community banktaxworkshopslides

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v

www.banktaxinstitute.com

PRESENTED BY:

Steve Corrie Justin Horst

Security National Bank Pinnacle Bancorp, Inc.

Sioux City, Iowa Omaha, Nebraska

John Cederberg John Cederberg

Lincoln, Nebraska Lincoln, Nebraska

Kevin Sell Kevin Sell

Heiskell MacGillivray & Assoc Heiskell MacGillivray & Assoc

Spokane, Washington Spokane, Washington

Disney Contemporary Hotel Marriott Marquis Hotel

Orlando, Florida San Francisco, CA

November 5, 2014 December 2, 2014

PRESENTED BY:

www.banktaxinstitute.com

Topics

• Notice the absence of the disclaimer this year– The revised Circular 230 Regulation specifically

exempts CPE sessions from “covered opinions”• Generally speaking, the topics are listed more or less

in the order that we believe they are important to cover in the session.– If we don’t finish the entire outline, the attendees

will have the outline as a reference resource.

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2

Developments in the Past Year

• Another quiet year

• No significant legislation

• The significant tax Regulations have been more

general in application; not specifically banking

• The notable “official” publications so far:

– Rev Proc 2014-16

– Regulatory Guidance on tax dividends by S corps

– Regulatory revisions to tax sharing agreements

– An interesting District Ct decision on withholding

penalties

4

Industry Resolution - Bad Debts

• A now three year effort by Fran Mordi, the

community bank tax specialist at the ABA

• Fran was told that LB&I’s goal was to publish the

Directive on the examination of bad debts before

the BTI

• Fran is here to discuss this project with us

5

Industry Resolution - Bad Debts

• Scope of the LB&I Directive

– Technically, binding only on LB&I field examiners

• Includes every bank and thrift examination

• Any institution with over $10 million in assets is

in LB&I’s jurisdiction

– There are “effective dates” in the Directive

• Will have to see whether followed in the field

– No technical effect on Appeals

• Appeals Officers saying individually they will

follow

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3

Tax Accounting for OREO

Holding Period Costs

• The February 2013 GLAM appears to have “settled”

the controversy

– Had become a high profile and emotional issue

with community bankers

• Separate from the direct effect on holding period

costs, the GLAM is important

– Reaffirmation by IRS that OREO is Section

1221(a)(1) property - Ordinary gain and loss

– The concept that foreclosure and OREO is an

extension of the credit function is helpful

7


Holding Period Costs

• Rev Proc 2014-16 Section 3.10

– The automatic change of accounting method from capitalization to the current expense method

• Change number 195

• Scope of the change

– Originate or acquire and hold mortgages

– Acquire the real property collateral through foreclosure or deed in lieu of foreclosure

– Does not apply to truly capital costs

• Send the copy of Form 3115 to Ogden8

Notice 2013-35

• Notice 2013-35 requested public comments to

“inform” a proposed revision of Regulation 1.166-2

• No public movement on the Notice since comments

were due on October 8, 2013

• Appears to be some shift in attitude toward

conformity; more favorable now than when

the Notice was published

• Conformity is more likely to survive and

become more user friendly

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4

Notice 2013-35

• Possible future of conformity

– Would like it to be the default method

– Could extend to the subsidiaries of banks, and perhaps even to the holding company

– Would like to extend the election to securities

– Would like for the EDL letter to be a “standard” report on every federal exam

• Perhaps for state exams as well

– Hope for revisions in the EDL wording to accommodate credit crises like 2007 – 2009

– Hope to resolve the issue of examiner ordered restatements

10

Conformity Election

• Recommendations pending the revision of the

Regulation

– Get the EDL letter at every federal exam

• No downside risk, even if no election is made

– If a Federal Reserve exam, and there are ordered

charge-offs, get their confirmation letter

– If a state examination, and there are ordered

charge-offs, and if the examiners will write a

Federal Reserve like confirmation letter, get it

11

Conformity Election

• We still encourage banks to make the Conformity Election

– Hesitation because of Notice 2013-35

– The only technical gateway to regulatory standards

– Should “bypass” the estimated disposition cost issue

– Smooths the nonaccrual interest issue for accrual method banks

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5

The Conformity Election

• A bank-by-bank election

– Every bank in the C corporation consolidated

group needs to make its own election

• Elections by some banks in a multi-bank

group do not effect the availability of other

banks to make the automatic election later

– The same is true of a multi-bank S corporation/

QSub group

• A “new bank” makes the election in the first

return with bad debt losses – No Form 3115

– More “new banks” than meet the eye13

Conformity Election

• Effect of acquisitions on the election

– Bank continues as a separate bank – no effect

– Bank is merged with acquiing bank

• The larger bank’s method continues

– Bank acquired in an asset transaction –

election terminates

• When is the first election required?

