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Transcript of Community banktaxworkshopslides
1
v
www.banktaxinstitute.com
PRESENTED BY:
Steve Corrie Justin Horst
Security National Bank Pinnacle Bancorp, Inc.
Sioux City, Iowa Omaha, Nebraska
John Cederberg John Cederberg
Lincoln, Nebraska Lincoln, Nebraska
Kevin Sell Kevin Sell
Heiskell MacGillivray & Assoc Heiskell MacGillivray & Assoc
Spokane, Washington Spokane, Washington
Disney Contemporary Hotel Marriott Marquis Hotel
Orlando, Florida San Francisco, CA
November 5, 2014 December 2, 2014
PRESENTED BY:
www.banktaxinstitute.com
Topics
• Notice the absence of the disclaimer this year– The revised Circular 230 Regulation specifically
exempts CPE sessions from “covered opinions”• Generally speaking, the topics are listed more or less
in the order that we believe they are important to cover in the session.– If we don’t finish the entire outline, the attendees
will have the outline as a reference resource.
3
2
Developments in the Past Year
• Another quiet year
• No significant legislation
• The significant tax Regulations have been more
general in application; not specifically banking
• The notable “official” publications so far:
– Rev Proc 2014-16
– Regulatory Guidance on tax dividends by S corps
– Regulatory revisions to tax sharing agreements
– An interesting District Ct decision on withholding
penalties
4
Industry Resolution - Bad Debts
• A now three year effort by Fran Mordi, the
community bank tax specialist at the ABA
• Fran was told that LB&I’s goal was to publish the
Directive on the examination of bad debts before
the BTI
• Fran is here to discuss this project with us
5
Industry Resolution - Bad Debts
• Scope of the LB&I Directive
– Technically, binding only on LB&I field examiners
• Includes every bank and thrift examination
• Any institution with over $10 million in assets is
in LB&I’s jurisdiction
– There are “effective dates” in the Directive
• Will have to see whether followed in the field
– No technical effect on Appeals
• Appeals Officers saying individually they will
follow
6
3
Tax Accounting for OREO
Holding Period Costs
• The February 2013 GLAM appears to have “settled”
the controversy
– Had become a high profile and emotional issue
with community bankers
• Separate from the direct effect on holding period
costs, the GLAM is important
– Reaffirmation by IRS that OREO is Section
1221(a)(1) property - Ordinary gain and loss
– The concept that foreclosure and OREO is an
extension of the credit function is helpful
7
Tax Accounting for OREO
Holding Period Costs
• Rev Proc 2014-16 Section 3.10
– The automatic change of accounting method from capitalization to the current expense method
• Change number 195
• Scope of the change
– Originate or acquire and hold mortgages
– Acquire the real property collateral through foreclosure or deed in lieu of foreclosure
– Does not apply to truly capital costs
• Send the copy of Form 3115 to Ogden8
Notice 2013-35
• Notice 2013-35 requested public comments to
“inform” a proposed revision of Regulation 1.166-2
• No public movement on the Notice since comments
were due on October 8, 2013
• Appears to be some shift in attitude toward
conformity; more favorable now than when
the Notice was published
• Conformity is more likely to survive and
become more user friendly
9
4
Notice 2013-35
• Possible future of conformity
– Would like it to be the default method
– Could extend to the subsidiaries of banks, and perhaps even to the holding company
– Would like to extend the election to securities
– Would like for the EDL letter to be a “standard” report on every federal exam
• Perhaps for state exams as well
– Hope for revisions in the EDL wording to accommodate credit crises like 2007 – 2009
– Hope to resolve the issue of examiner ordered restatements
10
Conformity Election
• Recommendations pending the revision of the
Regulation
– Get the EDL letter at every federal exam
• No downside risk, even if no election is made
– If a Federal Reserve exam, and there are ordered
charge-offs, get their confirmation letter
– If a state examination, and there are ordered
charge-offs, and if the examiners will write a
Federal Reserve like confirmation letter, get it
11
Conformity Election
• We still encourage banks to make the Conformity Election
– Hesitation because of Notice 2013-35
– The only technical gateway to regulatory standards
– Should “bypass” the estimated disposition cost issue
– Smooths the nonaccrual interest issue for accrual method banks
12
5
The Conformity Election
• A bank-by-bank election
– Every bank in the C corporation consolidated
group needs to make its own election
• Elections by some banks in a multi-bank
group do not effect the availability of other
banks to make the automatic election later
– The same is true of a multi-bank S corporation/
QSub group
• A “new bank” makes the election in the first
return with bad debt losses – No Form 3115
– More “new banks” than meet the eye13
Conformity Election
• Effect of acquisitions on the election
– Bank continues as a separate bank – no effect
– Bank is merged with acquiing bank
• The larger bank’s method continues
– Bank acquired in an asset transaction –
election terminates
• When is the first election required?
