Proposed Regulations to Update Bad Debt Deductions Under IRC Section 166
March 5, 2024
On December 28, 2023, the Internal Revenue Service (IRS) released proposed regulations to IRC Section 166 to provide guidance on when debts could be conclusively presumed to be wholly or partially worthless. The proposed regulations will provide an option for regulated financial companies and members of regulated financial groups to use a new method of accounting for federal tax purposes that will align the allowable bad debt deductions to GAAP (book) charge-offs. An eligible company will generally be able to conclusively presume that charge-offs of debt instruments reported on their applicable financial statements will satisfy the IRC Section 166 requirements for the bad debt deduction. Companies like bank holding companies, banks, insurance companies, and certain affiliates are examples of the eligible entities listed as regulated financial companies under the proposed guidelines for Section 166.
The new regulations update the existing guidance, providing clarity on the determination of worthlessness of the debt instrument and expanding the taxpayers that will be eligible to apply the method. The new regulations, however, do not change the treatment for entities that are not included as part of the regulated financial company definition. These companies will continue to utilize IRC Section 165 to determine allowable loss deductions on debt securities.
Internal Revenue Code Section 166 Background
Section 166 of the Internal Revenue Code (IRC) and the associated regulations provide the timing and allowable amount of the tax deduction for a wholly or partially worthless debt instrument. The current regulations provide two scenarios for conclusive presumptions of worthlessness for bad debts for banks and certain other regulated entities. However, those scenarios both require a regulatory order of the charge-offs, which makes each of these scenario criteria difficult to utilize. In addition, the term worthless is not defined in Section 166 or its regulations. Absent the “bad debt conformity election” and obtaining an “express determination letter” from the financial institution’s primary regulator, the conclusive presumption of worthlessness is generally based on facts and circumstances. The facts and circumstances to determine a wholly or partially worthless debt include the value of the underlying collateral securing the debt and the debtor’s financial state.
A number of industry directives have been used to reduce the administrative burden to taxpayers and to provide clarity on the application of the conclusive presumption determination. Treasury, for example, established the “bad debt conformity election” in the Section 166 regulations to provide a conclusive presumption of worthlessness for loans. As noted above, however, to comply with the election, the taxpayer must secure an express determination letter from its primary regulator each exam cycle.
What Will Change If These Regulations Are Finalized?
The proposed regulations would create an Allowance Charge-off Method for determining the tax bad deduction for wholly or partially worthless debt instruments of eligible entities. The method would allow taxpayers to conclusively presume that charge-offs of debt instruments reported in their applicable financial statements are considered worthless for purposes of IRC Section 166. Entities eligible to adopt the new method include a regulated financial company or a member of a regulated financial company group – primarily banking and insurance companies. The proposed regulations include a definition of a regulated financial company, and these companies will be permitted to adopt the new Allowance Charge-off Method. Not included in the definition of eligible entities are credit unions or U.S. branches of foreign banks, specifically.
Another change prompted by the proposed regulations applies to entities that currently have a book conformity election in place. Should these entities request to change their current federal tax accounting method to the new Allowance Charge-off Method, they will no longer have to request the express determination letter from their primary regulator. This change will reduce the administrative burden of requesting and tracking express determination letters that are currently required under the book conformity election.
Important Points to Remember
The proposed regulations, if finalized and adopted by a taxpayer, would generally apply to charge-offs reported in a taxpayer’s applicable financial statements for tax years ending on or after the date the final regulations are published. Early adoption is available for taxpayers who adopt the new method and choose to apply the final regulations to charge-offs reported in a taxpayer’s applicable financial statements that occur in tax years ending on or after December 28, 2023.
The proposed Allowance Charge-off Method is considered a method of accounting, and therefore, taxpayers wishing to change to this method would file a Form 3115, Application for Change in Method of Accounting, with the IRS to adopt the new method.
Let Us Be Your Guide
At Cherry Bekaert, our focus remains on strategic insights and adaptability to assist our clients as they navigate evolving industry and tax law changes. Our Financial Services professionals can assist qualified financial services companies to evaluate and adopt the new tax accounting method proposed under IRC Section 166 regulations.