– IRS view is before the election year

– Some CPAs believe during the election year

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• Form 3115

– The “taxpayer” is the holding company

– The “applicant” is the bank

– Must attach a statement declaring that the EDL

requirement has been met

– “ELECTION UNDER section 1.166-2(d)(3)” must be

written in the top margin

– File a copy with the IRS National Office

• May not be required

• No downside risk to filing

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• Attach a power of attorney

– Should be noncontroversial

– The CPA is in a much better position to answer

a question by either the Service Center or the

National Office than the bank

• Check the box “yes” regarding the conference of

right

– Again, if there is a problem with the election,

the CPA wants to have an opportunity to try to

fix it before a rejection letter is sent

16


• When to file

– The manually signed copy of Form 3115 may

be sent to National Office any time after the

first day of the election year and before the

return is filed

– CPA should control the mailing

– The earlier the better

17

Nonaccrued Interest

• Much of the problem seems to be driven by agent

inexperience with Rev Rul 80-361

• The Conformity Election seems to be avoiding

most of the problems

• Banks without the conformity election are having

severe headaches with the IRS

• Principal technical issue for Conformity Election

banks is the tax accounting for interim cash

payments

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7

Nonaccrued Interest - Conformity

• Revenue Ruling 2007-32 controls

– The Revenue Ruling is mandatory; it is not elective

– Conformity with financial reporting

• If nonaccrual for book purposes, also nonaccrual

for tax purposes – no questions should be asked

– Difference from financial accounting

• Financial accounting - not recorded in income

• Tax accounting - included in interest income and

also in charge-offs for bad debt purposes

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• The difference may not “zero out”

– Banks on the reserve method for bad debts

– The addition of the nonaccrued interest to

charge-offs may effect the loss experience ratio

and the amount of the allowable reserve

20


• Interim cash payments

– Rev Rul 2007-32 – recognize interim cash

payments as income up to the accumulated

charge-offs for nonaccrued interest

– However, this must be read in the context of

Rev. Rul. 80-361

– If the reasonably expected cash flow after the

interim payment is not greater than the

income tax basis in the loan, under Rev Rul 80-

361 the payment is not recognized in income

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8

Nonaccrued Interest

No Conformity Election

• This is where the real headaches occur

– Many examiners have never heard of Rev. Rul. 80-

361, or believe that it was revoked by Rev. Rul.

2007-32

– Some examiners do not know that “nonaccrual” is

a “charge-off” for Section 166(a)(2)

• See Rev Rul 2007-32

• Non-conformity banks are on a “facts and

circumstances” basis

– The key is factual development

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Nonaccrued Interest

No Conformity Election• Note that Rev. Rul 80-361 refers to whether

collection of the interest is “reasonably expected”

– If the reasonably expected collection is equal to

the unpaid principal, the loan is properly

nonaccrual without any charge-off on the books

– If there has been a partial charge-off, the

“reasonable collection” is the charged-down

principal, and the loan is properly nonaccrual

23

Nonaccrued Interest


• The IRS examination guide makes several comments

about loans that “require special scrutiny” that do

not appear consistent with Rev. Rul. 80-361

– Examining agents typically interpret “special

scrutiny” as National Office saying that the loans

should be on accrual

• Loans with partial charge-offs

• Loans with sporadic payments

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9

Nonaccrued Interest


– Loans that require “special scrutiny” (cont):

• Loans on nonaccrual because other loans to

the same borrower are in default

• Loans on nonaccrual because of a lapse of

time

–Here is where the conformity election is

very helpful

– The issue in all of these cases is whether the

interest is factually “reasonably expected” to

be collected25

Examiner Ordered Restatements

• If the regulatory examiners order charge-offs to be recognized in prior periods and the call reports restated

• It is not clear in the existing Regulation when the charge-offs are deductible

– In the year of the examination?

