Disclaimer - This outline is intended for the general information of the attendees of the TwentiethAnnual Community Bank Tax Workshop. It is not intended to provide tax advice. Attendees of theWorkshop must perform their own research to confirm the application of the topics discussed hereinto the facts and circumstances of their respective clients.
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FIL-40-2014.1
I. 2014 Tax Changes Specifically Affecting Banks - This is the second consecutive "quiet" yearfrom a formal guidance perspective.
A. There has been no new legislation affecting banks since the Small Business Jobs Act of2010, enacted September 27, 2010.
B. The regulatory activity has been focused on Dodd Frank implementation and Basel IIIcapital guidelines.
C. The significant tax regulations have been of more general application:
1. Fixed asset Regulations and Revenue Procedures to implement related changes inaccounting methods.
2. Repair Regulations and the Revenue Procedures to implement related changes inaccounting methods.
3. The final Net Investment Income Tax Regulations.
a. These do have a material effect on S corporation banks and will be discussedat some length.
4. There has been little else in the nature of Regulations, Revenue Rulings, RevenueProcedures, et. al. specifically affecting banks this year.
D. There have been no court decisions materially affecting most community banks since theCircuit Court decision in Vianisi.
E. Miscellaneous developments since the session last year.
1. Regulatory guidance from the FDIC regarding requests by S corporation bankholding companies and banks for permission to pay dividends to shareholders forincome tax payments when the BHC or bank do not meet the Capital Conservationbuffer.1
2. Regulatory guidance regarding tax sharing agreements by C corporationconsolidated groups, following up on several court decisions.
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3. The District Court upheld an assessment of nearly $253,000 for failure to makewithholding tax deposits by electronic transfer pursuant to Regulation 31.6302-1(h)(2)(ii).
II. Bad Debts
A. The long anticipated directive from LB&I on the examination of bad debts, especiallybad debts of "nonconformity banks," is still pending as of October 15, 2014.
B. We have been talking about this "forever." The American Bankers Association has beenpressing LB&I for a resolution of the conflict over supporting bad debt deductions forover three years.
1. In late March 2013, LB&I asked the ABA to formally submit the issues for IRSguidance under the Industry Issue Resolution program (IIR). That was done.
2. The ABA and a small group of member banks have met with LB&I personnel onseveral occasions, most recently on August 26 in Washington.
a. The guidance appears to be essentially finished except for incorporatingminor revisions that resulted from the meeting and resolving some "effectivedates."
b. No further meetings are planned in connection with the ABA’s request forIRS guidance under the Industry Issue Resolution program.
c. We had thought that the guidance would likely to be published by about thefirst of October.
C. Effect of the LB&I directive when it is published.
1. The most direct "official" effect will be on how LB&I field examiners examine baddebts of banks during examinations.
a. Since all businesses with more than $10 million in assets are under thejurisdiction of LB&I, even the smallest community banks will be within thescope of the Directive.
2. The guidance will not be binding on Appeals.
a. The faculty's personal experience is that individual Appeals Officers withpending cases have delayed settlements, saying that they will follow theguidance.
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b. Technically, if LB&I issues an examination report and the case transfers toAppeals, the bank could lose its access to the guidance for the years underexam.
III. Deductibility of Holding Period Costs of OREO
A. The Generic Legal Advice Memorandum [GLAM] that was issued by the AssociateChief Counsel's Office on February 22, 2013 is the only tangible result to date of theABA's effort with LB&I to resolve some of these bad debt issues.
B. Even though the memorandum states that it cannot be cited as precedent, it seems tohave made OREO holding period costs abruptly disappear as an examination issue.
C. This is an issue which erupted during the fiscal crisis.
1. Banks must expense holding period costs as incurred for financial reportingpurposes.
2. The Service had a long-standing position, dating back to at least the 1990s, thatholding period costs must be capitalized under Section 263A.
a. The examination guide for the Commercial Banking Industry was firstreleased in July 1997, and then updated in July 2001. In Chapter 6(Gain/Loss on Foreclosed Property), the examination guide states that theholding period expenses of nonoperating OREO must be capitalized by thebank into the basis of the property.
"One of the most common issues to consider in this area dealswith the expenses which are deducted by the bank during theperiod of time the repossessed property is held for sale.
"In many cases the bank will deduct as current expenses suchitems as prior year property taxes, selling expenses, substantialrepairs and improvements, and the legal expenses of acquiring theproperty. These expenses are of a capital nature and are notcurrently deductible. These amounts are considered to be part ofthe cost of the property until sold.
"After the bank takes possession of the property, no portion of theexpenses is currently deductible if the bank is holding theproperty for resale or sale to customers. The OREO property issimilar to inventory, and therefore, all expenses are considered
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to be part of the basis of the property. If, however, the bank isholding the property out for rent, normal maintenance expenses,including depreciation, are deductible by the bank whenincurred." [italics added]
b. This was a national issue with the IRS examination division.
c. Appeals officers were stonewalling taxpayers, essentially "daring" them tolitigate the issue.
3. Very few people, and especially bankers, were aware of this position. It was onlydescribed in the IRS examination manual, which even practitioners were notreading because the Service was not examining banks until the recent fiscal crisis.
4. It came as a big surprise to bankers when examining agents disallowed currentdeductions for OREO holding period costs.
a. It also was an emotional issue with bankers for a couple of reasons.
(1) First, they had to expense the costs on their books, which was a chargeto critical capital.
(a) S corporation banks received no book offset at all for the relateddeferred tax asset.
(b) At the time, most C corporation banks were having to "reserve"their deferred tax assets.
(2) Second because these costs could almost never be recovered upon saleof the OREO, from the bankers' perspective, it was a simple deferral ofdeductions for losses already incurred and paid.
D. Separate from the concession that OREO holding period costs are not subject to Section263A and are deducible as incurred or paid, depending upon the bank's overall methodof accounting, the GLAM implies some other favorable concepts for banks.
1. First, is the reaffirmation of the Service's longstanding position that that OREO isSection 1221(a)(1) property held for sale to customers in the ordinary course ofbusiness.
a. Some bankers had been arguing against the disallowance of a currentdeduction for holding period costs on the grounds that OREO is neither held
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for sale to "customers" nor held for sale in the "ordinary course of business."
b. This assertion was "dangerous" to the industry because Section 1221(a)(1)is the only technical gateway to ordinary losses on sale of OREO.
(1) OREO doesn't meet any of the other criteria in Section 1221(a) forordinary gain and loss treatment.
(2) Losses so far exceed gains that the industry relies on ordinary treatmentto deduct the losses.
2. Second, the conclusion that the foreclosure or deed-in-lieu of foreclosure andsubsequent sale of the OREO are properly viewed as an extension of Bank's loanorigination activity has a number of positive implications, especially for Scorporations, which is discussed further below in the passive loss and netinvestment income tax discussions.
a. The GLAM states in part relevant to this point:
"As a result of the special rule in § 1.263A-1(b)(13), Bank'sactivity of originating loans is not considered the acquisition ofproperty for resale within the meaning of § 263A(b)(2)(A). Thus,Bank's acquisition and sale of the property securing the loan donot convert Bank into a reseller if the foreclosure or deed-in-lieuof foreclosure and subsequent sale of the OREO are properlyviewed as an extension of Bank's loan origination activity.
"Under the facts presented, Bank is acting in its capacity as alender and not as a traditional reseller of property. Bank iseconomically compelled to acquire the property and takes titleand possession only as a last resort to recover funds originallyloaned to the borrower. Bank is not acquiring property for thepurpose of reselling it at a profit."
3. Some lawyers have criticized the GLAM for referring consistently to the bank"originating" the loan, suggesting that it excludes purchased loans, purchasedparticipations, et. al. However, the faculty has not yet been told that thisdistinction is being made by IRS examiners in the field.
a. In addition, the wording of Revenue Procedure 2014-16 suggests that theGLAM includes purchased loans as well as originated loans.
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The change number still is not listed in the instructions to Form 3115. The instructions only go up to change 180.2
E. Revenue Procedure 2014-16 - The new development this year is the Service's promisedautomatic change of accounting method from the capitalization method to the currentdeduction method.
1. The automatic change is a bit difficult to locate if one does not remember theRevenue Procedure number. Revenue Procedure 2014-16 is principally theautomatic changes related to the final repair regulations, and that tends to be theway that it is indexed in research services.
2. Section 3.10, the last change in the Procedure, is the automatic change from thecapitalization method to the current expense method for OREO holding periodcosts.
3. The automatic change number is 195.2
4. Scope of change:
a. The bank must originate, or acquire and hold for investment, loans that aresecured by real property.
(1) The reference to acquiring loans and holding them for investmentappears to be a response to the criticism from some that the GLAMonly addressed loans "originated" by the bank which incurs the loss.
b. The bank must acquire the real property that secures the loans at a"foreclosure sale, by deed in lieu of foreclosure, or in another similartransaction."
c. The automatic change does not apply to costs capitalized under § 263A(b)(1)and § 1.263A-2(a)(1) by the taxpayer to the acquired real property as a resultof production activities.
5. The copy of Form 3115 is to be sent to the Ogden Service Center rather than theNational Office.
IV. The Conformity Election
A. Notice 2013-35 requesting comments on the conformity election and the prospect forrevising Regulation 1.166-2(d).
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1. There has been no public movement on this project and we are hearing that anydevelopments are likely two years away at a minimum.
2. There also appears to be a shift in the National Office attitude about the conformityelection based on Associate Chief Counsel's participation in the Industry IssueResolution Request.
B. What does the author speculate will happen?
1. I personally believe that the conformity election is so important to the industry thatit will not be removed from a new regulation.
2. To the contrary, I believe that it will be made more user friendly.
a. It would not surprise me if "conformity" were to become the "default"method of accounting, from which banks could elect out if need be.
b. It would not surprise me if the Express Determination Letter were to becomea standard "report" on every examination, rather than issued only uponrequest, and possibly extended to state examinations.
c. It also would not surprise me if the EDL letter were revised to focus moretightly on whether:
(1) Charge-offs are limited to "loss" assets, and
(2) Charge-offs are taken not earlier than they should be taken underregulatory standards.
(a) This last revision of the letter would alleviate the problem thatarose during the fiscal crisis where the regulatory examinersrefused the EDL letter because they believed charge-offs weretaken too late.
C. What should banks be doing during the interim?
1. The faculty encourages every bank, whether C or S corporation to request theExpress Determination Letter for every federal examination, whether or not theConformity Election has, or will, be made.
a. The EDL letter has no technical authority unless the Conformity Election hasbeen made, but it is still "evidence" that the bank is following establishedbest practices in making its charge-offs. Except for issues relating to
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"Since 1973, the Federal Reserve has been willing to provide a state member bank with a 'confirmation letter' upon3
the bank's request and in appropriate circumstances. This procedure, which remains in effect, was set forth in SR-225,
dated September 7, 1973." [SR 92-39, October 30, 1992]
The separate letter is not confidential like the examination report. The policy statement also does not require that the
confirmation letter be requested during the examination, but experience with IRS examiners is that it should be
contemporaneous with the examination report, not later when the bank is under IRS examination.
estimated selling costs and nonaccrued interest, it should be helpful in anexamination.
b. There is no downside risk to having the EDL letter in hand.
c. The examination manuals of all three federal regulatory agencies say that theletter must be requested during the examination.
(1) On occasion, field examiners will issue a letter as of a previousexamination date, but that is probably because they are nor aware of theprohibition in the manuals.
d. State examiners cannot provide a valid Express Determination Letter.
