The Large Business and International division (LB&I) of the IRS recently issued a directive to its examining agents providing guidance for examining bad debt deductions under Section 166 for banks and bank subsidiaries.

According to the directive, agents should not challenge a bank's bad debt deduction for taxable years 2010 through 2014 if the amount is the same as the credit-related impairment reported in the applicable financial statements. Additionally, the IRS will not challenge the inclusion of certain estimated selling costs in the bank's or bank subsidiaries' bad debt deduction.

To determine their bad debt deduction, and whether debt is worthless, banks may apply the general facts and circumstances test in Treas. Reg. Sec. 1.166-2(a). Alternatively, they may also use one of two special rules provided specifically for banks. The first provides a "conclusive presumption rule" under which worthlessness is generally presumed to occur in the same year that a bank charges off debt in whole or in part pursuant to federal or state bank regulatory rules or pursuant to a specific order by a bank regulator. The second alternative method provides a "conformity election" under which worthlessness is conclusively presumed if a bank's regulator makes an express determination that the bank maintains and applies loan loss classification standards that are consistent with regulatory standards.

The new directive is meant to alleviate controversy by instructing examiners not to challenge bank's bad debt deductions in certain circumstances, pending future guidance. The directive provides that in the case of banks using the general method of Treas. Reg. Sec. 1.166-2(a), agents should not challenge a bank's bad debt deduction for eligible debt and eligible debt securities if the deduction is the same amount as the credit-related impairment portion of its charge-off as reported in its applicable financial statements. Applicable financial statements are defined as either a financial statement that is required to be filed by a bank with the SEC or a financial statement that is required to be provided by a bank to a bank regulator.

In the case of banks using the "conclusive presumption rule," the IRS will not challenge a bank's bad debt deduction for eligible debt and eligible debt securities if the deduction is the same amount as the credit-related impairment portion of its charge-off as reported in its applicable financial statements and the portion of the charge-off in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation by a bank regulator. For those taxpayers who have made the "conformity election," the IRS will not challenge a bank's bad debt deduction for eligible debt if the bank made a property conformity election regardless of whether the express determination requirement is satisfied.

Additionally, the IRS will not challenge the inclusion in the bank bad debt deduction of any estimated selling costs to the extent such estimated selling costs are included in the charge-off reported in the bank's applicable financial statement.

Banks or bank subsidiaries may choose to apply this directive as early as 2010 (and through 2014), as long as it is applied consistently. To implement the directive, taxpayers can amend returns or make the changes in the current taxable year.

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