– In the prior year which is restated?

• Raised the question in my comment letter on Notice 2013-35

• Report this year of at least one set of amended returns being examined and accepted

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Conformity Method Banks

• Regulation – In the year charged off for regulatory

purposes

• The Treasury Decision – Implies that the deduction is

in the year of the examination

• The conformity method bank should seriously

consider following the regulators and amend returns

– The only year in which the charge-off will appear

in the regulatory books

• Alternative – claim the loss in the year the loan is

wholly worthless27

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• No similar Regulation reference

• The “conclusive presumption” regarding examiner

ordered charge-offs clearly implies that if the

examiners order a restatement for bad debts,

worthlessness is presumed to occur in the earlier

year

– Presumption only in the year ordered

– Presumption only if deducted “at the time of

filing the return for the taxable year in which

the charge-off takes place.”28


• Importance of who requests the restatement

– The Regulation refers only to Regulatory

standards

– No reference to GAAP

– No reference to a factual determination

• Banks not on the conformity method

– When did the loss factually occur?

– The proof issue is present again

29

“Charge-offs”

• Applicable to

– Conformity Election

– Partial Charge-offs

• Removes the Asset from the Books

– Ewald & Co. v Commissioner

– Commissioner v McDonald Engineering

Company

– Revenue Ruling 2007-32

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11

7 Year Statute of Limitations for Bad

Debts

• Seven year statute of limitations on claiming

refunds resulting from late discovered bad debts –

Sec 6511(d)(1)

• Scope

– Bad debts on loans

– Worthless securities

• Note - the statute runs from the original due date

of the return; not the extended due date

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“Charge-offs”

• Specific Reserves

– Regulation 1.166-2(d)(4)(ii)

– FAA 20123002F

– FSA 199912005

– Applicable to Commercial Banks?

– Summary

• Available Only to Absorb Losses on one Loan

32


Unpaid Pre-Foreclosure Costs

• OREO costs incurred by the “borrower” before the

foreclosure; e.g. real estate taxes, utilities

– The borrower’s costs and not deductible by the

bank - Not “incurred” by the bank

– Paid by the bank before the foreclosure

• Added to loan

• Included in the charge-off on the foreclosure

– Paid by the bank after the foreclosure

• Liabilities assumed in the acquisition

• Added to basis in the OREO33

12


Foreclosure Costs

• The bank’s legal costs to foreclose

• The IRS audit guide, and examiners generally,

capitalize the foreclosure costs in the basis of the

OREO as an asset acquisition cost

• The Tax Court in Community Bank v.

Commissioner added foreclosure costs to the loan

for purposes of determining gain or loss on the

foreclosure

• More consistent with standard loan

contracts

34

Charge-offs on Securities

• Whether OTTI adjustments are deductible, or

partially deductible, seems to have died down as an

issue

– LB&I Directive on examination of insurance

company bad debts on securities

– Despite no formal conformity election for

insurance companies, the LB&I directive tells

examiners to follow the books as long as they

conform to SSAP 43R of the National Association

of Insurance Commissioners

35


• How much of the OTTI is deductible?

– The LB&I Directive for the insurance industry

suggests a different result

– SSAP43R used followed by the insurance

industry mirrors the GAAP OTTI accounting

that banks use

• Projected cash collections are present

valued

– The LB&I Directive does not challenge the

present valuation of projected collections

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13


• Is the post OTTI security an accrual asset?

– If the bank does not “present value” the projected collections

• The post-OTTI security is a nonaccrual asset

– If the bank follows the books, then probably an accrual asset if cash flow follows projections

• Changes in projected cash flow

– If projected cash flow decreases, then there should be another charge-off and bad debt

– If projected cash flow increases, then income should be accrued based on new projection

37


• Banks on the reserve method for bad debts on

loans are by definition on the charge-off method

for securities

– The bad debt for securities is always on the

direct charge-off method under Section 166

– Securities are not included in total loans for the

Section 585 experience method

– Losses are not included in charge-offs

• Conformity Election does not include securities

38

Securities or Loans?