– IRS view is before the election year
– Some CPAs believe during the election year
14
The Conformity Election
• Form 3115
– The “taxpayer” is the holding company
– The “applicant” is the bank
– Must attach a statement declaring that the EDL
requirement has been met
– “ELECTION UNDER section 1.166-2(d)(3)” must be
written in the top margin
– File a copy with the IRS National Office
• May not be required
• No downside risk to filing
15
6
The Conformity Election
• Attach a power of attorney
– Should be noncontroversial
– The CPA is in a much better position to answer
a question by either the Service Center or the
National Office than the bank
• Check the box “yes” regarding the conference of
right
– Again, if there is a problem with the election,
the CPA wants to have an opportunity to try to
fix it before a rejection letter is sent
16
The Conformity Election
• When to file
– The manually signed copy of Form 3115 may
be sent to National Office any time after the
first day of the election year and before the
return is filed
– CPA should control the mailing
– The earlier the better
17
Nonaccrued Interest
• Much of the problem seems to be driven by agent
inexperience with Rev Rul 80-361
• The Conformity Election seems to be avoiding
most of the problems
• Banks without the conformity election are having
severe headaches with the IRS
• Principal technical issue for Conformity Election
banks is the tax accounting for interim cash
payments
18
7
Nonaccrued Interest - Conformity
• Revenue Ruling 2007-32 controls
– The Revenue Ruling is mandatory; it is not elective
– Conformity with financial reporting
• If nonaccrual for book purposes, also nonaccrual
for tax purposes – no questions should be asked
– Difference from financial accounting
• Financial accounting - not recorded in income
• Tax accounting - included in interest income and
also in charge-offs for bad debt purposes
19
Nonaccrued Interest - Conformity
• The difference may not “zero out”
– Banks on the reserve method for bad debts
– The addition of the nonaccrued interest to
charge-offs may effect the loss experience ratio
and the amount of the allowable reserve
20
Nonaccrued Interest - Conformity
• Interim cash payments
– Rev Rul 2007-32 – recognize interim cash
payments as income up to the accumulated
charge-offs for nonaccrued interest
– However, this must be read in the context of
Rev. Rul. 80-361
– If the reasonably expected cash flow after the
interim payment is not greater than the
income tax basis in the loan, under Rev Rul 80-
361 the payment is not recognized in income
21
8
Nonaccrued Interest
No Conformity Election
• This is where the real headaches occur
– Many examiners have never heard of Rev. Rul. 80-
361, or believe that it was revoked by Rev. Rul.
