bti e-11-6-accounting-methods

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Accounting Method Issues within the Banking Industry

Gary G. Genenbacher, CPA Jennifer M. Sanders, CPAPartner, BKD CPAs and Advisors Director, BKD CPAs and Advisors

Patrick Egan Senior Vice President, New York Community Bancorp

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Agenda Accounting method defined

Accounting method change procedures

Accounting method changes in banking

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Accounting Method Defined

Taxable income shall be computed under the method of accounting used in keeping the taxpayer’s books (Code §446)

Consistent treatment of material item involving proper time for inclusion in income or taking a deduction (Reg. §1.446-1)

Overall methods• Cash • Accrual

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Accounting Method Defined

“Consistent Treatment” is treatment of material item the same way on two or more consecutively filed tax returns • Exception for depreciation methods

Two year requirement does not apply if proper method used on first return that reflects the item

Revenue Ruling 90-38

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Accounting Method Changes

Change in accounting method requires IRS consent (Code §446(e))• File Form 3115

• Includes change from non-permissible to permissible method

• Automatic versus non-automatic

• May offer audit protection • Generally prevents IRS from raising this issue in prior years

• Generally eliminates FIN 48 reserves and Schedule UTP disclosures

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Sec. 481(a) adjustment generally required• Cumulative catch up adjustment as of the beginning of the year of change

• Positive adjustments – included in income over 4 periods

• Negative adjustments – reduce income in one period

• De minimis rule – under $50,000, include/reduce income in one period

• Cut-off basis versus Sec. 481(a) adjustment

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Items that are not accounting method changes• Permanent differences

• Correction of mathematical or posting errors

• Change in characterization

• Change in facts

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Types of accounting method changes:• Voluntary changes

• Statutorily mandated changes

• Changes under Code §381 transactions

• Involuntary changes (IRS changes method of accounting under exam)

• Unauthorized changes (changing method without IRS consent)

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Non-automatic changes in method:• Form 3115 is filed in the year of change

• File with IRS National Office

• User fee due with Form 3115 (currently $8,600 plus additional fee for number of entities included in the application per Rev. Proc. 2015-1)

• Consider including approval consent from the IRS to applicable year’s tax return

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Automatic changes in method:• Form 3115 is filed with the return for the year of change

• Copy of Form 3115 is filed with the IRS National Office

• No user fee

• IRS has provided specific guidance on methods which are considered an automatic change (Rev. Proc. 2011-14)

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Rev. Proc. 2015 -13 Changes the rules for the manner and timing of filing of forms 3115, Application for Change in Accounting Method, for certain taxpayers

Effective for accounting method change applications filed on or after 1/16/15, for a year of change ending on or after 5/31/14

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Rev. Proc. 2015 -13• Taxpayer not under examination

• No significant changes for filing of form 3115

• Under the de minimis exception, a taxpayer may elect a one‐year Section 481(a) spread period for a positive adjustment that is less than $50,000 (previously was $25,000)

• Taxpayer may elect to use a one‐year Section 481(a) spread period if it engages in an eligible acquisition transaction.

– Once this election is made, it is irrevocable


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Rev. Proc. 2015 -13• Taxpayer under examination

• Sec. 481(a) adjustment spread period for a positive adjustment is two years (previously was four)

– Sec. 481(a) adjustment spread period remains four years under the following exceptions:– Change in accounting method is filed in the window period

– Current method is not before the director

– Change is filed on behalf of a new member of a consolidated group in CAP


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• Audit protection is granted in only certain circumstances– During a new three‐month window period (changed from 90 day window to 3

month window)

– During a 120‐day window period

– If the taxpayer is a new member of a consolidated group in the CAP program

– If the present method is not before exam because the impermissible item arose in a year after the years under exam

– If the change results in a negative adjustment for the year of change and all years in exam

