Thurs 145-315-accounting methods-am

Accounting Method Issues within the Banking Industry

Brian Mall, CPA Jennifer Sanders, CPADirector, BKD CPAs and Advisors Director, BKD CPAs and Advisors

Patrick Egan Senior Vice President, New York Community Bancorp

Agenda

Accounting method defined

Accounting method change procedures

Accounting method changes in banking• Bad debt conformity

• Nonaccrual loan interest

• OREO costs

• Repair Regulations

• Sec. 475 – mark to market

• Global election for OID

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Accounting Method Defined

Taxable income shall be computed under the method of accounting used in keeping the taxpayer’s books (Code §446)

Consistent treatment of material item involving proper time for inclusion in income or taking a deduction (Reg. §1.446-1)

Overall methods• Cash • Accrual

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Accounting Method Defined

“Consistent Treatment” is treatment of material item the same way on two or more consecutively filed tax returns • Exception for depreciation methods

Two year requirement does not apply if proper method used on first return that reflects the item

Revenue Ruling 90-38

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Accounting Method Changes

Change in accounting method requires IRS consent (Code §446(e))• File Form 3115

• Includes change from nonpermissible to permissible method

• Automatic versus nonautomatic

• May offer audit protection • Generally prevents IRS from raising this issue in prior years

• Generally eliminates FIN 48 reserves and Schedule UTP disclosures

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Sec. 481(a) adjustment generally required• Cumulative catch up adjustment as of the beginning of the year of change

• Positive adjustments – included in income over 4 periods

• Negative adjustments – reduce income in one period

• De minimis rule – under $25,000, include/reduce income in one period

• Cut-off basis versus Sec. 481(a) adjustment

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Items that are not accounting method changes• Permanent differences

• Correction of mathematical or posting errors

• Change in characterization

• Change in facts

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Types of accounting method changes:• Voluntary changes

• Statutorily mandated changes

• Changes under Code §381 transactions

• Involuntary changes (IRS changes method of accounting under exam)

• Unauthorized changes (changing method without IRS consent)

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Nonautomatic changes in method:• Form 3115 is filed in the year of change

• File with IRS National Office

• User fee due with Form 3115 (currently $7,000 plus additional fee for number of entities included in the application per Rev. Proc. 2014-1)

• Consider including approval consent from the IRS to applicable year’s tax return

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Automatic changes in method:• Form 3115 is filed with the return for the year of change

• Copy of Form 3115 is filed with the IRS National Office

• No user fee

• IRS has provided specific guidance on methods which are considered an automatic change (Rev. Proc. 2011-14)

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Scope Limitations for filing Form 3115:• Final year of trade or business

• Previous change for same item (within last 5 years)

• Taxpayer may change method when under IRS examination, with certain exceptions• Request approval from examining agent

• 90 day window (first 90 days of taxable year)

• 120 day window (120 days after conclusion of the exam)

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Accounting Method Changes in Banking

Bad debt conformity

Nonaccrual loan interest

OREO costs

Repair Regulations

Sec. 475 – mark to market

Global election for OID

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Bad Debt Conformity

IRS continues to focus on the deductibility of bad debts and interest considered collectible on nonaccrual loans

Bad debt conformity allows a Bank to use a method of accounting that establishes a conclusive presumption of worthlessness for debt

Debts charged off, in whole or in part, for regulatory purposes during a taxable year are conclusively presumed to have become worthless for tax purposes (Reg. 1.166-2(d))

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Bad Debt Conformity

Election provides certainty on the deductibility of loans classified as loss assets for regulatory purposes

Provides for conformity for charge-offs for book and bad debt deduction for tax (whole or partial charge-offs)

Provides for conformity for charge-off of interest on nonaccrual loans• Exception: subsequent payments received on loans previously classified

as nonaccrual are considered interest for tax purposes first, then principal

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Bad Debt Conformity

Requirements for Election• Must obtain an “Express Determination Letter” from primary federal

regulator annually

• File Form 3115 to adopt the election (automatic change)

• Include a copy of the Express Determination Letter with the Form 3115

• Made on a bank by bank basis

• Election is made on cut-off basis (no Sec. 481(a) adjustment)

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Bad Debt Conformity

Benefits:• Eliminates uncertainty around timing of deductibility of bad debts and

interest on nonaccrual loans

• Future IRS examinations should be more efficient

• S Corporations may want to consider this election to reduce the impact of filing amended returns if the IRS proposes adjustments surrounding bad debts and nonaccrual loans

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Bad Debt Conformity

Benefits:• IRS also challenges timing of deductibility of estimated selling costs for

