, so bringing theinterest current is not a change of circumstances under Regulation Section


1.1275-2(h)(6)(ii).

E. What information reports are required?

1. The issuer should report the interest income to the holders on Form 1099-INTas long as interest payments have not been deferred.

2. Once interest has been deferred, then the issuer should switch for Form 1099-OID.

a. Deferred interest would be reported in Box 1.

b. Box 2 would not be used until the issuer has paid the interest current.

c. Subsequent interest payments would be reported in Box 2.

(1) Box 1 would be zero for as long as the interest continues to be paidcurrently as scheduled.

XIII. Prohibited Transactions by Self-Directed IRA AccountsNot something that CPAs deal with every day; more properly the province of ERISAcounsel. However, a couple of

A. The Department of Labor views the beneficiary of a self-directed IRA account as afiduciary.

1. Accordingly, any act that would be a prohibited transaction by a fiduciary of aqualified plan is also prohibited to the beneficiary.

B. Co-investing is a Prohibited Transaction

1. It is the view of the Department of Labor that an investment by a self directedIRA account in the same closely held business by as the beneficiary is investedis a prohibited transaction.

a. Citations

(1) Advisory Opinion 2000-10A(2) Advisory Opinion 2006-9A

b. Investment in a closely held entity by a self-directed IRA account and byany member of the beneficiary’s family is also "co-investing" and aprohibited transaction.


(1) The members of the "family" are the beneficiary's spouse, thebeneficiaries' ancestors and their spouses, and the beneficiariesdescendants and their spouses.

C. Possible prohibited transactions

1. Investment in a closely held business may be a prohibited transaction if:

a. The beneficiary is an officer, director, or highly compensated employeeof the business in which the IRA account invested.

b. A member of the beneficiary’s family is an officer, director, or highlycompensated employee.

c. The beneficiary is a service provider to other IRA accounts invested in thesame entity.

D. The Department of Labor places great emphasis on contemporaneous writtenopinions of ERISA Counsel on IRA investments in closely held entities.

1. Oral conversations with general corporate counsel regarding whether theinvestment is a prohibited transaction, even if noted in counsel's invoice for thetime spent researching and discussing the question with the beneficiary, is notwell received.

E. Summary - Only in the most obvious situations should an IRA invest in a closely heldentity without a written Opinion of Counsel.

XIV. Taxable Acquisitions Using the Stock of the Acquirer.

A. The recession has created a situation, especially with banks, in which shareholdersof a "troubled" bank are willing to accept shares of the acquirer to salvage some valuefrom their investment. The typical scenario is:

1. The Acquirer wants to use stock as the consideration, either to save capital tosupport the combined organization, or to create capital.

2. The Target shareholders are willing to take the stock, but they want a taxable"sale" of their loss shares.

3. The tax free reorganization provisions of Section 368 are not "elective." Onecannot have a taxable exchange simply by "electing" to have a taxableexchange. If the transaction meets the requirements of any of thereorganizations in Section 368, there is no loss on the exchange of the loss


shares.

B. The ideal vehicle for a taxable exchange of shares is the "Plan of Share Exchange"that is now part of the corporation statutes of most states.

1. The Plan of Share Exchange is effectively a "non-merger merger." A majority,or super-majority depending upon the articles of incorporation, vote binds 100%of the target shares just as would be the case in a corporate merger.

a. At closing, the shareholders of Target surrender their shares to acquiringin exchange for acquiring shares, but there is no corporate merger. UnlessAcquiring does a subsequent transaction, Target becomes the 100%subsidiary of Acquiring.

2. Because there is no merger, the only available tax-free reorganization is a "B"exchange of shares.

a. Many transactions would be ineligible for a "B" reorganization under anycircumstances because of the requirement for a "B" reorganization that theconsideration be solely voting stock of acquiring. Many previoustransactions may make the Target ineligible to participate in a Breorganization.

(1) The most common is probably a cash redemption of shares.

b. More to the point, a B reorganization can be avoided by including somecash in the consideration to the Target shareholders.

(1) Technically, even $1 in cash to one target shareholder would avoidthe B reorganization.

(2) Being that aggressive, however, is in my view very unwise. Thecash does not need to be great, but I advise making it reasonable andto all of the Target shareholders.

C. Absent a plan of share exchange, I recommend a reverse triangular merger in whichthe consideration to the purchaser is less than 80% stock of the acquirer parent.

1. Acquirer creates Newco subsidiary; Newco is merged into Target in a reversemerger. The consideration is less than 80% by value of Acquirer's stock and thebalance in cash.

a. The reverse merger fails the "control" test of Section 368(a)(2)(E).


40 Rev. Rul. 90-95, Scenario 2.

41 Also Rev. Rul. 90-95, Scenario 2.

b. The merger is a "qualified stock purchase" of Target if the section 338(g)and (h)(10) elections are desired to be made.40

(1) In the Revenue Ruling, all the consideration was cash, but thatshould not be material to the holding if the reverse merger fails thecontrol test. In that case, the Acquirer's stock is "other property."

c. If Target is subsequently merged into Acquiring, that is honored as aliquidation under Section 332; separate and subsequent to the reversemerger. The transaction is not recharacterized as an A reorganization.41

D. Issues confronted in a "taxable merger" using a plan of share exchange.

1. If the transaction would otherwise meet the continuity of interest test for an Areorganization, I discourage the Acquirer from merging the Target into asubsidiary immediately after closing a Plan of Share Exchange.

a. The Plan of Share Exchange is not covered by Rev. Rul. 90-95, and it isnot clear that the Service will not attempt to recharacterize the transaction.

b. Second, if the subsequent step is a "statutory merger" of Target into anAcquiring subsidiary [as it would be in the banking environment], that isa "merger," not a liquidation.

c. If the step transaction doctrine is applied, then the Plan of Share Exchangeis ignored, Target is merged into Acquiring subsidiary, and the transactionmeets the continuity of interest rules for a tax-free A reorganization byvirtue of (a)(2)(D).

d. In this event, I encourage (i) waiting at least until the following tax yearto merge target into acquiring subsidiary, (ii) have no provision in the planof share exchange agreement regarding the intention to merge thecompanies, and (iii) have any subsequent merger considered and approvedby the Boards of the two companies in the later year.

2. Wash Sale - By definition, the taxable plan of share exchange has the potentialfor a wash sale because the target shareholders are exchanging a direct interestin their company for an indirect interest, through the acquiring corporation, intheir company.


42 Reg. 1.1233-1(d)(1) .

a. Section 1091 defers a loss on the "sale" of shares if "substantiallyidentical" shares are acquired within 30 days before or after the lossshares are sold.

b. We normally think of a "wash sale" applying to a sale of loss shares in themarket and the purchase of the same shares within 30 days before or afterthe sale. However, it can apply as well to a taxable exchange of shares.

c. The relevant standard is whether the target shares exchanged are“substantially identical” to the acquiring corporation's shares received.

d. “Substantially identical” as used in Section 1091 is defined in the Section1233 Regulations, which state in relevant part:

"Substantially identical property. The term "substantiallyidentical property" is to be applied according to the facts andcircumstances in each case. In general, as applied to stocks orsecurities, the term has the same meaning as the term"substantially identical stock or securities" used in section1091, relating to wash sales of stocks or securities. …Ordinarily, stocks or securities of one corporation are notconsidered substantially identical to stocks or securities ofanother corporation. In certain situations they may besubstantially identical; for example, in the case of areorganization the facts and circumstances may be such thatthe stocks and securities of predecessor and successorcorporations are substantially identical property. Similarly,bonds or preferred stock of a corporation are not ordinarilyconsidered substantially identical to the common stock of thesame corporation. However, in certain situations, as, forexample, where the preferred stock or bonds are convertibleinto common stock of the same corporation, the relativevalues, price changes, and other circumstances may be such asto make such bonds or preferred stock and the common stocksubstantially identical property. Similarly, depending on thefacts and circumstances, the term may apply to the stocks andsecurities to be received in a corporate reorganization orrecapitalization, traded in on a when issued basis, as comparedwith the stocks or securities to be exchanged in suchreorganization or recapitalization.”42

e. The guidance on when stocks of two different corporations are


43 Field Service Advices are memoranda from the IRS Associate Chief Counsel’s Office to examining agentsresponding to questions asked by the examining agent for an examination in progress. Technically, they have noprecedential authority. Field Service Advices are even lower on the hierarchy of guidance than Technical AdviceMemoranda because (i) the taxpayer is not involved in the request for assistance [there is no “taxpayer provided position”in the request for assistance and there is no conference of right by the taxpayer with the Associate Chief Counsel’sOffice], and (ii) the examining agent is not required to follow the Associate Chief Counsel’s advice even on theexamination for which it was requested.

44 The FSA cites the same Regulation quoted above, the 3rd Circuit decision in Hanlin et. al. v. Commissioner [108F.2d 429 (3 CA, 1939), and the Board of Tax Appeals decision in Knox v. Commissioner [33 BTA 972 (1936), nonacq].

“substantially identical” is scarce.

(1) The general rule is that stocks of two different corporations are not“substantially identical.” The deference accorded the “general rule”becomes obvious in the Field Service Advice 1998-184. Unless anexception clearly applies, the general rule will prevail.

(2) The only IRS guidance which I have located is Field Service Advice1998-184.43 The taxpayer was a corporation, which had entered intoan agreement to sell at least one subsidiary to another corporationfor cash. On the same day as the closing, the selling corporationpurchased shares of the buying corporation for cash. The agentasked whether Section 1091 applied to disallow the loss on the saleof the subsidiary.

(a) The National Office advised that the shares of the acquiringcorporation which were purchased were not “substantiallyidentical” to the shares of the subsidiary which were sold, andthat Section 1091 did not apply. The Service concluded:

“… a court would likely hold that the indirectinterest that *** held in the *** subsidiariesthrough an interest in *** [the acquiringcorporation whose stock the taxpayer hadpurchased] was not substantially identical to the*** subsidiaries securities that *** owned prior tothe series of transactions and that section 1091would not preclude *** from claiming the loss.

“Accordingly, we conclude that the wash saleprovisions of section 1091 should not be assertedas a basis for disallowing a portion of the $***capital loss reported by *** on the sale of ***subsidiaries to ***.”44


45 Capitalized transaction costs are added to the cost of the acquired assets; they are not a separate intangible asset thatis amortized like organization expenses or start-up costs. Reg. 1.263(a)-5(g)(2)(i).

(3) A material consideration is whether:

(a) The corporations themselves are substantially identical.

(i) The perfect example would be a newly formed bankholding company doing a taxable plan of share exchangeto acquire a loss bank.

(b) Whether the shares of the two corporations are likely to trade“in tandem” with each other.

f. It appears unlikely that taxable exchanges will be wash sales in mostcases, but Target shareholders need to be wary of this issue because IRSexaminers have clearly raised the issue on examination.

