January 12, 2024

Updated July 19, 2024

In brief

What happened? 

Update: Rev. Proc. 2024-30, issued on July 2, 2024, allows regulated financial companies and members of regulated financial groups (excluding banks using the Section 585 reserve method) to use automatic procedures to change to the Allowance Charge-off Method set forth in the proposed regulations. This automatic method change would apply on a cut-off basis to charge-offs occurring in tax years ending on or after December 28, 2023. Taxpayers changing their method to the Allowance Charge-off Method are treated as revoking a prior conformity election.

Treasury and the IRS recently issued proposed regulations under Section 166 that would provide guidance regarding whether a debt instrument is conclusively presumed to be worthless for Federal income tax purposes for eligible entities, primarily banks and insurance companies. Under the proposed rules, regulated financial companies and members of regulated financial groups would have the option to use a new method of accounting for Federal income tax purposes that generally follows book charge-offs for recognizing tax losses from partially worthless or wholly worthless debts.

Why is it relevant?  

The proposed regulations would update the “book conformity method” currently applicable to banks for determining when a debt instrument is conclusively presumed to be worthless. If finalized, banks, as well as other regulated financial companies or members of a regulated financial group, would be allowed to account for worthless debts using the Allowance Charge-off Method, which generally would allow these taxpayers to conclusively presume that charge-offs of debt instruments reported on their financial statements satisfy the Section 166 requirements for a bad debt deduction. The proposed regulations, if adopted, generally would apply to charge-offs made by a regulated financial company or a member of a regulated financial group on its applicable financial statement (AFS) that occur in tax years ending on or after the date that final regulations are published in the Federal Register, although these taxpayers may choose to apply the final regulations to charge-offs made on its AFS that occur in tax years ending on or after December 28, 2023, and before the date of publication of final regulations.

Actions to consider

As proposed, these rules appear to require nearly all taxpayers operating in the banking and insurance industries wishing to secure a conclusive presumption of worthlessness of debt instruments to file a request to change to the Allowance Charge-off Method with the IRS National Office. Affected entities should consider submitting comments by February 26, 2024.

Observation: Under Rev. Proc. 2024-30, eligible entities may use the automatic procedures to file a method change. Eligible entities under continuous IRS exam may wish to file method changes in their next window period – July 15 to October 15 for calendar-year taxpayers – in order to secure audit protection for possible exposures with their prior conformity method.

New conclusive presumption rules 

Citing sufficiently similar standards for regulatory, accounting, and Federal income tax purposes, Treasury and the IRS have proposed rules on the conclusive presumption of worthlessness under Section 166 for eligible financial companies. Similar to recent legislative and regulatory provisions that use applicable financial statement (AFS) amounts to determine tax treatment, the proposed regulations generally would allow these taxpayers to rely on their AFS in determining their deductions for losses from partially or wholly worthless debts.

The proposed regulations provide that debt held by an eligible financial company would be conclusively presumed to be worthless, in whole or in part, to the extent that the amount of any charge-off determined under a new method, the Allowance Charge-off Method, is claimed as a Section 166 deduction for the tax year in which the charge-off takes place. Under the proposed regulations, a charge-off is defined as an accounting entry or set of accounting entries for a tax year that reduces the basis of the debt when the debt is recorded in whole or in part as a loss asset on the AFS. For a regulated insurance company whose AFS is its annual statement, the proposed regulations would define the term charge-off as an accounting entry or set of accounting entries that reduces the debt's carrying value and results in a realized loss or a charge to the statement of operations (as opposed to recognition of unrealized loss) in the annual statement. The proposed regulations also would provide relief for taxpayers claiming bad debt deductions in years subsequent to the year of charge-off.

Observation: Stakeholders should consider submitting comment letters and consider addressing the charge-off definition in the proposed regulations. The definition set forth in the proposed regulations appears to retain the loss asset classification requirement in the current regulations, but the “loss asset” definition has been dropped.  Because a “loss asset” is a banking regulatory concept, it is unclear how retention of the term might impact the application of the conclusive presumption of worthlessness to non-bank entities. For example, some IRS examination teams have used loss asset classification documentation as a means to rebut the Conclusive Presumption Regulations, making it difficult for taxpayers seeking certainty and reduced controversy burdens.

Observation: Foreign insurance companies that elect to be treated as domestic insurance companies under Section 953(d) would not be included in the definition of a regulated insurance company (see below) under the proposed regulations. Such companies are not required by their local regulator to prepare financial statements in accordance with the National Association of Insurance Commissioners (NAIC) standards. However, Subchapter L generally requires that the NAIC statutory accounting principles must be followed in determining taxable income.

Method change

Under the proposed regulations, a change to the Allowance Charge-off Method is a change in method of accounting that requires IRS consent. Upon promulgation of final rules, the preamble to the proposed regulations states that eligible financial companies would be required to use the Allowance Charge-off Method in order to secure a conclusive presumption of worthlessness; otherwise, these taxpayers would not be entitled to a conclusive presumption of worthlessness and would be required to use the specific charge-off method – i.e., facts and circumstances to determine worthlessness – for deducting bad debts.

Observation: Rev. Proc. 2024-30 modifies Rev. Proc. 2024-23 to provide a new automatic change in method of accounting to the Allowance Charge-off Method for charge-offs made by a regulated financial company or a member of a regulated financial group on its applicable financial statement that occur in tax years ending on or after December 28, 2023. Accordingly, these entities may change to the Allowance Charge-off Method using the automatic method change procedures by attaching Form 3115 with their timely filed 2023 federal income tax returns. Under Rev. Proc. 2024-30, this method change is made on a cut-off basis, and no Section 481(a) adjustment is permitted; charge-offs that occurred prior to the year of change must be accounted for under the taxpayer's former method of accounting. The limitation on using the automatic procedures to change a method of accounting for an item more than once in five tax years is waived for the taxpayer's first or second tax year ending on or after December 28, 2023.