5 2 00pm - loan workouts

Loan WorkoutsJames D. Goeller, CPA, Partner

Crowe Horwath LLP, San Francisco, CADavid A. Thornton, CPA, PartnerCrowe Horwath LLP, New York, NY

Agenda• Update on Loan Workout Issues

• Section 1001 Issues and Findings

• FASB ASC 310‐40 [TDR Exposure Draft]

• Post §382 Workouts

• From 1099‐C Update

• OREO Carrying Costs and AM2013‐001• Discussion and Implications

• Adopting the New Position

Update on Loan Workout Issues

§1001 Did Not Go Away… • Low Interest Rates and §1001

– You don’t value the loan being re‐negotiated, you value the loan issued.

– New loan valued at face unless below market

– July 2013 rates [Rev. Rul. 2013‐15], monthly compounding– Short‐term 0.23%– Mid‐term 1.22%– Long‐term 2.76%

– Compare to Normal – July 2004 rates [Rev. Rul. 2004‐66] – Short‐term 2.24%– Mid‐term 4.04%– Long‐term 5.21%

§1001 Did Not Go Away… • Poor Performing Loan ‐ Results

– 5.0% loan with 5 years left; $1,000 face no prior charge‐offs on the loan

– Change the interest rate to 2.00%– Make the payments interest only– Principal payments deferred until maturity

– Yes, this is a §1001 transaction– New loan’s interest rate > AFR, so value is face

– No, we don’t care – FMV of new loan issued $1,000– Tax basis of old loan is $1,000– No impact

– Higher interest rates often result in modification with lower interest rates, causing more exposure to §1001

§1001 Did Not Go Away… • However, if the basis of a loan is NOT face the §1001 rules

continue to impact taxable income.• Acquired portfolios that were purchased at a discount from face

– Often accounted for under SOP 03‐3; and – Renegotiation may not have a significant impact on book income, but the discount from face is accelerated for tax

– Reg. §1.166‐3 – Deemed Charge‐off rules• ACE Under §56(g)(4)(G)

– Capital raises in which the issuance of shares triggered a §382 change‐in‐control and NUBIL exists

– For ACE purposes, the assets restated to FMV on the date of the change‐in‐control

– Re‐negotiation of loans triggers tax gain (for ACE)

FASB Exposure Draft on TDRs• On 7/19/2013, FASB issued an exposure draft dealing with

troubled debt restructurings and foreclosures (Subtopic 310‐40)• The guidance is intended to clarify when a foreclosure has

actually occurred and can be recorded as such for GAAP purposes (i.e. when the transfer to OREO should occur)

• Clarifies that a creditor is considered to have foreclosed on the OREO property upon:– 1) The creditor obtaining legal title to the OREO property; or– 2) Completing a deed in lieu of foreclosure or similar legal agreement

• Currently, some lenders record a foreclosure upon assuming control / responsibility for the OREO, even if the foreclosure has not yet legally been executed

Loan Workouts After a §382 Ownership Change

• If a Net Unrealized Built‐in Loss (“NUBIL”) exists upon an ownership change, targeted tax planning may be necessary to mitigate the impact of the annual limitation on post‐ownership change bad debt deductions

• NUBIL exists if the tax basis of total assets exceeds the fair market value of total assets immediately before the ownership change AND the NUBIL exceeds a deminimis threshold


• NUBIL is not an issue unless the total NUBIL immediately before the ownership change exceeds the lesser of– $10 million; or– 15% of the fair market value of the total assets immediately

before the ownership change, exclusive of cash and marketable securities whose tax basis does not differ substantially from fair market value

• If the NUBIL exceeds this threshold, then recognized built‐in losses (“RBIL”) with respect to the pre‐ownership change assets within prescribed time periods after the ownership change date are subject to the annual §382 limitation


• RBILs in excess of the annual limitation are carried forward for 20 years, thus according them a treatment similar to pre‐change NOLs

• The general rule for treatment of post‐ownership change losses on NUBIL assets is that losses recognized from the sale or other liquidation of the asset within 5 years of the ownership change date are RBIL to the extent of the excess of tax basis over fair market value of the asset immediately prior to the ownership change


• However, special rules apply to bad debt deductions resulting from charge‐offs of loans

