47thBANK & CAPITAL MARKETS TAX INST IT U T Eannual Pre-Conference Workshop 18TH ANNUAL COMMUNITY BANK TAX WORKSHOP Fantasia E/F November 7th, 8:30am – 5:00pm 47th ANNUAL BANK & CAPITAL MARKETS TAX INSTITUTE DISNEY CONTEMPORARY HOTEL Speakers: JOHN CEDERBERG STEVEN CORRIE JAMES GOELLER 47 BANK I N S T I T U MARKET th annual TA X & CAPITAL TE NOVEMBER 7-9, 2012 E.COM WWW.BANKTAX I N ST I T U T D I S N E Y C O N T E M P O R A RY H OT E L | ORLANDO
Eighteenth Annual COMMUNITY BANK TAX WORKSHOP Contemporary Hotel Orlando, Florida November 7, 2012 Faculty:JOHN E. CEDERBERG JAMES D. GOELLER 1248 O Street, Suite 760 Partner, Crowe Horwath, LLP Lincoln, NE 68508 575 Market Street, Suite 3300 Tel (402) 475-8155 San Francisco, California 94105 firstname.lastname@example.org Tel. (415) 946-7448 email@example.com ADVISORY BOARD MEMBER STEVEN W. CORRIE Senior Vice President - Finance Security National Bank 601 Pierce Street Sioux City, Iowa 51101 Tel (712) 277-6640 firstname.lastname@example.org Summit Business Media Contemporary Hotel, Orlando Florida November 7, 2012
Table of Contents I. 2011 - 2012 Developments Specifically Affecting Banks . . . . . . . . . . . . . . . . . . . . . 1 A. Tax Changes Specifically Affecting Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 B. Administrative Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1. Fixed Asset Regulations 2 2. Other Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 II. IRS Examination Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 A. Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1. No Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2. Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 B. Nonaccrual Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 C. Pre-Foreclosure Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 D. Foreclosure Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 E. OREO Holding Period Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 F. Partial Charge-offs on Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 III. Examiner Ordered Restatements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 IV. Loans Restored to the Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 V. The Conformity Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 VI. Loan Modifications - Reg. 1.1001-3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 VII. OREO - "In Substance Foreclosures" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 VIII. TARP Transactions - Gain or Loss on Sale and Section 382 . . . . . . . . . . . . . . . . . . 48 IX. S Corporations - Character of Income or Loss on Foreclosed Operating Assets . . . 54 X. S Corps and Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 XI. S Corps at a Stock Offering Cross-Roads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 XII. Trust Preferred Securities - Deferred Interest Payments . . . . . . . . . . . . . . . . . . . . 64 XIII. Prohibited Transactions by Self-Directed IRA Accounts . . . . . . . . . . . . . . . . . . . . . 68 XIV. Taxable Acquisitions Using the Stock of the Acquirer . . . . . . . . . . . . . . . . . . . . . . 69 XV. Asset Acquisitions - Failed Bank Assets; Section 338; QSub Purchases . . . . . . . . 74 XVI. Maintaining a Valid S and QSub Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 XVII. Miscellaneous Accounting Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 A. Section 448 Change to the Accrual Method . . . . . . . . . . . . . . . . . . . . . . . . . 88 B. Change by S Corporations to the Cash Method . . . . . . . . . . . . . . . . . . . . . . . 88 C. Prepaid Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 D. Deferred Loan Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91Disclaimer: This outline is intended for the general information of the attendees of theEighteenth Annual Community Bank Tax Workshop. It is not intended to provide tax advice.Attendees of the Workshop must perform their own research to confirm the effect of the topicsdiscussed herein to the facts and circumstances of their respective clients.In accordance with professional regulations of tax practitioners encompassed in InternalRevenue Service Circular 230, any written tax advice contained in, forwarded with, or attachedto this material is neither written nor intended to be used by any person for the purpose ofavoiding penalties which may be imposed under the Internal Revenue Code or applicable state orlocal tax laws, and such advice may not be used for such purpose.
Community Bank Tax Workshop Page 1 of 912012 Outline November 7, 2012I. 2011 - 2012 Tax Changes Specifically Affecting Banks A. Tax Changes Specifically Affecting Bank 1. There has been no new legislation affecting banks since the Small Business Jobs Act of 2010, enacted September 27, 2010. Many of those provisions expired at the end of 2011 or are set to expire at the end of 2012. 2. There is no new material litigation specifically affecting banks since the Circuit Court decision in Vainisi and the Tax Court decision in PSB Holdings, Inc. B. Scheduled changes in existing law. 1. The S corporation built-in gains recognition period reverted to 10 years at the beginning of 2012. a. The built-in gains recognition period was 7 years for 2009 and 2010. b. It was 5 years for taxable years beginning in 2011. c. A Representative from Missouri has introduced a bill to make 5 years permanent, but it has not advanced. d. The recognition period is determined by the closing date of the asset sale, not the definitive agreement date, or even the effective date. 2. Depreciation. a. Bonus depreciation (1) 100% from September 9, 2010 through December 31, 2011. (2) 50% during calendar year 2012 (3) Expires under present law at December 31, 2012. b. Section 179 first year depreciation. (1) $500,000 for taxable years beginning in 2010 and 2011. (a) The threshold of total additions for the phase-out of Section 179 depreciation was $2 million for both years. (2) $139,000 for 2012. (a) The threshold of total additions for the phase-out is $560,000.
Community Bank Tax Workshop Page 2 of 91 2012 Outline November 7, 2012 (3) The deduction is scheduled to revert to $25,000 for 2013. (a) The threshold of total additions for the phase-out is scheduled to be $200,000. c. Computer software is included in Section 179 property through 2012.1 d. Certain real estate was Section 179 property during 2010 and 2011, but that provision was not extended to 2012. The most likely property applicable to banks was qualified leasehold improvements described in Sections 168(e)(6) and (k)(3). 3. The 2010 exclusion from self-employment income for self-employed health insurance costs was not extended to 2011 or 2012.2 C. The new fixed asset Regulations 1. Issued in December 2011 in Proposed and Temporary form. Effective for 2012. 2. The Service’s third attempt to issue more detailed Regulations on capitalization v. expensing of fixed asset related costs. The previous “editions” were only in Proposed form, and have been withdrawn. 3. There are 250 pages of complex Regulations. a. Only going to hit the high spots in this Workshop. 4. Adopting new capitalization and depreciation standards to conform to the Regulations is a change of accounting method. a. The change is automatic. b. Most changes will require a Section 481(a) adjustment. c. Some specific changes use the cut-off method. 5. “New” concepts in the Regulations. a. The “unit of property” concept.1 Sec. 179(d)(1).2 Sec. 162(l)(4).
