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. 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. Charge-offs and the bad debt conformity election 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. 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. 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. Switching between the two methodsĬ corporations must switch from the experience method to the specific charge-off method when their average assets exceed $500 million. In addition, any recoveries are included as taxable income in the year of recovery. The specific charge-off method does not include any provision for loan loss, used to increase the reserve balance for GAAP purposes. 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 tax reserve is generally different from the book loan loss reserve, often creating a net deferred tax asset. Net recoveries are not included in taxable income but instead increase the bad debt reserve and reduce future net charge-offs. This reserve is replenished with a tax basis loan loss expense based on actual charge-off history. 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. Both of these methods will be discussed in turn, along with tips to minimize potential tax exposure in the event of an IRS exam. 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. 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.Ī C-corporation bank can use either the experience method or the specific charge-off method if its average total assets are below $500 million. For tax purposes, the deduction is generally not allowed until the loan is charged off. What does this mean for current and future tax returns?įinancial institutions are not allowed the same provision deduction for income tax purposes that they record under Generally Accepted Accounting Principles (GAAP). Many institutions are setting aside reserves for customers who may not be able to fulfill their loan obligations in the future. Financial institutions are preparing for an increase in defaults and bad loans as the COVID-19 pandemic continues to threaten our nation.
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