2. If a state chartered, Federal Reserve member bank is examined by the FederalReserve, and there are any charge-offs ordered by the federal examiners, then alsorequest a confirmation letter regarding the ordered charge-offs separate from theexamination report.3
3. Some state examiners will issue a similar confirmation letter if they order charge-offs, especially if the bank is a Fed Member. Obtain the letter if (i) there are stateordered charge-offs, and (ii) the state examiners will issue it.
4. We continue to believe that the Conformity Election should be recommended tobanks that have not made it.
a. Technically, it is the only "gateway" to the "regulatory standards" criteria fordeducting bad debts. Without the election, the bank is technically requiredto "prove" that the recoverable amount on the loan was less than the incometax basis.
b. It "solves" the issue plaguing nonconformity banks regarding how to "prove"that their charge-offs are in accordance with regulatory standards.
c. It will solve the issue regarding whether estimated disposition costs aredeductible for tax purposes.
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Regulation 1.166-2(d)(3)(iii)(A).4
Regulation 1.166-2(d)(3)(C)(1).5
d. Finally, for accrual basis banks, it solves the nonaccrued interest issue.[Revenue Ruling 2007-32]
D. Miscellaneous issues that continue to "come-up" regarding the conformity election.
1. The Conformity Election is a change of accounting method, but it is controlled byRegulation 1.166-2(d)(3)(iii), not by the automatic procedures in RevenueProcedure 2011-14.
2. The Conformity Election is made on a bank by bank basis.4
a. In multi-bank holding companies, if bank "A" has its EDL letter, it maymake the conformity election in year one, even if the remaining banks haveto wait to year two because they don't have EDL letter.
b. The process is identical for C and S corporations.
(1) The Conformity Election is a special bank rule, so the deemedliquidation at the date of the QSub election is ignored.
(2) Each QSub bank needs to have its own EDL letter.
3. A new bank adopts the conformity method by attaching a statement to its incometax return for its first tax year during which it incurs a bad debt.5
a. The Regulation refers to the first year in which the bank incurs a bad debt,not its first tax year. It may be able to make the conformity election via thereturn statement in its second, or even third tax year.
b. No Form 3115 is required.
c. The Statement "must include the name, address, and taxpayer identificationnumber of the electing bank and contain a declaration that the expressdetermination requirement of paragraph (d)(3)(iii)(D) ... is satisfied for thetaxable year of the election ... "
4. Certain acquisitions.
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a. If a bank is acquired, in either a taxable purchase of stock or a Section 368tax-deferred reorganization, and is operated by the acquirer as a separatebank, then the acquired bank's Conformity Election continues in effect.
(1) It is a "bank" election. The common parent is immaterial.
b. If the bank in "a" is subsequently merged into the acquirer's subsidiary bank,whether under Section 332 or Section 368, then Section 381(c)(4) andRegulation 1.381(c)-1(c) regarding the carryover of accounting methodsapply.
(1) If both banks have made the Conformity Election, then that method ofaccounting would continue without a new election.
(2) If one bank has made the Election and the other has not, then theaccounting method of the larger bank is the "principal method ofaccounting" for bad debts and continues by the merged bank.Accordingly;
(a) If the acquiring bank is the larger bank, and it has made theConformity Election, the combined bank will be under theConformity Election regardless of whether the acquired bank hadmade the Election.
(b) On the other hand, if the acquiring bank is larger and it has notmade the Conformity Election, the combined bank will not beunder the Conformity Election even though the acquired bankmay have made the Election. If the acquired bank had made theConformity Election, it will terminate in the merger.
(c) Similarly, should the target bank be the larger bank, and if it hadnot made the Conformity Election, the acquiring bank'sConformity Election will terminate upon the merger.
c. If a bank (a) is acquired in an asset transaction under either Section 338,336(e), a purchase of the QSub stock, or by a purchase of assets andassumption of liabilities, and (b) is operated by the acquirer as a separatelychartered bank, then:
(1) The bank is a "new bank" and must re-elect the conformity methodeven though it may have previously made the Conformity Electionsbefore the transaction.
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Regulation 1.166-2(d)(3)(iii)(D).6
(2) Since it is a new bank it may make the Election automatically on thefirst post transaction return in which there are bad debs.
d. If the bank in (c) is merged into acquirer's subsidiary bank, then the acquiredassets will automatically come under the acquirer's Conformity Election.
5. When is the first Express Determination Letter required?
a. The Regulation does not specifically say when the EDL letter is required.The Regulation states simply:
"Express determination requirement. In connection with its mostrecent examination involving the bank's loan review process, thebank's supervisory authority must have made an expressdetermination (in accordance with any applicable administrativeprocedure prescribed hereunder) that the bank maintains andapplies loan loss classification standards that are consistent withthe regulatory standards of that supervisory authority." [italics6
added]
b. The key question is the meaning of "most recent examination."
(1) Is it the most recent examination before the effective date of theElection?
(2) Is it the most recent examination during the year of the election?
(3) Is it the most recent examination before the Form 3115 is filed?
c. Some accounting firms are adamant that the first letter is due during theelection year. They cite the regulatory language that the Form 3115 must"contain a declaration that the express determination requirement ofparagraph (d)(3)(iii)(D) of this section is satisfied for the taxable year of theelection" to conclude that the requirement is satisfied "for the election year"by an EDL letter during the election year.
d. To my knowledge, LB&I has not changed its historical position that the EDLletter must be as of an examination date before the effective date of theConformity Election, which is the first day of the taxable year of the election.
6. Observations regarding the Form 3115.
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a. Enter the name and tax ID # of the parent in the first box for the "taxpayer."This is true for both C corporation consolidated return groups and Scorporation bank holding companies.
b. Enter the name of the bank in the fourth box for the "Applicant."
(1) Only the "bank" may make the Conformity Election. If you do notenter the bank's name as the "applicant," an examining agent mightallege that there is no valid election because "it was made by a non-bank."
(2) This is true of a QSub bank as well as a C corporation subsidiary bank.
(3) As noted above, because the Conformity Election is a "special bankrule," the deemed liquidation of the QSub bank is ignored.
c. There is no Section 481(a) adjustment.
d. "The words 'ELECTION UNDER section 1.166-2(d)(3)' must be typed orlegibly printed at the top of the statement or page 1 of the Form 3115."
e. The Regulation requires that a specific declaration must be made on the Form3115 that the EDL requirement is met.
"When a Form 3115 is used, the declaration must be made in thespace provided on the form for 'Other changes in method ofaccounting.'"
(1) The space referred to in the Regulation has long since been removedfrom the Form 3115.
(2) I have been told by LB&I that, because the requirement is in aRegulation, the declaration is still required and should be made in astatement attached to the Form 3115.
f. It is not clear whether a copy of the Form 3115 must be filed with the IRSNational Office, but from an abundance of caution the faculty recommendsthat it be timely filed with the National Office.
g. The faculty recommends attaching a Power of Attorney.
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(1) Even though Conformity Elections should be noncontroversial, if anycontacts are to be made by either the IRS Service Center or theNational Office, you want the call to come to you, rather than the bank.You are the person who will understand the question and be able toprovide the proper response.
h. Similarly we recommend checking the box "yes" that the taxpayer requestsa conference.
(1) If the election is going to be rejected for any reason, the CPA certainlywants advance notice rather than the client simply receiving a letter inthe mail.
V. Nonaccrual Interest Income - This continues to be a difficult examination issue for accrualmethod banks. The lack of IRS examiner experience with bank, and banking terminology, iscosting banks a lot of representation time.
A. Banks with a Conformity Election
1. This may be the most important benefit of the Conformity Election for accrualmethod banks. The Election appears from the author's consulting experience tosolve most of the issues on nonaccrual interest.
2. The legitimate open "tax issue" is the tax accounting for interim cash receipts onnonaccrual loans.
a. Revenue Ruling 2007-32 states that interim cash receipts from the borrowermust be recognized in income equal to the lesser of (i) the accumulated,nonaccrued interest, or (ii) the cash received.
b. Revenue Ruling 2007-32 also cites favorably Revenue Ruling 80-361 and thecourt decisions in European Am. Bank & Trust Co. and Jones Lumber Co.
"A fixed right to a determinable amount does not require accrual,however, if the income is uncollectible when the right to receivethe income item arises. Accrual of income is not required whena fixed right to receive arises if there is not a reasonableexpectancy that the claim will ever be paid." European Am. Bank& Trust Co. v. United States, 20 Cl. Ct. 594, 605 (1990)(footnotes omitted), aff'd per curiam, 940 F.2d 677 (Fed. Cir1991); see also Jones Lumber Co. v. Commissioner, 404 F.2d764, 766 (6th Cir. 1968) (stating that "[t]he right to receive ...determines the accrual of income unless, at the time the right
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At the time, Mr. Guiliano was the IRS examination division Senior Counsel, Commercial & Foreign Banking Industry7
Counsel.
arises, there exists a reasonable 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 collectibility of a debtis a sufficient reason to justify its nonaccrual as income"); Rev.Rul. 80-361, 1980-2 C.B. 164 (citing Jones Lumber Co., supra.)
3. Whether interim cash receipts are included in income was explained by VinceGuiliano, at the 2010 Bank Tax Institute as follows:7
a. The recognition of interim cash receipts in the Revenue Ruling addresses thecommon situation in which the bank must place performing loans onnonaccrual status for regulatory purposes. It is not focused on loan workouts,loan liquidations, or loans in foreclosure.
b. If application of the interim cash receipt to the income tax basis in the loan(i.e. loan principal plus previously recognized accrued interest, minus charge-offs and payments), reduces the income tax basis in the loan to less than thereasonably projected remaining cash collections on the loan, then the cashreceipt must be recognized in income as described in Revenue Ruling 2007-32 in the amount that increases the income tax basis in the loan to thereasonably expected cash collections.
c. If application of the interim cash receipt to the income tax basis in the loanresults in the income tax basis and the reasonably projected future cashcollections being approximately equal, then the cash receipt is not includedin income. Mr. Guiliano specifically stated that Revenue Ruling 80-361applies.
d. Logically, if the application of the interim cash receipt to the income taxbasis in the loan results in an income tax basis greater than the reasonablyprojected future cash collections, then a further charge-off is appropriate.
4. The example used in the question was liquidating a dairy loan, resulting in cashfrom the auction of the cattle, followed some time later by cash from the auctionof the equipment, and finally wound up with cash from the sale of the land andbuildings. In this example, Vince said that the cash proceeds from interim salesof collateral would not be "nonaccrued interest income."
5. Other issues that the faculty has encountered in practice.
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a. Examiners' lack of familiarity with Revenue Ruling 80-361, or belief that itwas repealed by Revenue Ruling 2007-32.
(1) As a result, the examiners insist on recognizing nonaccrued interestregardless of whether there is any reasonable expectation of collection.
b. Some examiners do not know that the accounting method in Rev. Rul. 2007-32 is mandatory for banks with the Conformity Election.
(1) They allege that the bank is not entitled to "charge-off" the booknonaccrued interest because the bank has not filed a Form 3115electing the Revenue Ruling 2007-32 method of accounting fornonaccrued interest.
(2) There is nothing in all of Revenue Ruling 2007-32 to indicate that themethod of accounting for nonaccrued interest is "elective" for bankswith the Conformity Election.
c. Some examiners, observing correctly that nonaccrued interest is a deductionfor "partial worthlessness" of the loan, look for the "charge-off" that is athreshold requirement for the deduction of a partially worthless bad debt.