Community Bank Tax Workshop Page 3 of 912012 Outline November 7, 2012 (1) Probably has minimal effect on most personal property. Most banks probably capitalize personal property now more or less on the unit of property basis. (2) Most of the effect for banks is on buildings. The Regulations somewhat codify the “component depreciation” concept but with specified “units of property” rather than the consultants’ choice of components. There are eight units of property in a building: (a) The building structure; walls roof, et. al. (b) Heating, air conditioning, and ventilation systems. (c) Plumbing systems. (d) Electrical systems. (e) Gas distribution systems. (f) Escalators and elevators. (g) Fire protection and fire alarm systems. (h) Security equipment. If it doesn’t fit in units “ii” through “viii”, it is part of the building structure; i.e. unit “i”. b. Contrary to the component depreciation concept, all of the “units of property” are depreciated over 39.5 years. (1) Effectively, slowing up building depreciation significantly. c. Disposition of a “building component.” A favorable change from the current practice. (1) Note the reference difference between a “building component” and a “unit of property.” The disposition rule applies to any material building component, such as a roof, interior walls, etc. (2) Example, using the roof as a common replacement event:
Community Bank Tax Workshop Page 4 of 912012 Outline November 7, 2012 (a) Under previous practice, the “acquired” roof that was on the building when it was purchased was depreciated over 39.5 years, regardless of how many times it was replaced during that period. (b) New roofs were capitalized and also depreciated over 39.5 years beginning in the replacement year. (c) If the business owned the building long enough, it could possibly be depreciating three or four roofs. (d) Under the disposition rule, the business deducts the depreciated income tax basis of the old roof in the year that it is replaced and capitalizes the new roof. As a result, it only is depreciating one roof at a time. d. The Regulations obsolete the “Plan of Rehabilitation Doctrine.” (1) Whether an expenditure is a repair expense or capitalized is determined by “unit of property,” not by whether it is part of a larger renovation of part or all of the building. (2) Example - Expenditures on the HVAC system might be a repair expense, even though it occurs during a renovation of the building for which other expenses are capitalized. e. Simplifying conventions (as if anything about these Regulations were simply). (1) The Regulations retain the concepts from the Section 263(a) Regulations that the wages of overhead employees and overhead expenses are not capitalized. (a) However, it is an election to allocate overhead costs to acquired assets and capitalize them if the taxpayer wishes. (b) The election is separate for every project; not even required to be consistent within the same tax year. (2) The Regulations codify some di minimis scopes for capitalization, though the first one is so small as to be relatively useless. (a) $100.00.
Community Bank Tax Workshop Page 5 of 91 2012 Outline November 7, 2012 (b) 0.10% of gross revenue. (c) 2.00% of book depreciation. (3) There are “safe harbor” rules for “routine maintenance.” 6. The faculty have already encountered significant “push-back” from bankers to the work, and cost, associated with conforming to the new Regulations. a. Clients typically consider fixed assets immaterial. b. The work should already be underway, but in most cases, there isn’t going to be time after the first of the year to be ready for the tax returns, especially the S corporation returns that are timely filed. D. Accrued Bonuses - Revenue Ruling 2011-29 1. An accrual basis taxpayer may deduct accrued bonuses in the year accrued, providing the liability for the total “bonus pool” is fixed and determinable. a. It is not necessary for the “bonus pool” to be allocated by payee before the end of the year. 2. It is also not necessary for the employees in the “bonus pool” to be guaranteed receiving a bonus if they are not employed when the bonus is paid. However, if the employees must be employed when the bonus is paid, then: a. The total pool must be allocated among the employees who are paid. b. If “forfeited” bonuses revert to the employer, then the entire pool is not deductible until the bonuses are paid. c. A change to adopt Revenue Ruling 2011-29 is a change of accounting method. It is automatic. The number is 133.3 E. Revenue Ruling 2012-1 - Prepaid expenses deductible by accrual method taxpayers under Regulation Section 1.263(a)-4(f). 1. When the Section 263(a) Regulations were issued, many accrual method taxpayers viewed Section 1.263(a)-4(f) as an opportunity to accelerate the deduction for prepaid expenses.3 See Section 19.01(2) of Revenue Procedure 2011-14.
Community Bank Tax Workshop Page 6 of 912012 Outline November 7, 2012 2. Revenue Ruling 2012-1 is both a detailed analysis of the prepaid expenses which are deductible by accrual method taxpayers, and a discussion of two prepaid expenses in particular: a. Prepaid lease rents. b. Prepaid service contracts. 3. Deductible prepaid expenses must be both “immaterial” to taxable income, and 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 Section 461(h)(3)(A) to evaluate “materiality” and “matching.” b. While, the Ruling states that GAAP accounting is not dispositive, it is clear from reading the conclusions that it is very influential. (1) If the prepaid expense must be amortized for the future period for GAAP, then it must be either “material” to income or amortization must better match income and expense. c. Conforming to the Ruling is an automatic change of accounting method - change # 161.II. IRS Examination Issues - Where all of the action is this year. A. "Conclusive Presumptions" that book charge-offs are worthless for tax purposes. 1. There are two “conclusive presumptions” in the income tax Regulations. a. The historical presumption that has been used for more than 50 years by banks that do not have a valid conformity election – Reg. 1.166-2(d)(1). b. The Conformity Election, which was added to the Regulations in 1992 – 1.166-2(d)(3). 2. What is a "Charge-Off" for tax purposes? a. For partially worthless debt, Section 1.1 66(a)(2) indicates that financial institutions can deduct such losses, but that it should be accompanied by a "charge off or similar entry" in the books of the bank for the year deducted. Some controversy exists over what accounting entries need to be made to meet this standard.