2007-32
– Some examiners do not know that “nonaccrual” is
a “charge-off” for Section 166(a)(2)
• See Rev Rul 2007-32
• Non-conformity banks are on a “facts and
circumstances” basis
– The key is factual development
22
Nonaccrued Interest
No Conformity Election• Note that Rev. Rul 80-361 refers to whether
collection of the interest is “reasonably expected”
– If the reasonably expected collection is equal to
the unpaid principal, the loan is properly
nonaccrual without any charge-off on the books
– If there has been a partial charge-off, the
“reasonable collection” is the charged-down
principal, and the loan is properly nonaccrual
23
Nonaccrued Interest
No Conformity Election
• The IRS examination guide makes several comments
about loans that “require special scrutiny” that do
not appear consistent with Rev. Rul. 80-361
– Examining agents typically interpret “special
scrutiny” as National Office saying that the loans
should be on accrual
• Loans with partial charge-offs
• Loans with sporadic payments
24
9
Nonaccrued Interest
No Conformity Election
– Loans that require “special scrutiny” (cont):
• Loans on nonaccrual because other loans to
the same borrower are in default
• Loans on nonaccrual because of a lapse of
time
–Here is where the conformity election is
very helpful
– The issue in all of these cases is whether the
interest is factually “reasonably expected” to
be collected25
Examiner Ordered Restatements
• If the regulatory examiners order charge-offs to be recognized in prior periods and the call reports restated
• It is not clear in the existing Regulation when the charge-offs are deductible
– In the year of the examination?
– In the prior year which is restated?
• Raised the question in my comment letter on Notice 2013-35
• Report this year of at least one set of amended returns being examined and accepted
26
Examiner Ordered Restatements
Conformity Method Banks
• Regulation – In the year charged off for regulatory
purposes
• The Treasury Decision – Implies that the deduction is
in the year of the examination
• The conformity method bank should seriously
consider following the regulators and amend returns
– The only year in which the charge-off will appear
in the regulatory books
• Alternative – claim the loss in the year the loan is
wholly worthless27
10
Examiner Ordered Restatements
No Conformity Election
• No similar Regulation reference
• The “conclusive presumption” regarding examiner
ordered charge-offs clearly implies that if the
examiners order a restatement for bad debts,
worthlessness is presumed to occur in the earlier
year
– Presumption only in the year ordered
– Presumption only if deducted “at the time of
filing the return for the taxable year in which
the charge-off takes place.”28
Examiner Ordered Restatements
• Importance of who requests the restatement
– The Regulation refers only to Regulatory
standards
– No reference to GAAP
– No reference to a factual determination
• Banks not on the conformity method
– When did the loss factually occur?
– The proof issue is present again
29
“Charge-offs”
• Applicable to
– Conformity Election
– Partial Charge-offs
• Removes the Asset from the Books
– Ewald & Co. v Commissioner
– Commissioner v McDonald Engineering
Company
– Revenue Ruling 2007-32
30
11
7 Year Statute of Limitations for Bad
Debts
• Seven year statute of limitations on claiming
refunds resulting from late discovered bad debts –
Sec 6511(d)(1)
• Scope
– Bad debts on loans
– Worthless securities
• Note - the statute runs from the original due date
of the return; not the extended due date
31
“Charge-offs”
• Specific Reserves
– Regulation 1.166-2(d)(4)(ii)
– FAA 20123002F
– FSA 199912005
– Applicable to Commercial Banks?
– Summary
• Available Only to Absorb Losses on one Loan
32
Tax Accounting for OREO
Unpaid Pre-Foreclosure Costs
• OREO costs incurred by the “borrower” before the
foreclosure; e.g. real estate taxes, utilities
– The borrower’s costs and not deductible by the
bank - Not “incurred” by the bank
– Paid by the bank before the foreclosure
• Added to loan
• Included in the charge-off on the foreclosure
– Paid by the bank after the foreclosure
• Liabilities assumed in the acquisition
• Added to basis in the OREO33
12
Tax Accounting for OREO
Foreclosure Costs
• The bank’s legal costs to foreclose
• The IRS audit guide, and examiners generally,
capitalize the foreclosure costs in the basis of the
OREO as an asset acquisition cost
• The Tax Court in Community Bank v.