• Some assets classified as “securities” on the

books are “loans” for tax purposes

– Regular interests in REMICS are loans

• See PLRs 9423002 and 200439041

– Pass-through mortgage pools are loans

• The investor owns an undivided interest in

the underlying loan assets

–As contrasted with purchasing the debt of

the issuer “collateralized” by the

underlying assets

–Revenue Ruling 84-10 and PLR 942300239

14

Net Investment Income Tax

• Five Year Rule

• Self-Rentals

• Self-Charged Interest

• Active Participation Activities – 500 Hours

– Passed-Through Income is not NII

– Passed-Through Loss is not a Passive

Activity Loss

– Gain on sale is not NII

40


• Significant Participation Activities

– Requires More than One Passive Activity

– Over 100 Hours of Participation

– The Total of All Significant Participation Activities is Over 500 Hours

– Passed Through Income is not NII

– Passed Through Loss is not a Passive Activity Loss

– Gain on Disposition is not NII

41


• Significant Participation Passive Activities

– Over 100 Hours of Participation

– There are not Other Significant Participation

Activities to Bring the Total to 500 Hours

– Passed Through Income is not NII

– Passed Through Loss is a Passive Activity

Loss

– Gain on Disposition is not NII

42

15


• Whether an S corporation is

– An active activity

– A significant participation activity

– A significant participation passive activity, or

– A passive activity

is determined year-by-year based on hours

– No consistency requirement

– May change status every year

• Critical to maintain accurate logs of hours

43


• Other S Corporation NIIT Issues

– Income on Invested Working Capital

– Interest and Dividend Income of the Bank

– Interest income of the BHC

– Dividend income of the BHC

– Rental of Operating OREO

– Rental of Premises

– Gain from mortgage origination and sale

44

Section 336(e)

• Expansion of the Available Asset Transactions

– Buyer may be an Individual, LLC, or

Partnership

– Distributions of Subsidiary Stock to

Shareholders when not a Section 355 Tax

Free Split-up

– Distributions of Subsidiary Stock when

Section 355(d) or (e) Apply

• Protective Elections Against (d) and (e)

45

16

Section 336(e)

• Requirements for Section 336(e) to Apply

– Section 338 would not apply

– Seller, or Distributor, Must be a Corporation or S

Corporation Shareholders

– The Disposition Must be a Qualified Stock

Disposition – at Least 80%

– Taxable Transaction

– Buyer or Distributee Cannot be a Related Party

46

Section 336(e)

• Use When the Buyer is Not a Corporation

• Use to Make Protective Elections if there is a

Likelihood of a Post-Distribution Change of Control

• Does not Affect the Built-in Gain Tax When the Seller

is an S Corporation

• Does not Affect the Double Tax on C Corporation

Sales of Assets & Liquidations

47

Disaffiliation of Failed Banks

• C corporations

– “Disaffiliate” the failed bank and its subsidiaries

from the rest of the group

– Without disaffiliation, the failed bank is still a

member of the consolidated return group and

must file returns

– Disaffiliation relieves the BHC shareholders of

the cost of compliance

• The FDIC is responsible for post filing returns

– Allows the BHC to wind up and liquidate

48

17


• C corp disaffiliation - Regulation 1.597-4(g)

– Election within 120 days of the bank failing

– Done by a registered letter to the FDIC as

receiver of the bank

– Copy of letter and “green card” attached to

return

• Will not cost the FDIC any loss. The insolvent

bank is exempt from tax

49


• S corporations may also “disaffiliate” the failed

bank, but there is no special Regulation to do so

– Revoke the QSub election

– S corporation holding company files a

statement with the IRS Service Center

• An S corporation may “disaffiliate” the failed bank

retroactive to before it fails

– Can revoke retroactively up to two months and

15 days

50


• An S corporation holding company should also

probably revoke its S election

– Should not do so until after the QSub election

for the bank is revoked

• Otherwise creates a new C corporation

consolidated return group

– Should do so before there is any discharge of

debt income

51

18

Bad Debts of Failed Banks

• If a failed bank is examined the by IRS, the most

difficult problem is recovering the documentation to

purport the bad debt deductions

– Without the loan files, the failed bank is unable

too support that it incurred any bad debt losses

– Bishop v. Commissioner

• Failure is not an orderly process

– Files, and papers in files, become lost

52

Bad Debts of Failed & Failing Banks

• Recommendation

– Have a bank in danger of failing at a minimum

• All of the loan files on which there have been charge-offs during any open year, and

• All of the securities files on which there have been OTTI adjustments or disposition losses in any open year

scanned to a disk and store the copy off-site

– If the bank has already failed:

• Locate the loan files and try to get whomever has them to provide a digital copy

53

Tax Sharing Agreements

• Who is entitled to the tax refunds when a bank fails?