Community Bank Tax Workshop Page 7 of 912012 Outline November 7, 2012 (1) The Tax Court, in Kentucky Rock Asphalt Co v Helburn stated that "if, before an income tax return is due, entries were made on the books showing the charge off, the provisions of the statute would be met." (2) In summary, an entry that removes the asset from the books should be a “charge-off” for purposes of the deduction for partial or complete worthlessness of a loan or security. b. There is a history of specific reserves in the thrift industry, and the Service has consistently taken the position with thrifts that a specific reserve is a “charge-off.” (1) If a loan is classified for regulatory purposes as having a "specific reserve" under FAS 114 at year end, and is subsequently charged off in the first two quarters of the following year, does this meet the "similar entry" of Reg 1.166(a)(2)? (a) Regulation Section 1.166-2(d)(4)(ii) states: “Charge-off . For banks regulated by the Office of Thrift Supervision, the term "charge-off" includes the establishment of specific allowances for loan losses in the amount of 100 percent of the portion of the debt classified as loss.” c. The IRS audit examination guide addresses "charge-offs" in Chapter 10, but there are few "bright line" criteria listed for the examining agents. (1) One "bright line" requirement is that the loan must be classified loss for the charge-off to be deductible. (2) A second "bright line" requirement is a book charge-off. (a) Most charge-offs, except for small, unsecured consumer debt, are really charge-offs for "partial worthlessness." (b) The Code is clear that partial charge-offs are not deductible in excess of the amount charged off on the books. (c) A working position has also evolved that wholly worthless loans must also be charged-off the books to support a deduction.
Community Bank Tax Workshop Page 8 of 912012 Outline November 7, 2012 (3) A third, less specific "bright line" requirement is that the burden of proof is on the bank to document the reduced value of the debt. (a) This is established through the support in the loan file regarding the troubled loan, efforts to collect, the value of collateral, et. al. d. From the perspective of challenging specific charge-offs, the following quotes from the examining guide are instructive: "Review the loan files for comments and notes by the loan officer on the possibility of subsequent events that could affect the collectibility or recoveries in future years. "Request the current status reports for several of the larger loans. Analyze the bad debt recoveries in subsequent years. A large recovery and consistent future payments on a particular loan may indicate that the loan should not have been written off during the examination year. "... However, it should be noted that the taxpayer is not bound by subsequent events, such as recoveries or future events to determine a charge-off. Also, the IRS does not have to accept subsequent events to determine if a debt is bad in the current year. "An aggressive position can be taken on the charge-offs. It is the banks responsibility to establish the worthlessness of the debt. Failure to properly document the reduced value of the debt precludes the taxpayer from taking a deduction. "a. The taxpayer must document the worthlessness of each loan. The documentation for one loan does not permit the deduction for any other loan. Each loan stands on its own merits and substantiation, or lack thereof. "b. Failure by the taxpayer to provide a loan file can give rise to a complete disallowance of any deduction taken for that particular loan. Unusual facts and circumstances should be considered that would affect the availability of the loan file. "c. It should be remembered that a loan officers determination as to the collection potential for a particular loan is self serving. ... His or her comments should not automatically be accepted without other substantiating evidence supporting their opinion. The facts
Community Bank Tax Workshop Page 9 of 91 2012 Outline November 7, 2012 contained in the loan file should speak for themselves. "d. ... many of the adjustments we [make are] based on the taxpayers failure to provide sufficient proof of worthlessness. The taxpayer was also unable to show that sufficient attempts were made to collect the debt at the point in time of the charge-off. " e. The industry can concur with much of what is said in the examination guide, but several statements require some analysis. (1) The tenor of the guides commentary is misleading to examining agents who are not well versed in banking. The most critical financial ratio to banks is their Tier I capital, not their effective current income tax rate. (a) To the extent that charge-offs reduce the reserve, and require the reserve to be replenished by a book provision for bad debts, the charge-off will represent at least a 65% charge to Tier I capital for a C corporation bank. (i) It may be higher for small banks that have a less than 35% effective federal tax rate. (ii) It will be 100% for S corporation and QSub banks. (b) All C corporation banks of every size are required by the federal and state regulators to account for income tax expense on an accrual method. While charge-offs may affect the current tax liability, only in rare instances will it effect income tax expense. Accordingly, most bankers no longer view the deduction for bad debts as a "tax shelter" as may have been the case 20 to 30 years ago. (c) Comments and notes by the loan officer on the possibility of subsequent events that could affect the collectibility or recoveries needs to be read in the context of the Fifth Circuits discussion of worthlessness in Echols.4 The fact that future circumstances might result in some speculative recovery does not establish that the asset is not "virtually worthless" now. (d) The implication of the comment that a loan officers notations4 Echols v. Commissioner, 935 F.2d 703, 91-2 USTC 50,360, 5 CA (7/15/1991). See a discussion of the Echolsdecision beginning at page 24.
Community Bank Tax Workshop Page 10 of 912012 Outline November 7, 2012 in the loan file are "self-serving" is open to misinterpretation. Indeed, the officers comments in the loan file may be "self- serving," but the loan officers incentive is to make the loan appear as sound as possible, not the opposite. 3. No conformity Election - Examiner ordered charge-offs and Regulation Section 1.166-2(d)(1). a. The conclusive presumption in (d)(1)(I) is the “default” provision which applies to every bank which does not have a valid Conformity Election. b. The threshold for the presumption in (d)(1) is a charge-off “in obedience to the specific orders of such authorities,” which requires “proof” that the examiners in fact ordered the charge-offs. c. Banks, their tax advisers, and IRS examiners have long had questions about just how banks could prove to the IRS examiners that certain loans qualify for the conclusive presumption under (d)(1)(I) because all the bank has is the examination reports from the regulatory safety and soundness examiners. Those reports, whether Federal or State, are confidential. Access to those reports is very strictly limited, and IRS examiners are not among the permitted users. (1) Banks, CPAs, and IRS examiners have traditionally solved the “proof” problem by following an informal working protocol that there is nothing so confidential on the pages of the reports which only list the loss assets and charge-offs required by the examiners that the bank cannot show those pages to the examiners. (2) This year, some IRS examiners have begun to state, with the support of the IRS Examination Divisions national industry specialists, that: (a) The bank regulators’ examination reports are confidential, (b) IRS personnel are not on the list of permitted users of the reports, and (c) It is illegal for the bank to show any part of the report to the examiner unless the bank has written permission from the regulator to do so. (d) Without the written permission, the IRS examiner will not look at the examination report pages to support the bank’s claim of the 1.166-2(d)(1) conclusive presumption of
Community Bank Tax Workshop Page 11 of 912012 Outline November 7, 2012 worthlessness. d. If the IRS examiner takes this attitude, the default conclusive presumption in subsection (d)(1) is effectively voided. (1) The IRS examiner takes the position that the bank must “prove” that the safety and soundness examiners have ordered the charge-offs. (2) The only “proof” available to the bank is the examination report, which the IRS examiner cannot look at. e. The IRS examiners are not uniform over the country. (1) A CPA who spoke at a conference this summer reported that the only states where the attendees reported the problem were in Michigan and Wisconsin. I have heard since that it has spread to Minnesota. (2) In late summer, Mr. Cederberg conducted a survey of CPA firms with community bank clients. (a) Respondents in many parts of the country reported that IRS examiners, considering the economic issues during the recessions, simply "assumed" that book charge-offs were deductible. (b) Numerous respondents also reported that examiners had still used the "charge-off pages" of the safety and soundness examination reports. f. What is the bank’s alternative? (1) Mr. Cederberg has been told that the FDIC has refused in writing to either (i) grant permission to show even the charge-off pages to the IRS examiners, or (ii) to provide a confirmation letter (either contemporaneous with the examination or later) regarding the charge-offs that were ordered during the examination. (2) Only one federal regulator, the Federal Reserve, has a policy statement permitting the field examiners to write a separate letter confirming ordered charge-offs, or charge-offs which would have been ordered if the examination had occurred on the date of the charge-off.