Commissioner added foreclosure costs to the loan
for purposes of determining gain or loss on the
foreclosure
• More consistent with standard loan
contracts
34
Charge-offs on Securities
• Whether OTTI adjustments are deductible, or
partially deductible, seems to have died down as an
issue
– LB&I Directive on examination of insurance
company bad debts on securities
– Despite no formal conformity election for
insurance companies, the LB&I directive tells
examiners to follow the books as long as they
conform to SSAP 43R of the National Association
of Insurance Commissioners
35
Charge-offs on Securities
• How much of the OTTI is deductible?
– The LB&I Directive for the insurance industry
suggests a different result
– SSAP43R used followed by the insurance
industry mirrors the GAAP OTTI accounting
that banks use
• Projected cash collections are present
valued
– The LB&I Directive does not challenge the
present valuation of projected collections
36
13
Charge-offs on Securities
• Is the post OTTI security an accrual asset?
– If the bank does not “present value” the projected collections
• The post-OTTI security is a nonaccrual asset
– If the bank follows the books, then probably an accrual asset if cash flow follows projections
• Changes in projected cash flow
– If projected cash flow decreases, then there should be another charge-off and bad debt
– If projected cash flow increases, then income should be accrued based on new projection
37
Charge-offs on Securities
• Banks on the reserve method for bad debts on
loans are by definition on the charge-off method
for securities
– The bad debt for securities is always on the
direct charge-off method under Section 166
– Securities are not included in total loans for the
Section 585 experience method
– Losses are not included in charge-offs
• Conformity Election does not include securities
38
Securities or Loans?
• Some assets classified as “securities” on the
books are “loans” for tax purposes
– Regular interests in REMICS are loans
• See PLRs 9423002 and 200439041
– Pass-through mortgage pools are loans
• The investor owns an undivided interest in
the underlying loan assets
–As contrasted with purchasing the debt of
the issuer “collateralized” by the
underlying assets
–Revenue Ruling 84-10 and PLR 942300239
14
Net Investment Income Tax
• Five Year Rule
• Self-Rentals
• Self-Charged Interest
• Active Participation Activities – 500 Hours
– Passed-Through Income is not NII
– Passed-Through Loss is not a Passive
Activity Loss
– Gain on sale is not NII
40
Net Investment Income Tax
• Significant Participation Activities
– Requires More than One Passive Activity
– Over 100 Hours of Participation
– The Total of All Significant Participation Activities is Over 500 Hours
– Passed Through Income is not NII
– Passed Through Loss is not a Passive Activity Loss
– Gain on Disposition is not NII
41
Net Investment Income Tax
• Significant Participation Passive Activities
– Over 100 Hours of Participation
– There are not Other Significant Participation
Activities to Bring the Total to 500 Hours
– Passed Through Income is not NII
– Passed Through Loss is a Passive Activity
Loss
– Gain on Disposition is not NII
42
15
Net Investment Income Tax
• Whether an S corporation is
– An active activity
– A significant participation activity
– A significant participation passive activity, or
– A passive activity
is determined year-by-year based on hours
– No consistency requirement
– May change status every year
• Critical to maintain accurate logs of hours
43
Net Investment Income Tax
• Other S Corporation NIIT Issues
– Income on Invested Working Capital
– Interest and Dividend Income of the Bank
– Interest income of the BHC
– Dividend income of the BHC
– Rental of Operating OREO
– Rental of Premises
– Gain from mortgage origination and sale
44
Section 336(e)
• Expansion of the Available Asset Transactions
– Buyer may be an Individual, LLC, or
Partnership
– Distributions of Subsidiary Stock to
Shareholders when not a Section 355 Tax
Free Split-up
– Distributions of Subsidiary Stock when
Section 355(d) or (e) Apply
• Protective Elections Against (d) and (e)
45
16
Section 336(e)
• Requirements for Section 336(e) to Apply
– Section 338 would not apply
– Seller, or Distributor, Must be a Corporation or S
Corporation Shareholders
– The Disposition Must be a Qualified Stock
Disposition – at Least 80%
– Taxable Transaction
– Buyer or Distributee Cannot be a Related Party
46
Section 336(e)
• Use When the Buyer is Not a Corporation
• Use to Make Protective Elections if there is a
Likelihood of a Post-Distribution Change of Control
