In the midst of the COVID-19 pandemic, many financial institutions have been busy focusing on PPP loans and working to make their offices and lobbies safe for employees and customers.
Now faced with an increasingly fragile economic environment, those same financial institutions are beginning to modify loans and increase their reserves for future anticipated losses. With these changes come tax consequences that might not have been top of mind since the last recession.
Troubled debt restructuring
Given the ongoing health pandemic and economic environment, many borrowers are finding themselves struggling to keep up with their loans. As a result — and at the urging of the federal financial institution regulatory agencies and state banking regulators — many banks are working to modify loan terms to benefit their borrowers, thus expecting a substantial increase in debt restructuring activity.
While most short-term loan modifications, such as payment deferrals, fee waivers and extensions of repayment terms, may not be considered troubled debt restructuring (TDR) in the current environment, it is important to understand the parameters.
A TDR occurs when a debt is restructured for economic or legal reasons related to the borrower’s financial difficulties and the financial institution grants a concession to the borrower that it would not otherwise consider.
Debt restructuring can cause unforeseen tax consequences.
If classified as a TDR, the result can be a deemed taxable exchange. In certain circumstances when the loan modification is considered significant, both the lender and the borrower should consult with their tax advisors.
Possible adverse tax consequences may arise, such as recognition of cancellation of debt (COD) income and the accrual of original-issue discount (OID) deductions over the remaining term of the debt to the borrower but immediate gain/loss recognition and OID income to the financial institution. Interest limitations may also come into play for the OID deductions.
Bad debt deductions
In general, when a financial institution calculates a bad debt reserve under GAAP for book purposes, it is not allowed this same provision deduction for tax purposes. The bad debt deduction must instead be calculated using either the specific charge-off method of accounting or the reserve (or experience) method.
For income tax purposes, large banks (defined as banks with total assets with an adjusted basis in excess of $500 million) and all S-corporation banks are required to use the specific charge-off method of accounting for bad debts. Under this method, the bank is allowed a bad debt deduction only in the year the loan is determined to be wholly or partially worthless and is charged off on the books under GAAP.
In turn, recoveries during the taxable year of any portion of a bad debt that was previously charged off and deducted by the taxpayer using the specific charge-off method are taxable in the recovery year.
Small C-corporation banks may be allowed a tax deduction for a reasonable addition to the reserve for bad debts. Under the reserve method, the addition to the bad debt reserve is calculated at the end of each tax year.
The allowable reserve addition is equal to an amount necessary to increase the balance of the reserve account, after adjustments for net charge-offs, to the greater of the reserve balance using a moving-average approach or calculated by reference to the “base year” amount. As a general rule, if the base year reserve balance is greater than the balance allowable under the moving-average formula, a reserve addition up to the amount necessary to increase its reserve balance to the base year amount is permitted.
Some scenarios require specific rules that are beyond the scope of this article, so please consult with your tax advisor.
Bad debt conformity
Worthlessness of debt is a matter of facts and circumstances and is a gray area that has been disputed by IRS agents in the past.
A debt is often presumed worthless when it is charged off, in whole or part, in accordance with the established policies of the regulator. The IRS has recently indicated it will not intentionally focus in this area any longer and will likely accept bad debts if they are charged off for book purposes.
It now also provides an “insurance policy” to banks to solidify this conformity in the event of an audit or exam. This conformity election was designed to provide a financial institution greater certainty in the tax treatment of its bad debts. Regulation Section 1.166-2(d)(3) permits banks to make an election to take their tax charge-offs in conformity with regulatory classifications. The regulation ensures that loans charged off for regulatory purposes are also considered worthless by the IRS for tax purposes.
This conformity is elected by a one-time filing of Form 3115 with the IRS. To make the election, the institution must have obtained an express determination letter from its regulatory authority at its most recent examination and will need to do so at each exam thereafter. The letters state the bank applies loan loss classification standards that are consistent with regulatory standards and must be provided to the IRS in the event of an audit.
Information reporting for discharge of indebtedness
It is important first to distinguish the difference between the cancellation of debt and a charge-off.
A charge-off is an accounting entry, and the cancellation of a debt is a legal decision. A cancellation of debt occurs once there has been an “identifiable event” and the financial institution is no longer attempting to collect the debt.
After a debt has been considered cancelled (and assets repossessed), a financial institution must determine whether Form 1099-C or Form 1099-A should be filed.
In general, the institution must file Form 1099-C when a debt of $600 or more has been cancelled. Form 1099-A should be filed if the institution receives property in partial or full satisfaction of a debt, acquires an interest in property that is security for a debt or has reason to know that a property has been abandoned by a debtor. This form is required only for real or personal property used in a trade or business (or for investment). If in the same calendar year a debt is cancelled in connection with foreclosure or abandonment, only Form 1099-C is required.
Foreclosures and OREO
A foreclosure is considered a payment in satisfaction of a debt on which a gain or loss will be recognized. At the date of foreclosure, the difference between the loan basis (on the property) and the fair market value of the property (net of selling expenses) is charged as a loan loss on the books to the allowance.
It is important to maintain proper documentation, such as an appraisal, regarding the fair market value determination of the other real estate owned (OREO). Expenses incurred while holding the property (e.g., property taxes, repairs, utilities, legal expenses) are generally expensed on the financial statements. In early 2013, the IRS issued GLAM 2013-001, confirming that those qualified expenses can be expensed as incurred for tax purposes as well.
The tax accounting for other items related to OREO property can differ significantly from the book accounting. For tax purposes, it has been the position of the IRS (absent a conformity election) that OREO be recorded at fair market value, ignoring selling expenses. Also, subsequent book write-downs are generally not deductible for tax purposes until the property is sold.
In-substance foreclosures where the bank does not have legal ownership of the property are classified as OREO for financial statement purposes; however, for tax purposes, they are treated similarly to a loan. Specific information for in-substance foreclosures are beyond the scope of this article and should be discussed with your tax advisor.
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See the services we offer financial institutions on our web page or read our article on troubled debt restructuring.
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