OREO

• Generally, under GAAP and regulatory requirements, charge-off related to a secured loan is the amount by which the loan balance exceeds the fair value of the collateral, net of estimated selling costs

• Conformity election provides for the deductibility of selling costs at the time of repossession of the property as opposed to when the property is sold

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Bad Debt Conformity

Disadvantages:• Only applies to Banks defined under Code §581, therefore does not apply

to other subsidiaries that originate loans

• Removes flexibility to defer bad debt deductions for partial charge-offs until later years • to create taxable income to utilize NOL and tax credit carrryforwards

• to avoid built in losses treatment after an ownership change under Code §382

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Bad Debt Conformity

Disadvantages:• Regulators may not provide Express Determination Letter annually upon

examination

• If Express Determination Letter is not obtained, election is terminated

• Termination of election requires filing of Form 3115 (automatic change)

• Subsequent re-election requires filing of Form 3115 (non-automatic change)

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Bad Debt Conformity

Is additional guidance from the IRS forthcoming in regard to the deductibility of bad debts?

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Nonaccrual Loan Interest

Regulation §1.451-1(a) requires income to be accrued when all the events have occurred to fix the right to receive the income and the amount can be determined with reasonable accuracy

Applies to accrual basis Banks

Applies if a Bank has not elected Bad Debt Conformity

A Bank may not stop accruing interest for tax purposes because a loan is overdue a certain length of time (e.g. 90 days)

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A Bank must accrue interest on these loans until either:• The loan is worthless under Code §166 and charged-off or

• The interest is deemed uncollectible

• In order to be considered uncollectible, a Bank must substantiate, on a loan by loan basis, taking into account all facts and circumstances, that it has no reasonable expectation of payment

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Compliance with Reg. §1.451-1(a) requires a change in accounting method (automatic change)

The change applies for all of the Bank’s loans

Sec. 481(a) adjustment represents the amount of qualified stated interest on nonaccrual loans outstanding at the beginning of the year of change that should have been accrued under Code §451, but was not accrued

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OREO Costs

Generally, costs to carry property are expensed for GAAP purposes and in the past Banks have deducted these costs when incurred

Upon audit, IRS has required Banks to capitalize direct and indirect costs of carrying the property under Code §263A• Maintenance and repairs

• Utility costs

• Insurance

• Property taxes

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OREO Costs

In response to the IRS’s exam activity, many Banks acquiesced to the issue on audit

Some Banks voluntarily changed their method of accounting to capitalization (non-automatic change)

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OREO Costs

As a result of IRS exam activity, the IRS issued additional guidance• FAA 20123201F

• GLAM 2013-001

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OREO Costs

Field Attorney Advise FAA 20123201F:• Requires direct and indirect costs associated with OREO to be capitalized

• Costs for OREO held for production of rental or investment income are currently deductible

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OREO Costs

GLAM 2013-001 • Discusses application of Code §263A to property acquired by a Bank

through foreclosure

• Facts are limited and only cover examples where the Bank originated the loan for which it foreclosed

• Conclusion: the Bank is not a traditional reseller of property• The Bank acquires the OREO in its capacity as lender and not as a traditional

reseller of property

• The Bank is compelled to acquire the property to recover the funds it originally loaned

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OREO Costs

GLAM 2013-001• When a bank originates loans, those loans are not treated as the

acquisition of property for resale under Code §263A

• Acquisition of the property securing the loan should not convert the bank to a reseller; acquisition of the OREO is an extension of the Bank’s loan origination activity

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OREO Costs

Revenue Procedure 2014-16• IRS officially abandons the capitalization of direct and indirect costs for

carrying OREO

• Allows taxpayers that had previously capitalized costs to currently deduct these costs when incurred through the filing of Form 3115 (automatic change)

• Change in method could have been filed with 2013 returns

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Repair Regulations

Finalized and effective January 1, 2014, although early adoption was permitted

Impacts the timing of a variety of capitalization versus deduction, including:• Capitalized improvements versus deductible repairs

• Capitalizing costs to acquire fixed assets

• Adopting fixed asset expensing/capitalization policy

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Repair Regulations

Change in accounting method is likely required to be filed to comply with the new capitalization policies

Change in accounting method is automatic change

Multiple changes of accounting method may be included on same Form 3115

Sec. 481(a) adjustment will likely be required, could be positive or negative

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Repair Regulations

Formal adoption of fixed asset expensing policy may be required (Reg. 1.263(a)-1(f))• Taxpayers with Applicable Financial Statements (AFS) may follow book

capitalization policy up to $5,000 per item or invoice

• Taxpayers without AFS may have a capitalization policy of $500 per item or invoice