• Does not Affect the Built-in Gain Tax When the Seller
is an S Corporation
• Does not Affect the Double Tax on C Corporation
Sales of Assets & Liquidations
47
Disaffiliation of Failed Banks
• C corporations
– “Disaffiliate” the failed bank and its subsidiaries
from the rest of the group
– Without disaffiliation, the failed bank is still a
member of the consolidated return group and
must file returns
– Disaffiliation relieves the BHC shareholders of
the cost of compliance
• The FDIC is responsible for post filing returns
– Allows the BHC to wind up and liquidate
48
17
Disaffiliation of Failed Banks
• C corp disaffiliation - Regulation 1.597-4(g)
– Election within 120 days of the bank failing
– Done by a registered letter to the FDIC as
receiver of the bank
– Copy of letter and “green card” attached to
return
• Will not cost the FDIC any loss. The insolvent
bank is exempt from tax
49
Disaffiliation of Failed Banks
• S corporations may also “disaffiliate” the failed
bank, but there is no special Regulation to do so
– Revoke the QSub election
– S corporation holding company files a
statement with the IRS Service Center
• An S corporation may “disaffiliate” the failed bank
retroactive to before it fails
– Can revoke retroactively up to two months and
15 days
50
Disaffiliation of Failed Banks
• An S corporation holding company should also
probably revoke its S election
– Should not do so until after the QSub election
for the bank is revoked
• Otherwise creates a new C corporation
consolidated return group
– Should do so before there is any discharge of
debt income
51
18
Bad Debts of Failed Banks
• If a failed bank is examined the by IRS, the most
difficult problem is recovering the documentation to
purport the bad debt deductions
– Without the loan files, the failed bank is unable
too support that it incurred any bad debt losses
– Bishop v. Commissioner
• Failure is not an orderly process
– Files, and papers in files, become lost
52
Bad Debts of Failed & Failing Banks
• Recommendation
– Have a bank in danger of failing at a minimum
• All of the loan files on which there have been charge-offs during any open year, and
• All of the securities files on which there have been OTTI adjustments or disposition losses in any open year
scanned to a disk and store the copy off-site
– If the bank has already failed:
• Locate the loan files and try to get whomever has them to provide a digital copy
53
Tax Sharing Agreements
• Who is entitled to the tax refunds when a bank fails?
– Typically, such banks have large net operating
losses which can be carried back for refunds of
previously paid taxes
– If a parent holding company exists, the refund is
issued by the IRS to the holding company, not the
bank
54
19
Tax Sharing Agreements
• For federal tax purposes, the parent of a
consolidated group receives refunds from the IRS in
its capacity as “agent” for the group members (Reg
§1.1502-77(a))
• Under state corporate law, the members are free to
allocate among themselves the tax payments and
refunds by agreement (In Re Bob Richards Chrysler-
Plymouth Corp)
55
Tax Sharing Agreements
• However, in 1998, regulators issued the
Interagency Policy Statement that required all
insured banks to maintain a Tax Sharing
Agreement that was supposed to address how
banks and their parent holding companies
agreed to return refunds
56
Tax Sharing Agreements
• In recent years, several bankruptcy court
challenges have emerged to question who is
entitled to retain such tax refunds
– In the 9th Circuit, in FDIC v Siegel, the court held
that the holding company could keep the refunds
under the Tax Sharing agreement in place
– In Zucker, the 11th Circuit ruled the refunds
belonged to the FDIC
57
20
Tax Sharing Agreements
• During 2014, in FDIC v AmFin Financial Corp,
the 6th Circuit found that the TSA never
addressed who was entitled to refunds, and
required the district court to look at the
parties intentions under Ohio state law
• Conclusion: Tax sharing agreements did not
provide the FDIC with adequate legal grounds
to take all tax refunds
58
Tax Sharing Agreements
• On June 19, 2014 the FDIC issued FIL-30-2014 which provided an addendum to the 1998 Interagency Policy Statement
– Applies to all FDIC insured banks
– Requires all institutions to modify their tax sharing agreements by October 31, 2014
– Requires TSA’s include language that:
• A Parent is acting as an agent for the bank
• The TSA cannot indicate that refunds belong to the parent
59
S Corporations
Discharge of Debt
• The insolvency exclusion is not elective
• Insolvency is determined at the corporate level.