• IRS Notice 2003‐65 provides two alternative approaches for determining the RBIL from assets after an ownership change:– The §1374 Approach; and – The §338 Approach

• The §1374 approach contains a simplifying assumption with respect to bad debt charge‐offs that may be very appealing from a tax planning perspective and may also be administratively convenient to apply


• The §1374 approach:– Assumes that the entire amount of any bad debt deduction claimed within the first year after an ownership change is RBIL, regardless of the excess of tax basis over the fair market value of the loan immediately before the ownership change

– Bad debt deductions claimed after the first anniversary of the ownership change date are not treated as RBIL

– Planning strategies that effectively delay bad debt deductions until after the first anniversary of the ownership change will enable the deduction to escape the §382 annual limitation

Loan Workouts After a §382 Ownership Change• The §1374 approach – EXAMPLE

– Assume Bank has experienced an ownership change (with NUBIL) and incurs the following charge‐off on a particular loan:

• $1,000,000 partial charge‐off within the first year after the ownership change on a loan whose tax basis exceeded fair market value by $800,000 immediately before the ownership change

– If the $1 million partial charge‐off is claimed as a current deduction, it will be treated as RBIL and subject to the §382 annual limitation


• Tax Planning Point:– While IRC §166 does not permit the deferral of bad debt deductions for wholly‐worthless loans beyond the year in which they become wholly‐worthless, bad debt deductions for partially‐worthless loans may be deferred and claimed when the loan becomes wholly worthless or is otherwise settled

– By deferring bad debt deductions for partial‐charge‐offs until later years, banks may be able to mitigate the impact of the §382 annual limitation on RBIL from loan charge‐offs

Loan Workouts After a §382 Ownership Change• Tax Planning Point (Continued):

– However, in order to effectively implement this planning strategy, the bank must have the flexibility to defer the tax deduction for partial charge‐offs

– Such a deferral is a departure from book‐tax conformity and, consequently, the deferral strategy is not possible if the bank has the §166 bad debt conformity election in place

– For this reason, many banks facing a potential NUBIL limitation from a pending ownership change either avoid adopting the bad debt conformity election or revoke it prior to the year in which the ownership change occurs


• The §338 approach:– Applies no special rule to bad debt deductions, so the general rule applies

– Bad debt deductions claimed within the first 5 years after an ownership change are RBIL, but only to the extent of the excess of tax basis over the fair market value of the loan immediately before the ownership change

– Delaying partial bad debt deductions may also work under the §338 approach, but they would need to be deferred until after the fifth anniversary of the ownership change date

Loan Workouts After a §382 Ownership Change• The §338 approach – EXAMPLE

– Assume Bank has experienced an ownership change (with NUBIL) and incurs the following charge‐off on a particular loan:

• $1,000,000 partial charge‐off during the fourth year after the ownership change on a loan whose tax basis exceed fair market value by $800,000 immediately before the ownership change

– If the $1 million of partial charge‐off is claimed as a deduction in the fourth year after the ownership change; $800,000 of this deduction will be treated as RBIL and subject to the §382 annual limitation; the excess $200,000 is not considered to be a built‐in loss


• Note that the special 1‐year rule under the §1374 approach only applies to bad debt deductions

• Losses from the sale or other taxable disposition of loans are RBIL, up to the amount of the original day‐1 NUBIL, if they occur within 5 years of the ownership change date under both the §1374 and §338 approaches (i.e. the general rule applies)

• Charge‐offs claimed immediately before, or commensurate with, a loan sale should be scrutinized


• Alternative Minimum Tax Issue:– If the NUBIL as of the ownership change date exceeds the deminimis threshold amount, IRC §56(g)(4)(G) requires that the tax basis of each asset is adjusted to its fair market value immediately before the ownership change for Adjusted Current Earnings (“ACE”) purposes

– Thus, the ACE calculation will have to be determined using a tax basis in each asset that is different than the basis for regular tax purposes


• Alternative Minimum Tax Issue (Continued):– Given the NUBIL circumstances that cause this basis re‐determination, the 75% ACE adjustment is likely to be a (potentially substantial) increase to AMT taxable income

– This tracking is necessary for the entire holding period of these assets, not just during the applicable RBIL windows