• AFS includes 10K, certified audited financial statements, and financial statements for a federal or state regulatory agency

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Repair Regulations

Election related to fixed asset expensing policy is made on 1/1 of each year

Observation:• The Bank may follow the same capitalization policy for GAAP and tax

purposes

• If the Bank changes its capitalization policy for GAAP mid-year, this policy does not change for tax, which could make for difficult tracking

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Repair Regulations

Revenue Procedure 2014-54 provides additional guidance on dispositions, including late partial disposition election

The late partial disposition election allows a Bank to claim a retirement loss on retired structural components of buildings, as well as components of other assets, that were retired in tax years beginning before January 1, 2012

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Repair Regulations

If a Bank filed a change in accounting method under the proposed or temporary regulations before September 18, 2014, an amended Form 3115 may be filed before December 31, 2014 that encompasses the items noted in this Rev. Proc.

If a Bank filed a change in accounting method under the non-automatic rules before September 18, 2014, and consent has not yet been received, an amended Form 3115 may be filed under the automatic change procedures pursuant to this Rev. Proc.

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Sec. 475 - Mark to Market

If a Bank is considered a “dealer” in securities under Code §475, it is required to use mark to market accounting for these securities (e.g. loans held for sale)

The IRS has provided specific guidance for dealers in commodities and traders of securities and commodities in regard to mark to market accounting (Code §475(e) and (f))

If a Bank makes an election to follow Code §475(e) and (f), then beginning with the first taxable year of the election, mark to market is the only permissible method of accounting

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Sec. 475 – Mark to Market

In order to make an election under Code §475(e) and (f), a Bank must file a statement no later than the due date (without regard to extensions) of the original tax return for the taxable year immediately preceding the election year

Statement must be attached to either the return or request for extension

For example, the election year is 2009, a Bank must file the statement on or before March 15, 2009, with the timely filed return for 2008 or the timely filed extension request

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Election statement to apply Code §475(e) and (f) must include the following information: • Description of election being made

• First taxable year the election is effective and

• Trade of business for which the election is being made (if using Code §475(f), which is a trader in securities and commodities)

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The Form 3115 for the change in accounting method to comply with Code §475(e) and (f) must indicate that the Bank has filed the statement in compliance with Rev. Proc. 99-17 (automatic change)

Sec. 481(a) adjustment may result when filing Form 3115

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In regard to loans held for sale, a Bank is considered a dealer in a securities, not a trader in securities

The IRS has distinguished a dealer from a trader in regard to changing the accounting method to comply with Sec. 475

For a dealer in securities, a change in accounting method to comply with Sec. 475 requires the filing of Form 3115 (non-automatic change)

Sec. 481(a) adjustment may result when filing Form 3115

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§1.1272-3 – The Global Election

Exception to the normal accounting method change rules that require a Form 3115

Applies to debt instruments acquired during the year and identified as part of the Global Election

Continue to apply previous method of accounting in effect for debt instruments acquired in prior years

Therefore, properly made election is a regulatory authorized change in method using a cut-off method

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In contrast to Treas. Reg. 1.446-1(e)(3), Treas. Reg. 1.1272-3 does not state that the Commissioner’s consent is required to make the election — rather Treas. Reg. 1272-3(d) describes the procedures to follow in implementing the election which involve attaching a statement to a timely filed Federal income tax return containing a specifically required declaration.

The election applies to all items of interest (all items constituting “interest” for federal income tax purposes) attributable to the debt instrument. If the Taxpayer fails to include all interest on the debt instrument, the Taxpayer is deemed not to have followed the correct procedures for the election and interest on the new debt is not allowed for the OID inclusion.

Election must include identification of debt instruments, or group of instruments for which election is being made

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Benefit of global election over safe harbor accounting method• Mid-month convention versus proportional method

Disadvantages of global election over safe harbor accounting method• No audit protection• Annual election required

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Other Accounting Method Changes in Banking

Cash basis accounting for S Corporations Bad debt reserve under Code §585 to specific charge-off method

under Code §166 Accrued bonus Accrued self insured employee medical benefits Prepaid expenses Loan costs

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Questions?

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Contact Information

Patrick Egan Senior Vice President, New York Community [email protected]

Brian Mall, CPA Director, BKD CPAs and [email protected]

Jennifer Sanders, CPADirector, BKD CPAs and [email protected]

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Documents

Thurs 145-315-accounting methods-am