Internal Revenue Service Provides Guidance on Non-accrual Loans

Kentucky Banker Magazine, Aug 2007

Crowe Chizek and Company LLC

In recent years, the 1RS has put considerable focus on the tax treatment of non-accrual loan interest income. In fact, for banks under examination by the 1RS, this has become a frequent area of contention and frustration. Last month, the 1RS released additional guidance (in Revenue Ruling 2007-32) stating its position on the tax treatment of non-accrual loan interest income. The 1RS also published procedures (in Revenue Procedure 2007-33) for banks to adopt a "safe harbor" method for accounting for non-accrual loan interest income for tax purposes. Whether or not this guidance will eliminate all contention between the 1RS and banks is yet to be seen, but it does provide some insight into the thought process the 1RS employs in examining the issue.

Regulatory Rules

Before jumping right into the tax issues, we will start with an overview of the federal banking rules that generally apply to non-accrual loan interest income. For regulatory financial statement (i.e., book) purposes, unless a loan is both well secured and in the process of collection, federal banking rules generally require that a bank suspend the recognition of income on a loan (and reverse any previously recognized uncollected interest income) if:

* The loan is maintained on a cash basis because of deterioration in the borrower's financial condition;

* Payment, in full, of principal or interest is not expected; or

* Payment of principal or interest has been in default for a period of 90 days or more.

For many banks, the last item listed above (i.e., in default for 90 days or more) will be the typical trigger for putting the loan on non-accrual status for regulatory/book purposes. As such, the bank will stop recording interest income on the loan and will also reverse, from book income, the accrued interest receivable on the loan. Once put on non-accrual status, any subsequent payments received from the borrower will generally be applied to the principal on the loan, unless otherwise provided for in the loan agreement. The bank would then resume recording interest income on the loan when principal payments are current and the non-accrual loan receivable is considered to be fully collectible.

IRS Tax Position

One thing is for certain: Regulatory accounting rules are not controlling for tax purposes. As a general rule, for accrual basis taxpayers, non-accrual loan interest income is taxable as it is earned over the period of the loan. When continued payment of a loan becomes questionable and it is determined that there is not a reasonable expectancy of payment, then accrual of the interest income may be discontinued for tax purposes. However, accrual may not be discontinued if there is merely a delay in payment or if the debtor is encountering temporary financial difficulties. There must be substantial evidence that there is no reasonable expectancy of payment (i.e., that the loan or interest income is uncollectible).

Banks use various methodologies for assessing whether or not interest income on non-accrual loans will be collected. For loans deemed uncollectible, no interest income is recorded for tax purposes, resulting in book-tax conformity. However, if payments on the loans are collected at a later time, the 1RS will view the payments as interest income for tax purposes (to the extent of any accrued, but uncollected, interest on the loans), even though for regulatory/book purposes the payment (or a portion thereof) may be treated as a reduction in the principal balance of the loans. For loans that are determined to be collectible for tax purposes, banks must track the book-tax difference on the income recognition of these loans, since the taxable income is being recognized currently, while the book income may not be recognized until a later year (or maybe not at all). This creates a record-keeping burden.

The determination that interest income is uncollectible, even if based upon a well-documented analysis, can still be challenged by the 1RS, and in many cases it is. So how can a bank minimize its audit exposure and the amount of time and resources that can potentially be spent contesting the issue upon examination? Based on recently published guidance, the 1RS provides two options as discussed below.

Conformity Election

Banks subject to supervision by federal banking authorities (or comparable state authorities) are permitted to use a conformity method of accounting to determine when a loan becomes worthless, and thus deductible, for tax purposes. Under the conformity election, loans that are charged off, in whole or in part, for regulatory purposes are conclusively presumed to become worthless for tax purposes at the time of the regulatory charge off. As such, the bank is allowed a bad debt deduction for the taxable year in which the loan is conclusively presumed to have become worthless.

For a bank with a conformity election in place, the presumption of worthlessness can also be applied to interest income on non-accrual loans. When the accrual of interest is discontinued for regulatory/book purposes, and the loan put on non-accrual status, the accrued interest income is presumed to be worthless for tax purposes and is treated as a bad debt. As such, the interest income is not included in taxable income (or book income), resulting in book-tax conformity.