XV. Asset Acquisitions - Failed Bank Assets; Section 338 Acquisitions; QSub Purchases;Purchase & Assumptions.

A. Purchase price. The purchase price is likely to be different for book and tax purposes.

1. Income tax - The sum of (i) cash paid to the seller, (ii) the liabilities assumed,and (iii) the capitalized transaction costs if any.45

2. Financial accounting - Only the liabilities assumed.

a. Cash paid to the FDIC for fixed assets is normally treated as a separatepurchase of assets transaction, and the fixed assets are recorded at “cost.”

b. Transaction costs are expensed as incurred under FAS 141R.

B. Income tax treatment of cash paid to the FDIC to purchase the fixed assets, andperhaps some other assets, such as “retained loans” which the acquiring bank hassome period of time to review and decide whether to purchase.

1. It is the oral position of the IRS National Office that any subsequent purchasesof assets from the FDIC are included in a single purchase of assets transaction.

a. The IRS National Office does not view the purchase of premises andpersonal property at appraised value, even if acquired several months afterthe initial closing, to be a separate transaction. They believe that the steptransaction doctrine applies. This has the effect of:


46 Reg. 1.263(a)-5(d)(1).

47 Reg. 1.263(a)-5(d)(1).

48 Reg. 1.263(a)-5(d)(3).

(1) Adding the purchase price for the separately acquired assets to the“purchase price” allocated among all the assets.

(2) The separately purchased assets are then added to their respectiveClasses under the Section 338 Regulations. For example:

(a) Premises and fixed assets are added to Class V.

(b) Loans are added to Class II or III depending upon whether theseparately purchased loans are subject to a loss sharingagreement.

2. This may result in the acquiring bank having no income tax basis in assets forwhich it manifestly paid a sum of money, but the result is probablyadvantageous. Including the purchase price for the fixed assets in the overallpurchase price increases the amount allocable to shorter lived assets in higherClasses.

C. Capitalized transaction costs for tax purposes.

1. The Section 263(a) Regulations to apply to capitalize transaction costs.

2. The “whether and who” test is met in an FDIC failure when the bank makes thedecision to respond to the FDIC’s invitation with a bid. Unlike most non-assisted acquisitions, there are unlikely to be any transaction costs that can beexpensed under the exception in the Regulations for the “process ofinvestigating and pursuing” an acquisition before the “whether and who”decision is made.

3. In house salaries are not capitalized.46

4. Ordinary in house overhead expenses are not capitalized.47

5. If all other costs, including legal fees and accounting fees, total less than$5,000, they are not capitalized. If all other transaction costs total more than$5,000, then all of those costs are capitalized.48


49 Reg. 1.263(a)-5(c)(6).

50 Reg. 1.263(a)-5(l), Example 6.

6. Integration costs to integrate the operations of the failed bank with the acquiringbank are not capitalized, regardless of when the integration activities occur.49

a. Under the Regulation, integration costs include, “costs to relocatepersonnel and equipment, provide severance benefits to terminatedemployees, integrate records and information systems, prepare newfinancial statements for the combined entity, and reduce redundancies inthe combined business operations.”50

b. This would include any costs of conforming tax accounting methods,conforming the financial accounting methods, “auditing” the purchaseaccounting for the acquisition, etc.

c. The integration cost exception would also apply to printing newletterhead, forms, et. al.

7. The costs of new signs is a separate, depreciable fixed asset purchased by theacquiring bank.

D. Allocating the purchase price among the assets purchased.

1. The allocation process is entirely different between book and tax. Theacquiring bank will need “two sets of books” to properly distinguish betweenbook and tax accounting.

a. FAS 141R creates a parallel calculation for financial reporting purposes.

(1) The purchase price in one column.

(2) The fair market value of all the assets acquired in the other column.

(3) The difference between the totals is either a “bargain purchase gain”or goodwill.

(a) A bargain purchase gain is not “realized gain” for income taxpurposes. It becomes taxable as it is realized throughdispositions of the assets for more than their allocated incometax basis.

(b) Book core deposit value or goodwill does not necessarily have


income tax basis.

b. Income tax allocations are based on the “Class” system in the Section 338Regulations.

(1) The tax purchase price is allocated first to the Class I assets, then tothe Class II assets, etc. until the purchase price is exhausted.

(2) Once the purchase price is fully allocated, the assets in lower classeshave no income tax basis.

(3) It is common to have no purchase price available to allocate toClasses V [other tangible assets], VI [identifiable intangibles] or VII[goodwill].

2. Unlike financial accounting, bargain purchase gain occurs for tax purposes inonly two situations:

a. Class I [cash, including the FDIC’s cash] exceeds the purchase price,which I have never personally encountered.

b. There is a loss sharing agreement and the sum of Class I and Class IIassets exceeds the purchase price, which I used to see frequently in 2008and 2009 acquisitions, but has been much less common in 2011.

(1) When gain is recognized under this scenario, it is included intaxable income ratably over six years, which is much moreadvantageous to the bank than if the basis in Class II assets werereduced that than amount.

(2) Class II acquired assets normally have a much shorter average lifethan six years straight-line.

E. Asset Classes for income tax purposes.

1. Class I Cash, including the cash inserted by the FDIC to balance the closing.Class I is always allocated at face value.

2. Class II Investment securities, and accrued interest on investments; allocatedat the lesser of (i) fair market value, or (ii) the purchase price remaining afterClass I.

a. The IRS National Office has told Mr. Cederberg orally that they believethat FHLB stock and stocks of other government sponsored agencies is


51 Sections 860A through 860G.

52 See TAM 9423002 and 200439041.

53 Reg. 1.597-5(c)(3)(ii).

more economically akin to investments and should be included in ClassII rather than Class V.

b. Assets commonly classified for book purposes in securities but which are“loans” for income tax purposes and should be in Class III:

(1) REMIC regular interests are “loans.”51

(2) Similarly, mortgage-backed securities that are participation interestsin pools of loans are “loans” whether or not insured by the FNMA,GNMA, or the FHLMC.52

c. Assets covered by a loss sharing agreement.

(1) Any asset covered by a loss sharing agreement is moved from itsnormal class to Class II.53 This rule is all inclusive, so it isimportant to study the loss sharing agreement to determine exactlywhat is covered. The loss sharing agreement typically covers:

(a) Loans, but in recent periods not all loans. Most of the FDICdescriptions of loss sharing agreements since late 2010 hasreferred to less than all loans. Performing loans, for example,are usually not covered.

(b) Some accrued interest on covered loans, but not all accruedinterest.

(i) The book value of accrued interest at the closing isprobably a covered asset.

(ii) Nonaccrued interest might be a covered asset, butprobably not. If any of the nonaccrued interest isbooked in the purchase accounting adjustments, it isprobably in Class III.

(iii) Some accrued interest post closing may be a coveredasset.


54 “The fair market value of an asset covered by a Loss Guarantee immediately after the Taxable Transfer is deemedto be not less than the greater of the asset's highest guaranteed value or the highest price at which the asset can be put.”Reg. 1.597-5(c)(3)(ii).

55 Reg. 1.597-5(d)(2)(iii).

(c) Other real estate owned, but not necessarily.

(d) It is not uncommon to have both Class II and Class III loans,or to have Class II loans, Class III loans, and Class IV OREO.

d. Covered assets must be valued at “not less than” the minimum recoveryunder the loss sharing agreement if the borrower pays nothing.54

(1) For example, if a $100,000 loan is covered to 80% of principal andaccrued interest, then the loan must be valued for at least 80% andthe accrued interest receivable must be valued for at least 80%.

(2) If a parcel of OREO has a book value to the failed bank of$100,000, and the OREO is covered at 80%, then the OREO mustbe valued for at least $80,000, which assumes that the OREO provesunsalable at any price.

e. It is usually advantageous to allocate more than the minimum value tocovered assets if the purchaser can establish that the fair market value ofthe covered assets is actually more. Even if allocating more fair marketvalue to the covered assets results in gain, the recognition period for thegain [six years straight line] will almost always be longer than therecognition period for realization on the covered assets.

(1) This is the one situation in which “fair market value” is differentfrom “fair market value” for book purposes.

(2) The Section 597 Regulation substitutes a “deemed” FMV for actualFMV.

f. If the sum of Class I and Class II assets exceeds the purchase price, theexcess is recognized in income on the straight-line method over theacquisition taxable year and the subsequent five taxable years.55

(1) Note that this is a special rule in Section 597. If there is no losssharing agreement Section 597 does not apply. The acquirerrecognizes no gain on the transaction date even should Class I andClass II assets exceed the purchase price. The allocation to Class II


56 If gain is recognized after the allocation to Class II, the income tax basis in Class III loans is zero, which couldaccelerate a lot of taxable income if there are significant, performing loans in Class III.

57 This is the regulatory support for REMIC regular interests and pass-through mortgage pools being included in loansrather than securities.

assets is simply reduced.

3. Class III Loans not covered by a loss sharing agreement, and accrued interestreceivable on loans; allocated at the lesser of (i) fair market value, or (ii) thepurchase price remaining after Class II.56

a. Accrued interest receivable on loans in Class II because the principal isa covered asset may still be in Class III if the accrued interest is notcovered.

b. “Loans” are “loans” for federal income tax purposes, which commonlyincludes assets that may be classified elsewhere in the statement ofcondition. Regulation Section 1.585-2(e)(2) states that “the term loanmeans debt as the term debt is used in section 166 and the regulationsthereunder.” Regulation Section 1.585-2 includes in “loans:”

(1) Overdrafts in good faith, whether or not other deposit accounts ofthe same customer have balances in excess of the overdraft.

(2) Bankers acceptances purchased or discounted by the bank.

(3) Loan participations to the extent that the taxpayer bears a risk ofloss.57

(4) A loan to a bank or to a domestic branch of a foreign corporation towhich section 1.585-1 applies, including a repurchase transaction orother similar transaction [i.e. federal funds sold and repurchaseagreements].

(5) Bank funds on deposit in any bank (foreign or domestic) such as adeposit represented by a certificate of deposit or any other form ofinstrument evidencing the deposit of a sum of money with theissuing bank.

(6) Federal funds sold, irrespective of the purchaser or borrower.

(7) A loan, whether made directly or indirectly to, or guaranteed insuredby the United States, a possession or instrumentality thereof, or a


State or political subdivision thereof.

c. Loans for tax purposes do not include commercial paper and a debtevidenced by a security (as defined in section 165(g)(2)(C) and theRegulations.

4. Class IV Class IV is said in the Section 338 Regulations to be “inventory,”which most banks do not have.

a. The oral position of the IRS National Office is that foreclosed OREO islike inventory and should be in Class IV.

b. This is favorable to the acquirer because it puts OREO ahead of otherassets in the purchase price allocation, including long-lived depreciableassets Class V.

c. Purchase price is allocated to the Class IV assets equal to the lesser of (i)fair market value, or (ii) the purchase price remaining after Class III.

