Source: https://www.bkd.com/article/2017/12/yes-cecl-affects-taxes-too
Timestamp: 2019-04-25 13:02:31+00:00

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By now, most of the banking industry is aware of the Financial Accounting Standards Board’s (FASB) issuance of the current expected credit loss (CECL) standard. The CECL model requires the use of historical, current and forecasted information to estimate expected losses over the life of a loan. While generally accepted accounting principles (GAAP) accounting for CECL has been discussed in numerous previous articles, the tax effect of the related adjustments has received little attention. Understanding the tax effect of CECL’s adjustment to loan losses, capital and the tax treatment of bad debt charge offs in general is essential to help banks avoid surprises and take advantage of tax planning opportunities to mitigate unwelcome results.
A probable consequence of a change to the CECL model is an increase in the allowance for loan losses, which doesn’t directly result in an increase to charge offs. To understand CECL’s tax effect, it’s helpful to understand the tax treatment of the allowance for loan losses and charge offs. In general, an allowance for bad debts isn’t deductible for tax purposes. The deduction is delayed until there’s a charge off. This means when CECL increases a GAAP allowance, it will increase expense and reduce capital without resulting in a corresponding tax deduction. Since the allowance is a timing difference for tax purposes, banks’ deferred tax assets will increase for C corporations. As discussed below, the deferred tax asset and related tax deduction hang on the balance sheet until the debt becomes worthless for tax purposes. Since a tax deduction isn’t available for the allowance, the deduction for charge offs should be increased where possible. Over the years, several methods of accounting for the timing of bad debt worthlessness, i.e., charge offs, have been created for tax purposes.
§582(c), debt securities, e.g., bonds, may result in a tax deduction when only partially worthless, up to the amount of the charge off. Conversely, there isn’t a special rule for equity securities, i.e., stocks, FNMA, FHLMC, etc. Therefore, a deduction isn’t allowed until the security becomes wholly worthless.
Determining when a debt becomes wholly or partially worthless is based on the facts and circumstances and subject to a review of each separate debt. Per Regulation §1.166-2, the IRS “will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor.” It goes on to note that “Legal action not required. Where the surrounding circumstances indicate the debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment...” An indicator of poor financial condition for an unsecured and preferred debt would be bankruptcy of the debtor.
It’s important to note there isn’t an IRC requirement for the IRS to follow charge offs reported for financial or regulatory purposes. Historically, this has resulted in numerous disagreements between the IRS and banks under exam. In an effort to relieve discord, regulations were provided for guidance on what the IRS would accept. Reg. §1.166-2(d)(1) provides that worthlessness is presumed when a loan is charged off in obedience to regulators’ specific orders or in accordance with established policies of such authorities, and upon the first examination after the charge off, the regulators confirm in writing the charge off would’ve been subject to specific orders for a charge off. While this method isn’t commonly used in practice, it’s available.
Reg. §1.166-2(d)(3) provides for a conformity election. This election effectively allows loss deductions for partial and wholly worthless debts to follow GAAP, or more technically, to follow loan loss standards consistent with the bank’s applicable regulatory standards. In addition, it allows for a deduction of estimated selling costs related to loans, if those costs are allowed or required by regulators. This election also requires the bank to obtain an express determination letter from its regulator confirming the regulatory standards were followed in its most recent exam. Accounting for bad debt deductions through the conformity election is a tax method of accounting. Therefore, a change from or to a different method requires filing Form 3115, Application for Change in Accounting Method. This can be beneficial as it allows for a catch-up of deductions in the year of the change and provides audit protection on that specific change.
Banks with $500 million or less in assets may use the reserve method (also called the experience method) to determine their loss deductions under IRC §585. There are two available calculations described in IRC §585(b)(2), and the most beneficial result is applied. Both calculations look back to prior-year reserves, and they generally result in more favorable tax deductions, e.g., smaller tax addbacks, than the methods available to larger banks.
In 2014, the IRS issued a directive to its Large Business & International (LB&I) examiners to provide guidance on how they should treat bad debt deductions through LB&I-04-1014-008. This resulted in yet another alternative method for banks to follow. While the directive isn’t law, it does carry weight since its very purpose is to reduce disagreements between the IRS and banks. The directive, like the conformity election, generally allows for loss deductions for partial and wholly worthless debts to follow those reported for GAAP and regulatory purposes. The LB&I directive, however, doesn’t require the express consent letter or the filing of Form 3115 like the conformity election. The election is made by running the applicable positive or negative tax differences between the bank’s current method and the LB&I directive, e.g., GAAP method, through an original or amended 2010 to 2014 return. This means amending a bank’s 2014 return while it’s still open under the typical three-year statute of limitations could be the last opportunity to apply this option. An election isn’t required to be formally made on a filed return. However, if audited, an examiner could request a completed certification statement, which is provided within the directive in the form of a fillable template. Once adopted, the directive “election” doesn’t appear to be revocable.
As described above, there are multiple tax methods available for determining the amount and timing of bad debt deductions. A simplistic view of CECL’s tax effect would be to take the increase in the allowance and reverse it for tax purposes. While this is necessary to properly model and evaluate CECL’s effect, opportunities to mitigate the unwanted result of a GAAP-only deduction shouldn’t be overlooked. Evaluate the bad debt method being used for tax purposes and open a dialogue with your tax team and/or advisors to determine if the method is one of the “approved” options. If not, the associated risk of IRS adjustments under exam should be weighed.
While these are available regardless of CECL, banks may find themselves searching for extra tax deductions in the year of adopting CECL to help soften the income statement and capital effect and lower the cash outflow to cover income tax. In addition, if tax reform is passed and tax rates are reduced, accelerating these temporary deductions could result in a permanent tax savings. The best advice for truly understanding and mitigating CECL’s tax effect is to start planning as soon as possible.
Contact your trusted BKD advisor with questions or for more information.

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