[Section 108(d)(7)(A)]
– If insolvency exceeds amount discharged
• All is excluded [Sec. 108(a)(1)(C)]
– Insolvency is less than the amount discharged
• The excess discharged is included in S
corporation operating income
60
21
S Corporations
Discharge of Debt
• The S corporation may elect to reduce basis in
depreciable assets first. (Section 108(b)(5))
• Not helpful because the depreciable property will
have been sold by the Receiver
– Recall that reductions are as of the beginning of
the following year.
• The election, if made, is done by completing Form
982 and attaching it to the return
61
S Corporations
Discharge of Debt
• The excluded discharge income reduces tax attributes in the following order:
– The S corporation’s income tax basis in depreciable assets if the 108(b)(5) election is made
– The shareholders’ "excess losses" passed through from the S corporation & suspended because they exceed bases
• Allocated proportionate to each shareholders’ suspended losses to the aggregate suspended losses of shareholders’ with losses
• Not pro-rata per share
62
S Corporations
Discharge of Debt
• Reduction of Tax Attributes (cont)
– The shareholders’ general business credits from
the S corporation carried forward
• Allocated like losses carried forward.
– The shareholders’ capital losses carried over.
• Also allocated like excess losses
63
22
S Corporations
Discharge of Debt
• Reduction of tax attributes (cont)
– The reduction shifts to the S corporation,
reducing tax basis in assets
• First, real property, other than Section
1221(a)(1) real property; i.e. OREO
• Second, tangible personal property other
than inventory, accounts receivable, and
notes receivable; i.e. loans.
•
64
S Corporations
Discharge of Debt• Reduction of tax attributes of the corporation:
– Third, remaining property used in a trade or
business or held for investment, other than
inventory, accounts receivable, notes receivable,
and section 1221(a)(1) real property
– Fourth, inventory, accounts receivable, notes
receivable, and section 1221(1) real property
– Fifth, property not used in the business nor held
for investment
65
S Corporations
Discharge of Debt
• Reduction of tax attributes (cont)
– Then the allocation shifts back to the
shareholders.
• The shareholders’ passive activity losses and
passive activity credits carried forward.
–Allocated like the excess losses
– Any remaining balance is disregarded
66
23
S Corporations
Restrictions on Dividends
• By statute, an FDIC insured institution may not pay a
dividend if, after payment of the dividend, the
institution would be undercapitalized pursuant to the
agencies prompt corrective action regulations.
– See 12 USC §1831o(d)(1)(A)
• Moreover, poorly rated banks or subject to written
supervisory actions are generally barred from paying
any dividends
67
S Corporations
Restrictions on Dividends
• New Basel III capital rules will be effective for all
banks effective 1/1/15
• The effect of such rules is to generally increase
the amount of capital banks must maintain by
creating a “capital conservation buffer”
– Restricts dividends of “adequately capitalized”
or even “well capitalized” (if less than 0.5%
above thresholds) banks
68
S Corporations
Restrictions on Dividends
• The restrictions are phased in over next 3
years
• Dividend restrictions begin at 60 percent of
income for well capitalized banks, and then
are reduced to 40%, 20% and finally 0% for
low risk based capitalized banks
69
24
S Corporations
Restrictions on Dividends
• However, in 12 CFR 324.11(a)(4)(iv) the new Basel III
rules provide the ability for banks to request
exceptions to the buffer restrictions to allow
shareholders to pay taxes on the flow thru income
from the bank
• On July 21, 2014 the FDIC issued FIL-40-2014, which
describes how they will consider such requests
70
S Corporations
Restrictions on Dividends
• The FIL lists the following factors it will
consider for each request:
– Is the dividend more than 40% of net income
– Is the dividend necessary for the shareholders to
pay income taxes
– Is the bank a 1 or 2 rated bank and not subject to
a written supervisory directive
– Will the bank continue to be “adequately
capitalized after the dividend?