– Typically, such banks have large net operating

losses which can be carried back for refunds of

previously paid taxes

– If a parent holding company exists, the refund is

issued by the IRS to the holding company, not the

bank

54

19


• For federal tax purposes, the parent of a

consolidated group receives refunds from the IRS in

its capacity as “agent” for the group members (Reg

§1.1502-77(a))

• Under state corporate law, the members are free to

allocate among themselves the tax payments and

refunds by agreement (In Re Bob Richards Chrysler-

Plymouth Corp)

55


• However, in 1998, regulators issued the

Interagency Policy Statement that required all

insured banks to maintain a Tax Sharing

Agreement that was supposed to address how

banks and their parent holding companies

agreed to return refunds

56


• In recent years, several bankruptcy court

challenges have emerged to question who is

entitled to retain such tax refunds

– In the 9th Circuit, in FDIC v Siegel, the court held

that the holding company could keep the refunds

under the Tax Sharing agreement in place

– In Zucker, the 11th Circuit ruled the refunds

belonged to the FDIC

57

20


• During 2014, in FDIC v AmFin Financial Corp,

the 6th Circuit found that the TSA never

addressed who was entitled to refunds, and

required the district court to look at the

parties intentions under Ohio state law

• Conclusion: Tax sharing agreements did not

provide the FDIC with adequate legal grounds

to take all tax refunds

58


• On June 19, 2014 the FDIC issued FIL-30-2014 which provided an addendum to the 1998 Interagency Policy Statement

– Applies to all FDIC insured banks

– Requires all institutions to modify their tax sharing agreements by October 31, 2014

– Requires TSA’s include language that:

• A Parent is acting as an agent for the bank

• The TSA cannot indicate that refunds belong to the parent

59

S Corporations

Discharge of Debt

• The insolvency exclusion is not elective

• Insolvency is determined at the corporate level.

[Section 108(d)(7)(A)]

– If insolvency exceeds amount discharged

• All is excluded [Sec. 108(a)(1)(C)]

– Insolvency is less than the amount discharged

• The excess discharged is included in S

corporation operating income

60

21

S Corporations

Discharge of Debt

• The S corporation may elect to reduce basis in

depreciable assets first. (Section 108(b)(5))

• Not helpful because the depreciable property will

have been sold by the Receiver

– Recall that reductions are as of the beginning of

the following year.

• The election, if made, is done by completing Form

982 and attaching it to the return

61

S Corporations

Discharge of Debt

• The excluded discharge income reduces tax attributes in the following order:

– The S corporation’s income tax basis in depreciable assets if the 108(b)(5) election is made

– The shareholders’ "excess losses" passed through from the S corporation & suspended because they exceed bases

• Allocated proportionate to each shareholders’ suspended losses to the aggregate suspended losses of shareholders’ with losses

• Not pro-rata per share

62

S Corporations

Discharge of Debt

• Reduction of Tax Attributes (cont)

– The shareholders’ general business credits from

the S corporation carried forward

• Allocated like losses carried forward.

– The shareholders’ capital losses carried over.

• Also allocated like excess losses

63

22

S Corporations

Discharge of Debt

• Reduction of tax attributes (cont)

– The reduction shifts to the S corporation,

reducing tax basis in assets

• First, real property, other than Section

1221(a)(1) real property; i.e. OREO

• Second, tangible personal property other

than inventory, accounts receivable, and

notes receivable; i.e. loans.

•

64

S Corporations

Discharge of Debt• Reduction of tax attributes of the corporation:

– Third, remaining property used in a trade or

business or held for investment, other than

inventory, accounts receivable, notes receivable,

and section 1221(a)(1) real property

– Fourth, inventory, accounts receivable, notes

receivable, and section 1221(1) real property

– Fifth, property not used in the business nor held

for investment

65

S Corporations

Discharge of Debt

• Reduction of tax attributes (cont)

– Then the allocation shifts back to the

shareholders.

• The shareholders’ passive activity losses and

passive activity credits carried forward.