(1) They reason that the nonaccrued interest must be "recognized" for taxpurposes because the bank has a legal right to it.
(2) Since there is no charge-off on the books, the deduction for partialworthlessness is not allowed.
(3) They miss the discussion in the Revenue Ruling itself thatnonrecognition on the books is a "charge-off." Revenue Ruling 2007-32 states specifically:
"X's failure to recognize the ... accrued interest forregulatory financial statement purposes is tantamount torecognizing the accrued interest as income and immediatelycharging off the uncollected accrued interest receivable asa loss asset."
d. Some examiners do not understand that banks routinely “extend” and/ormodify loans in an effort to keep the borrower paying as long as possible, butthat the underlying loan and accrued interest is still not “reasonablyexpected” to be collected.
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(1) The bank extended the maturity, or refinanced the loan; therefore theaccrued interest must be collectible and has to be recognized.
(2) In reality, the refinancing might be a "significant modification" whichwould support not only a loss on the loan principle, but certainly theloss of any accrued interest.
B. Banks without a Conformity Election - This is the much more difficult examination issuefor accrual method banks. The historical arguments regarding whether the accruedinterest is worthless continue.
1. The key is developing the facts about the nonaccrued interest early in theexamination and in detail.
a. Once IRS examiners have a misunderstanding of a loan, it is very difficult tocorrect the situation.
Example - The bank personnel referred to a pool of loans as “refinanced,”which the IRS examiner interpreted to mean that they must be “collectible”and included the nonaccrued interest in a proposed adjustment.
In fact, the loans were pooled and sold at a discount from the principalamount.
b. 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 provides thatunder an accrual method of accounting, income is includible ingross income when all events have occurred that fix the right toreceive such income and the amount thereof can be determinedwith reasonable accuracy.
"... [T]he right to receive interest income becomes fixed ratablyover the period of the loan so long as all events have accrued tofix the right to receive income and the amount thereof can befixed with reasonable accuracy.
"A fixed right to a determinable amount does not require accrual,however, if the income item is uncollectible when the right toreceive the item arises. Jones Lumber Co. v. Commissioner, 404F.2d 764 (6th Cir. 1968).
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"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 is accruedand becomes uncollectible during the same taxable year. SpringCity Foundry Co. v. Commissioner, 292 U.S. 182 (1934), Ct.D.829, XIII-1 C.B. 28 (1934). Also Atlantic Coast Line RailroadCo. v. Commissioner, 31 B.T.A. 730, 751 (1934), acq., XIV-2C.B. (1935)."
2. In summary, Revenue Ruling 80-361 indicates that:
a. Loans are properly nonaccrual when there is no reasonable expectation ofcollecting the nonaccrued interest.
b. All accrued interest is properly charged off to the reserve, or deducted as abad debt, in the year that it becomes uncollectible. There is no reversalagainst income.
c. Subsequent payments are applied against principal as long as there is noreasonable expectation of collecting the nonaccrued interest.
3. How does Revenue Ruling 80-361 compare to the financial reporting standards fornonaccrual of interest?
a. Collection of the principal and interest is not reasonably expected shouldsupport nonaccrual for tax purposes as well as book purposes.
b. Having taken a partial charge-off should be strong evidence that thecollection of the interest is not reasonably expected.
c. Collection of the interest should not be reasonably expected on a collateraldependent loan which is under collateralized.
d. Sufficient deterioration of the borrower’s financial condition also probablysupports nonaccrual for tax purposes because it creates the expectation thatprincipal and interest will not be collected in full.
4. There is likely to be a legitimate issue from a tax perspective if the borrower iscurrent on payments, and perhaps even if some of the payments are late or theborrower is behind the agreed upon schedule.
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a. Merely being in default for 90 days may not support nonaccrual in somecases, but if the bank can show a history that little if any of the interest isever collected on loans that default for 90days or more, then collection of theinterest should not be "reasonably expected."
b. 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.
5. The examination guide also offers the examining agents examples of loans thatshould still be on accrual, some of which the industry would not concur with.
a. Loans placed on nonaccrual because of a lapse of time.
(1) We would probably concur if, historically, this bank has collectedaccrued interest on loans of the same category which have been indefault the suggested period, such as 90 days.
(2) However, the industry would not concur if the bank has historicallycollected little if any accrued interest on such loans after they havebeen in default for the specified period.
b. Loans with only partial charge-offs.
(1) The industry would not concur with this statement.
(2) The suggestion is that loans which have been only partially charged offshould accrue interest on the remaining book amount.
(a) This is inconsistent with how partial charge-offs are determined,even for tax purposes. The bank charges off the portion of theprincipal which is a "loss asset." The amount not charged off isthe amount which the bank reasonably expects to collect, whichis all principal.
(b) After the partial charge-off, there is no reasonable expectation ofcollecting any interest in addition to the principal not charged off.
c. Loans with sporadic payments.
(1) Whether loans with sporadic payments should be on accrual for taxpurposes is a facts and circumstances determination, based on thesource of the payments.
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(2) If the borrower is making payments from positive cash flow fromoperations, but is "sporadic" because of "sporadic" cash flow, thenperhaps the guide has a point.
(3) If the borrower is in the process of liquidating assets, and is makingpayments from the proceeds of the asset sales, then there is areasonable expectation of collecting interest only to the extent that therealizable value of the assets, minus other liabilities, exceeds theprincipal.
(4) Loans that are current, but are to borrowers which are delinquent onother loans.
(a) The industry would concur only if the sources of payments forthe delinquent loans are different from the sources of payment ofthe "current loans."
(b) If the sources of payments are identical, then the loans cannot beevaluated separately for the expectation of collecting the interest.
d. Note that the Revenue Ruling refers to whether collection of the interest is"reasonably expected." This clearly is not a "bright line" test.
VI. Examiner Ordered Restatements.
A. If the regulatory examiners conclude that the bank has not recognized material loanlosses which occurred in a previous accounting period, the examiners will not onlyrequire the bank to recognize the losses, but to do so in the "correct" accounting periodand file amended call reports.
When are the losses that the examiners have moved to a different accounting perioddeductible as bad debts?
1. In the year that the bank is examined and physically records the charge-off?
2. In the year during which the examiners ordered them recognized in the callreports?
B. We have discussed this issue in previous sessions. The new information this year is thatthe author has received one report recently of amended returns that claimed the charge-offs in the year to which the regulatory examiners moved them being examined andaccepted.
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. Treasury Decision 8396; 57 F.R. 6291-6296, February 24, 1992.8
C. Conformity Election - If the bank has made the Conformity Election, then this scenariois addressed , but not at all clearly, by Regulation Section 1.166-2(d)(3)(ii)(B). TheRegulation 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 been madein an earlier year. ...”
1. The plain language of that sentence is that the conclusive presumption applies inthe year that the debt is charged-off “for regulatory purposes.”
a. If the examiners order the bank to recognize the charge-off in an earlier yearand to restate call reports, then the loss is charged-off “for regulatorypurposes” in the earlier year.
2. The Treasury Decision accompanying the final Regulation appears to suggest adifferent interpretation. The relevant paragraph “b” of the comment section states8
in relevant part:
“Debts charged off in wrong year. Commentators also asked forguidance on the tax treatment of a debt that is charged off in one year,when a bank's supervisory authority subsequently determines it shouldhave been charged off in an earlier year. The commentators suggestedthat the debt should be presumed worthless for tax purposes in the yearof the charge-off rather than in the earlier year, despite theafter-the-fact determination by the supervisory authority.
“It is consistent with the concept of a conclusive presumption that abank be permitted to claim a tax deduction for a debt charge-off for ayear in which the bank satisfies the requirements of the presumption,notwithstanding that its regulator subsequently determines that thecharge-off should have been made in an earlier year. Accordingly, thefinal regulations provide that a charge-off qualifies for the presumptionin the year of the charge-off, provided the requirements of theRegulations are otherwise satisfied. A pattern of charge-offs in thewrong year, however, may result in revocation of the bank's election.”
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a. The Service implies in the second paragraph that it is acceding to thecommentators’ request that the charge-off qualifies for the conclusivepresumption in the year that it was initially charged-off by the bank,notwithstanding the regulatory examiners’ subsequent determination.
b. Unfortunately, there are a number of problems with the implementation ofthe 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 paragraph inthe Treasury Decision is not consistent with the implication. It doesn’tuse words like “in the year of the initial charge-off” or “in the yearcharged-off by the bank.”
(3) Even more difficult is the reference to “provided the requirements ofthe 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 a taxableyear are conclusively presumed to have become worthless,or worthless only in part, as the case may be, during thatyear, but only if the charge-off results from a specific orderof the bank's supervisory authority or corresponds to thebank's classification of the debt, in whole or in part, as aloss asset, as described in paragraph (d)(3)(ii)(C) of thissection; ... .” [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.
3. In summary, it appears to the author that a bank on the conformity method shouldamend the income tax returns and claim the loss in the earlier year. That is theonly year in which the loss will be reflected in regulatory financial statements.
4. The alternative is to wait until the loan is “wholly worthless” and then claim theloss under Section 165.
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D. No Conformity Election - If the bank has not made the Conformity Election, there is nosimilar reference in Regulation Section 1.166-2(d)(1) regarding examinerdeterminations 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 to thisconsideration deleted:
“If a bank ... which is subject to supervision by Federal authorities, orby State authorities maintaining substantially equivalent standards,charges off a debt in whole or in part, ... in obedience to the specificorders of such authorities, then the debt shall, to the extent charged offduring the taxable year, be conclusively presumed to have becomeworthless, or worthless only in part, as the case may be, during suchtaxable year. But no such debt shall be so conclusively presumed to beworthless, or worthless only in part, as the case may be, if the amountso charged off is not claimed as a deduction by the taxpayer at the timeof filing the return for the taxable year in which the charge-off takesplace.”
a. Two provisions of this paragraph create a significant conundrum.
(1) The first sentence states that if the bank makes a “charge-off” upon thespecific orders of the safety and soundness examiners, the conclusivepresumption applies only to the year of the charge-off.
(a) However, it doesn’t indicate whether the charge-off is made whenthe examiners make their determination or when the examinersdetermine that the loss occurred.
(b) If the examiners require amended call reports, the charge-off willonly appear in the regulatory books for the prior period.
(c) Accordingly, it would seem that the loss should be deducted inthe 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.”
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(a) In many, if not most, cases, the tax return will have already beenfiled when the safety and soundness examiners determine that theregulatory reports must be restated.
(b) Does the last sentence refer to only the original return, or to anyreturn for the year?
(3) Finally, subsection (d)(2) limits the deductibility of the charge-off ina “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 show that(i) The debt became wholly worthless in the later taxable year, orbecame recoverable only in part subsequent to the taxable year of theinvoluntary charge-off, as the case may be ...”
3. The bank which is not on the conformity method also may show that the lossfactually 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 to restatethe call reports.
b. However, the amended call reports are not confidential, and the workpaperswhich develop the amount of the loss are probably not confidential.
4. In summary, there doesn’t seem to be as clear guidance for banks that are not onthe Conformity Method, but it still seems that the year determined by theexaminers that the loss occurred is an appropriate year to claim the deduction,particularly if the original return is still under extension when the examiners orderthe amended call reports.
E. 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 occurred inthe previous year, would not seem to be eligible for the conclusive presumptionunder the conformity election.