71
Tangible Asset Regulations
• “Everybody” has written and analyzed
these final regulations
• Applicable Financial Statements
– The most material “take away” for banks
– Definition (c) is financial statements filed with
a government agency other than the IRS
– All banks and thrifts have “applicable financial
statements” because of the Call Reports
– Bank holding companies have “applicable
financial statements” because of the FR Y-9
72
25
Tangible Asset Regulations
• “Safe harbors” for expensing di minimis asset
purchases
– Increased to $5,000 per invoice, providing:
• The business has applicable financial statements
• There is a written financial policy
• Books conform
– New $500 “safe harbor” for companies without
“applicable financial statements”
– Note – the safe harbor is per invoice, not per
activity as in the Section 263(a) regulations for
expensing di minimis M & A costs73
Tangible Asset Regulations
• Final Regulations retain the “unit of
property” concept for buildings
– If a component is removed and disposed of, a
loss is allowed for the undepreciated cost of
the component
– The cost of removing the component is also
expensed
– The replacement, and cost of installation, is
capitalized
74
Investments by Self-Directed IRA
Accounts
• Prohibited transactions
– Investment in the same closely held business
by an individual and the individual’s IRA
account
• Advisory Opinion 2000-10A
• Advisory Opinion 2006-9A
– Investment in a closely held entity of the
beneficiary and members of the beneficiary’s
family own over 50% of the entity
75
26
Investments by Self-Directed IRA
Accounts
• Possible Prohibited Transactions
– Investment in a closely held business if:
• The beneficiary is an officer, director, or
highly compensated employee
• A member of the beneficiary’s family is an
officer, director, or highly compensated
employee.
• The beneficiary is a service provider to other
IRAs invested in the same entity
76
Investments by Self-Directed IRA
Accounts
• The Department of Labor places great emphasis on
contemporaneous written opinions of ERISA Counsel
on IRA investments in closely held entities
• Ellis v. Commissioner
– The purchase of a 98% interest in an LLC by a self-
directed IRA account became a prohibited
transaction
• Ellis was paid compensation
• Ellis and his family were co-investors through
another controlled LLC77
Investments by Self-Directed IRA
Accounts
• Peek & Fecht v. Commissioner
– Guaranteeing loans to a company owned by
the IRA accounts was a prohibited transaction
• IRS memorandum
– Investments by a newly established prof-it
sharing plan in stock of the plan sponsor may
be a prohibited transaction
78
27
Failure to Deposit Penalties
• Bank’s trust department deposited all of its
withholding taxes imtely and in full
• Failed to deposit by electronic transfer
– Regulation 31.6302-1(h)(2)(ii)
• IRS assessed a $253,000 “failure to deposit
penalty”
• Bank claimed there wasn’t a failure to
deposit, just a failure to pay electronically
• District Court sided with the IRS
79
Prepaid Expenses – Accrual Basis
Taxpayers
• Deduction of prepaid expenses by accrual basis
taxpayers under Reg. 1.263(a)-4(f)
• IRS’ attempt to control the accelerated deduction
of prepaid expenses
– A detailed analysis of prepaid expenses
– Applies the “recurring item exception”
principles of Section 461(h)(3)(A)
• Must be immaterial
• Must be a clear reflection of income – The
matching principle
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Prepaid Expenses – Accrual Basis
Taxpayers
• Ruling analyzes two specific prepaids
– Prepaid lease rents
– Prepaid service contracts
• Ruling holds that financial accounting is not
“dispositive” but reading the ruling, it sure is
influential
– If not “material” it shouldn’t be capitalized as a
prepaid
– If capitalization and amortization is not a more clear
reflection of income, it should be expensed
• A change to conform is automatic 81
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“Modification” of Charged-off Loan• If the modified loan has been the subject of a
partial charge-off, then there is a “deemed charge-off” in the modification calculation
