Financial institutions are preparing for an increase in defaults and bad loans as the COVID-19 pandemic continues to threaten our nation.
Many institutions are setting aside reserves for customers who may not be able to fulfill their loan obligations in the future. What does this mean for current and future tax returns?
Financial institutions are not allowed the same provision deduction for income tax purposes that they record under Generally Accepted Accounting Principles (GAAP). For tax purposes, the deduction is generally not allowed until the loan is charged off. There are two primary methods a financial institution can use for reporting bad debts for income tax purposes: the specific charge-off method and the reserve (experience) method.
A C-corporation bank can use either the experience method or the specific charge-off method if its average total assets are below $500 million. C corporations with average total assets in excess of $500 million and all S corporation banks, regardless of their size, are required to use the specific charge-off method. Both of these methods will be discussed in turn, along with tips to minimize potential tax exposure in the event of an IRS exam.
The experience method uses a rolling six-year average of the percentage of total loans that are historically bad debts and establishes a tax bad debt reserve. This reserve is replenished with a tax basis loan loss expense based on actual charge-off history. Net recoveries are not included in taxable income but instead increase the bad debt reserve and reduce future net charge-offs. The tax reserve is generally different from the book loan loss reserve, often creating a net deferred tax asset.
Specific charge-off method
The specific charge-off method allows a deduction in the year the loan is determined to be wholly or partially worthless and charged off. The specific charge-off method does not include any provision for loan loss, used to increase the reserve balance for GAAP purposes. In addition, any recoveries are included as taxable income in the year of recovery.
Switching between the two methods
C corporations must switch from the experience method to the specific charge-off method when their average assets exceed $500 million. In the year a bank becomes a large bank, it is treated as having made an automatic change in the accounting method for the disqualification year and must recapture the tax bad debt reserve into taxable income. Generally, the recapture can be brought into taxable income over four years (10 percent in the disqualification year and 20, 30 and 40 percent in the next three years); however, there are tax planning opportunities to take the full recapture in one year, such as in a year of NOLs or to lock in the current tax rates.
Similarly, if a C corporation elects to become an S corporation or is acquired by an S corporation, the bank may elect to take the full recapture into taxable income in the year immediately preceding the change to avoid built-in gains associated with the conversion to an S corporation.
Charge-offs and the bad debt conformity election
In the past, bad debt tax deductions were a heavily audited area for the IRS, and the IRS often disputed whether a loan was wholly or partially worthless for tax purposes. In 2014, the IRS issued a directive to its auditors to accept charge-off amounts reported by banks for GAAP or regulatory reporting purposes as sufficient evidence of worthlessness for tax purposes. The directive does not apply to small banks using the experience method of accounting for loan losses, and it cannot be relied on as law; therefore, while the IRS directive is helpful, banks should consider the bad debt conformity election as a means to minimize future IRS scrutiny.
The bad debt conformity election provides additional assurance against future IRS audit adjustments, allowing the bank to use the same standard for charge-offs for both book and tax purposes. It also provides protection of nonaccrual loan interest for accrual-basis taxpayers, other-than-temporary impairment on investments, and initial write-downs to fair market value on other real estate properties.
Filing the conformity election requires a formal change in accounting method by filing a Form 3115 with the IRS. The bank must obtain an express determination letter from the federal examiner to document its compliance in charging off loans. This letter must be received in the year of the accounting method change and every year the examiners come in thereafter.
Once the election has been made, the IRS is required to accept all charge-offs made for book purposes. This would close one door for potential IRS audit adjustments and expedite the audit process. This can be especially attractive for S corporations, since they can potentially avoid amending numerous K-1s should the IRS make an adjustment.
Bonus note – information reporting for PPP loan forgiveness
There are still a lot of unknowns with the Paycheck Protection Program (PPP) loans under the CARES Act, but recently the IRS issued some favorable guidance for lenders. It has indicated in Announcement 2020-12 that lenders should not file information returns or furnish payee statements to report the PPP loan forgiveness. Typically, any discharge of indebtedness of at least $600 requires the bank to issue a Form 1099-C, Cancellation of Debt; however, with this guidance, the IRS has asked that lenders not issue these for debt forgiveness related to the PPP loans. If they were filed, the IRS expects this would to lead to confusion and businesses reporting it as income.
How Wipfli can help
Our team takes a proactive approach that delivers confidence in results when meeting the tax challenges of financial institutions. We have in-depth specialized knowledge of the financial institutions industry and provide proactive tax planning and consultation, compliance and audit assistance. Learn more on our web page.