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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-off results froma specific order of the bank's supervisory authority” under subsection (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 deduction onthe conformity method because of the following statement from subsection(A)(2):
“A bad debt deduction for a debt that is subject to regulatory lossclassification standards is allowed for a taxable year only to theextent that the debt is conclusively presumed to have becomeworthless under paragraph (d)(3)(ii)(A)(1) of this section duringthat year.” [italics added].
This sentence seems to preclude a factual presentation that the loss occurredin another period.
VII. Seven Year Statute of Limitations under Section 6511(d)(1).
A. Examiner ordered restatements reminds us that there is a special seven year statute oflimitations for claiming refunds resulting from the discovery of a bad debt loss.
1. Applies to both bad debts on loans and worthless securities.
B. Section 3511(d)(1) states in relevant part:
"Seven-year period of limitation with respect to bad debts and worthlesssecurities. If the claim for credit or refund relates to an overpayment of taximposed by subtitle A on account of (A) the deductibility by the taxpayer,under section 166 or section 832(c), of a debt as a debt which becameworthless, or, under section 165(g), of a loss from worthlessness of asecurity, or (B) the effect that the deductibility of a debt or loss describedin subparagraph (A) has on the application to the taxpayer of a carryover, inlieu of the 3-year period of limitation prescribed in subsection (a), the periodshall be 7 years from the date prescribed by law for filing the return for theyear with respect to which the claim is made. If the claim for credit or refundrelates to an overpayment on account of the effect that the deductibility of
such a debt or loss has on the application to the taxpayer of a carryback, theperiod shall be either 7 years from the date prescribed by law for filing thereturn for the year of the net operating loss which results in such carrybackor the period prescribed in paragraph (2) of this subsection, whicheverexpires the later."
1. Note that the seven year statute is not extended for extensions of time to file theoriginal return. Regulation 301.6511(d)-1(a)(1)(ii) reads in relevant part; "theperiod shall be 7 years from the date prescribed by law for filing the return(determined without regard to any extension of time for filing such return) ... ."
VIII.What Constitutes a Charge-off under Section 166 for Tax Purposes?
A. Note that the "charge-off" requirement only applies in two events:
1. To all bad debt deductions by Conformity Election banks.
2. To partial charge-offs by nonconformity banks.
3. If the debt is wholly worthless and the bank has not made the conformity election,it is not technically required to show that the loan was charged-off.
B. Courts have held that a “charge-off” removes the asset from the books and records of thetaxpayer, but that there is no specific requirement regarding how the asset is removedfrom the books.
1. In particular, there is no requirement that it be done specifically by a charge to thereserve for losses.
a. The Board of Tax Appeals stated in Ewald & Co. v. Commissioner that:
“The fundamental purpose in requiring the charge-off is toevidence the worthlessness of the debt, ... and this end isaccomplished and the charge-off effected by the elimination ofthe bad debt from the taxpayer’s assets. If the debt is in factascertained to be worthless, it should no longer be treated orconsidered as an asset. The effective elimination of the debt asan asset meets the statutory requirement as to charge-off.”9
b. The U.S. Court of Appeals for the Seventh Circuit followed the samereasoning in Commissioner v. MacDonald Engineering Co.:
“There is no fixed mode of charge-off. The principal reason forthe requirement is to prevent a taxpayer from taking advantage ofthe loss for tax purposes while continuing to carry the item on hisbooks as an asset for other purposes. Anything which manifeststhe intent to eliminate an item from assets is sufficient toconstitute a charge-off.”10
C. Revenue Ruling 2007-32 expands on this concept by holding that failure to recognizeaccrued income for financial statement purposes is tantamount to recognizing theaccrued income and immediately charging it off as a loss asset.
"For regulatory purposes, X does not recognize as income any of the $23,000of accrued interest attributable to the period January 17, 2007 throughDecember 31, 2007 because X's right to the $23,000 of accrued interest hassuch little value that recognition of the accrued interest receivable as abankable asset is not warranted. Under these circumstances, X's failure torecognize the $23,000 of accrued interest for regulatory financial statementpurposes is tantamount to recognizing the accrued interest as income andimmediately charging off the uncollected accrued interest receivable as aloss asset. " [italics added]
D. "Specific Reserves," are they deductible charge-offs for tax purposes?
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1. "Specific reserves" are a somewhat outdated thrift concept. Thrifts would establish"specific reserves" for losses on secured loans rather that write down the assetaccount. The specific reserve was a contra-asset account.
2. Regulation 1.166-2(d)(4)(ii) states that a thrift's specific reserves are a "charge-off"for tax purposes.
“(ii) Charge-off. For banks regulated by the Office of ThriftSupervision, the term "charge-off" includes the establishment ofspecific allowances for loan losses in the amount of 100 percent of theportion of the debt classified as loss.”
3. There is precious little guidance on this regulation. An electronic search revealsno citations to the Regulation in any court decision, any other regulation, or anypublished Revenue Ruling or Procedure. There are only two citations in ChiefCounsel materials, of which the most helpful is Field Attorney Advice [FAA]20123002F dated June 8, 2012.
a. The thrift had entered into a cease and desist agreement with the Office ofThrift Supervision to establish adequate general reserves for losses. Whena loss was identified in a specific secured loan, the amount of the loan inexcess of the FMV of the collateral would be moved from the general reserveto a specific reserve. The field attorney advised that the transfer to thespecific reserve was a charge-off.
b. In Field Service Advice 199912005 dated December 11, 1998, the AssociateChief Counsel's Office advised an examining agent that a thrift was alloweda "charge-off" for amounts classified "loss" and transferred to specificreserves, but not amounts classified "substandard" or "doubtful," unless thetransfers were ordered by the Office of Thrift Supervision examiners.
c. The faculty has located no guidance which applies the Regulation to acommercial bank, but Section 581 states that a "thrift" is a "bank" for taxpurposes, so the absence of guidance for commercial banks is probably amatter of usage rather than law.
4. A specific reserve that is only available to absorb losses on the loan for which itis established should be a "charge-off" so long as the amount recorded in thespecific reserve was classified a "loss."
a. FAA 20123002F assumes that the specific reserve is recorded in a separateaccount; not as a simple allocation of the general reserve.
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See Chapter 6.11
MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.12
b. If the "loss" is subsequently collected and the specific reserve is moved backinto the general reserve, that entry would be treated as a recovery.
E. In summary, any method which removes an asset from the books and records, or doesnot include a legally accruable amount among the assets in the books and records, is a"charge-off" for income tax purposes.
IX. Other Loan Related Costs
A. 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, utility bills,mechanics liens, etc. The lender ends up paying the bills either before or after theforeclosure.
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 the propertyis 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.11
a. Service’s Position - Pre-acquisition expenses incurred by the debtor and paidby the lender before the change of ownership increase the bank’s income taxbasis in the loan. The MSSP states that:
“The basis of the loan is further increased by other costs, such as backtaxes, insurance, legal expenses, and similar items paid by the bank forprotecting the value of the property prior to the transfer of ownershipto the bank.” [underscoring in original but italics added]12
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Estate of Schieffelin v. Commissioner [4 B.T.A. 137 (1941).13
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.
(a) The costs will be expensed on the books. The book expenseshould be a "charge-off" for tax purposes, thereby satisfying theSection 166 requirement that a deduction for partialworthlessness be supported by a book charge-off. See RevenueRuling 2007-32.
(2) If the bank pays the costs after the transfer of ownership, then they areadded to the income tax basis in the property, further increasing thebasis 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, a very old case13
from 1941 and not involving a Bank. The taxpayer in the case was anindividual who owned two loans, each secured by different properties. Bothloans defaulted and the decedent foreclosed, obtaining possession of bothproperties.
(1) In one case, the lender had paid real estate taxes on the property beforethe foreclosure.
(2) In the other case she paid the real estate taxes and water bills after theforeclosure.
(3) The Board of Tax Appeals held for the taxpayer with respect to taxespaid before the foreclosure but for the Service with respect to the taxesand utilities paid after the foreclosure.
(4) The Board cited Minnie M. Coward, 39 B.T.A. 1158 (affirmed as to thepoint at issue, 110 Fed.(2d) 725) to say that it was well settled that ifthe purchaser of real estate pays taxes thereon which have accrued priorto the date of purchase, such payments are an additional cost of theproperty to the purchaser and are therefore not deductible by him as histaxes. The Board also cited Lifson v. Commissioner, 98 Fed.(2d) 508,and Merchants Bank Building Co. v. Helvering, 84 Fed.(2d) 478.
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MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.14
B. Foreclosure Costs:
1. GAAP requires that foreclosure costs be expensed as incurred for financialreporting purposes.
2. Tax accounting - The Service’s position is that foreclosure costs must be added tothe income tax basis in the property.
a. The MSSP states that, “Legal costs and other similar expenses incurred inconnection with the foreclosure proceedings increase the basis of the OREOproperty.” [underscoring in original]14
b. Under the MSSP, a formal foreclosure transaction proceeds in the followingsteps:
(1) The amount by which the bank’s income tax basis in the loan exceedsthe bid price, if any, is a bad debt allowable under Regulation Section1.166-6.
(2) If the bank purchased the property at the foreclosure auction, then thedifference between the fair market value of the property and the bidprice 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 in thebank having an income tax basis in the property greater than its fairmarket 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 of proofon the Commissioner to sustain fair market values in excess of the bid price,resulting in the bank recognizing gain on the foreclosure. However, inreciting the facts of the case, the Court states:
“Petitioner, as authorized by section 1.166-6(a), Income Tax Regs.,charged against its bad debt reserve an amount equal to the difference
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between (1) the balance due under the note plus costs of foreclosureand (2) the bid price of the property acquired.” [italics added]
Later in a discussion of each of the Service’s arguments to the Court, theCourt states again:
“Respondent [i.e. the Service] alternatively argues that petitioner’sdeduction for bad debts should reflect an amount equal to thedifference between the balance due under the notes plus costs offoreclosure and the fair market value (rather than the bid price) of theproperty acquired.” [italics added]
Both quotations indicate that the foreclosure costs were added to the loan todetermine the bad debt, without any objection from the Service.
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, itappears that they should be added to the basis in the note in determining thebad debt charge-off resulting from either the foreclosure or the transfer of theproperty by deed in lieu of foreclosure.
X. Bad Debt Charge-offs on “Securities”
A. We are far enough through the examination of fiscal crisis returns that most agents aregenerally familiar now with Section 582.
B. This issue was probably helped by an LB&I Directive dated July 30, 2012 that LB&Iexaminers should not challenge partial worthlessness deductions by insurance companieson "eligible securities."
While the Directive clearly does not apply to banks, there are so many parallels betweenbank investments in mortgage backed securities and structured investments andinsurance company investments, that we observe that LB&I examiners have tended tofollow the concepts of the insurance company directive in bank examinations.
1. The Directive recites that, "Independently determining partial worthlessnessamounts under section 166 imposes a significant burden on both insurancecompanies and LB&I."
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2. The Directive also recites a "conformity principal" with the National Associationof Insurance Commissioners Accounting Practices and Procedures Manual:
"Insurance companies are required by state law to file AnnualStatements using the accounting principles set out in the NationalAssociation of Insurance Commissioners (NAIC) Accounting Practicesand Procedures Manual which have been adopted by the states. SSAP43R provides accounting rules that must be followed when loan-backedand other structured securities are impaired and subject to a charge-off.SSAP 43R became effective on September 30, 2009, and applies for allreporting periods ending on or after September 30, 2009."