5. Class V Class V is all other tangible assets, most commonly premises andpersonal property, capitalized mortgage servicing rights, prepaid expenses,perhaps bank owned life insurance if that is not retained by the FDIC, andwhatever other miscellaneous tangible assets are acquired.

a. As with Classes II, III, and IV, purchase price is allocated to the Class Vassets equal to the lesser of (i) fair market value, or (ii) the purchase priceremaining after Class IV.

b. A few of comments about Class V:

(1) Most accrued interest receivable is included in either Class II orClass III with the related assets. The National Office people withwhom the faculty visited agreed.

(2) Regardless with whether the buyer technically acquires a prepaidexpense under the purchase and assumption agreement with theFDIC, no purchase price is allocated to a prepaid expense that thebuyer cannot utilize. There is no written guidance to this effect, butthe prepaid asset has no fair market value for allocation.

6. Class VI Identifiable intangible assets, most commonly core deposit values.

a. If purchase price is available to Class VI, and if the purchase andassumption agreement provides an amount of premium paid for the


deposits, the allocation is commonly the lesser of (i) the purchase priceremaining after Class V or the amount indicated in the purchase andassumption agreement.

b. If the purchase price is exhausted before Class VI, there is no allocationto core deposit value even if an amount is provided in the purchase andassumption agreement with the FDIC.

7. Class VII Goodwill, equal to whatever purchase price remains after Class VI.

8. If the purchase price remaining after allocation to the previous Class is less thanthe fair market value of the assets in the next Class, the available purchase priceis allocated among the assets in the Class pro-rata to their respective fair marketvalues.

9. Once all of the purchase price is allocated, the assets in any lower Classes haveno income tax basis.

XVI. Maintaining a Valid S or QSub Election

A. There is no self-help way to make a technically invalid election valid except to obtaina waiver from the IRS.

1. Bankers seem to believe that if they eliminate the problem and the statute oflimitations closes, then the election is valid again. Not so. Once the electionbecomes invalid, it remains invalid until a new election is made or the IRSwaives the termination.

2. What happens if an invalid election is discovered years later:

a. The S returns are not invalid. There is ample case law that filing thewrong return in good faith is not a nonfiling that keeps the statute openforever.

b. The three year statute normally applies.

(1) Unless there are other issues in the company’s return that omit morethan 20% of gross revenue, the three year statute would apply to thecompany.

(2) Similarly, the three year statute will normally apply to theshareholders because, absent a loss, they will have usually includedmore than the correct income.


c. The “killer” is that the shareholders’ basis adjustments to the shares is lostretroactive to the date of the invalidity of the election.

(1) The statute of limitations on the tax basis in the shares does not startto run until the shares are sold.

B. Automatic waivers of invalid elections.

1. Revenue Procedure 2003-43.

a. Applies to late S elections, QSub elections, QSST elections, and ESBTelections.

b. Must be less than 24 months late.

c. No returns have been filed, or returns have been filed consistent with avalid election.

d. Procedure:

(1) Late S election.

(a) File a completed Form 2553 with the Service Center.

(b) All shareholders during the entire S corporation period mustsign.

(c) Attach a declaration signed by every shareholder that theincome was reported consistent with an effective S election.

(d) Attach a statement providing the “reasonable cause” for beinglate.

(e) Attach a penalties of perjury statement signed by an officer ofthe Company.

(2) Late QSub election.

(a) File a completed Form 8869 with the Service Center.

(b) Attach a statement that the company qualifies as a QSub andthat returns have been filed consistently with a valid QSubelection.


(c) Attach the “reasonable cause” statement.

(d) Attach the penalties of perjury statement.

(3) Late QSST election.

(a) File a completed election with the Service Center.

(b) Attach a statement that the trust qualifies as a QSST and thatreturns have been filed consistently with a valid QSubelection.


(d) Attach the penalties of perjury statement signed by thebeneficiary of the QSST.

(4) Late ESBT election.

(a) File a completed election with the Service Center.

(b) Attach a statement that the trust qualifies as a QSST and thatreturns have been filed consistently with a valid QSubelection.


(d) Attach the penalties of perjury statement signed by the trusteeof the ESBT.

2. Revenue Procedure 2004-35

a. Applies solely to elections that are invalid because one or more spouseswith community property interests in the S corporation shares did not signthe Form 2553.

b. Both spouses with a community property interest in the shares must signthe Form 2553. The Community Property states are:

Arizona Idaho Nevada Texas WisconsinCalifornia Louisiana New Mexico Washington

c. Procedure - File a Statement with the Service Center saying that it is filedunder Revenue Procedure 2004-35.


(1) Include the names, addresses, and tax identification numbers of thecorporation and of all the community property spouses.

(2) That each community property spouse reported the incomeconsistently with the S election.

(3) Each spouse signs the penalties of perjury statement.

3. Revenue Procedures 2004-48 and 2007-62.

a. Applies only to relief for both a late classification election and a late Selection. Will not normally have much application to banks because of thescarcity of LLC banks.

(1) An unincorporated entity intended to be classified as an Scorporation but filed neither Form 2553 nor Form 8832, or Form8832 was not deemed to have been filed under Regulation Section301.7701 -3T(c)( 1 )(v)(C).

b. If no returns have been filed, Rev. Proc. 2007-62 applies.

(1) Attach a completed Form 2553 with all required signatures to thefirst timely filed Form 1 120S, including extensions.

(2) Indicate however it can be done electronically “Filed Pursuant toRev. Proc. 2007-62."

(3) Attach a reasonable cause statement.

c. If returns have been filed, Rev. Proc. 2004-48 applies.

(1) Due within six months of the original due date of the first intendedS corporation return.

(2) File a completed Form 2553 with the Service Center.

(3) Write in the top margin, “Filed Pursuant to Rev. Proc. 2004-48.”

(4) Attach a reasonable cause statement.

4. No user fee applies to any of the automatic waivers.

C. Nonautomatic waivers.


1. If none of the above Revenue Procedures apply, then must file with the NationalOffice for a private letter ruling.

2. The user fee during 2012 is $18,000.

a. User fees typically change the first or second day of February.

D. Suggested due diligence steps.

1. Obtain either copies of the QSST or ESBT elections filed by every trust that isnot a "grantor trust", or a signed statement by counsel or CPA that the electionshave been filed, and keep the elections in a permanent tax file.

2. Determine that every other trust is a "grantor trust."

3. Maintain in the firm's "due date control" the last day for every formertestamentary or former "grantor trust" to be an eligible shareholder under thetwo year grace period.

4. Encourage the Board of Directors to adopt a resolution that the documentationof every transfer of shares be submitted to the company for review somereasonable number of dates before the transfer is closed.

a. The faculty have experience with both shareholders and their estateplanners setting up family entities for transfer planning purposes butwhich are ineligible shareholders.

b. We know of several S corporations who have saved multiple IRS user feesby this procedure.

5. Discourage IRA account shareholders.

6. If a beneficiary of a self-directed IRA account insists on the account becominga shareholder:

a. Confirm that the IRA account has owned all of the shares from beforeOctober 22, 2004.

(1) Acquiring even one share after October 22, 2004 makes the IRAaccount an ineligible shareholder.

(2) We are far enough away from that date that only the most inactiveIRA accounts are still eligible shareholders.


58 Sections 1361(c)(1)(b)(iv) and 1362(a)(2) and Reg. 1.1362-6(b)(2)(iv).

b. Make sure that the beneficiary signs the Form 2553 for the IRA account.The faculty has experience with the custodian signing.58

c. Have the beneficiary of every IRA account shareholder sign a disclosurestatement when they sign the Form 2553 declaring that they understandand accept the application and scope of the Unrelated Business IncomeTax which the IRA account will pay.

(1) The faculty has considerable experience with IRA shareholdersalleging that they did not understand that the IRA will owe tax,regardless of how much discussion there has been.

7. Confirm ownership annually.

a. Send a positive confirmation with the Schedules K-1 that the shareholderstill owns the stated number of shares, has no co-owners, has nottransferred any shares during the year, and that the tax identificationnumber on the Schedule K-1 is correct.

b. The faculty has been told by preparers who use this confirmationprocedure that confirmations sent with the Schedules K-1 are usuallyreturned, typically by the preparer of the shareholder’s return.

XVII. Miscellaneous Accounting Methods

A. What if a cash method C corporation with consolidated average annual gross receiptsover $5 million misses its Section 448 year of change? Is the change to the accrualan automatic change?

1. Yes.

2. If the change is being made for a year other than the first Section 448 year, thenthe automatic change number is "122."

"Designated automatic accounting method change number. Thedesignated automatic accounting method change number for achange under section 14.1 of this APPENDIX for (a) a taxpayer notsubject to § 448, or (b) a taxpayer subject to § 448 that is not


59 Revenue Procedure 2011-14, Appendix section 14.01(7). Phrase (a) would apply to an S corporation bank voluntarilychanging to the accrual method. Phrase (b) applies to a C corporation bank that is either voluntarily making the changebefore the first Section 448 year or that missed the Section 448 year and is making the change late.

60 This is a change in Rev. Proc. 2008-52. The previous threshold was $10 million.

making the change for its first § 448 year is “122.” 59

3. Other than the first Section 448 year may be either before or after the Section448 year. Accordingly, even if the change is late, it is automatic.

B. Change of accounting methods by S electing banks from the accrual to the cashmethod pursuant to Rev. Proc. 2011-14, Appendix Section 14.12.

1. The change is automatic if average gross revenues are under $50 million.60

2. Section 14. 12(5)(a) has an unusual description of average annual gross receiptsthat many people have not observed.

“(a) Average annual gross receipts. A bank has average annual grossreceipts not in excess of $50,000,000 if, for each prior taxable yearending on or after December 31, 2006, the bank's average annual grossreceipts for the three prior taxable-year period ending with the applicableprior taxable year do not exceed $50,000,000. If a bank has not been inexistence for three prior taxable years, the bank must determine itsaverage annual gross receipts for the number of years (including shorttaxable years) that the bank has been in existence. See in existence. SeeSection 448(c)(3)(A).” [italics added]

a. If average gross receipts for 2006 or any year since were over $50 million,then the bank is not eligible for the automatic change even though averagegross receipts for the year of change are less than $50 million.

3. Appendix Section 14.12(4) also includes the following “additional requirement”for an automatic change to the cash method.

“In addition to complying with all other applicable requirements, theForm 3115 must describe each specific item of the bank’s income orexpense that is affected by the change under this Section 14.12 of theAPPENDIX and, for each such item, identify the following: theaccounting method under which the bank reports that item for federalincome tax purposes immediately before the change; and the amount ofthe §481(a) adjustment associated with changing that item to the cashmethod under this section 14.12 of the APPENDIX.” [caps in the


61 This requirement that the Section 481(a) adjustment be identified by “item of income or expense” appears to be newin Rev. Proc. 2008-52.