Community Bank Tax Workshop Page 12 of 91 2012 Outline November 7, 2012 "Since 1973, the Federal Reserve has been willing to provide a state member bank with a "confirmation letter, upon the banks request and in appropriate circumstances. This procedure, which remains in effect, was set forth in SR-225, dated September 7, 1973."5 (3) Some state departments of banking have been willing to issue a similar confirmation letter if asked. (a) However, Mr. Cederberg has also been told by CPAs that the IRS examiners have rejected confirmation letters from the state Departments of Banking because they were issued during the IRS’ examination, not contemporaneous with the state safety and soundness examination. g. Status: (1) The ABA is working with the IRS Examination Division at the National level in an attempt to develop a protocol to resolve this issue. The most recent meeting was on October 11, 2012. (2) Suggestions for the banks: (a) Make the conformity election as soon as possible. (b) State member banks should obtain the confirmation letter from the Federal Reserve examiners at the completion of the examination. (c) State nonmember banks, and state member banks for that matter, should ask their chief field examiner for the confirmation letter at the conclusion of the examination, unless the bank has already done so, or the state has issued guidance that it will not provide a confirmation letter. (3) In the meantime, it appears that most IRS examiners who are taking the hard line on examiner ordered charge-offs really want to review the loan files and reach their own, independent position on how much of the charge-offs are deductible. Principal targets for disallowance are: (a) Estimated selling costs; the most uniform and material5 SR 92-39 Dated October 30, 1992.
Community Bank Tax Workshop Page 13 of 912012 Outline November 7, 2012 adjustment. (b) Examiner ordered reductions in the fair market value of collateral based on the age of the most recent appraisal when the property was foreclosed upon, or upon changes in the average real estate values in the community since the last appraisal. (c) Examiner ordered reductions in the fair market value of collateral “because it will be owned by a bank,” which seems to be a somewhat localized issue in some of the places hardest hit by the real estate recession. (d) However, Mr. Cederberg has heard reports of much more extreme positions taken by individual examiners. 4. Charge-offs on the Conformity Method. a. Banks on the conformity method don’t have the “proof” problem because the threshold for deductibility is not whether the regulatory safety and soundness examiners approved or ordered the specific charge-off, but rather that the federal safety and soundness examiners found that the bank charged off loans in compliance with regulatory standards and signed the Express Determination Letter. b. Respondents to Mr. Cederberg’s survey reported that by-and-large, the Conformity Election has eliminated virtually all controversy over charge- offs. (1) Respondents also said that the Conformity Election eliminated most controversy over nonaccrual interest by accrual method banks. c. However, what we all thought was “conformity” may not really be conformity after all. (1) Similar to the comment that was made about the default conclusive presumption, Mr. Cederberg is hearing isolated reports from CPAs that some IRS examiners are saying that GAAP accounting has so diverged from the IRS’ views on tax accounting for bad debts that not all book charge-offs are deductible. (2) As discussed above, the targets appear to be: (a) Estimated selling costs;
Community Bank Tax Workshop Page 14 of 912012 Outline November 7, 2012 (b) Estimated decreases in the fair market value of collateral, either prior to foreclosure or at the foreclosure date, from the most recent appraisal. (3) Nevertheless, the Examination Division nationally tells the ABA that the Service wishes that every bank were on the Conformity Method, and the Election appears to have had significantly reduced the volume of proposed adjustments, examination time, and professional fees. B. Nonaccrual Interest Income. 1. The lack of IRS examiner experience with bank, and banking terminology, is costing banks a lot of representation time. a. It appears that many examiners have never heard of Revenue Ruling 2007-32 for banks with the Conformity Election. b. Some examiners do not know that the accounting method in Rev. Rul. 2007-32 is mandatory for banks with the Conformity Election. They ask for the banks Form 3115 to "elect" Rev. Rul. 2007-32. (1) There is nothing in all of Rev. Rul. 2007-32 that says that it is "elective" for banks with the Conformity Election. c. Some examiners have never heard of Rev. Rul. 80-361, or erroneously think that it was obsoleted by Rev. Rul. 2007-32. d. Some examiners, observing correctly that nonaccrued interest is a deduction for "partial worthlessness" of the loan, look for the "charged- off" that is a threshold requirement for the deduction of a partially worthless bad debt. There is no charge-off on the books, so the deduction for partial worthlessness is not allowed. (1) Revenue Ruling 2007-32 states specifically, "Xs failure to recognize the $23,000 of accrued interest for regulatory financial statement purposes is tantamount to recognizing the accrued interest as income and immediately charging off the uncollected accrued interest receivable as a loss asset." e. Some examiners do not realize that banks routinely “extend” and/or modify loans in an effort to keep the borrower paying as long as possible,
Community Bank Tax Workshop Page 15 of 912012 Outline November 7, 2012 but that the underlying loan and accrued interest is still not “reasonably expected” to be collected. (1) The bank extended the maturity, or refinanced the loan; therefore the accrued interest must be collectible and has to be recognized. (2) In reality, the refinancing might be a "significant modification" which would support not only a loss on the loan principle, but certainly the loss of any accrued interest. f. Some examiners do not appear to know that Rev. Proc. 2007-33 is "elective" and attempt to impose it on banks without the conformity election. 2. Banks without a Conformity Election - The historical arguments regarding whether the accrued interest is worthless continue. a. Respondents to the survey reported relatively good results unless the bank has an openly hostile examiner. b. The key is developing the facts about the nonaccrued interest early in the examination and in detail. (1) Once IRS examiners have a misunderstanding of a loan, it is very difficult to correct the situation. (a) Example - One of the respondents described a situation in which the bank personnel referred to a pool of loans as “refinanced,” which the IRS examiner interpreted to mean that they must by “collectible” and included the nonaccrued interest in a proposed adjustment. It was a six figure amount. (b) In fact, the loans were pooled and sold at a discount from the principal amount. The “bank” had refinanced itself, not the borrower! c. Without the conformity election, income tax accounting for nonaccrual interest 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 that under an accrual method of accounting, income is includible in gross income when all events have occurred that fix the right to receive such income and the amount thereof