3. The Directive concludes that, "LB&I examiners should not challenge an insurancecompany’s partial worthlessness deduction under §166(a)(2) for eligible securitiesif the company complies with the following ... [provisions of the Directive,involving generally first year adjustments and conformity with SSAP 43R. ]."
4. Definitions:
a. "Eligible Securities" are investments in loan-backed and structured securitieswithin the scope of SSAP 43R, subject to Section 166, and not subject toSection 165(g)(2)(C).
(1) Eligible Securities include REMIC regular interests.
b. "Charge-off."
" 'Charge-off' means an accounting entry or set of accounting entriesthat reduce the debt’s carrying value and results in a realized loss or acharge to the statement of operations (as opposed to recognition of anunrealized loss) that is recorded on an insurance company’s AnnualStatement."
C. The issues that still come up.
1. If the bank is on the reserve method for bad debts, it is difficult for bankers, andfor some examiners and practitioners as well, to get their mind around the fact thatthe bank is simultaneously on two accounting methods for bad debts:
a. The reserve method for loans; and
b. The charge-off method under Section 166 for Securities.
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2. Securities are not "loans" for purposes of the Section 585 reserve calculations.
a. Securities are not included in total loans.
b. The losses on securities are not included in "charge-offs" for purposes ofdetermining the allowable reserve.
c. Securities charge-offs have no effect on the allowable tax reserve for baddebts.
3. However, a few categories of "securities" for financial reporting and regulatory callreport purposes are "loans" for tax purposes. If the bank is using the reservemethod for bad debts, they should be included in total loans, and losses should beincluded in the reserve calculation.
a. Investments in REMIC regular interests have been held by the Service to be“loans” as defined in Regulation Section 1.585-2(e)(2).
(1) Section 860B(a) of the Code states in relevant part, “... a regularinterest 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, "A regularinterest in a REMIC is considered debt for purposes of the Codewithout regard to the actual form of the instrument. See Section860B(a). Thus, the obligations are 'loans' within the meaning ofSection 1.585-2(e)(2), without regard to the underlying collateral thatsecures 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 tax purposes.Therefore, a regular interest in a REMIC is a loan within the meaningof § 1.585-2. ..."
b. Other pass-through mortgage backed securities, even if not REMICs, are also“loans” for income tax purposes.
(1) 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 for
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qualification as by thrifts under Section 7701. The trust certificateswere in registered form, stated that they represented fractionalundivided interests in the mortgage loans, pool proceeds, andmortgaged property acquired by foreclosure.
(2) 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 NationalMortgage Association (FNMA), the Government NationalMortgage Association (GNMA) or the Federal Home LoanMortgage Corporation (FHLMC), but some of themortgage-backed securities insured by those agencies wereREMIC regular interests as described in Sections 860Athrough 860G of the Code.”
The Service held that the pass-through investments were “loans” asdefined in Regulation Section 1.585-2(e)(2).
4. In its current formulation, the Conformity Election does not apply to securitieslosses.
5. The normal rules of Section 166 apply to securities as well as loans.
a. To the extent that the reasonably expected projected cash flow, principal andinterest, on “securities” is less than the bank's income tax basis in thesecurity, including accrued interest if included in income, the shortfall is a"credit loss" that is a deductible bad debt for a partially worthless debt.
b. For GAAP accounting, the projected cash flow is discounted to presentvalue, using the interest rate in the security. This present value is notdeductible.
(1) To deduct it would be to deduct future income, in which the bank hasno income tax basis.
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Regulation 1.469-5T(a)(5).15
c. For financial reporting purposes, the security may be an accrual basis assetif the projected cash flow is reliable.
d. However, for income tax purposes, since the "charge-off" is down to the fullreasonably expected cash flow, principal and interest, the post-charge-offsecurity is a non-accrual asset.
XI. Net Investment Income Tax Final Regulations - With the first year's experience with the netinvestment income tax on passive income, we are a bit more aware of some of the implicationsof that tax for S corporation bank shareholders.
A. Five Year Rule - An Active Activity [the individual has over 500 hours per year in theactivity] remains an active activity for five years after no longer meeting the 500 hourtest.
1. If an individual materially participated in the activity for any five taxable years(whether or not consecutive) during the ten taxable years that immediately precedethe taxable year, then the activity is an "active activity of the individual.15
a. This can be an important provision for retiring and other former S and QSubbank officer/shareholders.
b. Their allocable share of the S corporation's income for the five years after nolonger actively participating in the bank is not subject to the net investmentincome tax.
c. If they happen to sell their stock, or it is redeemed, during the five yearperiod, of if the bank happens to be sold, the gain on sale is not subject to thenet investment income tax.
B. Self-rentals - Do not overlook the frequency with which an S corporation or QSub bank"rents" its headquarters or branch facilities from a partnership of the shareholders, orlead shareholders.
1. In a concession from the proposed regulations, the final regulations allow rentalincome from self-rental arrangements to be excluded from NIIT.
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Regulation 1.1411-4(g)(6).16
a. A "self-rental" is net rental income from property rented for use in a trade orbusiness in which the individual taxpayer materially participates.16
(1) The business may be in either S or C corporation form.
(2) Eliminates an excessive passive loss if the rental results in a loss.
2. Gain or loss from the disposition of a self-rented property is also excluded from netinvestment income.
C. There is a similar exception for self-charged interest.
1. The percentage of interest income from a nonpassive entity is recharacterized asnot net investment income equal to the individual's percentage ownership in thenonpassive entity reportable by the same person.
2. Unlike self-charged rent, this only applies to pass-through nonpassive entities, i.e.an S corporation in banking.
3. Also unlike self-charged rent, the "lender's" interest income is recharacterized onlyto the extent that the lender is claiming a deduction for the pass-through of theoffsetting interest expense.
D. Significant Participation Activities
1. Business activities in which the taxpayer participates over 100 hours during theyear, but the taxpayer does not otherwise materially participate. If the taxpayer’saggregate time with all SPAs exceeds 500 hours, the taxpayer materiallyparticipates in all of the SPA activities.
2. The income from all of the Significant Participation Activities is recharacterizedas not passive.
3. Gain on sale of any of the Significant Participation Activities while it is asignificant participation activity is also excluded from the passive investmentincome tax.
E. Significant Participation Passive Activities (SPPAs) - A subset of significantparticipation activities.
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1. These are Significant Participation Activities in which the taxpayer has more than100 hours of participation in the activity, but less than 500 aggregate hours in allSignificant Participation Activities.
2. If a Significant Participation Passive Activity produces a loss, it is a passiveactivity loss.
3. However, if it produces a gain, it is recharacterized as not a passive activity, andthe income is excluded from the net investment income tax.
F. Whether the S corporation is an Activity, a Passive Activity, a Significant ParticipationActivity, or a Significant Participation Passive Activity is determined annually and maychange from year to year.
G. It is extremely important for directors of S corporation bank holding companies andQSub bank directors, members of audit and loan committee, et al. to keep accurate logsof their time spent on the A corporation's behalf.
H. Other S corporation NIIT Issues.
1. Income on invested working capital. Banks, and bank holding companies, keeptheir working capital invested. There was originally some concern whether therewould be some form of allocation of income as Net Investment Income to reflectthe investments of working capital.
a. The Final Regulations include a cross reference to an exception in Regulation1.469-2T(c)(3)(ii) for interest and other portfolio income derived in theordinary course of business, which should take care of most bank income.
2. Interest and dividend income of the holding company. This is a more materialissue if the holding company has accumulated a significant "war chest" that isinvested in either taxable securities or perhaps stocks of publicly traded bankholding companies.
a. Section 1362(d)(3)(C)(v) is an exception from passive investment income forpurposes of determining whether an S election is terminated after three years:
"Exception for banks, etc. In the case of a bank (as defined insection 581) or a depository institution holding company (asdefined in section 3(w)(1) of the Federal Deposit Insurance Act(12 U.S.C. 1813(w)(1)), the term 'passive investment income'shall not include (I) interest income earned by such bank orcompany, or (II) dividends on assets required to be held by such
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bank or company, including stock in the Federal Reserve Bank,the Federal Home Loan Bank, or the Federal AgriculturalMortgage Bank or participation certificates issued by a FederalIntermediate Credit Bank." [italics added]
b. There does not appear to be a cross-reference to Section 1362 in the FinalNIIT Regulations, but Section 1362 should provide support for excluding theholding company"s interest income from the NIIT.
c. Dividends on various C corporation stocks held by the bank holdingcompany and/or QSub bank.
(1) Banks typically do not hold any C corporation stocks unless they werecollateral for a loan that has been foreclosed. The GLAM on OREOholding period costs suggests that dividend income received onforeclosed stocks before they are sold should be "loan income," notincluded in net investment income.
(a) The question then arises whether those dividends should bereported as "qualified dividends" on Schedules K-1.
(b) The author believes that they should be separately reported asqualified dividends, but not as investment income.
(2) Dividends on C corporation stocks held by the bank holding company.
(a) If the stocks are foreclosed collateral, the author believes thatthey should not be included in net investment income for theNIIT for the same reason as foreclosed stocks held by the QSubbank.
(b) The holding company as a separate legal entity cannot hold mostof the stocks that are in Section 1362, so the exception in Section1362 from passive income should not apply.
(c) There is no exception in Section 1362 for other stocks held by thestate law holding company, and they are probably (a) separatelyreported as qualified dividends on Schedules K-1, included ininvestment income on Schedules K-1, .and included in netinvestment income subject to the NIIT.
3. Rentals of operating OREO. Is net income or loss from rentals of operating OREOincluded in net investment income?
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a. The GLAM on OREO holding period costs views OREO as an extension ofthe lending function. The GLAM would suggest that rental income or lossshould be a form of loan income.
(1) This would suggest that it is ordinary operating income or loss on Page1 of the S corporation return. If so, it would be excluded from the NIITof active shareholders.
b. However, the Section 469 Regulations measure whether rental of propertyis incidental to a nonrental activity differently from what most bankers wouldexpect.
(1) Gross rents of OREO would almost always be a very small percentageof the gross income of the bank; and would be considered "incidental"by the banker.
(2) However, Regulation 1.469-1T(e)(3(vi) measures "incidental" rental ofproperty used in the trade or business (which pursuant to the GLAMshould include OREO) by the percentage of gross rents to basis in theproperty and its fair market value. The Regulation states in partrelevant to OREO which is not held for investment:
"In general. ... the rental of property shall be treated asincidental to a nonrental activity of the taxpayer ... if andonly if-- (3) the gross rental income from such property forthe taxable year is less than two percent of the lesser of (i)the unadjusted basis of such property; and (ii) the fairmarket value of such property.
(3) The result seems manifestly unfair, but the reference in the Section 469Regulation to "if and only if" suggests that it would override theextension of loan income from the GLAM.
4. Rental of Building Premises to Third Parties. Many S corporations rent out excessspace to third parties, either on short term leases pending using the space for theirown operations, or more or less permanently.
a. The quoted Regulation refers to the basis and fair market value of "suchproperty."
b. Is "such property" the entire branch building, or only the 15% or 20% of theproperty that is rented?
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c. If "such property" is the whole branch building, then many of the excessspace rentals are likely to be "incidental" under the Section 469 Regulation,and therefore not subject to the NIIT for active shareholders.
d. If the space is rented on a more or less permanent basis (e.g. the top fivefloors of a ten story headquarters office building), then the rentals willusually fail the "incidental" test and generate net investment income for eventhe active S corporation shareholders.