62 Accrued expenses may already effectively be on the cash method under Reg. 1.263(a)-4.

original]61

a. Instead of simply calculating the accrual to cash transition adjustment asof the beginning of the year of change, the Form 3115 requires a schedulethat would appear something as follows:

Income or expense affected by thechange to the cash method

Method of reporting thisitem for federal income taxpurposes before the change

Sec. 481(a)transition

adjustment

Accrued interest receivable oninvestment securities Accrual $(xxx,xxx)

Accrued interest receivable on loans Accrual (xxx,xxx)

List the remaining accrued incomeaccounts

Accrued interest payable on deposits Accrual62 xxx,xxx

List the remaining accrued expenseaccounts

Prepaid expenses Accrual (xxx,xxx)

Total Sec 481(a) Adjustment $xxx,xxx

4. De novo banks:

a. A de novo bank which is also making the S election is allowed to adoptthe cash method regardless of its gross receipts.

b. An independent, C corporation de novo bank is automatically allowed touse the cash method its first year. If the de novo bank is part of anaffiliated group, then whether it can use the cash method is determined onthe basis of the affiliated group’s gross receipts.

(1) If its first year gross receipts exceed $5 million, it must change tothe accrual method the second year.

(2) If its first year gross receipts are less than $5 million, and its secondyear receipts are over $5 million, but the average for the two yearsis less than $5 million, it may continue to use the cash method forthe third year.


63 Reg. 1.1273-2(g).

64 Reg. 1.1273-2(g).

65 Sec 461(g)(2) related to points paid on a loan secured by a principal residence which are deductible by the borrowerin the year paid. Note that this exception applies only to the borrower, not the lender. It is consistent with the borrower’sdeduction for the points in the year paid.

C. Prepaid Interest - Accrual method banks do not need to recognize prepaid interestwhen the payment is received. The claim of right doctrine does not apply.63

D. Deferred loan fees.

1. This accounting method has been around since the first final Original IssueDiscount Regulations were issued on February 2, 1994.

2. Loan fees and points reduce the issue price of the loan and create OID.64

3. It is not important whether the borrower finances the fees (i.e. the bankdisburses the loan net of the fees) or pays the fees from separate funds. Theresult is the same.

“(g)Treatment of certain cash payments incident to lending transactions:

“(1) Applicability. The provisions of this paragraph (g) apply to cashpayments made incident to private lending transactions (including sellerfinancing).

“(2) Payments from borrower to lender - (i) Money lending transaction.In a lending transaction to which Section 1273(b)(2) applies, a paymentfrom the borrower to the lender (other than a payment for property or forservices provided by the lender, such as commitment fees or loanprocessing costs) reduces the issue price of the debt instrument evidencingthe loan. However, solely for purposes of determining the taxconsequences to the borrower, the issue price is not reduced if thepayment is deductible under Section 461(g)(2).”65

See also Example 1 in Reg. 1.1273-2(g)(5).

4. It is not important whether the bank is an accrual or a cash method taxpayer, theresult is the same.

5. There is no financial statement consistency requirement.


a. A small bank which is still on current recognition for book purposes mayuse the deferral method for tax purposes.

6. Only fees that are “interest” for the use or forbearance of money can beincluded in the deferral as OID.

a. The easy example is points measured by the size of the loan.

b. Charges to reimburse the lender for loan expenses (i.e. credit reports,appraisals, surveys, filing fees, taxes, etc) are offsets to the expense andare not included in the deferred fees.

c. Nonrefundable loan application fees are a fee for services and are notincluded in the deferred fees.

7. Loan fees are recognized as OID over the life of the loan.

8. Deferred loan fees are not built-in gain when the bank makes the S election.

a. They are not accrued income.

b. They do not represent fair market value of the loan in excess of theincome tax basis.

Example of information provided by Treasury with respect to the auction of TARP: September, 2012

DEPARTMENT OF THE TREASURY WASHINGTON, D.C. 20220

Re: Capital Purchase Program- Additional Information Regarding Opt-Out Auctions As you know, the United States Department of the Treasury (Treasury) has been winding down the Capital Purchase Program (CPP) investments, in part through a series of auctions of its investments which began in March 2012 and will continue into next year. In June, we sent you a letter informing you that Treasury was considering including its investment in your institution as part of a series of pooled auctions of CPP investments. At that time, we also stated that an institution would have the opportunity- assuming it has regulatory approval- to opt-out of the pooled auction if it made a qualifying bid to repurchase all its remaining outstanding CPP securities. Additionally, the institution could also designate a single outside investor (or single group of investors) to make a bid to purchase all their outstanding CPP securities. Any such bid would have to be above a minimum price set by Treasury. Additionally, Treasury informed you that the decision to initially remove an investment from a pooled auction does not mean that the institution, or its designated bidder, is entitled to purchase the investment at the submitted bid price and that Treasury would determine whether to conduct an individual auction or other process to ensure good value for taxpayers. Furthermore, Treasury reserved the right to place an institution back into a pooled auction process if, at the time of any individual auction or other purchase, the final and best submitted bid does not meet Treasury's minimum. We also noted as part of that letter that we would provide additional information from time to time regarding the entire sale process, including the sale process for those institutions that successfully opt-out of the pooled auctions.

This letter is to inform you that Treasury anticipates that the first of these "opt-out" auctions, covering a set of qualifying institutions, will occur as early as October 2012. We expect to conduct several of these "opt-out" auctions, each time covering a few institutions, over the next several months. Similar to our other recent CPP preferred auctions, we expect that these "opt-out" auctions will be structured as a sealed bid, modified Dutch auction. Several investments would be auctioned on a given day, but each investment is bid on and sold separately. The rules will be similar to our prior auctions except for two differences: (i) auctions will be conducted over the course of two days; and (ii) if the clearing price in the auction is equal to the minimum price, the institution and/or its designated bidder will be allocated the entire position. Institutions selected to be auctioned will be contacted by our strategic advisor, Houlihan Lokey, with specific details regarding next steps, timing and the preparation process for these auctions.

Please note, Treasury may update and, in its sole discretion, modify these procedures from time to time. Furthermore, Treasury retains the right, at all times, to decide whether, when and at what price it will sell the CPP investments. In addition, Treasury reminds potential participants in any sale of CPP investments, that the purchasers are responsible for compliance with all applicable laws, including the Bank Holding Company Act of 1956, as amended, and the Investment Company Act of 1940, as amended. As we have noted before, we believe that the procedures we have outlined to wind down the Capital Purchase Program will help support our nation's community banks and protect taxpayer interests. We'll continue to communicate with you regularly about the pooled auction process and provide additional information on the procedures moving forward. If you have any questions, please feel free to contact us at [email protected]. Best regards, Michael Harris Director of the Capital Purchase Program

1

Eighteenth AnnualCommunity Bank Tax Workshop

John E. Cederberg James D. Goeller

Lincoln, Nebraska Crowe Horwath San Francisco, CA

Steven W. Corrie

Security National Bank

Sioux City, Iowa

Summit Business Media

Contemporary Hotel, Orlando Florida

November 7, 2012 1

DisclaimerThese slides and the accompanying outline are intended for thegeneral information of the attendees of the Eighteenth AnnualCommunity Bank Tax Workshop. They are not intended toprovide tax advice. Attendees of the Workshop must performtheir own research to confirm the effect of the topics discussedherein to the facts and circumstances of their respective clients.

In accordance with professional regulations of tax practitionersencompassed in Internal Revenue Service Circular 230, anywritten tax advice contained in, forwarded with, or attached tothese slides or the accompanying outline are neither written norintended to be used by any person for the purpose of avoidingpenalties which may be imposed under the Internal RevenueCode or applicable state or local tax laws, and such advice maynot be used for such purpose.

2

Agenda• 2011- 2012 Developments Affecting Banks

– Tax Changes

– Administrative Changes

• Fixed Asset Regulations

• IRS Examination Issues

– Deduction for Bad Debts

– Nonaccrual Interest

– Foreclosure and OREO Issues

– Losses on Securities

• Examiner Ordered Restatements

3

2

Agenda• Loans Restored to the Books

• The Conformity Election

• Modification of Partially Charged-off Loans

• Accounting for Foreclosed Collateral

• OREO – In Substance Foreclosures

• TARP Transactions

• S Corporations – Character of Operating Losses on Foreclosed Operating Assets

• S Corporations and Life Insurance

• S Elections at a Cross-Roads

4

Agenda• Trust Preferred Securities with Deferred Interest

• Prohibited Transactions by Self-Directed IRAs

• Taxable Acquisitions using Acquirer’s Stock

• Bank Asset Acquisitions

• Maintaining a Valid S and QSub Election• Miscellaneous Accounting Method Topics

– Late Sec. 448 Changes to the Accrual Method– S Corporation Changes to the Cash Method– Prepaid Interest Income– Deferred Loan Fees– Loan Origination Costs

5

2011 - 2012 Developments

• No new legislation specifically affecting banks

• No material new litigation decisions specifically affecting banks

• 2011 and 2012 changes scheduled in existing law

– S corporations – BIG period reverts to 10 years in 2012

– Note: 10 year rule is actually 120 months

– Had been 60 months in 2011

6

3

2011 - 2012 Developments• Changes scheduled to occur (cont)

– Bonus Depreciation - 50% in 2012

• Expires December 31, 2012

– Computer software and qualified leasehold improvements eligible for bonus depreciation through 2012

– Section 179 election may be made and revoked on amended returns only 2012• Only 179 election can be changed on an

amended return• Bonus depreciation election can not be revoked

7

2011 - 2012 Developments

• Changes scheduled to occur (continued)

• Section 179

–2012 - $125,000 deduction

Phase out begins at $500,000

–2013 - $25,000 deduction

Phase out begins at $200,000

8

2011 - 2012 Developments• 3.8% Medicare tax on passive income of S corporations

– The tax takes effect January 1, 2013

– The rate is 3.8% of the lesser of:

• Net “investment income” or

• Adjusted gross income over $200,000 for single individuals and $250,000 for married couples filing joint returns

• Itemized deductions do not reduce the income subject to the 3.8% tax

9

4

2011 - 2012 Developments• 3.8% Medicare tax (cont.)

– Net investment income

• Interest and dividends Net income from rents

• Capital gains

• Income from pass-through entities, including S corporations, to passive equity owners

– This is the first time that the “passive” status of shareholders will have a direct effect on taxes “payable”

– Think about the active/passive status in 2012

10

Fixed Asset Regulations• Issued in December 2011 and effective for 2012

returns

– The Service’s third attempt at these Regulations

– Still “Proposed” but this time also “Temporary”

– Conforming to the new Regulations are an automatic change of accounting method with a Section 481(a) adjustment

• Some specific changes use the cut-off method

• There are 250 pages of complex regulations

– Only going to discuss some provisions that we expect to especially affect banks

11

Fixed Asset Regulations• The “unit of property” concept

• A building is several “units of property”

– Sort of a codification of the old “component depreciation” approach to buildings

– The building structure (i.e. walls, roof, et. al.)