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• “Springing audit protection”– For taxpayers under exam who do not fall under one of the exceptions described

above, and thus who do not receive audit protection at the time of filing a method change, there is the possibility of obtaining audit protection at a later date under the new rules

– The new rule would grant audit protection on the date that the exam closes if no adjustment related to the item was proposed and the item is not an issue under consideration in another year under exam

– As with the old rules, taxpayer filing a method change while under exam must provide a copy of the original form 3115 to the examining agent no later than the date the taxpayer timely files the form 3115

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Rev. Proc. 2015 -13• Other General Provisions

• All forms 3115 are now filed with the IRS in Ogden, Utah; the forms are no longer sent to the IRS National office in Washington DC

• Changes in accounting method that are now automatic that were previously advance consent (or non‐automatic) common in banking

– If re‐electing bad debt conformity after it was previously revoked

– Sec. 475, mark to market accounting

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Accounting Method Changes in Banking

Bad debt conformity

Nonaccrual loan interest

OREO costs

Prepaid expenses

Repair Regulations

Sec. 475 – mark to market

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Bad Debt Conformity

IRS continues to focus on the deductibility of bad debts and interest considered collectible on nonaccrual loans

Bad debt conformity allows a Bank to use a method of accounting that establishes a conclusive presumption of worthlessness for debt

Debts charged off, in whole or in part, for regulatory purposes during a taxable year are conclusively presumed to have become worthless for tax purposes (Reg. 1.166-2(d))

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Bad Debt Conformity

Election provides certainty on the deductibility of loans classified as loss assets for regulatory purposes

Provides for conformity for charge-offs for book and bad debt deduction for tax (whole or partial charge-offs)

Provides for conformity for charge-off of interest on nonaccrual loans• Exception: subsequent payments received on loans previously classified

as nonaccrual are considered interest for tax purposes first, then principal

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Bad Debt Conformity

Requirements for Election – Change #6• Must obtain an “Express Determination Letter - EDL” from primary federal

regulator annually – must have EDL as of beginning of year of change

• File Form 3115 to adopt the election (automatic change)

• Include a copy of the Express Determination Letter with the Form 3115

• Made on a bank by bank basis

• Election is made on cut-off basis (no Sec. 481(a) adjustment)

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Bad Debt Conformity

Benefits:• Eliminates uncertainty around timing of deductibility of bad debts and

interest on nonaccrual loans

• Future IRS examinations should be more efficient

• S Corporations may want to consider this election to reduce the impact of filing amended returns if the IRS proposes adjustments surrounding bad debts and nonaccrual loans

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Bad Debt Conformity

Benefits:• IRS also challenges timing of deductibility of estimated selling costs for

OREO

• Generally, under GAAP and regulatory requirements, charge-off related to a secured loan is the amount by which the loan balance exceeds the fair value of the collateral, net of estimated selling costs

• Conformity election provides for the deductibility of selling costs at the time of repossession of the property as opposed to when the property is sold

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Bad Debt Conformity

Disadvantages:• Only applies to Banks defined under Code §581, therefore does not apply

to other subsidiaries that originate loans

• Removes flexibility to defer bad debt deductions for partial charge-offs until later years • to create taxable income to utilize NOL and tax credit carrryforwards

• to avoid built in losses treatment after an ownership change under Code §382

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Bad Debt Conformity

Disadvantages:• Regulators may not provide Express Determination Letter annually upon

examination

• If Express Determination Letter is not obtained, election is terminated

• Termination of election requires filing of Form 3115 (automatic change)

• Subsequent re-election requires filing of Form 3115 (now automatic change)

• New change #211 – previous election automatically revoked

• Meets the express determination requirements

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Bad Debt Conformity

IRS Development – LB&I 04-1014-008• Bad Debt Directive

• Issued October 24, 2014

• Quote from the directive…“this directive provides an administrative resolution generally based on accepting charge‐off amounts reported by banks and bank subsidiaries for GAAP and regulatory purposes as evidence of worthlessness”