–Allocated like the excess losses

– Any remaining balance is disregarded

66

23

S Corporations

Restrictions on Dividends

• By statute, an FDIC insured institution may not pay a

dividend if, after payment of the dividend, the

institution would be undercapitalized pursuant to the

agencies prompt corrective action regulations.

– See 12 USC §1831o(d)(1)(A)

• Moreover, poorly rated banks or subject to written

supervisory actions are generally barred from paying

any dividends

67

S Corporations


• New Basel III capital rules will be effective for all

banks effective 1/1/15

• The effect of such rules is to generally increase

the amount of capital banks must maintain by

creating a “capital conservation buffer”

– Restricts dividends of “adequately capitalized”

or even “well capitalized” (if less than 0.5%

above thresholds) banks

68

S Corporations


• The restrictions are phased in over next 3

years

• Dividend restrictions begin at 60 percent of

income for well capitalized banks, and then

are reduced to 40%, 20% and finally 0% for

low risk based capitalized banks

69

24

S Corporations


• However, in 12 CFR 324.11(a)(4)(iv) the new Basel III

rules provide the ability for banks to request

exceptions to the buffer restrictions to allow

shareholders to pay taxes on the flow thru income

from the bank

• On July 21, 2014 the FDIC issued FIL-40-2014, which

describes how they will consider such requests

70

S Corporations


• The FIL lists the following factors it will

consider for each request:

– Is the dividend more than 40% of net income

– Is the dividend necessary for the shareholders to

pay income taxes

– Is the bank a 1 or 2 rated bank and not subject to

a written supervisory directive

– Will the bank continue to be “adequately

capitalized after the dividend?

71

Tangible Asset Regulations

• “Everybody” has written and analyzed

these final regulations

• Applicable Financial Statements

– The most material “take away” for banks

– Definition (c) is financial statements filed with

a government agency other than the IRS

– All banks and thrifts have “applicable financial

statements” because of the Call Reports

– Bank holding companies have “applicable

financial statements” because of the FR Y-9

72

25


• “Safe harbors” for expensing di minimis asset

purchases

– Increased to $5,000 per invoice, providing:

• The business has applicable financial statements

• There is a written financial policy

• Books conform

– New $500 “safe harbor” for companies without

“applicable financial statements”

– Note – the safe harbor is per invoice, not per

activity as in the Section 263(a) regulations for

expensing di minimis M & A costs73


• Final Regulations retain the “unit of

property” concept for buildings

– If a component is removed and disposed of, a

loss is allowed for the undepreciated cost of

the component

– The cost of removing the component is also

expensed

– The replacement, and cost of installation, is

capitalized

74

Investments by Self-Directed IRA

Accounts

• Prohibited transactions

– Investment in the same closely held business

by an individual and the individual’s IRA

account

• Advisory Opinion 2000-10A

• Advisory Opinion 2006-9A

– Investment in a closely held entity of the

beneficiary and members of the beneficiary’s

family own over 50% of the entity

75

26


Accounts

• Possible Prohibited Transactions

– Investment in a closely held business if:

• The beneficiary is an officer, director, or

highly compensated employee

• A member of the beneficiary’s family is an

officer, director, or highly compensated

employee.

• The beneficiary is a service provider to other

IRAs invested in the same entity

76


Accounts

• The Department of Labor places great emphasis on

contemporaneous written opinions of ERISA Counsel

on IRA investments in closely held entities

• Ellis v. Commissioner

– The purchase of a 98% interest in an LLC by a self-

directed IRA account became a prohibited

transaction

• Ellis was paid compensation

• Ellis and his family were co-investors through

another controlled LLC77


Accounts

• Peek & Fecht v. Commissioner

– Guaranteeing loans to a company owned by

the IRA accounts was a prohibited transaction

• IRS memorandum

– Investments by a newly established prof-it

sharing plan in stock of the plan sponsor may

be a prohibited transaction

78

27

Failure to Deposit Penalties

• Bank’s trust department deposited all of its

withholding taxes imtely and in full

• Failed to deposit by electronic transfer

– Regulation 31.6302-1(h)(2)(ii)

• IRS assessed a $253,000 “failure to deposit

penalty”

• Bank claimed there wasn’t a failure to

deposit, just a failure to pay electronically

• District Court sided with the IRS

79

Prepaid Expenses – Accrual Basis

Taxpayers

• Deduction of prepaid expenses by accrual basis

taxpayers under Reg. 1.263(a)-4(f)

