IRS Issues Proposed Regulations on Bad Debt Deductions for Regulated Financial Companies

January 16, 2024
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Key Takeaways

  • Proposed regulations provide guidance to determine if a debt instrument is worthless for federal income tax purposes and standardize the conclusive presumption of worthlessness determination.
  • Because regulated financial companies must adhere to specific accounting standards, the IRS is proposing conformity with financial standards for determining bad debt.
  • Guidance is applicable for regulated financial companies and members of regulated financial groups and may be relied upon for institutions with a tax year ending after December 28, 2023.

The IRS has released proposed regulations on bad debt deductions for regulated financial companies. Although the proposed regulations provide specific guidance, there is still some uncertainty that may be clarified when the final regulations are published.

Financial companies with tax years ending after December 28, 2023, may rely on the proposed regulations.

What are the proposed regulations?

The IRS recently released proposed regulations (REG-121010-17) addressing the worthlessness of debt instruments for federal income tax purposes.

The regulations update the standard used when determining whether a debt is conclusively presumed to be worthless and available for a bad debt tax deduction. This proposed guidance is a product of a process the IRS began in 2013 with Notice 2013-35.

The current regulations do not directly define the term “worthless” as it pertains to bad debts. The IRS may (currently and in the past) consider all pertinent facts and circumstances when determining whether a debt is wholly or partially worthless.

For example, the IRS may consider the financial condition of the debtor and the underlying value of collateral compared to the principal balance of the debt, among other factors.

With no clearly defined benchmark, this analysis often results in the IRS and the taxpayer reaching different conclusions regarding the degree of worthlessness of a debt.

What is the Allowance Charge-off Method?

Alongside providing guidance on a worthless debt deduction, the proposed regulations also provide a new tax method, called the Allowance Charge-off Method, for bad debt of regulated financial companies and members of regulated financial groups (insurance companies and large financial institutions).

The new method allows bad debt charged against the allowance for loan losses on the company’s financial accounting balance sheet (generally accepted accounting principles (GAAP) or statements of statutory accounting principles (SSAP)) to be deductible for federal income tax purposes. This consideration is made because of strict regulatory requirements. These companies must adhere to specific accounting rules and must meet other capital and/or leverage requirements.

The Allowance Charge-off Method is considered a new method separate from existing bad debt accounting methods, meaning Form 3115 is needed for the change. Without a method change, institutions must continue using the same method for determining bad debt, which is generally the specific charge-off method.

What are the next steps?

It is important for banks and other applicable regulated financial companies to discuss these new regulations with their tax advisors and thoroughly analyze the effects of changing the company’s accounting method for bad debt.

These potential changes could have a significant impact on the reporting of bad debt for regulated financial companies.

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About the Author(s)

Paul Sirek

Paul A. Sirek, CPA

Paul's focus is on the financial institutions industry. He provides management consulting, tax planning and tax compliance services to financial institutions ranging in size from less than $50 million to more than $1 billion. He conducts tax research projects, and he assists financial institutions with merger and acquisition issues, including tax structuring of transactions and the regulatory application process. Paul also assists bank holding companies and financial institutions with regulatory filings, including FR Y-9C, FR Y-9LP and FR Y-9SP reports.