Tax Bad-Debt Deductions — Conformity Election Revisited
By Mike Czarnota
Community Bank Advisor, 2007 Winter 

If your bank has not made a conformity election for bad-debt deductions for federal income tax purposes, you may want to consider doing so. If done appropriately, the conformity election should provide a “conclusive presumption of worthlessness” for loans charged off in whole or in part and thereby provide protection to the bank’s tax bad-debt deductions upon audit by the IRS.

Under Treasury Regulation Section 1.166-2(d)(3), a bank subject to supervision by federal authorities, or by state authorities maintaining substantially equivalent standards, may elect to use the conformity method of accounting to determine when a debt becomes worthless. This election is made by filing a 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, so IRS pre-approval is not required.

Under the conformity method, a conclusive presumption of worthlessness exists for loans charged off, in whole or in part, if a bank satisfies an “express determination requirement” and if the bank has classified the loan as a “loss asset” at the time of charge off. The express determination requirement is satisfied if the bank’s supervisory authority, in connection with its most recent examination of the bank’s loan review process, has made an express determination that the bank maintains and applies loan loss classification standards that are consistent with the authority’s regulatory standards. This “express determination letter” must be requested from the regulators each time they conduct an exam. This letter should be maintained on file as the bank is required to provide this letter to the IRS if audited.

The regulations define the term “loss asset” as a debt that the bank has assigned to a class that corresponds to a loss asset classification under the standards set forth in the “Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks” or similar guidance issued by the bank’s regulatory authority. Various procedures can be used by a bank to classify loans as loss assets. The most common method is to adopt a board of directors’ resolution that “authorizes the bank’s officers and employees to charge off loans, in whole or in part, only when the charge off is required under the loan-loss classification standards issued by the bank’s supervisory authorities, with such charge off simultaneously deemed to be a loss asset.” The bank may adopt the resolution as broad as stated above or may be more specific in the categories of authorized officers and/or employees.