– AMT paid as a result of this adjustment is credited to future periods, but can be an expense issue for a bank with a full valuation allowance against its deferred tax assets (i.e. any tax paid is ultimately recorded through expense)

Form 1099‐C and the Impact on Future Collection• Form 1099‐C has been with us since OBRA 1993• Regulations list 1099‐C reporting events (examples)

• Discharge of indebtedness under Title 11• Expiration of the statute of limitations for collection of an indebtedness• Decision of lender to no longer pursue; and • Expiration of the non‐payment testing period

• Thus, some are legal and identifiable events, some are less specific

• Non‐payment testing or decision to no longer pursue• IRS information letter INFO 2005‐0207 (Dec. 30, 2005) see quote below; and INFO 2005‐0208 (Dec. 30, 2005)

“Nevertheless, the Internal Revenue Services has declared the it ‘does not view a Form 1099‐C as an admission by the creditor that it has discharged the debt and can no longer pursue collection.”

Form 1099‐C and the Reed Case• Reed, U.S. Bankruptcy Court, E.D. Tennessee, 12‐30049, May

14, 2013• Bank issued a Form 1099‐C as a result of non‐payment testing period• Borrower entered Chapter 13, Bank submitted a claim stating the issuance of Form 1099‐C does not legally extinguish the debt

• The Bankruptcy Court denied the Bank’s claim post Form 1099‐C issuance

• Lessons Learned from Reed:• The issuance of a Form 1099‐C may impact subsequent collection – so potentially rethink the Form 1099‐C Reporting strategy

• The IRS information letters may have overstated their authority to impose their influence when discussing the impact of the issuance of a Form 1099‐C (particularly on the Bankruptcy Courts)

OREO Carrying Costsand AM2013-001

Deducting OREO Carrying Costs• In recent years, there had been a coordinated effort by the IRS

to require capitalization of carrying costs on non‐income‐ producing OREO property

• The IRS argument was based upon an assertion that the OREO property is inventory acquired for resale and, consequently, §263A requires all carrying costs to be capitalized to the basis of the individual properties (which would permit them to be deducted upon disposal of the applicable properties)

• Numerous taxpayers conceded this issue under examination because the IRS would not settle the issue in Appeals

Deducting OREO Carrying Costs• In March 2013, the IRS released a memorandum (AM

2013‐001) indicating a reversal of their position on this issue

• The memorandum holds that, in order for §263A to apply, OREO property must be BOTH – 1) held for sale to customers in the ordinary course of business

under IRC §1221(a)(1); AND– 2) acquired for resale

Deducting OREO Carrying Costs• The memorandum holds that OREO acquired through

foreclosure proceedings or by deed‐in‐lieu of foreclosure by the bank that originated the loan is not “acquired for resale”, but instead represents an extension of the lending transaction

• Consequently, the memorandum holds that OREO carrying costs are currently deductible because they represent an ordinary and necessary cost of carrying on the banking business

Deducting OREO Carrying Costs• The memorandum acknowledges that OREO property is held

for sale to customers in the ordinary course of business within the meaning of IRC §1221(a)(1)

• Consequently, there should be no concern regarding the treatment of OREO property as a capital asset, provided the bank actively seeks to sell the property

Deducting OREO Carrying Costs• The IRS has indicated that further guidance is forthcoming,

but it had not yet been issued at the time this presentation was prepared

• Consequently, many taxpayers with an established method of capitalizing OREO carrying costs (i.e. some of whom conceded this issue on a recent IRS examination) filed their 2012 income tax return with the capitalization method still in place

Deducting OREO Carrying Costs• Unanswered questions:

– The memorandum addresses the bank that originated the loan. What about…

• Loans purchased from another bank?• Non‐bank lenders?

– What happens to taxpayers who conceded this issue under examination, or might otherwise be capitalizing OREO carrying costs?

• Reversal of examination adjustments? Refund of interest?• Accounting method change (i.e. IRS form 3115)?

Disclaimers

The views expressed do not necessarily represent those of Crowe Horwath LLP.

This material is for informational purposes only and should not be construed as legal, tax, accounting or other professional advice.

Please seek guidance specific to your organization from qualified advisers in your jurisdiction.

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