– Heating, ventilation & air conditioning Plumbing Electrical Gas Distribution

Escalators Elevators

Fire Protection & Alarms Security Equipment

• All of the “units” are depreciated over 39.5 years12

5

Fixed Asset Regulations• Removal of a building component is a disposition

– The depreciated income tax basis is deductible

• Example

– The building was purchased for $10 million

– 5 years later, they spent $1 million to completely replace the roof

– The company determined that the purchase price for that roof was $573,000, and the depreciated tax basis was $500,000

– The existing roof was “disposed” of at a loss of $500,000

13

Fixed Asset Regulations

• The “Plan of Rehabilitation Doctrine” is obsolete

– Whether an expenditure is a repair expense or capitalized is determined by “unit of property”

– Whether it is part of a larger renovation project is immaterial

– Thus expenditures on the heating and air conditioning system might be a repair expense, even though many larger expenditures in the same project are capitalized

14


• Retain the rule from the Sec. 263(a) regulations

– Overhead employee wages are not capitalized

– Overhead expenses are not capitalized

• The taxpayer may elect to capitalize both wages and overhead

– The election is made project-by-project

– Not an accounting method

• When would banks make the election?

15

6


• The Regulations “codify” de minimis scope exceptions to capitalization

– $100.00, or

– 0.10% of gross revenues, or

– 2.00% of book depreciation

– Review the Regulations for how these exceptions apply

• There is a safe harbor for “routine maintenance”

16

Deductibility of Accrued Bonuses

• A possible year-end planning opportunity

– Almost all banks pay year-end bonuses

• Service conceded the accrued bonus issue

• Rev Rul 2011-29

• An accrual basis taxpayer may deduct accrued bonuses in the year accrued if the amount payable is fixed and determinable

• The allocation by employee may be made after year end

17

Deductibility of Accrued Bonuses

• The employee may be required to be employed on the payment date, if “forfeited” bonuses are reallocated among the other employees

• If “forfeited” bonuses revert to the employer, then deductible in the year paid

• Adopting Rev Rul is a change of accounting method

– The change is automatic - # 133

– Section 19.01(2) of Rev Proc 2011-14

18

7

Prepaid Expenses Deductibleunder Reg 1.263(a)-4(f)

• Rev Rul 2012-1

• A detailed analysis of what “prepaid expenses” are allowable deductions by an accrual basis taxpayer– Must be both immaterial and result in a better

matching of income and expense

– Introduces the principles of the recurring item exception in Sec 461(h)(3)(A)

19

Prepaid Expenses Deductibleunder Reg 1.263(a)-4(f)

• Determination of both materiality and matching

– The facts involved prepaid lease fees and prepaid service contract fees

– The Service held that both were “material” and failed the “matching of income and expense” tests

– They both should be amortized over the lease and service periods

• Conforming to the Rev Rul is an automatic accounting method change - # 161

20

IRS Examinations

• Examination issues are where the “action” has been this year

• Almost all of the respondents to a survey this summer reported some IRS examinations during this or last year

• Two respondents reported that 30% and 50% of community bank clients have been examined

• Very few respondents reported no exams

• Almost everyone who responded complained about the inexperience of the examining agents

21

8

Charge-Offs

• Overarching concepts

– The view of some at the IRS that GAAP has so diverged from the IRS’ view of tax deductible bad debts that IRS no longer agrees that safety & soundness ordered charge-offs are necessarily deductible

NO CONVERGENCE HERE!!!

– No appreciation on the part of the IRS examiners that loan losses are not a tax shelter!

22

Tax Requirements for a Charge-off

• The asset must be classified “loss”

• A charge-off for partial worthlessness must be charged-off the books

– Most charge-offs are partial charge-offs

– In practice, IRS also expects a deduction for a wholly worthless asset to also have been charged-off the books

• The burden is on the bank to “prove” the reduced collectability of the asset

23

Tax Definition of a Charge-off• Tax Court - a “charge-off” is an action that removes an

asset from the books

• It does not need to be charged against a book reserve for losses

• An entry reducing the book value of a loan and making a charge to the reserve for losses is a “charge-off”

• Specific reserves are a “charge-off,” at least for a thrift [Reg. 1.166-2(d)(4)(ii)]

• Reversing accrued interest against income is a “charge-off” [Rev. Rul. 2007-32]

• So is not accruing interest

24

9

Tax Definition of a Charge-offPLR 9338044

“Although section 166 of the Code and the regulations thereunder do not definethe term "charge-off,"authority exists that a "charge-off" is not limited to ataxpayer's physical act of charging off a debt. Rather, a taxpayer must takesome action to remove the worthless portion of an asset from its books as anindication that the debt is actually worthless. See, Fairless v. Commissioner, 67F.2d 475 at 478 (6th Cir. 1933), (affirming decision of United States Board ofTax Appeals and disallowing deductions for bad debts where taxpayer had notmade a charge-off on its books.) There the court stated: "It was clearly thepurpose of the Congress to condition allowance of deductionfor bad debts uponthe perpetuation of evidence that they were ascertained to be worthless withinthe taxable year, and upon some specific act of the taxpayer clearly indicatingtheir abandonment as assets." See also, Brandtjen & Kluge v.Commissioner, 34T.C. 416 at 441 (1960) acq. 1960-2 C.B. 4, where the court stated: "But,generally speaking, an effective charge-off has been made if the entries reliedupon have effectually eliminated the amount of the debt, or that part which isworthless, from the book assets of the taxpayer." [italics added]

25

Tax Requirements for a Charge-off

• IRS comments in the MSSP– Review the loan files for loan officer comments

and notes on the possibility of later collections

– Obtain current status reports for larger loans

– Bank must document the worthlessness of each loan

– Loan officer comments are “self-serving”

26

Charge-Offs No Conformity Election• Conclusive presumption – Reg. 1.166-2(d)(1)

– The default provision if no conformity election

– The threshold requirements:

• The charge-off is recorded on the books

• The charge-off is either:

–Ordered by the examiners, or

–The examiners state in writing that they would have ordered the charge-off if an examination had been done on the date of the charge-off

27

10

Charge-Offs No Conformity Election• The problem centers around “proving” that the

safety & soundness examiners approved the interim charge-offs and ordered the rest

– Confidentiality of the examination reports

– FDIC refuses to issue confirmation letters or to grant permission to show the charge-off pages of the examination reports

– Federal Reserve is the only federal examination agency with a confirmation letter policy

– Some states will issue confirmation letters

– “Untimeliness” of confirmation letters28

Charge-Offs No Conformity Election• The IRS agent’s objective is to review the

loan file to independently determine the deductible amount

• Targets– Estimated selling costs

– Examiner ordered reductions in the value of the collateral from the most recent appraisal

– Borrower expenses & foreclosure costs

29

Charge-Offs No Conformity Election

• Status

– No consistency among IRS examiners

– The ABA is working with the IRS trying to arrive as some protocol for the IRS examiners to implement the presumption of worthlessness

– Met most recently on October 11.

– Get the confirmation letter upon completion of the examination if available

– The Service still appears to want all the banks on the conformity method

30

11

Charge-Offs – Conformity Method• The Conformity Election seems to have avoided

most of the problems.

– The EDL letter by definition satisfies the “proof” issue for charge-offs.

– Starting to hear that IRS examiners are disallowing the part of charge-offs related to estimated selling costs, borrower costs, foreclosure costs, and examiner adjustments to collateral value

– The ABA is also discussing the Conformity Election with the Service

31

Nonaccrual Interest

• Much of the problem seems to be driven by agent inexperience – See examples on page 14 of outline

• Again, the Conformity Election seems to have avoided most of the problems

• Banks without the conformity election are having severe headaches with the IRS

• Principal technical issue for Conformity Election banks is the tax accounting for interim cash payments

32

Nonaccrued InterestNo Conformity Election

• No conformity election – Rev. Rul. 80-361 applies

– Accrued interest is not included in taxable income “if the income item is uncollectible when the right to receive the item arises”

– This is the source of the “no reasonable prospect of collection” test

33

12


• Revenue Ruling 80-361 would indicate that:

– Loans are properly nonaccrual when there is no reasonable expectation of collecting the interest

– Accrued interest is charged off to the reserve, or deducted as a bad debt, in the year it becomes uncollectible

– Subsequent payments are applied to principal as long as there is no reasonable expectation of collecting the nonaccrued interest

34


• Comparison to financial reporting

– Book nonaccrual but probably not tax• In default for 90 days if adequately collateralized, being

restructured, or if the eventual collection of principal and interest is expected

• Deterioration of the borrower’s financial condition if the borrower is current and making timely payments

– Both book and tax nonaccrual• Full collection principal and interest is not expected

• Partial charge-off of principal

• Under-collateralized and in an process of foreclosure

35


• IRS's audit examination guide states the key issue is whether interest is uncollectible or merely delinquent

• Examples of loans IRS thinks should be on accrual

– Placed on nonaccrual because of a lapse of time

– Loans with only partial charge-offs (?)

– Loans with sporadic payments (?)

– Loans that are current, but borrowers are delinquent on other loans

• Whose “judgment” should prevail on whether a loan is nonaccrual

36

13

Nonaccrued InterestConformity Method

• Revenue Ruling 2007-32 applies

– Conformity between book and tax “nonaccrual”

– All book nonaccrual loans are nonaccrual for tax purposes, regardless of the reason for placing them on nonaccrual

– All accrued interest is charged to the reserve or deducted as a bad debt when the loan is placed on nonaccrual

• No reversal against income

37


• Rev. Rul 2007-32 (cont)

– Interest on “nonaccrual” loans is both:

• Recognized in gross income, and

• Charged off as a bad debt

– Subsequent payments

• If the principal and interest is expected to be collected

– Payments are applied to interest income up to the accumulated interest charged-off

– Balance is applied to principal

• This will create a book-tax difference in both the “basis” in the loan and the outstanding principal on which “interest” accrues

38


• Revenue Ruling 2007-32 (cont)

– If the interest is not reasonably expected to be collected:

• Then Revenue Ruling 80-361 applies

• All payments are applied to principal

– If more than the book value is ultimately collected, payments are applied

• First to recovery of any charge-offs of principal

• The balance to nonaccrued interest

– Experience is that most agents do not understand this39

14


• Rev. Rul 2007-32 (cont)

– If nonaccrued interest is recognized and the principal and interest are not collected in full

• There will be additional tax basis in the principal to the extent of the nonaccrued interest recognized

• There is no “current” charge-off because there is no book charge-off on the conformity method

• Loss under Section 165 when loan is disposed

40

Tax Accounting for OREOUnpaid Pre-Foreclosure Costs

• Costs incurred by the “borrower” before foreclosure

– Expensed on the books when paid or assumed

– The borrower’s costs and not tax deductible by the bank - Not “incurred” by the bank

– Paid by the bank before the foreclosure

• Added to loan & included in the bad debt charged-off in the foreclosure

– Paid by the bank after the foreclosure

• A capitalized acquisition cost of the OREO

– Estate of Schieffelin -IRS’ MSSP agrees41

Tax Accounting for OREOForeclosure Costs

• The bank’s legal costs to foreclose

• Expensed on the books.

