IRS Issues New Guidance
by Jeannette Contreraz
Community Bank Advisor, 2007 Summer

Nonaccrual Loan Interest

On May 3, 2007, the IRS issued Revenue Ruling 2007-32, which requires an accrual method bank with a reasonable expectancy of receiving future payments on a loan to accrue interest in the tax year in which the right to receive the interest becomes fixed, even though the bank regulatory rules prevent current accrual of the interest. In general, an accrual method taxpayer is required to recognize accrued interest in the tax year in which all the events have occurred, which fixes the right to receive the interest, and the amount can be determined with reasonable accuracy. However, interest does not have to be accrued if there is no reasonable expectancy of payment. This requirement is on a loan-by-loan basis.

If a bank has made a conformity election with respect to the bad debt deduction for federal income tax purposes, the IRS has concluded that the uncollected accrued interest related to a loan is considered worthless in the year that the loan is charged off for regulatory financial statement purposes. The bank would be entitled to a bad debt deduction in that year for the uncollected accrued interest. In addition, if a subsequent payment is received on the loan, the payment must be characterized as interest for federal income tax purposes. If the bank had deducted the uncollected accrued interest as a bad debt, then the payment would be characterized as a recovery of that bad debt.

Safe Harbor Method

The IRS has determined that substantiation of uncollectible interest on a loan-by-loan basis can be burdensome and impractical. To address this, the IRS has issued Revenue Procedure 2007-33, which provides a procedure under which an accrual method bank can change its method of accounting for uncollected interest to an elective safe harbor method based on the bank’s experience. The safe harbor method applies to banks that use the accrual method of accounting for federal income tax purposes, are subject to supervision by federal or certain state authorities, and have uncollected interest.

Under the safe harbor method, a bank determines for each taxable year the amount of uncollected interest for which it’s considered to have a reasonable expectancy of payment by multiplying the total uncollected accrued interest for the year by the bank’s “recovery percentage” for that year. The bank includes the result in gross income. The bank determines its recovery percentage by dividing the total payments that the bank has received on loans (including principal and interest) during the five taxable years immediately preceding the taxable year by the total amounts that were due and payable to the bank on loans during the same five taxable years.

The change is made by filing Form 3115, Application for Change in Accounting Method, with the bank’s timely filed tax return for the year of change. This is considered an automatic change for banks with more than six years of collection experience.

There are several factors to consider in determining if a change in accounting method should be made. We would be happy to consult with you.