Community Bank Tax Workshop Page 16 of 912012 Outline November 7, 2012 can be determined with reasonable accuracy. "... [T]he right to receive interest income becomes fixed ratably over the period of the loan so long as all events have accrued to fix the right to receive income and the amount thereof can be fixed with reasonable accuracy. "A fixed right to a determinable amount does not require accrual, however, if the income item is uncollectible when the right to receive the item arises. Jones Lumber Co. v. Commissioner, 404 F.2d 764 (6th Cir. 1968). "When an income item is properly accrued and subsequently becomes uncollectible, a taxpayers remedy is by way of deduction rather than through elimination of the accrual. Moreover, this rule is applicable even when the item is accrued and becomes uncollectible during the same taxable year. Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934), Ct.D. 829, XIII-1 C.B. 28 (1934). Also Atlantic Coast Line Railroad Co. v. Commissioner, 31 B.T.A. 730, 751 (1934), acq., XIV-2 C.B. (1935)." d. In summary: Revenue Ruling 80-361 would indicate that: (1) Loans are properly nonaccrual when there is no reasonable expectation of collecting the nonaccrued interest. (2) All accrued interest is properly charged off to the reserve, or deducted as a bad debt, in the year that it becomes uncollectible. There is no reversal against income. (3) Subsequent payments are applied against principal as long as there is no reasonable expectation of collecting the nonaccrued interest. e. How does Revenue Ruling 80-361 compare to the financial reporting standards for nonaccrual of interest? (1) Collection of the principal and interest is not reasonably expected should support nonaccrual for tax purposes as well as book purposes. (2) Having taken a partial charge-off should be strong evidence that the collection of the interest is not reasonably expected.
Community Bank Tax Workshop Page 17 of 912012 Outline November 7, 2012 (3) Collection of the interest should not be reasonably expected on a collateral dependent loan which is undercollateralized. (4) Sufficient deterioration of the borrower’s financial condition also probably supports nonaccrual for tax purposes because it creates the expectation that principal and interest will not be collected in full. (5) There is likely to be a legitimate issue from a tax perspective if the borrower is current on payments, and perhaps even if some of the payments are late or the borrower is behind the agreed upon schedule. (6) Merely being in default for 90 days may not support nonaccrual in some cases, but if the bank can show a history that little if any of the interest is ever collected on loans that default for 90days or more, then collection of the interest should not be "reasonably expected." f. The IRSs audit examination guide states that the key issue is whether the interest is uncollectible or merely delinquent. Delinquent loans are not necessarily nonaccrual. Uncollectible interest is not accrued. g. The examination guide also offers the examining agents examples of loans that should still be on accrual, some of which the industry would not concur with. (1) Loans placed on nonaccrual because of a lapse of time. (a) We would probably concur if, historically, this bank has collected accrued interest on loans of the same category which have been in default the suggested period, such as 90 days. (b) However, the industry would not concur if the bank has historically collected little if any accrued interest on such loans after they have been in default for the specified period. (2) Loans with only partial charge-offs. (a) The industry would not concur with this statement. (3) The suggestion is that loans which have been only partially charged off should 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
Community Bank Tax Workshop Page 18 of 91 2012 Outline November 7, 2012 portion of the principal which is a "loss asset." The amount not charged off is the amount which the bank reasonably expects to collect, which is all principal. (b) After the partial charge-off, there is no reasonable expectation of collecting any interest in addition to the principal not charged off. (4) Loans with sporadic payments. (a) Whether loans with sporadic payments should be on accrual for tax purposes is a facts and circumstances determination, based on the source of the payments. (b) If the borrower is in the process of liquidating assets, and is making payments from the proceeds of the asset sales, then there is a reasonable expectation of collecting interest only to the extent that the realizable value of the assets, minus other liabilities, exceeds the principal. (c) If the borrower is making payments from positive cash flow from operations, but is "sporadic" because of "sporadic" cash flow, then perhaps the guide has a point. (5) Loans that are current, but are to borrowers which are delinquent on other loans. (a) The industry would concur with only if the sources of payments for the delinquent loans are different from the sources of payment of the "current loans." (b) If the sources of payments are identical, then the loans cannot be evaluated separately for the expectation of collecting the interest. h. Note that the Revenue Ruling refers to whether collection of the interest is "reasonably expected." This clearly is not a "bright line" test. i. Banks may want to consider the 5th Circuit Decision in Echols v. Commissioner,6 regarding the extent to which the bank must concede to the examining agents judgment regarding whether the collection of interest can be "reasonably expected."6 Echols v. Commissioner, 935 F.2d 703, 91-2 USTC 50,360, 5 CA (7/15/1991).
Community Bank Tax Workshop Page 19 of 912012 Outline November 7, 2012 (1) The Circuit Court in Echols discussed in great detail when a deduction for worthlessness of an asset is allowed. In the context relevant to both the allowance of charge-offs of loan principal and the nonaccrual of interest, the Court identified two elements: (a) A factual determination – is the property virtually worthless? The factual determination is a threshold requirement for a deduction for worthlessness. (b) A subjective determination – when did the taxpayer conclude that the property is virtually worthless to it? The subjective determination is largely at the discretion of the taxpayer and the Service is not allowed to substitute its subjective judgment for the taxpayers. The Echols court stated: "As long ago as 1943, federal courts recognized that the timing of a deduction based on worthlessness is largely within the discretion of the taxpayer, given objective indicia of absence of value." (c) The lesson of Echols is that so long as the bank documents that there is no "reasonable expectation" of collecting the nonaccrued interest, an IRS examining agent should not attempt to substitute his/her judgment for the banks regarding when the nonaccrual is allowed. 3. Banks with a Conformity Election a. This may be the most important benefit to accrual method banks from making the conformity election. The Election appears from the survey to solve most of the issues on nonaccrual interest. b. The legitimate issue is the tax accounting for interim cash receipts on nonaccrual loans. (1) Revenue Ruling 2007-32 states that interim cash receipts from the borrower must be recognized in income equal to the lesser of (i) the accumulated, nonaccrued interest, or (ii) the cash received. (2) Revenue Ruling 2007-32 also cites favorably Revenue Ruling 80- 361 and the court decisions in European Am. Bank & Trust Co. and Jones Lumber Co.