• Directive to examiners to not challenge deductibility of bad debts– Bad debt deductions that do not reduce tax basis below book basis

– Inclusion of estimated selling costs in bad debt deduction

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Bad Debt Conformity

IRS Development – LB&I 04-1014-008• Bad Debt Directive

• Applies to banks and bank subsidiaries that deduct bad debts under §166 (on an entity by entity basis)

• Excludes small banks (average assets under $500M) that use the bad debt reserve method

• Requires execution of Certification Statement within the Directive

• If relying on the Directive, it must be provided to the examining agent within 30 days of the request by the examining agent

• Effective tax years 2010‐2014– If elect for tax years 2010‐2014, taxpayer must apply consistently going forward

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Nonaccrual Loan Interest

Regulation §1.451-1(a) requires income to be accrued when all the events have occurred to fix the right to receive the income and the amount can be determined with reasonable accuracy

Applies to accrual basis Banks

Applies if a Bank has not elected Bad Debt Conformity

A Bank may not stop accruing interest for tax purposes because a loan is overdue a certain length of time (e.g. 90 days)

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A Bank must accrue interest on these loans until either:• The loan is worthless under Code §166 and charged-off or

• The interest is deemed uncollectible

• In order to be considered uncollectible, a Bank must substantiate, on a loan by loan basis, taking into account all facts and circumstances, that it has no reasonable expectation of payment

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Compliance with Reg. §1.451-1(a) requires a change in accounting method (automatic change #36)

The change applies for all of the Bank’s loans

Sec. 481(a) adjustment represents the amount of qualified stated interest on nonaccrual loans outstanding at the beginning of the year of change that should have been accrued under Code §451, but was not accrued

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OREO Costs

Generally, costs to carry property are expensed for GAAP purposes and in the past Banks have deducted these costs when incurred

Upon audit, IRS has required Banks to capitalize direct and indirect costs of carrying the property under Code §263A• Maintenance and repairs

• Utility costs

• Insurance

• Property taxes

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OREO Costs

In response to the IRS’s exam activity, many Banks acquiesced to the issue on audit

Some Banks voluntarily changed their method of accounting to capitalization (non-automatic change)

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OREO Costs

As a result of IRS exam activity, the IRS issued additional guidance• FAA 20123201F

• GLAM 2013-001

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OREO Costs

Field Attorney Advise FAA 20123201F:• Requires direct and indirect costs associated with OREO to be capitalized

• Costs for OREO held for production of rental or investment income are currently deductible

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OREO Costs

GLAM 2013-001 • Discusses application of Code §263A to property acquired by a Bank

through foreclosure

• Facts are limited and only cover examples where the Bank originated the loan for which it foreclosed

• Conclusion: the Bank is not a traditional reseller of property• The Bank acquires the OREO in its capacity as lender and not as a traditional

reseller of property

• The Bank is compelled to acquire the property to recover the funds it originally loaned

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OREO Costs

GLAM 2013-001• When a bank originates loans, those loans are not treated as the

acquisition of property for resale under Code §263A

• Acquisition of the property securing the loan should not convert the bank to a reseller; acquisition of the OREO is an extension of the Bank’s loan origination activity

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OREO Costs

Revenue Procedure 2014-16• IRS officially abandons the capitalization of direct and indirect costs for

carrying OREO

• Allows taxpayers that had previously capitalized costs to currently deduct these costs when incurred through the filing of Form 3115 (automatic change)

• Change in method could have been filed with 2013 returns – Change #195

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Prepaid Expenses

Background – IRS position under Rev. Proc. 2012-1• Service liability versus payment liability

• Generally applies to maintenance contracts

• Certain contracts are both service and payment liability

• 3 ½ month rule for prepayment of services

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Prepaid Expenses

Rev. Proc. 2015-39• Effective for taxable years ending on or after July 30, 2015

• Ratable service contract • Taxpayer must treat economic performance as occurring on a ratable

basis over the term of the service contract

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Prepaid Expenses

Rev. Proc. 2015-39

• Ratable service contract defined• The contract provides for similar services to be provided on a regular basis, such as daily, weekly, or monthly,