• The IRS audit guide, and examiners generally, capitalize the foreclosure costs in the basis of the OREO as an asset acquisition cost

• The Tax Court in Community Bank added foreclosure costs to the loan for purposes of determining gain or loss on the foreclosure

– More consistent with standard loan contracts

42

15

Tax Accounting for OREOHolding Period Costs

• This is a national issue that agents appear to be required to raise unless OREO is immaterial

• The problem is nonoperating OREO

– Banks routinely deduct as incurred

– The IRS manual states that holding period costs on OREO that is not income producing must be capitalized into the cost of the property

43

Tax Accounting for OREOOREO Holding Period Costs

• The interaction of Sec 263A and Sec 1221(a)(1)

– Section 1221(a)(1) is the bank’s only technically sound gateway to ordinary rather than capital loss on disposition of the OREO

– Section 263A cross-references to Section 1221(a)(1)

• Under the Service’s reasoning, Sec 1221(a)(1) property must be Section 263A property

• If 263A property, whether the expense is ordinary or necessary is immaterial, it is capitalized until the asset is sold

44


• Pages 23-24 in the outline are a technical analysis.

– Sec 263A(b)(2) defines Section 263A property as Sec 1221(a)(1) property acquired “for resale in the ordinary course of business”

– Banks should not argue that OREO is not held for sale to customers in the ordinary course of business

• Section 1221(a)(1) is the only available gateway to an ordinary loss on sale

45

16


• Banks who wish to argue the case, must rely on the “purpose of acquisition” test that OREO is not Sec 263A property

– The bank is manifestly holding the property for sale

– The bank acquired the property to collect a loan

– May sound like semantics, but semantics count.

• Sec. 1221(a)(1) does not require that the asset be acquiredfor sale to customers, only heldfor sale to customers

• At least one experienced tax counsel believes banks are unlikely to be successful litigating the issue 46


• Not a problem for “income producing” properties.

– The manual says the holding period costs are deductible, as well as depreciation

– Discover “income producing” properties

• There are several examples in the outline of properties that were income producing

• Capitalized costs need to be accounted for “by property”

– Otherwise, likely deferral of deduction47

Charge-offs of Loss Securities

• The issue becomes “expensive” for the bank to defend because of agent inexperience. Once the IRS agents understand the facts, the issue usually resolves itself.

– Agents are not aware of Section 582(a), much less the mechanics of how losses are deducted under Section 582(a)

– Agents are not accustomed to the bank simultaneously using the reserve method (loans) and the charge-off method (securities)

48

17


• Agent inexperience (cont)

– Agents are not aware that OTTI charges usually embed credit losses

– Agents are not aware that some “securities” are loans for tax purposes

• REMIC regular interests

• Pass-through loan pools, whether mortgages, credit cards, pre-owned autos, et. al.

49


• Again, no convergence between book and tax

– The “credit” loss for book purposes is the present valueof the projected cash flow

– The “credit” loss for tax purposes is the projected cash collections.

• No present value

• No income tax basis in the “future income”

– The balance of the OTTI is not deductible

50


• Tax accounting after an OTTI deduction

– If there is no change in the projected cash flow, the asset should be nonaccrual

• If projections are accurate, income tax basis will be zero when all of the cash is collected

– If projected cash flow decreases, then there should be another charge-off and bad debt

– If projected cash flow increases, then income should be accrued over the balance of the term, based on new projection

51

18

IRS Examinations Other Issues

• It was remarkable how few “other issues” were reported by respondents to this year’s survey

• The most common comment was some version of, “the agent focused on charge-offs, nonaccrual interest, OREO costs, and the valuation of OREO in the foreclosure, and was finished.”

• Not a lot of interest in officer expense accounts, or some of the other “minor” tax accounting that used to be typical of the rare bank examination

52

Examiner Ordered Restatements

• If the regulatory examiners order charge-offs to be recognized in prior periods and the call reports restated;

• When are the charge-offs deductible?

– The year of the examination?

– The prior year which is restated?

• Is the result different depending on whether the bank uses the Conformity Method?

• Are there alternatives?

53

Examiner Ordered RestatementsConformity Method

• Regulation 1.166-2(d)(3)(ii)(B)

– In the year charged off for regulatory purposes– The Regulation states in relevant part:

“Charge-off should have been made in earlier year. The conclusive presumption that a debt is worthless in the year that it is charged off for regulatory purposes applies even if the bank's supervisory authority determines in a subsequent year that the charge-off should have been made in an earlier year. …”

54

19


• Treasury Decision 8396, which accompanied the final Regulation, implies the deduction is in the year of the examination

– Seems to be acceding to practitioners’ request that the deduction be in the year of the examination

– However, the language is not that clear

• The conformity method bank probably should follow the regulators and amend returns

– The restated period is the only year in which the charge-off will appear for regulatory purposes

55


• Importance of who requests the restatement

– The Regulation refers only to Regulatory standards

– No reference to GAAP

– No reference to a factual determination

56

Examiner Ordered RestatementsNo Conformity Method

• Banks not on the conformity method

– No similar Regulation to subsection (d)(3)(ii)(B)

– Subsection (d)(1) states that the conclusive presumption applies only if the loss is deducted in the year “charged off”, which would be the restated period.

57

20


• What is the meaning of the phrase “deduction by the taxpayer at the time of filing the return for the taxable year in which the charge-off takes place.”

• Notice that the sentence does not refer to the filing of the “original return”

• The “time of filing” is a general reference that would refer to any time that the return is filed

58


• Appears to be a facts & circumstances test

– When did the loss factually occur?

– May be hard to show that it factually occurred later than the restated year

• The proof issue is present again

• Not as clear guidance, but the “safe” approach is probably to amend the restated year

59

Examiner Ordered Restatements• Bankers ask “what are the alternatives to amending

returns”?

– Both “conformity” and “non-conformity” banks may wait until the uncollected balance is “wholly worthless” and claim the deduction under Sec 165

• Should not lose the deduction permanently by not taking a partial charge-off

• The risk is greater if the regulators determine the loan is wholly worthless in the restated year

60

21

Examiner Ordered Restatements

• Alternatives (cont)– Nonconformity banks can claim the charge-off

in the year of the examination if they can show that the loss factually occurred that year.

• Argue that the asset wasn’t classified “loss” in the restated year

• Probably an “uphill” argument

61

Charged-off Loans Restored• Tax implications if a charged-off loan is restored

to the books

– Revenue Ruling 80-180

• Regulators changed their mind about a charge-off ordered in a prior year

• Allowed the loss to be restored

– Restoring the loan to the books was not a “recovery” in the Ruling

– To be a recovery, there must be receipt of an amount that was previously deducted or an event inconsistent with the prior deduction

62

Charged-off Loans Restored

• Conformity method banks

– The conformity method only applies to losses –Reg 1.166-2(d)(3)

– Recoveries are described in Section 111

– Rev. Rul. 80-180 should apply even though it pre-dates the conformity election

63

22

Conformity Election• Should banks make the election?

– Materially broader “presumption of worthlessness

• Conformity election covers all bad debts on loans

• The default presumption without the election covers only those specific loans either

– Ordered charged off by the examiners, or

– The charge-off was reviewed and approved in writing by the examiners

– Most loans should be charged off voluntarily between examinations as incurred

64

Conformity Election• Should banks make the election (cont)?

– Shortcuts the three most material controversies in an examination

• Whether charge-offs are deductible

• The loss on foreclosures

• Nonaccrual interest for accrual method banks

– Makes available the existing Regulation on restatements

– “Audit protection” for S and QSub banks

– Appears to materially improve relations with the IRS

• The Service says it wants all banks to make the election

65

Conformity Election• When is the first Express Determination Letter needed

– The last federal examination before the beginningof the election year

– Example – If the election year is calendar 2012, the Express Determination Letter is required for the last examination date beforeJanuary 1, 2012

• Must obtain the letter for every subsequent federal examination

– Note, charge-offs ordered by state examiners count for the presumption of worthlessness, but state examiners cannot issue the EDL

– See Rev Proc 92-84 for the standard wording of the EDL

66

23

Conformity Election• Election is made by including Form 3115 in a

timely filed return

• No transition adjustment

• Specific unique requirements for Form 3115

– Caption on the top of the Form 3115

– Automatic change #6

– Declaration regarding the Express Determination Letter

– Does a copy need to be filed with the IRS National Office? Recommend doing so

67

Conformity Election• Rev Rul 2001-59

– Conclusive presumption of worthlessness applies even to good faith errors

– Board resolution covers the “authorization” to charge-off and classification as a “loss” asset

• See page 41 of the outline

68

Conformity Election• The election is automatically revoked if an express

determination letter is not obtained at any subsequent federal examination

• An invalid election is treated as an election and a revocation

• The election can be revoked in any year by including another Form 3115 in the return

• A new election is not automatic

– Form 3115 is filed with the National Office

– The user fee for a change of accounting method applies

69

24

Conformity Election• Should the bank request the EDL even if:

– The bank does not intend to make the election?

– The election has been revoked because the examiners refused a prior letter?