Community Bank Tax Workshop Page 20 of 91 2012 Outline November 7, 2012 "A fixed right to a determinable amount does not require accrual, however, if the income is uncollectible when the right to receive the income item arises. Accrual of income is not required when a fixed right to receive arises if there is not a reasonable expectancy that the claim will ever be paid." European Am. Bank & Trust Co. v. United States, 20 Cl. Ct. 594, 605 (1990) (footnotes omitted), affd per curiam, 940 F.2d 677 (Fed. Cir 1991); see also Jones Lumber Co. v. Commissioner, 404 F.2d 764, 766 (6th Cir. 1968) (stating that "[t]he right to receive ... determines the accrual of income unless, at the time the right 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 debt is 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 Vince Guiliano,7 at the 2010 Bank Tax Institute as follows: (a) The recognition of interim cash receipts in the Revenue Ruling addresses the common situation in which the bank must place performing loans on nonaccrual 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, reduces the income tax basis in the loan, and recognized accrued interest, to less than the reasonably projected remaining cash collections on the loan, then the cash receipt must be recognized in income as described in Revenue Ruling 2007-32. (c) If, however, application of the interim cash receipt to the loan reduces both the income tax basis in the loan and the reasonably projected future cash collections so that after the receipt, the income tax basis in the loan and the projected cash collections are approximately equal, then the cash receipt is not included in income. Vince specifically stated that7 Mr. Guiliano is the IRS examination division Senior Counsel, Commercial & Foreign Banking Industry Counsel.
Community Bank Tax Workshop Page 21 of 91 2012 Outline November 7, 2012 Revenue Ruling 80-361 applies.8 (d) The example used in the question was liquidating a dairy loan, resulting in cash from the auction of the cattle, followed some time later by cash from the auction of the equipment, and finally wound up with cash from the sale of the land and buildings. In this example, Vince said that the cash proceeds from interim sales of collateral would not be "nonaccrued interest income." C. Pre-Foreclosure costs incurred by the borrower and paid by the lender. 1. It is relatively routine for borrowers in the process of foreclosure not to pay numerous expenses, among them real estate taxes, other assessments, utility bills, mechanics liens, etc. The lender ends up paying the bills either before or after the foreclosure. a. If the lender believes that there will be interested buyers at the auction, the lender 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 property is reduced to possession. 2. Both GAAP and regulatory accounting require that these payments be expensed for 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 Segment Specialization Program” for the Commercial Banking Industry, but the MSSP discussion is largely without citations.9 a. Service’s Position - Pre-acquisition expenses incurred by the debtor and paid by the lender before the change of ownership increase the bank’s income tax basis in the loan. The MSSP states that, “The basis of the loan is further increased by other costs, such as back taxes, insurance, legal expenses, and similar items paid by the bank for protecting the value of the property prior to the transfer of ownership to the bank.”8 This was also confirmed to Mr. Cederberg privately by Jeff Kammerman after the session at the same Institute.9 See Chapter 6.
Community Bank Tax Workshop Page 22 of 91 2012 Outline November 7, 2012 [underscoring in original but italics added]10 Accordingly: (1) If the bank paid the costs before the transfer of ownership, then the amounts are added to the loan for purposes of determining whether there is a charge-off for a bad debt, and if so the amount. (2) If the bank pays the costs after the transfer of ownership, then they are added to the income tax basis in the property, further increasing the basis over the fair market value of the property. b. The Service’s position appears to be consistent with the Board of Tax Appeals decision in Estate of Schieffelin v. Commissioner,11 a very old case from 1941 and not involving a Bank. The taxpayer in the case was an individual who owned two loans, each secured by different properties. Both loans defaulted and the decedent foreclosed, obtaining possession of both properties. (1) In one case, the lender had paid real estate taxes on the property before the foreclosure. (2) In the other case she paid the real estate taxes and water bills after the foreclosure. (3) The Board of Tax Appeals held for the taxpayer with respect to taxes paid before the foreclosure but for the Service with respect to the taxes and utilities paid after the foreclosure. (4) The Board cited Minnie M. Coward, 39 B.T.A. 1158 (affirmed as to the point at issue, 110 Fed.(2d) 725) to say that it was well settled that if the purchaser of real estate pays taxes thereon which have accrued prior to the date of purchase, such payments are an additional cost of the property to the purchaser and are therefore not deductible by him as his taxes. The Board also cited Lifson v. Commissioner, 98 Fed.(2d) 508, and Merchants Bank Building Co. v. Helvering, 84 Fed.(2d) 478. D. Foreclosure Costs: 1. GAAP requires that foreclosure costs be expensed as incurred for financial reporting purposes.10 MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.11 Estate of Schieffelin v. Commissioner [4 B.T.A. 137 (1941).
Community Bank Tax Workshop Page 23 of 91 2012 Outline November 7, 2012 2. Tax accounting - The Service’s position is that foreclosure costs must be added to the income tax basis in the property. a. The MSSP states that, “Legal costs and other similar expenses incurred in connection with the foreclosure proceedings increase the basis of the OREO property.” [underscoring in original]12 b. Under the MSSP, a formal foreclosure transaction proceeds in the following steps: (1) The amount by which the bank’s income tax basis in the loan exceeds the bid price, if any, is a bad debt allowable under Regulation Section 1.166-6. (2) If the bank purchased the property at the foreclosure auction, then the difference between the fair market value of the property and the bid price is a gain or loss on the foreclosure. (3) Finally, the bank’s income tax basis in the property is its fair market value plus the foreclosure costs. (4) The MSSP’s approach to foreclosure costs would always result in the bank having an income tax basis in the property greater than its fair market value equal to the foreclosure costs. 3. The MSSP appears in direct conflict with the Tax Court decision in Community Bank v. Commissioner, 62 T.C. 503, 7/9/74. a. The issue in Community Bank was really whether there was a burden of proof on the Commissioner to sustain fair market values in excess of the bid price, resulting in the bank recognizing gain on the foreclosure. However, in reciting the facts of the case, the Court states: “Petitioner, as authorized by section 1.166-6(a), Income Tax Regs., charged against its bad debt reserve an amount equal to the difference between (1) the balance due under the note plus costs of foreclosure and (2) the bid price of the property acquired.” [italics added] Later in a discussion of each of the Service’s arguments to the Court, the Court states again:12 MSSP Chapter 6, Computing the Basis of the Loan for Tax Purposes, numbered paragraph 3.