• Each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service is not dependent on the receipt of any previous or subsequent occurrence of the service, and

• The term of the contract does not exceed 12 months (contract renewal provisions will not be considered in determining whether a contract exceeds 12 months)

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Prepaid Expenses

Rev. Proc. 2015-39

• Ratable service contract • Recurring item exception applies

– Assuming taxpayer files a tax return 8 1/2 months after year end, taxpayer may deduct 8 ½ months of that prepaid contract on that tax return

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Prepaid Expenses

Rev. Proc. 2015-39

• Ratable service contract • If a single contract includes services that satisfy the requirements of a ratable service contract and services (or other items) that do not satisfy the requirements of a ratable service contract, the services (or other items) that do not satisfy the requirements of a ratable service contract must be separately priced in the contract for the contract to qualify as a Ratable Service Contract (and be eligible for the accelerated deduction).

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Repair Regulations

Finalized and effective January 1, 2014, although early adoption was permitted

Impacts the timing of a variety of capitalization versus deduction, including:• Capitalized improvements versus deductible repairs

• Capitalizing costs to acquire fixed assets

• Adopting fixed asset expensing/capitalization policy

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Repair Regulations

Change in accounting method is likely required to be filed to comply with the new capitalization policies

Change in accounting method is automatic change

Multiple changes of accounting method may be included on same Form 3115

Sec. 481(a) adjustment will likely be required, could be positive or negative

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Repair Regulations

Formal adoption of fixed asset expensing policy may be required (Reg. 1.263(a)-1(f))• Taxpayers with Applicable Financial Statements (AFS) may follow book

capitalization policy up to $5,000 per item or invoice

• Taxpayers without AFS may have a capitalization policy of $500 per item or invoice

• AFS includes 10K, certified audited financial statements, and financial statements for a federal or state regulatory agency

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Repair Regulations

Election related to fixed asset expensing policy is made on 1/1 of each year

Observation:• The Bank may follow the same capitalization policy for GAAP and tax

purposes

• If the Bank changes its capitalization policy for GAAP mid-year, this policy does not change for tax, which could make for difficult tracking

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Repair Regulations

Revenue Procedure 2014-54 provides additional guidance on dispositions, including late partial disposition election

The late partial disposition election allows a Bank to claim a retirement loss on retired structural components of buildings, as well as components of other assets, that were retired in tax years beginning before January 1, 2012

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Repair Regulations

If a Bank filed a change in accounting method under the proposed or temporary regulations before September 18, 2014, an amended Form 3115 may be filed before December 31, 2014 that encompasses the items noted in this Rev. Proc.

If a Bank filed a change in accounting method under the non-automatic rules before September 18, 2014, and consent has not yet been received, an amended Form 3115 may be filed under the automatic change procedures pursuant to this Rev. Proc.

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Repair Regulations

Simplified procedures for Small Business Taxpayers Taxpayer may rely on simplified procedures for first taxable year beginning in 2014

Taxpayer administrative burden is eased

Taxpayer applies repair regulations prospectively

Taxpayer does not file form 3115 and does not compute Sec. 481(a) adjustment

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Repair Regulations

Simplified procedures for Small Business Taxpayers Applies to each separate and distinct trade or business for which taxpayer

maintains separate set of books If taxpayer has more than one separate and distinct trade or business, taxpayer can choose the

simplified procedure for the trades or businesses that meet the criteria; therefore taxpayer may apply the procedure to some of its trade or business but not to others

Taxpayer may apply this procedure for each trade of business that meets one or both of the following criteria: Total assets of less than $10 million as of end of the tax year, or Average annual gross receipts of $10 million or less for the prior three taxable years

