Nonaccrual Loan Interest  
By Mike Czarnota
Community Bank Advisor, 2008 Winter

On May 3, 2007, the IRS issued Revenue Ruling 2007-32 which requires an accrual method bank with 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 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 that fix the right to receive the interest, and if 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 amount 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.

Should You Make the Conformity Election?

The decision to make the conformity election should not be based on the treatment of one item; however, the benefit of making this election cannot be ignored.

Historically, the conformity election was a tool used (by both the taxpayer and the Internal Revenue Service) to help reduce the cost of complying with the tax law (in the IRS’s case, the cost of enforcing the tax law by reducing its cost to audit). It did this by attempting to eliminate any uncertainty inherent in the bad debt rules of the Internal Revenue Code, and leveraging the Federal Regulators review and oversight of the banking industry. It basically states that if the bank’s charge offs (including “partial” charge off for tax purposes) are “in conformity” with the regulatory guidelines, then the IRS will not challenge that charge off.

This new guidance from the IRS again leverages the regulatory nature of the banking industry to solve this long-standing, controversial issue. It also forces each bank to re-evaluate the conformity election and weigh its benefits.