Bad Debts

Bad Debts

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Section 166(a) of the tax code says that "there shall be allowed as a deduction any debt which becomes wholly worthless within the taxable year." However, in the case of a guarantor of another party's debt, a special set of rules operates to determine the time such guarantor is entitled to a "bad debt" deduction (once the guarantor honors the obligation to the creditor).

Sec. 1.166-1 Bad debts.

(a) Allowance of deduction. Section 166 provides that, in computing
taxable income under section 63, a deduction shall be allowed in respect
of bad debts owed to the taxpayer. For this purpose, bad debts shall,
subject to the provisions of section 166 and the regulations thereunder,
be taken into account either as--
(1) A deduction in respect of debts which become worthless in whole
or in part; or as
(2) A deduction for a reasonable addition to a reserve for bad
debts.

The following case study is very useful :

ISSUES
1. What steps are necessary to record or memorialize the assignment of a loan
(or loan portion) as a loss asset for purposes of the conformity method of accounting
for worthless bad debts?
2. Does the conclusive presumption of worthlessness under the conformity
method apply to loans erroneously classified as loss assets?
FACTS
ABC corporation is a bank (as defined in  1.166-2(d)(4)(i) of the Income Tax
Regulations) and is subject to supervision by Federal authorities. ABC has elected
under  1.166-2(d)(3) to use the conformity method of accounting to determine when
debts owed to ABC become worthless bad debts.
Under a resolution adopted by ABCs board of directors, ABCs officers and
employees are authorized to charge off loans (or portions of loans) only when the
charge-off is required under the loan loss classification standards issued by the banks
supervisory authority. Thus, when ABCs officers and employees charge off a loan for
regulatory purposes, they do not take any additional steps to record or memorialize
whether, in their judgment, the charge-off is required by the loan loss standards that
have been issued by ABCs supervisory authority.
The loan loss standards require ABC to charge off loss assets. Loss assets
are loans (or portions of loans) determined to be uncollectible and of such little value
that their continuance as bankable assets is not warranted. In the case of a consumer
loan or credit card debt, regardless whether there is specific adverse information about
the borrower, ABC is required to charge off the asset when its delinquency exceeds
certain established thresholds.