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Repair Regulations

Simplified procedures for Small Business Taxpayers Considerations of relying on this procedure

No audit protection for the trade or business for amounts paid or incurred in taxable year beginning before January 1, 2014

If taxpayer decides to change its accounting method in a later taxable year by filing form 3115 and calculating a Sec. 481(a) adjustment, the Sec. 481(a) adjustment is calculated by taking into account only amounts paid or incurred, and dispositions, in taxable years beginning in 2014

IRS recommended a statement be included with the return indicating that the qualifying trade or business is utilizing this procedure

If taxpayer is not filing a form 3115 and is not following this procedure, IRS recommended a statement be included with the return indicating that the qualifying trade or business is not utilizing this procedure

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Sec. 475 – Mark to Market

If a Bank is considered a “dealer” in securities under Code §475, it is required to use mark to market accounting for these securities (e.g. loans held for sale)

The IRS has provided specific guidance for dealers in commodities and traders of securities and commodities in regard to mark to market accounting (Code §475(e) and (f))

If a Bank makes an election to follow Code §475(e) and (f), then beginning with the first taxable year of the election, mark to market is the only permissible method of accounting

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In order to make an election under Code §475(e) and (f), a Bank must file a statement no later than the due date (without regard to extensions) of the original tax return for the taxable year immediately preceding the election year

Statement must be attached to either the return or request for extension

For example, the election year is 2009, a Bank must file the statement on or before March 15, 2009, with the timely filed return for 2008 or the timely filed extension request

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Election statement to apply Code §475(e) and (f) must include the following information: • Description of election being made

• First taxable year the election is effective and

• Trade of business for which the election is being made (if using Code §475(f), which is a trader in securities and commodities)

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In regard to loans held for sale, a Bank is considered a dealer in a securities, not a trader in securities

The IRS has distinguished a dealer from a trader in regard to changing the accounting method to comply with Sec. 475

For a dealer in securities, a change in accounting method to comply with Sec. 475 requires the filing of Form 3115 (non-automatic change)

Sec. 481(a) adjustment may result when filing Form 3115

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Overall Cash Basis – S Corporation

• Change #127 – Overall Cash Basis – S Corp (automatic)– Bank as Defined Under §581– S corporation as Defined in §1361(a)(1) or

QSSS §1361(b)(3)(B)– Average annual gross receipts not in excess

of $50,000,000

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Electing Off Reserve Method

• Change #66 – Elect Off Reserve Method– Accelerate income– Four year spread for positive adjustment– Utilization of tax attributes

• NOLs• Tax credits• Income at bank – tax benefit payments to holding company

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Electing Off Reserve Method

• Change #66 – Elect Off Reserve Method– Last C corporation year– Take entire income in C Year– Elect off reserve several years before an S election

• Spread over multiple years• Recapture first year of S can be offset by charge offs for purposes of built – in – gains tax

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Thrift – Sale of Assets

• Thrift sale of assets• No longer in banking• Old thrift reserve subject to taxation• No deferred income tax provided for this future income

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Fixed Asset – Wrong LifeE

• Change #7 – Impermissible to Permissible– Client prepared schedule– Previous accountant’s schedule– Reverse cost segregation– Banking assets with 7 or 39 year classifications– Negative 481 adjustment – 1 year spread

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Mortgage Servicing Rights

• #76 – Automatic if Under Examination– Facts – not deferring – If not under examination – nonautomatic change

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• Costs related to covered transaction under Reg. 1.263(a)-5

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Electing Off Reserve MethodFixed Asset – Wrong LifeFixed Asset – Wrong Life

Merger/Acquisition Costs

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Questions?

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Contact Information

Gary G. Genenbacher, CPAPartner, BKD CPA’s and [email protected]

Jennifer M. Sanders, CPADirector, BKD CPA’s and [email protected]

Patrick Egan Senior Vice President, New York Community [email protected]

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