In a long anticipated directive, LB&I-04-1014-008, the IRS Large Business & International Division told its examiners on October 24 to generally accept bad debt deductions based on charge-off amounts reported by banks and their non-bank subsidiaries for GAAP and regulatory purposes as having "sufficient evidence of worthlessness." This directive also tells examiners not to challenge estimated selling costs that are often included as charge-off amounts when banks take ownership of loan collateral.

Frustrating Situation

Routinely, in a move that has perplexed and frustrated bankers, IRS examiners have been spending considerable time during their exams, reviewing loan files and making their own determination of the worthlessness of loans written off even though those same loans and charge-offs were, in most cases, also reviewed by bank regulators. It was common that IRS examiners would challenge deductions for these charge-offs taken for books and included in regulatory filings. In addition, examiners frequently disallowed charge-offs to the extent they related to estimated selling costs for repossessed property.

Problems Recognized

In the directive, the IRS recognizes the inefficiency and burden on both bankers and the IRS from asking its examiners to determine independently the worthlessness of amounts charged off. The directive clearly sets forth the process by which banks can apply the directive and, when asked by an examining agent, certify to its compliance.

The new exam guidelines change the administration of exams, but do not change the law or regulations relating to bad debt deductions. The directive specifically does not apply to those "small banks" that use the reserve method of accounting for bad debts, though the IRS may address these banks later with a separate directive. Still, many bankers should find this new directive to be good news. In particular, banks currently under exam by the IRS should discuss this directive with their representatives or examiners soon.

Questions Remain

The directive applies to tax years that begin in 2010, but it is not applicable to tax years that begin after December 31, 2014. Therefore, either additional guidance will be necessary, very shortly, to address tax years beginning in 2015 and thereafter, or, bankers will once again be wondering if they should follow the existing current regulations or continue to use the directive.

Please contact your local Eide Bailly tax professional if you have any questions about this new directive, IRS exam activity or other tax matters affecting banks.