5. Whether the gain from origination and sale of mortgage loans, and othersecuritised loans, is gain from “trading in financial instruments” and thereforeseparately reported income subject to the NIIT.
a. Section 1411(c)(2)(B) states in relevant part that a "trade or business" onwhich the income is "investment income" is:
"A trade or business is described in this paragraph if such tradeor business is ... (B) a trade or business of trading in financialinstruments ... ."
b. If the bank or thrift originates residential home mortgages and sells them intothe secondary market, is that "trading in financial instruments" to which thenet investment income tax applies? The existing guidance thus far does notsay.
c. The similar issue might be extended to selling loan participations, thoughmost ordinary participations are commonly bought and sold at par value.
d. However, the issue might arise with participations in federally guaranteedloans.
(1) As I understand the most common SBA guaranteed loan program:
(a) The originating bank obtains the SBA guarantee, closes the loan,and commonly sells the guaranteed portion into the market.
(b) The selling price is usually at a premium, representing the presentvalue of the difference between the loan interest rate and the"market" rate for the guaranteed loan.
(c) The originating bank retains servicing, and receives a fee equalto 100 basis points.
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(d) Is the gain on the sale of the SBA guaranteed participations NII?
(2) The FSA guaranteed loan program is somewhat similar, except that theparticipation in guaranteed portion of the loan is sold to Farmer Mac orto an investment bank at par.
(a) The originating bank retains servicing.
(b) The participation's percentage of the interest collected at thenominal loan rate is forwarded to the investor, but the differencebetween the loan rate and the rate that Farmer Mac or the investorpurchased the loan is returned to the originating bank as a"servicing fee." I understand that in the market, that is likely tobe over 200 basis points.
(c) Is some part of the servicing fee "gain" on the sale of tenfinancial instrument and NII?
e. The author wrote a memorandum last year concluding that originating loansand selling either the whole loan or participations in the loans should not be"the trade or business of trading financial instruments."
(1) Section 1411(c)(2)(B) has two requirements for a trade or business tobe subject to the NIIT; the asset must be a “financial instrument,” andthe bank must be a “trader” in that instrument.
(2) It is relatively clear from the definition of “financial instruments” inProposed Regulation 1.1411-5(c)(1) that the loans originated by thebank are “financial instruments.” That subsection defines “financialinstruments” in relevant part as follows:
“Definition of financial instruments. For purposes ofsection 1411 and the regulations thereunder, the termfinancial instruments includes stocks and other equityinterests, evidences of indebtedness, ... .”
(3) However, the Proposed Regulations do not include a similarly cleardefinition of a “trader.”
(a) Proposed Regulation 1.1411-4(a)(3) Example 3 refers to an Scorporation that “is engaged in a banking trade or business” butsimply states as a fact the bank “is not [in] a trade or business of
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The omitted citations to court decisions address whether “traders” are in a “trade or business.” They not helpful to17
the question of whether the bank is a trader when it originates and sells loans.
trading in financial instruments or commodities.” That is nothelpful in the context of whether the origination and sale of loansis “trading in financial instruments.”
(4) Section 6.C of the preamble to the Proposed Regulations addresses howto distinguish between a dealer, a trader, and an investor in financialinstruments, but the focus is on whether the activity rises to the levelof a section 162 trade or business, not the kinds of transactions thatmake an entity a “trader.” Subsection (C)(i) states in relevant part:
“Distinguishing between dealers, traders, and investors.Determining whether trading in financial instruments orcommodities rises to the level of a section 162 trade orbusiness is a question of fact. … In general, section475(c)(1) provides that the term dealer in securities meansa taxpayer who (A) regularly purchases securities from orsells securities to customers in the ordinary course of atrade or business, or (B) regularly offers to enter into,assume, offset, assign, or otherwise terminate positions insecurities with customers in the ordinary course of a tradeor business. In contrast, a trader seeks profit from short-term market swings and receives income principally fromselling on an exchange rather than from dividends, interest,or long-term appreciation. … A person will be a trader,and therefore engaged in a section 162 trade or business, ifhis or her trading is frequent and substantial, which hasbeen rephrased as "frequent, regular, and continuous."[Citations omitted; underscoring in the original; italicsadded]17
(5) The author concluded that banks are not “traders” when they originateand sell loans for two reasons.
(a) One half of the transaction is a market transaction. In theordinary course of business usage, “trading” requires both theacquisition and the disposition to be market transactions. Theorigination of a loan is not the acquisition of a financialinstrument in the market, but rather the creation of a newfinancial instrument.
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(b) Second, the gain from originating and selling loans is not "profitfrom short-term market swings" and is not done on an exchange.
f. The ABA has formally asked the IRS for guidance on this issue in theRegulations.
XII. Section 336(e) Regulations
A. Section 336(e) expands the scope of potential stock sales that the parties can elect to be"asset sale" transactions.
1. May be more practical as a convenient legal mechanism for changes of controlthan as a "new" tax tool.
2. In summary, the election under Section 336(e) may be available in the followingsituations where an election under Section 338(h)(10) would not.
a. The sale/exchange of US corporate target stock to individuals and/orpartnerships.
b. Distributions of US corporate target stock to stockholders when Section 355does not apply.
c. Distributions of US corporate target stock to stockholders when Section 355applies, but the distributing corporation is subject to tax under Section 355(d)or (e).
B. The following requirements must be met to qualify for the election.
1. The transaction does not otherwise qualify for an election under Sec. 338(h)(10)or Section 338(g).
a. There is no overlap between Sections 338 and 336(e).
b. Section 338 trumps.
2. The seller must be a U.S. corporation or S corporation stockholder(s).
3. The target must be a U.S. C corporation subsidiary of a US C corporation or an Scorporation.
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4. The buyer(s) must be individuals, or a partnership, including an LLC taxed as apartnership.
5. The transaction must be a "qualified stock disposition" [QSD], which, like Section338, is a disposition of at least 80 percent of the vote and value of target stock sold,exchanged, or distributed within a 12-month period.
6. The stock must generally be sold, exchanged or distributed in a taxable transaction.
7. The stock cannot be sold, exchanged or distributed to a related person.
C. Section 336(e) probably has greater application outside of financial institutions than tofinancial institutions because of the regulatory limitations on the form of transactions.
1. Somewhat to the author's surprise, we have not been consulted on a single Section336(e) change of control of a bank, thrift, or holding company.
a. The author has been told about one proposed transaction in which an LLCwas negotiating to acquire a bank from its holding company, but thattransaction did not close.
2. The principal expansion of the "deemed asset sale" concept from Section 338 isthat there can be multiple buyers, and the buyers do not have to be corporations.
a. In the 1970s when many, if not most acquisitions of community banks wereby individual investor groups, Section 336(e) would have been really useful.
(1) The shareholders of an S corporation BHC could sell 80% or more ofthe outstanding shares in the aggregate to a new group of individuals,and there would be no need to obtain regulatory approval of a newholding company.
(2) The change in control would still require regulatory approval under theBank Change of Control Act.
(3) Now most acquisitions of community banks are by larger bank holdingcompanies and Section 338 applies.
b. I was recently consulted about a bank holding company that hopes torecapitalize by issuing new shares equal to 85% ownership of the company.
(1) If they were an S corporation, a Section 336(e) election could apply.
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Regulation 1.597-4(g)(5)(i)(A).18
3. The second major use is a "protective election" in a Section 355 split-up that wouldonly come into effect of it is ultimately determined that gain is recognized underSection 355(d) [relating to changes of ownership during the five years before thesplit-up] or more likely Section 355(e) [regarding changes of ownership during thetwo years after the closing].
a. This could be really useful in split-ups of family farms and ranches, or otherfamily businesses, but again, is not likely to have much application in thefinancial institutions area.
D. While Section 336(e) gets the buyer control of a corporation with a purchase price basisin the assets, it does not eliminate the most common "double taxation" issues for sellers.
1. There is no adjustment to C corporation shareholders' basis in their C corporationstock for the gain on sale recognized by the selling parent corporation. The secondlayer of tax would still be recognized on liquidation of the selling parentcorporation.
2. If the selling corporation has been an S corporation for less than 10 years, it wouldstill owe the built-in gain tax on the sale of the subsidiary's assets.
XIII.Disaffiliation of Failed Banks
A. A C corporation bank holding company should “disaffiliate” from the failed bank withinthe 120 days allowed by the Regulations.
1. Regulation 1.597-4(g) states in relevant part:
"Elective disaffiliation. (1) In general. A consolidated group of whichan Institution is a subsidiary may elect irrevocably not to include theInstitution in its affiliated group if the Institution is placed in Agencyreceivership (whether or not assets or deposit liabilities of theInstitution are transferred to a Bridge Bank)."
a. The disaffiliation election must be done within 120 days after the bank isplaced in Agency receivership.18
b. The holding company "disaffiliates" the bank and all of the bank'ssubsidiaries. It has no effect on the holding company's subsidiaries.
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c. Disaffiliation is accomplished by (a) sending a written statement thatcomplies with the specific requirements of subparagraph (5)(i)(A) bycertified mail, return receipt requested, to the affected Institution and each ofits subsidiaries, and (b) including the statement(s) and return receipt card(s)in its return for the year of the election.
2. "Disaffiliation":
a. Allows the bank holding company to prepare one return that includes thebank through the closing date. The FDIC is responsible for any posttransaction returns.
b. Relieves the shareholders of the holding company from the cost of havingpost-failure returns prepared.
(1) Especially important if the bank is liquidated rather than its assets sold.The liquidation process can carry on for several years.
c. Allows the bank holding company to wind up its affairs and liquidate.
B. An S corporation bank holding company should revoke the QSub election of the failedbank, perhaps at the beginning of the month before the failure.
1. The QSub election is revoked by filing a statement with the IRS. Regulation1.1361-3(b) states in relevant part:
"(b) Revocation of QSub election. (1) Manner of revoking QSubelection. An S corporation may revoke a QSub election under section1361 by filing a statement with the service center where the Scorporation's most recent tax return was properly filed. The revocationstatement must include the names, addresses, and taxpayeridentification numbers of both the parent S corporation and the QSub,if any. The statement must be signed by a person authorized to sign theS corporation's return required to be filed under section 6037.
"(2) Effective date of revocation. The revocation of a QSubelection is effective on the date specified on the revocation statementor on the date the revocation statement is filed if no date is specified.The effective date specified on the revocation statement cannot be morethan two months and 15 days prior to the date on which the revocationstatement is filed and cannot be more than 12 months after the date onwhich the revocation statement is filed."
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a. Note that the statement may specify a revocation date up to 2 months and 15days before the date it is filed.
b. Otherwise, it becomes effective on the date filed.
2. Revocation insulates the shareholders from any tax liabilities that might result fromthe failure, such as the taxable federal financial assistance.
a. The then C corporation bank will be tax exempt because it is insolvent.
b. No income or recaptures will pass through to the shareholders.
c. Typically, the shareholders will have exhausted their basis as a result oflosses before the failure, so revoking the QSub election has no effect.
3. It relieves the holding company and the preparer of the responsibility for fightingits way through the failure to prepare a return.
C. The holding company should probably also revoke its S election before recognizingdischarge of debt income.
1. The holding company is probably insolvent and the discharge of debt income isexcluded.
2. However, as an S corporation, it is necessary to contact all of the shareholders todetermine their tax attributes carried forward since the allocation of the “reductionof tax attributes” is based not on shareholding but rather pro-rata to the totalshareholder tax attributes to be reduced.
