On December 28, 2023, the IRS issued a Notice of Proposed Rulemaking (REG-121010-17) to expand existing income tax regulations under Section 1.166-2. According to the proposed regulations, it would update standards for determining when a debt instrument held by a regulated financial company or a member of a regulated financial group will be conclusively presumed to be worthless for federal income tax purposes. The proposed rules provide for the “Allowance Charge-off Method,” which conclusively presumes that charge offs from the allowance for credit losses of debt instruments under §166 satisfy the requirements for a bad debt deduction.
Regulated financial companies or members of a regulated financial group may rely on the proposed regulations in taxable years ending on or after December 28, 2023 and before the final regulations are eventually published.
Most recently, the IRS set forth Revenue Procedure (Rev. Proc.) 2024-30 to establish procedures to elect the Allowance Charge-off Method under §446 and §1.446-1(e). Specifically, the procedure modifies Rev. Proc. 2024-23 (containing the list of automatic changes) and provides automatic consent procedures to change methods of accounting.
According to the revenue procedure, the method change is made on a cutoff basis and only applies to charge offs that occur on or after the beginning of the year of change. Therefore, a §481(a) adjustment is not warranted. Any charge offs occurring prior to the year of change are treated under the taxpayer's former method of accounting. A deduction may not be taken under the new method of accounting for any amount already deducted under the former method of accounting. Taxpayers that previously made a conformity election under §1.166-2(d)(3) are treated as having revoked the election if the method of accounting is changed. The designated automatic accounting method change number is “272.” For banks with less than $500 million in assets that are utilizing the §585 reserve for losses method, a change must be performed under the nonautomatic procedures when changing from the §585 reserve method to the Allowance Charge-off Method.
While the release of the proposed regulations and the revenue procedure provide applicable taxpayers guidance for moving forward with the method change, there are still outstanding questions that observers and commentators of the regulations are hoping to receive further clarification on. Such observations include the following:
- Section 1.166-2(d)(1)(i) defines a charge off as “from the allowance for credit losses,” seeming to exclude specific or direct charge offs reflected outside of the allowance.
- For taxpayers utilizing the current conformity election for bad debt deductions, Revenue Ruling 2007-32 provides an extension of regulatory conformity to the recognition of nonaccrual interest income for income tax purposes. The proposed regulations require a taxpayer to revoke the conformity election, assumably revoking the favorable and timesaving method for nonaccrual interest income as well.
- Section 1.166-2(d)(4)(iii) defines a regulated financial group to mean “one or more chains of corporations,” apparently excluding subsidiaries commonly used in financial service organizations such as partnerships, real estate investment trusts (REITs), or regulated investment companies (RICs). For taxpayers with these subsidiaries, this would introduce multiple tax methods among the subsidiaries and may create additional compliance burdens of maintaining two tax methods.
- While the proposed regulations expand the applicability to certain additional corporations within a regulated financial group, U.S. branches of foreign banks are explicitly excluded from adopting the proposed method.
Due to these lingering questions and concerns, taxpayers should first consider relevant issues to their organizations before quickly adopting a method change. If you have questions or need assistance concerning the income tax treatment of bad debt and the recent IRS guidance, please reach out to one of our professionals at Forvis Mazars.