– Reg 1.166-3(a)(3)
– Deemed charge-off is the lesser of
• The gain that would otherwise be recognized, or
• The greater of
–The FMV of the modified debt, or
–The amount recorded on the books
– Effect is to prevent “recovery” of the partial charge-off in the modification
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“Modification” of Charged-off Loan
Example of a deemed charge-off
Assume that
• The outstanding principal amount is $350,000
• The bank recorded a $100,000 charge-off, resulting in
book value of $250,000
• The accrued interest of $18,750 has not been
recognized in income
• The loan is modified to $300,000 principal, interest at
4.5%, payable $18,750 accrued interest at closing,
and 16 equal semi-annual installments of principal
and interest of $22,535 each
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“Modification” of Charged-off Loan
Example of deemed charge-off
“Proceeds” – issue price of new loan
Payment at closing $ 18,750
Stated principal of new loan 300,000
318,750
Basis in the old loan (250,000)
(i) Gain recognized $ 68,750
Gain is $18,750 nonaccrued interest
$50,000 modified principal over BV
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“Modification” of Charged-off Loan
Example of deemed charge-off (cont)
(ii) Tax basis in the new loan $318,750
Fair market value of new loan 318,750
Excess tax basis $ 0
(iii) Tax basis in the new loan $318,750
Book value of new loan 268,750
Excess tax basis $ 50,000
Deemed charge-off – lesser of (i)
and the greater of (ii) or (iii) $ 50,000
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“Modification” of Charged-off Loan
Example of deemed charge-off (cont)
• The bank recognizes the $18,750 nonaccrued
interest collected at closing for both book and tax
purposes
• For financial reporting purposes, the bank will:
– Recognize interest income at 4.5% beginning @
$250,000
– Recognize the $50,000 recovery when collected
– Recognize the $19,704 difference in interest after
the principal is collected in full
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“Modification” of Charged-off Loan
• Example of deemed charge-off (cont)
– For tax purposes, the bank will:
• Recognize interest income at 4.5% beginning @ $300,000
• Recognize the $50,000 recovery between $250,000 and $300,000 when collected
– Schedule M-3 Adjustments
• Increase book income by $68,750
• Decrease interest income by $18,750
• Increase bad debt expense by $50,000 deemed charge-off
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Trust Preferred SecuritiesDeferred Interest Payments
• Not customarily treated as OID obligations when issued
– The issuer’s option to defer interest payments was treated as a “remote” contingency
• Become OID obligations when the interest is first deferred – deemed retired and reissued
– Not a modification under the Sec 1.1001-3 Reg
88
Trust Preferred SecuritiesDeferred Interest Payments
• The accrued interest becomes OID rather than stated interest
– “Nonaccrual” does not apply to OID
– The holder must recognize the income even though not received
– The issuer may deduct the expense even though not paid [Sec 163(e)]
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Trust Preferred SecuritiesDeferred Interest Payments
• OID that is not collectible should be charged-off
as a bad debt under Sec. 166(a)(2) and (b)
– Recognized OID is added to basis in the asset –
Regulation 1.1272-1(g)
– The “nonaccrual” status of the asset for book
purposes is a “charge-off” for purposes of
meeting the Section 166 test for a partial bad
debt deduction - Rev Rul 2007-32
• The issuer will have discharge of debt income if
the recognized OID is never paid
90
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Trust Preferred SecuritiesDeferred Interest Payments
• Once an OID obligation, the security remains an
OID obligation even if the interest is later paid
currently
• Change the information report to Form 1099-OID
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Thank You for Attending the
20th Annual Community Bank Tax
Workshop
Questions?
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