Community Bank Tax Workshop Page 24 of 91 2012 Outline November 7, 2012 “Respondent [i.e. the Service] alternatively argues that petitioner’s deduction for bad debts should reflect an amount equal to the difference between the balance due under the notes plus costs of foreclosure and the fair market value (rather than the bid price) of the property acquired.” [italics added] 4. Normal banking practices also support adding the foreclosure costs to the note. a. Virtually all loan agreements provide that the debtor owes the lender reimbursement of all collection costs. b. Since the foreclosure costs become a legal part of the note when incurred, it appears that they should be added to the basis in the note in determining the bad debt charge-off resulting from either the foreclosure or the transfer of the property by deed in lieu of foreclosure. E. OREO Holding Period Costs 1. Service’s Position - According to the MSSP: a. If the property is operated or rented, then post-acquisition expenses, and depreciation, are deductible. b. If the property is held for sale, then post-acquisition expenses must be added to the basis in the property. c. The MSSP states in relevant part: “After the bank takes possession of the property, no portion of the expenses is currently deductible if the bank is holding the property for resale or sale to customers. The OREO property is similar to inventory, and therefore, all expenses are considered to be part of the basis of the property. If, however, the bank is holding the property out for rent, normal maintenance expenses, including depreciation, are deductible by the bank when incurred.”13 d. The MSSP does not cite Section 263A, but that clearly is the Service’s basis for capitalization. See FSA 1998-170, a Field Service Advice involving a thrift in which the National Office liberally cites Section 263A.13 MSSP, Chapter 6, Examination Techniques, third paragraph of numbered paragraph 3.
Community Bank Tax Workshop Page 25 of 912012 Outline November 7, 2012 2. This has emerged as a National issue with the IRS. a. Examining agents appear to have little if any discretion not to disallow the current deduction for the costs incurred to hold non-income producing OREO until it is sold. b. Mr. Cederberg has been told that Service personnel say there are at least four banks which have taken this issue to Appeals. c. The three banks whom Mr. Cederberg knows about have all had their appellate conferences, and have hit a "brick wall" on the subject. Appeals has been unwilling to offer any settlement. d. One tax counsel has told the Mr. Cederberg that the IRS appears to be so “dug in” on the subject that there appears to be only a remote likelihood of prevailing short of the Circuit Court of Appeals. e. This same counsel suggested that because of the total silence of both official guidance and legislative history on the application to OREO, courts is likely to defer to the “presumed correctness” of the Commissioner’s position. f. Technically, the case does not seem to be “open and shut”. (1) The definition of Section 263A property in Section 263A(b)(2), which reads in relevant part as follows: “(b) Property to which section applies. Except as otherwise provided in this section, this section shall apply to ... (2) Property acquired for resale. (A) In general. Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.” [italics added] (2) Section 1221(a)(1) reads in relevant part: “(a) In general. For purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include (1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business ... .” [italics added]
Community Bank Tax Workshop Page 26 of 912012 Outline November 7, 2012 (3) Banks probably should not argue that OREO is not Section 1221(a)(1) property because that is effectively their only gateway to an ordinary loss on disposition. (4) However, Section 263A introduces an “intent” test in addition to being Section 1221(a)(1) property; i.e. that the property “is acquired by the taxpayer for resale.” Bankers will argue with great passion that the OREO is not acquired for resale but rather to collect the loan. Restated, the origin of the OREO is in the loan, not in buying and selling real estate. (5) However, whether any bank is willing to spend considerable sums litigating that issue is yet to be seen. 3. This should not be a problem for Operating Properties, i.e. income producing properties. a. The IRS examination manual states that banks may deduct the holding period costs of "operating OREO," and may claim deprecation. b. Current deductions are not controversial. Except for inexperienced agents who havent read the IRS examination manual, I am not hearing about challenges. 4. The most common "error" is not discovering that OREO is actually income producing. Vacant residences are problematic, but development land in particular offers numerous creative opportunities to realize some income during the holding period, and that should make the property "income producing" and not subject to cost capitalization. a. In several cases, banks have cash rented failed developments to local farmers during the interim while they were trying to sell the property. b. A bank rented vacant OREO to a contractor for use as its construction trailer and equipment during construction of an adjacent project. c. In another case, a bank rented vacant OREO to the City for a similar purpose. d. In several cases, banks have turned vacant OREO into a short term parking lot and charged people to park there; usually without even paving the lot. e. In one case, the OREO was close enough to the bank that the bank
Community Bank Tax Workshop Page 27 of 91 2012 Outline November 7, 2012 allowed its employees to park there for free. That made it “premises” and the holding period expenses are currently deductible. 5. If holding period costs are capitalized, it is critical that the bank account for the capitalized costs by property so that it can reverse the Schedule M-3 item as the property sells. a. The faculty have heard from CPAs whose clients are by now on their second round of “recession examinations” that if the expenses cannot be tracked to specific OREO properties, IRS examining agents are alleging that the capitalized expenses cannot be deducted until all of the OREO is sold; or at least until all of the OREO owned during the year the expenses were capitalized is sold. (1) The theory is that deductions are a matter of legislative grace and must be proved. If the bank can’t prove what property was subject to capitalization, it isn’t entitled to a deduction. b. Of course, if all of the OREO owned in that year has been sold, then the bank has a deductible “loss” under Section 165. F. Partial Bad Debt Charge-offs on “Securities.” 1. Examining agents, usually those without a lot of experience examining banks, are challenging the deductions on at least two bases. a. That the charge-offs are “partial bad debt deductions” and that partial losses are not available except for loans. No loss is deductible until the “security” is either sold or wholly worthless. b. That OTTI adjustments to “fair market value” are not deductible. 2. The confusion is compounded by most agents inexperience with bank investments. Many of the mortgage investments are really investments in regular interests in real estate mortgage investment conduits ("REMICs") a. The agents are not aware that REMIC regular interests have been held by the Service itself to be “loans” as defined in Regulation Section 1.585- 2(e)(2), not “securities.” Accordingly, partial charge-offs are allowed when a "debt" becomes recoverable only in part.14 (1) Section 860B(a) of the Code states in relevant part, “... a regular14 Section 166(a)(2).