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Thus, ABC must charge off installment loans that are
120 days, or five payments, past due and credit card debts that are 180 days past due
after seven zero billings. In addition, if ABC receives specific adverse borrower
information (for example, the borrowers death or bankruptcy) confirming a loss before
the applicable 120 day or 180 day threshold date has passed, then an immediate
charge-off is required. See Comptroller of the Currency, Allowance for Loan and
Lease Losses, Comptrollers Handbook 10, 19 (June 1996); Uniform Agreement on
-2-
the Classification of Assets and Appraisal of Securities Held by Banks, Attachment to
Comptroller of the Currency Banking Circular No. 127, Rev. 4-26-91.
ABCs supervisory authority, in connection with its most recent examination of
the banks loan review process, made an express determination that ABC maintains
and applies loan loss standards that are consistent with the regulatory standards issued
by the Comptroller of the Currency.
During the taxable year ending on December 31, 2000, ABC charged off for
regulatory purposes certain credit card debts that were not required to be charged off
under applicable regulatory loan loss standards. Except for the erroneously charged off
credit card debts, ABC charged off only loans required to be charged off under the loan
loss standards.
On its Federal income tax return for 2000, ABC deducted as wholly worthless
debts all assets that it had charged off for regulatory purposes, including the debts that
had been erroneously charged off despite the absence of an applicable regulatory
requirement. Even so, the total amount of worthless bad debts claimed on the return
was not substantially in excess of the amount that would be warranted by the exercise
of reasonable business judgment in applying the loan loss standards of ABCs
supervisory authority.
LAW AND ANALYSIS
Section 166(a)(1) of the Internal Revenue Code allows a deduction for a debt
that becomes worthless during the taxable year. In addition,  166(a)(2) permits a
deduction for partially worthless debts if the taxpayer charges off an appropriate
amount on the taxpayers books and records and the Internal Revenue Service is
satisfied that the debt is recoverable only in part.
No precise test exists for determining whether a debt is worthless. In many
situations, no single factor or identifiable event clearly demonstrates whether a debt has
become worthless. Instead, a series of factors or events in the aggregate establishes
whether the debt is worthless. Among the factors indicating worthlessness are: a
debtors serious financial reverses, insolvency, lack of assets, continued refusal to
respond to demands for payment, ill health, death, disappearance, abandonment of
business, and bankruptcy. Additionally, a debts unsecured or subordinated status and
expiration of the statute of limitations can provide an indication that the debt is
worthless. Conversely, availability of collateral or third party guarantees, a debtors
earning capacity, payment of interest, a creditors failure to press for payment, and a
creditors willingness to make further advances are factors suggesting that the debt is
not worthless. Accordingly,  1.166-2 of the regulations requires consideration of all
pertinent evidence and provides that a deduction is warranted if the surrounding
circumstances indicate that the debt is uncollectible and that legal action to enforce
-3-
payment would in all probability not result in the satisfaction of execution on a
judgment.
In the case of a bank (as defined in  1.166-2(d)(4)(i) of the regulations) or
other corporation subject to supervision by Federal authorities, or by State authorities
maintaining substantially equivalent standards,  1.166-2(d)(1) provides administrative
simplicity by creating a conclusive presumption of worthlessness for loans charged off
in whole or in part in obedience to specific orders or in accordance with the established
policies of those authorities.
Additional simplification is provided by  1.166-2(d)(3) of the regulations for tax
years ending on or after December 31, 1991. Under the regulation, a bank subject to
supervision by Federal authorities, or by State authorities maintaining substantially
equivalent standards, may elect to use the conformity method of accounting to
determine when a debt becomes worthless. Under the conformity method, a conclusive
presumption of worthlessness applies to loans charged off, in whole or in part, for
regulatory purposes if the charge-offs correspond to the banks classification of the
loans, in whole or in part, as loss assets under applicable regulatory standards. Section
1.166-2(d)(3)(ii)(A)(2) provides that a bad debt deduction is allowed for the taxable year
in which a debt is conclusively presumed to have become worthless.
For the conclusive presumption of worthlessness to arise, a bank must satisfy
the express determination requirement of  1.166-2(d)(3)(iii)(D) of the regulations and
must classify the loan, in whole or in part, as a loss asset as described in  1.166-
2(d)(3)(ii)(C). The express determination requirement is satisfied if the banks
supervisory authority, in connection with its most recent examination of the banks loan
review process, has made an express determination that the bank maintains and
applies loan loss classification standards that are consistent with the authoritys
regulatory standards. See Rev. Proc. 92-84, 1992-2 C.B. 489 (providing the form for
the determination letter). Section 1.166-2(d)(3)(ii)(C) defines the term loss asset as a
debt that the bank has assigned to a class that corresponds to a loss asset
classification under the standards set forth in the Uniform Agreement on the
Classification of Assets and Appraisal of Securities Held by Banks or similar guidance
issued by the banks supervisory authority.
Various procedures can be used by a bank to classify loans (or loan portions) as
loss assets. For example, an officer or employee may record or memorialize on a form
the determination that a loan (or loan portion) is a loss asset. Loan or credit committee
reports or internal credit rating reports also can demonstrate that a loan has been
classified as a loss asset. Additionally, if officers and employees are authorized to
charge off loans (or loan portions) only if the loans (or loan portions) are loss assets,
then the charge-offs of the loans (or loan portions) demonstrate that the loans (or loan
portions) have been classified as loss assets.
-4-
ABC has made the conformity election under  1.166-2(d)(3) of the regulations
and has satisfied the express determination requirement described in  1.166-
2(d)(3)(iii)(D). Additionally, under the resolution adopted by ABCs board of directors,
ABCs officers and employees are authorized to charge off loans (or portions of thereof)
only if the charge-offs are required under applicable loan loss standards issued by
ABCs supervisory authority. Under these circumstances, ABCs charge-offs of certain
loans (or loan portions) are sufficient to demonstrate classification of those loans (or
loan portions) as loss assets under standards issued by ABCs supervisory authority.
Under  1.166-2(d)(3)(ii) of the regulations, the conclusive presumption of
worthlessness applies to loans charged off, in whole or in part, for regulatory purposes
if the charge-off corresponds to the banks classification of the loans, in whole or in part,
as loss assets under applicable regulatory standards. Although the applicable loan loss
regulatory standards did not require ABC to charge off certain credit card debts, the
conclusive presumption of worthlessness attached to those debts when ABC
erroneously charged off the debts for regulatory purposes.
Under  1.166-2(d)(3)(iv)(D) of the regulations, if an electing bank fails to follow
the conformity method of accounting to determine when debts become worthless, or if
the banks charge-offs are substantially in excess of those warranted by reasonable
business judgment in applying the regulatory standards of the banks supervisory
authority, then the Commissioner may revoke the banks election to use the conformity
method. Under the facts described above, however, except for the erroneously
charged off credit card debts, ABC properly used regulatory loan loss standards to
determine its worthless bad debts and did not claim a deduction on its return for bad
debts substantially in excess of the amount warranted by reasonable business
judgment under the applicable regulatory standards. If the deduction claimed had been
substantially in excess of that amount, the Commissioner could have revoked the
conformity election.
HOLDINGS
1. ABCs charge-offs of certain loans (or portions thereof), pursuant to a board of
directors resolution authorizing the charge-off of a loan (or portion thereof) only if the
charge-off is required under applicable regulatory standards issued by the banks
supervisory authority, are sufficient to demonstrate classification of the loans (or loan
portions) as loss assets for purposes of  1.166-2(d)(3) of the regulations.
2. The conclusive presumption of worthlessness applies to the credit card debts
that ABC erroneously charged off for regulatory purposes during the taxable year
ending on December 31, 2000. ABC, on its 2000 income tax return, properly deducted
the credit card debts as worthless bad debts.
DRAFTING INFORMATION
-5-
The principal author of this revenue ruling is Craig Wojay of the Office of the
Associate Chief Counsel (Financial Institutions and Products). For further information
regarding this revenue ruling, contact Mr. Wojay at (202) 622-3920 (not a toll-free call).
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