• Seems to be a good idea

– No tax downside to having the letter in the file

– National examination division people are adamant that it is worthless without a valid election

– Reported field experience in that the letter is helpful during examinations even without a valid election

– If the election was revoked “by” the examiners, a letter from a later examination is evidence that the bank has subsequently followed regulatory standards

70

“Modification” of Charged-off Loan• If the modified loan has been the subject of a

partial charge-off, then there is a “deemed charge-off” in the modification calculation– Reg 1.166-3(a)(3)– Deemed charge-off is the lesser of

• The gain that would otherwise be recognized, or

• The greater of–The FMV of the modified debt, or–The amount recorded on the books

– Effect is to prevent “recovery” of the partial charge-off in the modification

71

“Modification” of Charged-off LoanExample of a deemed charge-off

Assume that

• The outstanding principal amount is $350,000

• The bank recorded a $100,000 charge-off, resulting in book value of $250,000

• The accrued interest of $18,750 has not been recognized in income

• The loan is modified to $300,000 principal, interest at 4.5%, payable $18,750 accrued interest at closing, and 16 equal semi-annual installments of principal and interest of $22,535 each

72

25

“Modification” of Charged-off LoanExample of deemed charge-off

“Proceeds” – issue price of new loan

Payment at closing $ 18,750

Stated principal of new loan 300,000

318,750

Basis in the old loan (250,000)

(i) Gain recognized $ 68,750

Gain is $18,750 nonaccrued interest

$50,000 modified principal over BV

73

“Modification” of Charged-off LoanExample of deemed charge-off (cont)

(ii) Tax basis in the new loan $318,750

Fair market value of new loan 318,750

Excess tax basis $ 0

(iii) Tax basis in the new loan $318,750

Book value of new loan 268,750

Excess tax basis $ 50,000

Deemed charge-off – lesser of (i)

and the greater of (ii) or (iii) $ 50,000

74

“Modification” of Charged-off LoanExample of deemed charge-off (cont)

• The bank recognizes the $18,750 nonaccrued interest collected at closing for both book and tax purposes

• For tax purposes, the bank will:

– Recognize interest income at 4.5% beginning @ $300,000

– Recognize the $50,000 recovery between $250,000 and $300,000 when collected

• For financial reporting purposes, the bank will:

– Recognize interest income at 4.5% beginning @ $250,000

– Recognize the $50,000 recovery when collected

– Recognize the $19,704 difference in interest after the principal is collected in full

75

26

“In Substance Foreclosures”• The lender obtains control, but not ownership, of

the collateral

• Examples:

– Lender governs a single asset subsidiary

– Lender is manager of a single asset LLC

– Asset is transferred to a new single member LLC of which the lender is the manager

• Transfer has no tax significance

76

“In Substance Foreclosures”

• A book only concept– Financial accounting is identical to both foreclosures

and deeds in lieu of foreclosures– The asset is moved from loans to OREO on the

books– The book value of the asset is the fair value of the

OREO, just as in foreclosures and deeds in lieu of foreclosure

– Post control accounting is also identical

77

“In Substance Foreclosures”

• Major operating advantages

– No exposure to the hazards of “ownership”

– No exposure to merging creditor and equity interests

• Major tax advantages

– The loan remains outstanding and can be partially charged-off as the value of the collateral declines

– No issue regarding the fair market value of the OREO [there is no taxable exchange]

– No issues regarding the tax accounting for costs

78

27

“In Substance Foreclosures”• Income tax accounting

– Post “control” income & expenses are income & expenses of the borrower included in its return

– Gain or loss on disposition is also the borrower’s included in its return

– The lender has gain or loss on disposition of the loan• Ordinary under Sec. 582• Reported on Form 4797

79

TARP Transactions

• Gain (Loss) on Redemptions

– C Corps – Preferred stock

• No income statement effect

• Warrants are an allocation of earnings on statement of changes in capital

• No taxable income or loss

– S Corps – TARP securities are debt

• Costs are debt acquisition costs and amortized

80

TARP Transactions• S corporations

– Interest is tax deductible

• Included in the TEFRA disallowance ratio

– The warrants become OID – see page 49

– The company recognizes

• Taxable discharge of debt income upon redemption at a discount

• “Redemption” may mean purchase by a related party

81

28

TARP TransactionsS corporations• The principal issue is the maturity of the debt

– The legal maturity is 30 years– Regulation 1.1272-1(c)(5) states that the

“maturity” of debt is the period which results in the lowest yield to the holder• That is 5 years [Outline page 64]

– Accordingly• The “debt acquisition costs” are amortizable

over 5 years straight line• The OID is recognized over five years, and is

not di minimis82

TARP Transactions• Risks of Sec. 382 ownership change

– Merger, stock purchase, other acquisition

– Significant capital infusion

– Large-block stock purchase

• 50 percentage point increase in the ownership of greater than 5% shareholders

• Status of TARP securities under Sec. 382

– Preferred stock with not cause an ownership change

• While held by the Treasury or anyone else

83

TARP Transactions• Status of TARP securities under Sec. 382

– Warrants will not be deemed exercised as long as held by the Treasury

• Will be deemed exercised upon sale to others

• In general, only affects public companies

• Deals

– TARP redemptions – not an equity shift

– TARP sold, Treasury retains warrants – no effect

– TARP and warrants sold could trigger a change

84

29

TARP Transactions• Deals (cont)

– If “designated buyers” convert their TARP to something else, could cause a change date

• Cash Issuance Exception

– Stock issued solely for cash is partially excluded from the segregation rules for a change

– Conversion of TARP preferred is not a cash issue

85

S Corporations – Character of Income or Loss on Operating Foreclosed Assets

Question – If an S corporation operates a foreclosed asset, is the gain or loss on operations “passive income or loss”?

• Rental of foreclosed real estate collateral [shopping centers, office buildings, residences]

– Probably a passive activity unless the gross rental income is less than 2% of the lesser of the fair market value or income tax basis of the property

• A property-by-property determination

86


• Rental of foreclosed real estate collateral

– Is there one “passive activity” of rental OREO or one “passive activity” for each parcel?

• Probably want a separate activity for each parcel so that any excess passive losses are deductible as each parcel is sold

87

30


• Foreclosed operating business

– Is the business leased or operated?

• If leased, then a passive rental activity

• If operated, then the issue is whether any of the shareholders are “active” in the business

– i.e. the 500 hour threshold

• More likely than not, the bank will hire a “manager” and no shareholder will be active

• Therefore a passive activity for all of the shareholders of the S corporation

88

S Corps and Life Insurance

• Income tax “investment” and “basis” in the insurance policy – Rev. Rul. 2009-13

– “Investment” = The sum of premiums paid minus the amount withdrawn tax free as policy loans

– “Basis” = Investment in the contract, minus the cost of “insurance”

89

S Corps and Life Insurance• Gain on disposition – Rev Rul 2009-13

– Surrender of the policy

• Gain equals

–Cash surrender value received, minus

– Investment in the policy

• Gain is all ordinary

• The Ruling uses “investment” as the measure of gain because the proceeds of the surrender are already reduced by the accumulated cost of insurance

90

31


– Sale of the policy to a third party

• Gain equals

– Proceeds of sale, minus “basis”

• Gain up to the accumulated inside earnings is ordinary. Any additional gain is capital [also PLR 9443020]

– The calculation shifts to “basis” because the third party is not deemed to have reduced the purchase price by the accumulated past cost of insurance

• Proceeds are assumed to be the present value of the future death benefit

91


– Sale of a term policy without cash surrender value to a third party

• Gain equals proceeds

– All investment is assumed to have been “absorbed” by the cost of insurance

• All of the gain is capital

– There has been no untaxed “inside accumulation” of ordinary income on the investment

92

S Corps and Life Insurance• Effect on AAA, OAA, and shareholder basis

– Premium payments

• Cash surrender policies – probably none – a balance sheet entry

• Term policies

– IRS indicated in Pub. 589 that it reduces AAA

– The IRS view is that the policy is not a tax exempt asset until the insured dies

– Therefore, the premium/cost of insurance is not an expense “related to tax exempt income”

93

32


– Annual book income on the “inside build-up”

• National Office has advised orally that there is no “current” effect on AAA, OAA, or shareholder basis

– Not tax exempt income until the insured dies

– No “tax event” between the owner and the insurer

• See also

– PLR 9443020 – Viatical settlement ruling

– FSA 1999-832 – Exam focused on s/h basis

In each case, basis not increased by inside build-up

94


– Surrender of the policy to the insurer

• AAA and shareholder basis increased by the gain

– Sale of a cash surrender policy to a third party


– Sale of a term policy to a third party


– Surrender of the policy at maturity on death of the insured

• OAA and shareholder basis increased by the death benefit that is “tax exempt gain”

95

S Corp Election at a Cross-Roads

• S corps almost always have less capital than if they were C corps

– Most banks have net deferred tax assets

– S corps do not record the asset

• For an S corp in need of capital, revoking the election may be the equivalent of a stock issue

– No stock issuance costs

– No valuation discount

– No shareholder dilution

– No Section 382 change date96

33

S Corp Election at a Cross-Roads• There are, however, some limitations on recording the

deferred tax asset that may either defer or “stage” the effect

– The DTA limited to 10% of other Tier 1 capital

– The DTA is limited to the lesserof

• Tax recoverable through NOL carrybacks

– For former S corps zero in the first year

• The sum of (i) forecast tax on the next 12 months earnings, adjusted for permanent differences, and (ii) reasonable and practical tax planning strategies

97

S Corp Election at a Cross-Roads• Other election considerations

– Income tax rates on Shareholders

• Maximum federal rate on passive shareholders may go to 43.4%, 28% more than the rate on a C corp

– Likely to have a continuing, annual effect on capital as passive shareholders demand dividends to cover taxes

• However, if the company is paying more than its tax liability in dividends, the maximum federal individual rate on dividends may increase from 15% to 43.4%

– Increasingly multi-state operations, and state nexus changes, may over-complicate shareholder reporting

98

S Corp Election at a Cross-Roads• Other election considerations

– C corporations have an advantage in raising capital

• C corporations may issue multiple classes of stock

• C corporations may sell shares to “ineligible” shareholders

99

34

Trust Preferred SecuritiesDeferred Interest Payments

• Not customarily treated as OID obligations when issued

• Become OID obligations when the interest is first deferred – deemed retired and reissued– Not a modification under the Sec 1.1001-3 Reg

• The accrued interest becomes OID rather than stated interest– The holder must recognize the income even

though not received– The issuer may deduct the expense even though

not paid [Sec 163(e)]100

Trust Preferred SecuritiesDeferred Interest Payments

• OID that is not collectible should be able to be charged-off as a bad debt

– “Nonaccrual” does not apply to OID

• Once an OID obligation, the security remains an OID obligation even if the interest is later paid currently

• Change the information report to Form 1099-OID

101

Investments by Self-Directed IRA Accounts

• Prohibited transactions

– Investment in the same closely held business by an individual and the individual’s IRA account

– Investment in a closely held entity by an IRA account and members of the beneficiary’s family is also a prohibited transaction

• Advisory Opinion 2000-10A

• Advisory Opinion 2006-9A

102

35

Investments by Self-DirectedIRA Accounts

• Possible Prohibited Transactions

– Investment in a closely held business if:

• The beneficiary is an officer, director, or highly compensated employee

• A member of the beneficiary’s family is an officer, director, or highly compensated employee

• The beneficiary is a service provider to other IRAs invested in the same entity

103

Investments by Self-Directed IRA Accounts

• The Department of Labor places great emphasis on contemporaneous written opinions of ERISA Counsel on IRA investments in closely held entities

• Summary

– My hunch is that a very high percentage of IRA investments in closely held businesses are prohibited transactions

– Only in the most obvious situations should an IRA invest without an Opinion of Counsel

104

Taxable Mergers

• A new idea that seems to have just emerged since the first of the year

– How can the buyer use its stock for most of the consideration, and

– The selling shareholders still deduct their tax loss on sale of the bank

• A combination of:

– A shortage of capital on the buy side

– Built-in losses on the sell side

105

36

Taxable Mergers• The transaction is fairly easy to structure as a Plan of

Share Exchange

– No merger of corporations

– The only tax free reorganization for an exchange of shares is a “B” stock for stock exchange

• “Solely voting stock” rule for a “B” reorganization

– Use substantially all stock with some cash in the consideration

106

Taxable Mergers• Reverse triangular subsidiary merger

– Acquirer creates “Newco” subsidiary

• Note, “Newco” is a subsidiary of acquirer

• If the objective is for Target to either operate as a separate subsidiary of the holding company, or to be merged into the holding company, then “Newco” is a subsidiary of the holding company

• If the objective is for Target to be merged into the bank, then “Newco” must be a subsidiary of the bank

107

Taxable Mergers

• Reverse triangular subsidiary merger– “Newco” is merged into Target with Target

surviving.