XIV. Bad Debts of Failed, and Failing Banks.
A. The IRS has a habit of examining the final returns of failed banks.
1. These are often “nothing returns” from a practical perspective, but may not be fora couple of reasons:
a. They have large C corporation loss carryback claims.
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Section 7507(a) of the Code exempts a failed bank from any tax that would diminish the assets available for the full19
payment of depositors. This is an interesting provision. It does not turn the failed bank into a "tax exempt entity." It
must continue to fie corporation returns, and its S election is not terminated. Most importantly, it remains eligible to
claim tax refunds from carryback of net operating losses and other tax benefits.
"Whenever and after any bank or trust company, a substantial portion of the business of which consists
of receiving deposits and making loans and discounts, has ceased to do business by reason of
insolvency or bankruptcy, no tax shall be assessed or collected, or paid into the Treasury of the United
States, on account of such bank or trust company, which shall diminish the assets thereof necessary
for the full payment of all its depositors; and such tax shall be abated from such national banks as are
found by the Comptroller of the Currency to be insolvent; and the Secretary, when the facts shall
appear to him, is authorized to remit so much of the said tax against any such insolvent banks and trust
companies organized under State law as shall be found to affect the claims of their depositors."
See for example, the Tax Court decision in Bishop v. Commissioner, (T.C. Memo. 2013-98; Docket No. 20810-10;20
decision dated April 10, 2013). The Tax Court disallowed a bad debt deduction, not because there was no evidence that
the borrower was unable to pay, but because the taxpayer could not produce any documentation of the borrower's
inability to pay. The author has been told that IRS field examiners have cited this decision as support for disallowing
all bad debt deductions by failed banks for failing to carry the taxpayer's burden of proof that the loans were worthless.
b. While a failed bank is tax exempt under the Code, the bank holding19
company is not exempt if its have assets, and the S corporation shareholdersare not tax exempt.
(1) Any tax liability that can be created is the shareholders’, not the bank’sor the bank holding company’s, and the shareholders are not taxexempt.
B. The big issue in an examination is supporting the deduction for bad debts, especially ifthere was no conformity election.
1. The loan files are either at the FDIC or the acquiring institution.
2. A bank failure is not an "orderly" process, and the loan files are inspected by manypeople. Papers get shuffled into the wrong files, or get lost during the reviews.The author knows of one experience in which the most relevant loan files werewholly "lost" by the time the examination occurred.
3. Without the loan files, the bank holding company cannot “prove” that the loanswere even valid assets of the failed bank, much less that they had become partiallyor wholly worthless.
a. All of the bad debt deduction is disallowed for lack of support.20
4. If there is a conformity election, this should be less of an issue, but convincing theexaminers of that has been difficult.
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Section 108(d)(7)(A).21
Section 108(a)(1)(c).22
C. Recommendations:
1. If the bank is in danger of failing, have the bank hire a company to scan all of theloan records that have charge-offs in open years or carryback years, and put themon disks that are stored at the independent counsel’s office or the CPA’s office.
2. If the bank has failed, be pro-active in locating the loan files for charged-off loansand try to get the custodian, whether the FDIC or the acquiring bank, to scan themfor the preparer.
a. If done timely, the reason for asking is for the return preparer to have thesupport needed to sign the return.
b. If not done until the failed bank is under examination, I have had some issuewith the acquiring bank being unco-operative for fear of becoming involvedin the examination.
XV. Discharge of Debt Income - Insolvent S Corporations
A. This is a common issue involving defaults on bank stock loans, trust preferred securities,S corporation TARP securities, and even shareholder loans to the S corporation bankholding company.
B. Whether an S corporation is insolvent is determined at the corporate level.21
1. If the S corporation is solvent before the debt is discharged, then the discharge ofdebt income is ordinary, operating income recognized by the S corporation.
a. Reported in "Other income" on Line 5 of the return.
2. If the S corporation is insolvent before the debt is discharged, then:
a. The amount by which the S corporation was insolvent is excluded.22
b. The balance of the discharge is ordinary, operating income of the Scorporation.
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Section 108(b)(5).23
c. If the S corporation is insolvent by more than the amount of debt discharged,then all of the discharge of debt income is excluded.
3. It is not important whether the S corporation would have had net taxable incomeor loss either with or without the discharge of debt income.
C. Application of the excluded discharge income to the reduction of tax attributes.
This is the difficult part because (a) the attributes are not uniformly applied to theS corporation, and (b) they are not allocated among the shareholders pro-rata pershare.
1. The S corporation may elect to reduce basis in depreciable assets first before anyother tax attribute.23
a. The election can be very useful to a company with a lot of depreciableproperty, such as a manufacturer, but it is likely to have minimal benefit tobank holding companies.
(1) Even if the subsidiary bank has not failed, banks tend to have relativelyfew depreciable assets.
(2) More to the point, the reduction of basis happens as of the first day ofthe tax year following the discharge. If the bank has failed, the Scorporation is unlikely to have any depreciable assets as of the first dayof the following year.
b. The election is made by entering the appropriate information on Form 982,Reduction of Tax Attributes Due to Discharge of Indebtedness and attach theForm to the timely filed return, including extensions.
c. If the election is made, the income tax basis in depreciable assets is reduced,pro-rata, but not below zero.
d. If the amount discharged exceeds the income tax basis in depreciable assets,the balance reduces other tax attributes in the normal order.
D. Otherwise, the excluded discharge of debt income reduces tax attributes in the followingorder.
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If the bank has failed, the S corporation is unlikely to have much income tax basis in any assets as of the beginning24
of the following taxable year.
1. First, the shareholders’ "excess losses" that are suspended and carried forwardbecause they exceed the shareholder's income tax bases in their stock and debt.
a. The reduction is allocated among the shareholders proportionate to eachshareholder's portion of the aggregate "excess losses" carried forward by theshareholders with carryovers.
(1) It is not allocated pro-rata per share.
(2) Accordingly, in order to report the reduction of tax attributes on theSchedule K-1, it is necessary for the S corporation to obtain the amountof accumulated “excess loss” carried forward from every shareholder.
(3) This may not be an issue if the S corporation has only two or threeshareholders, but bank holding companies tend to have a lot ofshareholders, which is going to make this a considerable burden.
2. Second, the shareholders’ general business credits passed through from thecorporation and carried forward because they exceed tax basis in the stock, alsoallocated among the shareholders like excess losses carried forward.
3. Third, the shareholders’ capital losses carried forward, also allocated like excesslosses.
4. Then the reduction of attributes shifts from the shareholders to the S corporation.Unallocated reductions in attributes reduces the S corporation’s income tax basisin assets, as of the beginning of the following year, in the following order: 24
a. Real property used in a trade or business or held for investment, other thanreal property described in Section 1221(a)(1) ; i.e. OREO.
b. Personal property used in a trade or business or held for investment, otherthan inventory, accounts receivable, and notes receivable; i.e. loans.
c. Remaining property used in a trade or business or held for investment, otherthan inventory, accounts receivable, notes receivable, and real propertydescribed in section 1221(a)(1).
d. Inventory, accounts receivable, notes receivable, and real property describedin section 1221(a)(1).
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e. Property not used in the business nor held for investment.
5. Then the reduction in attributes shifts back to the shareholders.
a. Any remaining unallocated reduction in attributes reduces the shareholders’passive activity losses and passive activity credits carried forward, againallocated like excess losses.
6. Any remaining, unallocated excluded discharge of debt income is disregarded.
XVI. Final Regulations on Tangible Assets - This is a topic from last year and not exclusivelybanking, but a few observations are applicable to community bank returns.
A. Applicable Financial Statements - The Final Regulations, as did the TemporaryRegulations, have different thresholds and provisions for taxpayers with "applicablefinancial statements" and those without applicable financial statements.
1. Definition (C) of "applicable financial statements" will automatically include allbanks, thrifts, and bank holding companies.
"Applicable Financial Statements" include: ..."(C) A financial statement (other than a tax return) required to be
provided to the federal or a state government or any federal or stateagency (other than the SEC or the Internal Revenue Service)."
2. The bank and thrift call reports, and the bank holding company's Form FR Y-9should be "applicable financial statements."
B. Materials and supplies - The safe harbor for expensing materials and supplies is $200.
C. The safe harbor for expensing di minimis purchases of "depreciable property" introducesa "conformity" standard for businesses with "applicable financial statements."
1. Now there is a tax purpose, in addition to a management reason, for having writtenexpensing policies for di minimis acquisitions. If the policy is to expensepurchases costing $5,000 or less, and the bank follows those policies, it should beable to follow its books for income tax purposes.
2. There is also a safe harbor for property with an economic useful life of less than12 months, but still limited to $5,000 per item.
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a. Transaction costs, such as freight, installation labor, and similar costs areincluded in the $5,000 (or $500) di minimis amount if included in the sameinvoice, but the taxpayer is not required to include these transaction costs ifthey are invoiced separately.
3. The di minimis safe harbor is a taxable year election and is not an accountingmethod. Therefore, a change in the business' capitalization policy is not a changein accounting method for income tax purposes.
D. Buildings.
1. The Final Regulations retain the "unit of property" concept of the 2011Regulations, the "routine maintenance" safe harbor, and the optional regulatoryaccounting method.
2. The Final Regulations provide that if a component of a "unit of property" isremoved and disposed of, and a loss is properly claimed based on the adjustedbasis of the removed component, then the cost of removing that item is notcapitalized in the replacement. Rather, it is deducted as part of the loss on thedisposition.
XVII. Prohibited Transactions by Self-Directed IRA Accounts. We talked about this lastyear too, but it is so important that it bears repeating.
A. This is not something that CPAs deal with every day; more properly the province ofERISA counsel. However, we need to be aware of a couple of Department of Laborpolicy positions that can easily result in prohibited transactions.
1. The Department of Labor views the beneficiary of a self-directed IRA account asa fiduciary.
a. Accordingly, any act that would be a prohibited transaction by a fiduciary ofa qualified plan is also prohibited to the beneficiary.
2. Co-investing is a Prohibited Transaction
a. It is the view of the Department of Labor that an investment by a selfdirected IRA account in a closely held business is a prohibited transaction ifthe beneficiary of the IRA is personally invested in the same business.
(1) Citations - Advisory Opinions 2000-10A and Advisory Opinion 2006-9A
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Terry L. Ellis v Commissioner, T.C. Memo. [2013-245; 10/29/13].25
3. Investment in a closely held entity by a self-directed IRA account and by anymember of the beneficiary’s family is also "co-investing" and a prohibitedtransaction.
a. The members of the "family" are the beneficiary's spouse, the beneficiaries'ancestors and their spouses, and the beneficiaries descendants and theirspouses.
B. Investment in a closely held business may be a prohibited transaction if:
1. The beneficiary is an officer, director, or highly compensated employee.
2. A member of the beneficiary’s family is an officer, director, or highly compensatedemployee.
3. The beneficiary is a service provider to other IRA accounts invested in the sameentity.
C. The Department of Labor places great emphasis on contemporaneous written opinionsof 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 not wellreceived.
D. There are a couple of relatively recent Tax Court decisions on disqualifications of IRAaccounts as a result of prohibited transactions.