• IRS’ attempt to control the accelerated deduction

of prepaid expenses

– A detailed analysis of prepaid expenses

– Applies the “recurring item exception”

principles of Section 461(h)(3)(A)

• Must be immaterial

• Must be a clear reflection of income – The

matching principle

80

Prepaid Expenses – Accrual Basis

Taxpayers

• Ruling analyzes two specific prepaids

– Prepaid lease rents

– Prepaid service contracts

• Ruling holds that financial accounting is not

“dispositive” but reading the ruling, it sure is

influential

– If not “material” it shouldn’t be capitalized as a

prepaid

– If capitalization and amortization is not a more clear

reflection of income, it should be expensed

• A change to conform is automatic 81

28

“Modification” of Charged-off Loan• If the modified loan has been the subject of a

partial charge-off, then there is a “deemed charge-off” in the modification calculation

– Reg 1.166-3(a)(3)

– Deemed charge-off is the lesser of

• The gain that would otherwise be recognized, or

• The greater of

–The FMV of the modified debt, or

–The amount recorded on the books

– Effect is to prevent “recovery” of the partial charge-off in the modification

82

“Modification” of Charged-off Loan

Example of a deemed charge-off

Assume that

• The outstanding principal amount is $350,000

• The bank recorded a $100,000 charge-off, resulting in

book value of $250,000

• The accrued interest of $18,750 has not been

recognized in income

• The loan is modified to $300,000 principal, interest at

4.5%, payable $18,750 accrued interest at closing,

and 16 equal semi-annual installments of principal

and interest of $22,535 each

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Example of deemed charge-off

“Proceeds” – issue price of new loan

Payment at closing $ 18,750

Stated principal of new loan 300,000

318,750

Basis in the old loan (250,000)

(i) Gain recognized $ 68,750

Gain is $18,750 nonaccrued interest

$50,000 modified principal over BV

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29


Example of deemed charge-off (cont)

(ii) Tax basis in the new loan $318,750

Fair market value of new loan 318,750

Excess tax basis $ 0

(iii) Tax basis in the new loan $318,750

Book value of new loan 268,750

Excess tax basis $ 50,000

Deemed charge-off – lesser of (i)

and the greater of (ii) or (iii) $ 50,000

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Example of deemed charge-off (cont)

• The bank recognizes the $18,750 nonaccrued

interest collected at closing for both book and tax

purposes

• For financial reporting purposes, the bank will:

– Recognize interest income at 4.5% beginning @

$250,000

– Recognize the $50,000 recovery when collected

– Recognize the $19,704 difference in interest after

the principal is collected in full

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• Example of deemed charge-off (cont)

– For tax purposes, the bank will:

• Recognize interest income at 4.5% beginning @ $300,000

• Recognize the $50,000 recovery between $250,000 and $300,000 when collected

– Schedule M-3 Adjustments

• Increase book income by $68,750

• Decrease interest income by $18,750

• Increase bad debt expense by $50,000 deemed charge-off

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30

Trust Preferred SecuritiesDeferred Interest Payments

• Not customarily treated as OID obligations when issued

– The issuer’s option to defer interest payments was treated as a “remote” contingency

• Become OID obligations when the interest is first deferred – deemed retired and reissued

– Not a modification under the Sec 1.1001-3 Reg

88


• The accrued interest becomes OID rather than stated interest

– “Nonaccrual” does not apply to OID

– The holder must recognize the income even though not received

– The issuer may deduct the expense even though not paid [Sec 163(e)]

89


• OID that is not collectible should be charged-off

as a bad debt under Sec. 166(a)(2) and (b)

– Recognized OID is added to basis in the asset –

Regulation 1.1272-1(g)

– The “nonaccrual” status of the asset for book

purposes is a “charge-off” for purposes of

meeting the Section 166 test for a partial bad

debt deduction - Rev Rul 2007-32

• The issuer will have discharge of debt income if

the recognized OID is never paid

90

31


• Once an OID obligation, the security remains an

OID obligation even if the interest is later paid

currently

• Change the information report to Form 1099-OID

91

Thank You for Attending the

20th Annual Community Bank Tax

Workshop

Questions?

92

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