– Consideration is less than 80% stock of Acquirer parent.

– Merger fails the “control” test of 358(a)(2)(E)

– Qualified stock purchase if Sec 338 is elected

– If Target is merged into its new parent, whether the holding company or bank, a Sec 332 liquidation

108

37

Taxable Mergers

• The issues confronting a taxable merger

– The exchange of shares gets stepped with a subsequent merger that is not a Sec. 332 liquidation, and if the stock consideration would meet the continuity of interest test for an A reorganization

• Then the transaction becomes a tax free “A”

• Selling shareholders lose their loss on “sale”

109

Taxable Mergers• The issues confronting a taxable merger

– Wash sale – Does Sec 1091 disallow the loss on the exchange of Target for Acquiring shares?

– Key fact – are the shares “substantially identical”?

– General rule - shares of different corporations are not “substantially identical”

– Could be depending upon the facts:

• A new BHC acquires an existing BHC at a loss to the selling shareholders

110

Asset Acquisitions

• Book and tax accounting are different, and substantially so

NO CONVERGENCE HERE EITHER

• The purchase price is different

– Book treats the post closing purchase of the fixed assets, and perhaps loans, as a separate transaction

• Tax steps them together

– Book expenses transaction costs

• Tax probably capitalizes transaction costs111

38

Asset Acquisitions

• Transaction costs which are not capitalized for tax purposes

– In house salaries

– In house overhead

– Integration costs

– Di minimiscosts IF under $5,000 in total

• Liabilities are not “fair valued” for tax

– Liabilities included in the purchase price are the amounts owed to the counterparty

112

Asset Acquisitions• Purchase allocation among the assets is also different

– Book – parallel determination of the purchase price and fair market value of the assets acquired

• The difference is recognized as gain or as goodwill

• All assets start on Day 1 with a FMV book value

– Tax – the residual method by class until the purchase price is exhausted

• No gain or loss recognized except if there is a loss sharing agreement

• Probably results in some assets with tax basis less than FMV, perhaps materially so 113

Asset AcquisitionsValuations

• Book and tax valuations are identical in most cases

– Both are based on “fair market value” which has identical definitions for book and tax

• Exceptions

– Assets covered by a loss sharing agreement

• Tax Regulations introduce a “deemed” FMV equal to the minimum recoverable amount if the borrower pays nothing

• Bank may allocate anything between the deemed FMV and actual FMV

114

39

Asset AcquisitionsValuations

• Exceptions to equal book and tax valuations

– Book values the loss sharing agreement – Tax does not - See Section 597

– Because of the residual method of tax allocation, the value of identifiable intangibles [core deposits] is the lesserof book value or the unallocated purchase price

– The fair market value of Goodwill is immaterial

• It is whatever is left over, frequently zero115

Asset Acquisitions• There are a few surprises in the Tax Asset Classes

– Class III Loans are “loans” for tax purposes.

• REMIC Regular Interests

• Pass-through loan pools

• Overdrafts, even if the customer has net funds on deposit

• Bankers acceptances

• Certificates of deposit and other funds on deposit in banks

• Federal funds sold116

Asset Acquisitions

• Surprises in the Tax Asset Classes

– Perhaps not a surprise, but accrued interest receivable follows the asset. Not Class V

– The IRS National Office suggests orally that FHLB stock, and shares in other GSAs, are more akin to investments than to “other assets” and belong in Class II, not Class V

– IRS National Office says orally that OREO belongs in Class IV, not V

117

40

Asset Acquisitions• Tax allocation

– Begins with the “purchase price” – sum of

• Cash to the seller

– In a failed bank situation, this includes amounts paid later for fixed assets or other assets not purchased at closing

• Liabilities assumed

• Capitalized transaction costs

118

Asset Acquisitions• Allocate the purchase price among the assets in

the ascending order of Class

– Class I – Cash, including in a failed bank the FDIC’s cash to balance the closing.

• Allocated at par

– Class II

• Securities and related accrued interest receivable

–At fair market value

119

Asset Acquisitions• Allocation among the assets

– Class II (cont.)

• If an FDIC transaction with a loss sharing agreement, the covered loans, OREO, et. al, and the related accrued interest receivable is Class II

–Deemed minimum FMV equals the amount recoverable from the FDIC if nothing is realized from the borrower or asset

–May allocate anything between the deemed minimum FMV and actual FMV

120

41


– Class II (cont.)

• If there is a loss sharing agreement so that Sec 597 applies, and

• The sum of Classes I and II exceed the purchase price, then

• The excess is recognized as taxable income over six years on the straight-line basis

– Not a bad thing; usually defers tax

• There is no allocation to any higher classes

121


– Class III – loans and related accrued interest

• At fair market value

• Not necessarily the purchase price, especially in an FDIC transaction where there may be negative goodwill in the bid

– Class IV – OERO

– Class V – Fixed assets and other tangible assets

• Mortgage servicing rights, prepaid expenses, etc.

122


– Class VI – Identifiable intangibles

• Normally only core deposit value if booked

• Recorded at the lesser of the appraised value on the books or the available purchase price

– Class VII – Goodwill

• Whatever is left of the purchase price, if any

– If the available purchase price for any class is less than the FMV of the assets in the class

• Allocate proportionately among the assets

123

42

Asset Acquisitions

• I see a lot of delay in tax allocations until long after the book accounting is done

– Probably a function of when the return is due

– In my view, a major mistake.

– The tax preparer loses a lot of the planning opportunity for tax deferral that exists in the tax “residual method” if he/she doesn’t participate in the book accounting decisions.

124

Due Diligence on the S Election• Due diligence to maintain a valid S election is still one

of the most formidable issues facing S corps

• No self-help correction– The user fee for a waiver is now up to $18,000!– With timely due diligence, some of the most

common inadvertent terminations are the subject of Revenue Procedures for automatic corrections with no user fee

125

Due Diligence on the S Election• Until banks started making the S election, I had no idea

how many ways there were to mess it up• Most frequent sources of inadvertent terminations

– Failure of all the joint owners to sign the Form 2553– Failure of spouses with community property interest

to sign the Form 2553– Failure to file QSST and ESBT elections

• Counsel is not focused on the election or “assumes that the CPAs will prepare and file the election

• The CPAs assume that Counsel prepared and filed the election as part of the estate planning

– QSST elections made by the custodian126

43

Due Diligence on the S Election• Most frequent sources of inadvertent terminations

– Shareholders’ estate planners creating ineligible entities without informing the company• Especially partnerships and LLCs

– Shareholders’ transferring shares to ineligible shareholders

– Former grantor and testamentary trusts outliving their 2 years• There is no similar two year limitation on estates• Also no 2 year limit on former grantor trusts that

are “owned” by heirs

127

Due Diligence on the S Election

• Most frequent sources of inadvertent terminations– Inadvertent second classes of stock

• Directors’ qualifying shares that don’t conform to the exemption in the Code treating them as debt

• Specific buy-sell agreements without general application

– Ineligible shareholders! • IRA Accounts that acquired their interest after

October 22, 2004• Partnerships and LLCs• Charitable trusts 128

Due Diligence on the S Election• Most frequent sources of QSub issues

– QSub elections not made for new subsidiaries

– QSub elections made for unincorporated subsidiaries

– Unreported sales of an “equity” interest in a QSub

129

44

Due Diligence on the S Election

• Procedures to avoid terminations– Collect copies of all QSST & ESBT elections

– Determine that every other trust is a “grantor trust”

– Maintain a “due date control” for testamentary and former grantor trusts

– Adopt The BHC a formal procedures to monitor shareholding changes

• A BHC adopted a policy that for every transfer of shares:

– All of the legal documents will be provided to the company before closing

– The CEO will obtain an outside review of the effect on the election.

130

Due Diligence on the S Election• Despite bank push-back, I continue to hear good

results from confirmations included with the Schedules K-1

– Confirm no unreported change in shareholdings

– Confirm no new trusts or entities

• Response is good; the shareholders give the confirmation to their tax preparers with their Schedules K-1, who see that they are returned

– Even if problems are discovered late, they are likely within the period for automatic corrections w/o fees

131

Miscellaneous Accounting Methods• Change to the accrual method by C corps

– Due the year aftergross receipts exceed the $5 million average

– Automatic under Rev Proc 2011-14

• If made for the 1st Sec 448 year – Chg # 123

• If made earlier or later - Chg # 122

– Still automatic even if the change year is missed

• Include the Form 3115 in a timely filed return

• File a copy with the IRS National Office

– The transition period is the lesser of four years or the number of years on the cash method

132

45

Miscellaneous Accounting Methods• Change by S corps to the cash method

– Automatic if average gross receipts are under $50 million [Rev Proc 2011-14, App. 14.12]

– Average gross receipts is a three year average

• Three prior years – not including the current year

– Must have been under $50 million every year from 2006

– Otherwise, the change requires IRS approval and a $7,000 user fee; plus $150 per subsidiary

133

Miscellaneous Accounting Methods

• Change to the cash method by S corps (cont)

– The Rev Proc 2011-14 has a special requirement for this change

– An attachment to Form 3115 must individually identify each account that will be changed to the cash method

– See the sample table on page 89 of the outline

134

Miscellaneous Accounting Methods• Prepaid interest income

– Accrual method banks do not have to recognize when received

• Loan fees– May be deferred and amortized for books– May be deferred and recognized as OID for tax

• Whether financed or paid by the borrowers• Accrual or cash basis banks• No financial statement consistency

– Change of accounting method

135

46

Miscellaneous Accounting Methods

• Loan origination costs– May be capitalized and amortized for books– Should be deducted for tax [Sec. 263(a) Regs]

136

Questions?

137

Thank YouJohn Cederberg James D. Goeller

John E. Cederberg, CPA Partner, Crowe Horwath, LLP

1248 “O” Street, Suite 760 575 Market Street, Suite 3300

Lincoln, Nebraska 68508 San Francisco, California 94105

Telephone (402) 475-8155 Telephone (415) 946-7448

[email protected] [email protected]

Steve CorrieSecurity National Bank

601 Pierce Street; P. O. Box 147

Sioux City, Iowa 51101

Telephone 712-277-6640

E-mail - [email protected]

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