Proposed IRS regulations could impact the bad debt conformity election

On December 28, 2023, the IRS issued proposed regulations updating IRC Section 166 (§ 1.166) that provide guidance and clarity for financial institutions and affiliated holding companies regarding whether a debt instrument is worthless or partially worthless for federal income tax purposes.

These proposed regulations allow the use of a new method of accounting for federal tax purposes that is more closely aligned with GAAP’s allowable charge-offs that are taken on an applicable financial statement.

Existing regulations

Prior to the proposed regulations, Section 166 allows a taxpayer to deduct a portion of a partially worthless debt that does not exceed the amount charged off within the taxable year. In determining whether a debt is worthless or partially worthless, the IRS considers all relevant evidence, including the value of any collateral and the financial condition of the debtor. However, the current regulations do not define “worthless.”

Current regulations provide two presumptions on worthlessness for bad debt:

• First, § 1.166–2(d)(1) provides that if a bank or other corporation subject to supervision by federal regulators, or by state regulators with materially equal standards, charges off a debt in whole or in part, either 1) in obedience to the specific orders of such regulators, or 2) in accordance with the established policies of such regulators, then the debt is conclusively presumed to have become worthless, in whole or in part.
• Second, § 1.166–2(d)(3) provides that a bank subject to supervision by federal regulators, or by state regulators maintaining materially equal standards, may elect to use a method of accounting that establishes a conclusive presumption of worthlessness for debts, provided the bank’s supervisory authority has made an express determination that the bank maintains and applies loan loss classification standards that are consistent with the regulatory standards of that supervisory authority.

Both scenarios require regulatory authority, which can prove difficult when trying to utilize charge-offs.   

Proposed regulations

The proposed regulations update the existing guidance that clarifies the worthlessness or partial worthlessness of debt instruments. The proposed regulations revise § 1.166–2(d) to allow financial institutions and holding companies to use the allowance charge-off method for determining the deduction for wholly or partially worthless debt for federal income tax purposes. This allows the specified taxpayers to conclude that charge-offs from the allowance for credit losses of debt instruments subject to section 166 satisfy the requirements for a bad debt deduction under section 166.

Under these proposed regulations, a charge-off is defined as an accounting entry or set of entries for a tax year that reduces the debt’s carrying value and results in a realized loss. Qualified entities that currently have bad debt conformity election in place and want to change to the allowance charge-off method no longer must request an express determination letter from their regulator but must file a 3115 to change the method of accounting.

Change in method of accounting

Under the proposed regulations, a change in the bad debt conformity election will be a change in the method of accounting that requires the taxpayer to file a Form 3115. If an entity wishes to make this change to determine whether debt is wholly or partially worthless, they must file a Form 3115 by the end of the tax year that the change is to be effective.

How Wipfli can help

If you are interested in learning more about these proposed regulations, reach out to our financial institution group. Our team at Wipfli has in-depth, specialized knowledge of the financial institutions industry and can provide proactive tax planning and consultation, compliance and audit assistance. Learn more.