1. In Ellis v. Commissioner, the Tax Court case addressed an investment by a self-directed IRA account in a business owned principally by the IRA account'sbeneficiary.25
a. Terry Ellis rolled over his distribution from his previous employer’s Section401(k) plan into a new, self-directed IRA account. The IRA purchased 98%of a newly formed LLC. An unrelated individual purchased other 2%. Elliswas the general manager of the LLC and was paid compensation.
b. The Tax Court held that (i) Ellis was a disqualified person under Section4975(e)(2)(A) because he exercised discretionary authority over the IRAinvestments, (ii) the compensation paid to Ellis was a prohibited transaction,
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Lawrence Peek & Darrell G. Flecht v Commissioner [140 TC 12, 5/9/13]26
(iii) the IRA was disqualified, and (iv) because Ellis was not at least 59 and½, the 10% excise tax in Section 72(t)(1) also applied.
2. In Peek & Flecht v. Commissioner, the Tax Court addressed loan guarantees to abusiness owned by the IRA account beneficiaries.26
a. The Tax Court held that Peek and Flecht, two individuals, engaged inprohibited transactions when they personally guaranteed loans to a companyowned by their IRA accounts. The loan guarantees were prohibitedtransactions under section 4975(c)(1)(B), which prohibits any direct orindirect extension of credit between a retirement plan and a disqualifiedperson.
b. As a result, the accounts ceased to be IRAs and the individuals were liablefor taxes (a) in the year that the loans were guaranteed, and (b) on the gainfrom the sale of the company's stock when it was sold. The Court alsosustained the accuracy related penalty, holding that they were negligent infailing to report the gain on the stock sale.
c. The decision is a bit vague. They had been advised by their CPA thatprohibited transactions could result in the disqualification of the IRAs,though it is not at all clear that they were advised that guaranteeing the loanscould be prohibited transactions.
E. There is also a 2008 IRS memorandum which addresses another arrangement known asRollovers as Business Startups" which was apparently being promoted to peopleestablishing new businesses. Those transactions could also as easily describe somewhatcommon transactions in community bank holding companies.
1. In summary, a newly created C corporation established a profit-sharing plan intowhich the individual prospective entrepreneur would roll funds from anotherqualified plan. The profit-sharing plan would purchase stock of the sponsorcompany [i.e. employer securities] and use the capital to start a new business,according to the memorandum, typically to purchase a franchise. In most cases,the profit sharing plan was then amended to prohibit further investments inemployer securities, so no other individual had an opportunity to invest in thecompany's stock.
2. The memorandum raises two primary issues.
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Commonwealth Bank and Trust Company v. US [US District Court for the Western District of Kentucky, Docket No.27
3:13-cv-01204; 7/7/2014]
a. Violations of nondiscrimination requirements. The benefits may not satisfythe benefits, rights and features test of Regulation 1.401 (a)(4 )-4.
b. Prohibited transactions, both from the perspective of the beneficiary asfiduciary of the plan, whether the valuations of the company stock werereliable, and if the individual received compensation from the business.
3. The same reasoning can be applied to IRA account purchases of bank holdingcompany shares if the IRA beneficiary is a principal shareholder orofficer/employee of the bank holding company or subsidiary bank.
F. Summary - Only in the most obvious situations should an IRA invest in a closely heldentity without a written Opinion of Counsel.
XVIII. Failure to Deposit Withholding Taxes by Electronic Transfer27
1. Commonwealth Bank's trust department was a fiduciary of numerous pensionplans, individual retirement accounts, and employee benefit plans with respect towhich it is responsible for withholding federal income taxes.
a. For taxable years 2004, 2005, 2007, 2008, 2009, and 2010, Commonwealthtimely and fully deposited all withheld income taxes.
b. However, on at least some occasions, the trust department owed more than$200,000 but did not pay by electronic transfer as required by Regulation31.6302-1(h)(2)(ii).
2. The IRS assessed "failure-to-deposit" penalties of $252, 842.87.
3. Commonwealth paid the penalties and sued for refund, but the District Courtdismissed the suit. Commonwealth raised two defenses:
a. There was no "failure . . . to deposit." Commonwealth timely and fullydeposited all withheld income taxes.
b. Even if there were a failure to deposit, such failure was "due to reasonablecause and not due to willful neglect"
4. The IRS filed motion to dismiss the "failure to deposit" defense, asserting that"Section 6656(a) applies not only to a failure to deposit per se, but also a "failure
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. . . to deposit (as required by this title or by regulations of the Secretary ... ." andthe District granted the motion.
XIX. Prepaid Expenses Deductible by an Accrual Method Taxpayer - Revenue Ruling 2012-1.We discussed this the last two years, but there are apparently a substantial number of accrualmethod banks which have not made changes of accounting methods to comply with theRevenue Ruling.
A. What prepaid expenses deductible by accrual method taxpayers under RegulationSection 1.263(a)-4(f)?
1. When the Section 263(a) Regulations were issued, many accrual method taxpayersviewed Section 1.263(a)-4(f) as an opportunity to accelerate the deduction forprepaid expenses.
2. Revenue Ruling 2012-1 is both a detailed analysis of the prepaid expenses whichare deductible by accrual method taxpayers, and a discussion of two prepaidexpenses in particular:
a. Prepaid lease rents.
b. Prepaid service contracts.
3. Deductible prepaid expenses must be both (i) “immaterial” to taxable income, and(ii) the deduction must result in a “better batching of income and expense.
a. The Ruling looks to the principles of the recurring item exception in Section461(h)(3)(A) to evaluate “materiality” and “matching.”
b. While, the Ruling states that GAAP accounting is not dispositive, it is clearfrom reading the conclusions that it is very influential.
c. If the prepaid expense must be amortized over future period(s) for GAAP,then it must be either “material” to income or amortization must better matchincome and expense.
4. Conforming to the Ruling is an automatic change of accounting method - change# 161.
XX. Loan Modifications - Regulation 1.1001-3. Loan modifications are a relatively complexRegulation, but it is important to review a little observed provision for a special "deemedcharge-off" that prevents a bank from recognizing a "recovery" when a loan that has been thesubject of a charge-off is modified.
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The only requirements for the deemed charge-off are that a deduction for partial worthless was allowed under28
subparagraph (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. 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 prior to themodification.
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:
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 banks whichhave made the conformity election and those which have not.28
D. Example - Facts
Assume that the initial balance of the loan was $400,000. Payments of principal havereduced the unpaid balance to $350,000. The bank has recorded a $100,000 charge-off,reducing the book value and income tax basis to $250,000, and has put the loan onnonaccrual. The nonaccrued interest of $18,750 has not been included in either book ortaxable income.
The terms of the modified loan are (i) the borrower will pay the accrued interestimmediately, (ii) the principal amount will be $300,000, (iii) the interest rate will be4.5%, and (iv) the borrower will make 16 equal semi-annual installments of principaland interest of $22,535 each.
[The balance of this page is intentionally left blank so thatthe example on the following page can all be on one page]
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Note that the fair market value includes the nonaccrued interest that will now be collected.29
The tax basis in the modified debt includes the tax gain of $68,750.30
The book value includes the nonaccrued interest which will be collected at closing on the modification, and becomes31
for an “instant” accrued interest receivable.
The following table illustrates the income tax accounting for the modification:
Issue price of the “new” modified note:
Nonaccrued 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
The 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 note $318,75029
Tax basis in the modified debt 31875030
Excess tax basis over fair market value $ 0
(b) Tax basis in the modified debt over book value
Tax basis in the modified debt $318,750
Book value of the modified debt 26875031
Excess tax basis $ 50,000
Deemed charge-off - lesser of (i) or greater of (ii)(a) or $ 50,000
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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].
a. The net taxable income of $18,750 is the nonaccrued interest which wascollected and should properly be included in income.
3. Will accrue interest income at 4.5% of $300,000, the stated principal amount of themodified debt, declining as payments are made.
4. Will recognize the $50,000 recovery of the deemed charge-off after the $250,000tax basis in principal is collected.
F. For financial reporting purposes the bank:
1. Will recognize $18,750 interest income at the modification date for the collectionof 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 payments exceedthe $250,000 book value of the modified loan;
b. The $19,704 difference in interest income on the stated principal balance of$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 nonaccrual interest that is includedin the modification gain in "a".
c. Decreasing book income by the deemed charge-off of $50,000.
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Reg. 1.1272-1(c)(2).32
As discussed again below, Section 163(e) allows the issuer a deduction for original issue discount parallel to the33
amount recognized by the holder.
Section 163(e)(5) relates to high yield obligations that are not an issue with trust preferred securities.34
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 the termof the modified loan by the difference between 4.5% interest on the book value ofthe 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 and taxpurposes.
4. There will be adjustments reducing book interest income by the "recognition" ofthe nonaccrued interest on the $50,000 difference between the book value andstated principal amount of the modified loan.
5. Book and taxable income will exactly equal over the eight years - $110,560.
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 having OID.
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 to occur."32
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 payments onthe instrument are subject to either a remote or incidental contingency.Whether a contingency is remote or incidental is determined as of theissue date of the debt instrument, including any date there is a deemedreissuance of the debt instrument under paragraph (h)(6)(ii) or (j) ofthis section or section 1.1272-1(c)(6). Except as otherwise provided,the treatment of the contingency under this paragraph (h) applies for allpurposes of sections 163(e) (other than sections 163(e)(5) ) and 127133 34
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through 1275 and the Regulations thereunder. For purposes of thisparagraph (h), the possibility of impairment of a payment byinsolvency, default, or similar circumstances is not a contingency.
"(2) Remote contingencies. A contingency is remote if there isa remote likelihood either that the contingency will occur or that thecontingency will not occur. If there is a remote likelihood that thecontingency will occur, it is assumed that the contingency will notoccur. If there is a remote likelihood that the contingency will notoccur, 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 on theissuing banks, probably support the position that the publicly issued trustpreferreds, whether single bank issues or pools, were not OID obligations.
c. Private issues used to raise capital for a bank that was incurring significantlosses 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)applies to a debt instrument when there is a change in circumstances. Forpurposes of the preceding sentence, there is a change in circumstances if -
"(A) A remote contingency actually occurs or does not occur, contraryto the 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 notinsignificant.
"(ii) In general. If a change in circumstances occurs, solely for purposes ofsections 1272 and 1273, the debt instrument is treated as retired and then
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reissued on the date of the change in circumstances for an amount equal tothe instrument's adjusted issue price on that date."
1. This is not a modification of the debt obligation under Regulation Section 1.1001-3. 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 original document.
C. The practical effect is that the accrued interest expense becomes OID rather than statedinterest.
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 the aggregatedaily portions of the original issue discount during the taxable year. Thisamount is equal to the amount included in the taxable income of 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, whetheron the accrual or cash method, for deferred interest that has not been received
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 as abad debt under Section 166(a)(2) and (b).
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(1) It is necessary for the holder to both recognize the OID on the books asincome and an addition to the OID security, and charge the OID off tothe reserve for loan and lease losses on the books.
(a) Recognition is the step that includes the OID in the basis of theobligation.
(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 partial baddebt deduction is only allowed under Section 166(a)(2) to the extent 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, it remainsan OID obligation until it is retired.
a. The Trust Preferred did not become an OID obligation because the interestwas deferred, but rather because the deferral was no longer a "remotecontingency." Once the interest has been deferred, the likelihood of adeferral 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) tohave been redeemed and reissued when there was a change in circumstances.Again, the "change in circumstances" was not the deferral of the interest, butrather the remote contingency actually occurring contrary to the assumptionmade when the obligation was issued. Paying the interest currently was nota remote contingency, so bringing the interest current is not a change ofcircumstances 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-INT aslong as interest payments have not been deferred.
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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.