Community Bank Tax Workshop Page 28 of 912012 Outline November 7, 2012 interest in a REMIC ... (if not otherwise a debt instrument) shall be treated as a debt instrument." Note that the Code refers to a "debt instrument", not to a "debt security." (2) In technical advice memorandum 9423002, the Service held "A regular interest in a REMIC is considered debt for purposes of the Code without regard to the actual form of the instrument. See Section 860B(a). Thus, the obligations are loans within the meaning of Section 1.585-2(e)(2), without regard to the underlying collateral that secures the debt." (3) In technical advice memorandum 200439041, the Service cited 9423002 and stated, "Pursuant to § 860B(a), a regular interest in a REMIC is treated as a debt instrument for federal income tax purposes. Therefore, a regular interest in a REMIC is a loan within the meaning of § 1.585-2. ..." 3. Pass-through securities. Even if the “security” is not a REMIC, if it is a pass- through mortgage backed security, it is also a “loan” for income tax purposes. a. This issue was first addressed by the Service in Revenue Ruling 84-10, where the Service held that FNMA guaranteed mortgage pass-through securities were investments in mortgages secured by real estate for real estate investment trusts and residential real estate mortgages for qualification as by thrifts under Section 7701. The trust certificates were in registered form, stated that they represented fractional undivided interests in the mortgage loans, pool proceeds, and mortgaged property acquired by foreclosure. b. TAM 9423002 also involved pass-through securities that were not REMICs. The “facts” were stated by the Service as follows: “Most of the mortgage-backed securities were participation interests issued and insured by the Federal National Mortgage Association (FNMA), the Government National Mortgage Association (GNMA) or the Federal Home Loan Mortgage Corporation (FHLMC), but some of the mortgage-backed securities insured by those agencies were REMIC regular interests as described in Sections 860A through 860G of the Code.” c. The Service held that the pass-through investments were “loans” as defined in Regulation Section 1.585-2(e)(2).
Community Bank Tax Workshop Page 29 of 91 2012 Outline November 7, 2012 "LAW - ... Section 1.585-2(e)(2) of the Regulations defines the term loan (for purposes of Section 585) as debt within the meaning of Section 166 and the related Regulations. The term specifically includes, in relevant part, a loan participation to the extent that the taxpayer bears a risk of loss. Section 1.585-2(e)(2)(i)(c).” 4. The suggestion that securities are not subject to partial worthlessness is simply an issue of inexperience with banks. a. Section 582(a) provides that credit losses incurred by banks [as defined in Section 581] on securities [as defined in Section 165(g)(2)(C)] , are allowable under Section 166 as bad debt losses. b. Having moved the bank’s credit loss from Section 165 to 166, the partial bad debt provision of Section 166(a) apply. c. Reg. 1.585-1(a) specifically provides that bad debts on partially or wholly worthless debt securities are deducted under Section 166(a) by virtue of its reference to Section 582(a) and the Section 582 Regulations. Accordingly, reading the Code and Regulation together, a deduction is allowed for a partially worthless debt security in the year during which it is determined that it became partially worthless equal to the lesser of (i) the "loss" of principal, and interest to the extent included in income by an accrual basis taxpayer, or (ii) the amount charged off on the books. d. Regulation Section 1.585-1(a) also clarifies at least three other practical issues. (1) Securities are not included in “total loans” for purposes of calculating the experience ratio. They are excluded from the definition of loans.15 (2) Bad debt losses on Securities are not included in “bad debts” for purposes of calculating the experience loss percentage because they15 After the adoption of Section 585, and under the Proposed Regulations under Section 585, it was believed that“securities” were included in total loans but not eligible loans. I don’t have a paper copy of Treasury Decisions 7532and 7835 which accompanied the final Section 585 Regulations, but I distinctly recall that the definition of “loans” waschanged in the Final Regulation to exclude securities. This is the source of the December 31, 1976 effective date forthe exclusion of securities from the definition of loans. [Reg. 1.585-2(e)(2)(ii)(C)]
Community Bank Tax Workshop Page 30 of 91 2012 Outline November 7, 2012 are not charged to the Section 585 reserve.16 (3) The bad debt deduction for partial or wholly worthless securities is not required to have been charged to the Section 585 “reserve for losses.” It is only required to have been “charged off,” which has been held to mean that the asset was effectively removed from the books of the taxpayer. 5. The objection whether the OTTI represents a worthlessness loss or a market value adjustment is fair to the extent that the OTTI adjustment either (i) reflects a reduction of the book value of the security to "fair market value" less than its reasonably expected cash flow, or (ii) future cash flows are discounted to present value. a. Unless the bank is a dealer in securities, and has adopted the mark-to- market method of accounting under Section 475, it is well settled that "fair market value" adjustments of securities, or most other assets for that matter, are not deductible. b. Most OTTI charges for partially worthless securities do include some discount of future cash flows to their present value. This portion of the OTTI is not a credit loss because the Bank has no income tax basis in the net present value discount. 6. Post Charge-off Accounting. a. What is the proper tax treatment if the financial prospects of a debt security changes in a year after the Bank takes an OTTI charge. (1) For example, assume a security with an income tax basis of $5 million. At the end of Year 1, the projected cash collections are $4 million, with a present value of $3 million. The Bank takes a $2 million OTTI on the books, and deducts the $1 million credit loss on its income tax return. (2) By the end of Year 2, the cash collection prospect has further deteriorated. The bank has collected $500,000, but the total remaining collections are projected to be only $3 million. Since the book value is now $2.5 million after the collection, the bank determines that no further OTTI is required.16 The Regulation does not specifically illustrate the operation of the bad debt reserve under Section 585. However,the examples in Reg. 1.585-2 consistently refer to "bad debts charged to the reserve for losses on loans," clearly implyingthat only bad debts on loans are charged to the Section 585 reserve.