Internal Service, Treasury § 1.166–2

as a bad under section 166 in re- See section 166(e). For provisions al- spect of such receivables shall be lim- lowing the deduction of a loss resulting ited to such fair market value even from the worthlessness of such a debt, though it is less than their face value. see § 1.165–5. (b) A purchaser of accounts receiv- (2) The provisions of subparagraph (1) able which become worthless during of this paragraph do not apply to any the taxable year shall be entitled under loss sustained by a bank and resulting section 166 to a deduction which is from the worthlessness of a security based upon the price he paid for such described in section 165(g)(2)(C). See receivables but not upon their face paragraph (a) of § 1.582–1. value. (ii) claim. Only the dif- [T.D. 6500, 25 FR 11402, Nov. 26, 1960, as ference between the amount received amended by T.D. 6996, 34 FR 835, Jan. 18, 1969; T.D. 7902, 48 FR 33260, July 21, 1983; T.D. 8071, in distribution of the assets of a bank- 51 FR 2479, Jan. 17, 1986] rupt and the amount of the claim may be deducted under section 166 as a bad § 1.166–2 Evidence of worthlessness. debt. (iii) Claim against decedent’s estate. (a) General rule. In determining The excess of the amount of the claim whether a debt is worthless in whole or over the amount received by a creditor in part the district director will con- of a decedent in distribution of the as- sider all pertinent evidence, including sets of the decedent’s estate may be the value of the collateral, if any, se- considered a worthless debt under sec- curing the debt and the financial condi- tion 166. tion of the debtor. (e) Prior inclusion in income required. (b) Legal action not required. Where Worthless arising from unpaid the surrounding circumstances indi- wages, salaries, fees, rents, and similar cate that a debt is worthless and items of taxable income shall not be al- uncollectible and that legal action to lowed as a deduction under section 166 enforce payment would in all prob- unless the income such items represent ability not result in the satisfaction of has been included in the return of in- execution on a judgment, a showing of come for the year for which the deduc- these facts will be sufficient evidence tion as a bad debt is claimed or for a of the worthlessness of the debt for prior taxable year. purposes of the deduction under section (f) Recovery of bad debts. Any amount 166. attributable to the recovery during the (c) Bankruptcy—(1) General rule. taxable year of a bad debt, or of a part Bankruptcy is generally an indication of a bad debt, which was allowed as a of the worthlessness of at least a part deduction from gross income in a prior of an unsecured and unpreferred debt. taxable year shall be included in gross (2) Year of deduction. In bankruptcy income for the taxable year of recov- cases a debt may become worthless be- ery, except to the extent that the re- fore settlement in some instances; and covery is excluded from gross income in others, only when a settlement in under the provisions of § 1.111–1, relat- bankruptcy has been reached. In either ing to the recovery of certain items case, the mere fact that bankruptcy previously deducted or credited. This proceedings instituted against the paragraph shall not apply, however, to debtor are terminated in a later year, a bad debt which was previously thereby confirming the conclusion that charged against a reserve by a tax- the debt is worthless, shall not author- payer on the reserve method of treat- ize the shifting of the deduction under ing bad debts. section 166 to such later year. (g) Worthless securities. (1) Section 166 (d) Banks and other regulated corpora- and the regulations thereunder do not tions—(1) Worthlessness presumed in year apply to a debt which is evidenced by a of charge-off. If a bank or other cor- , , note, or certificate, or poration which is subject to super- other evidence of indebtedness, issued vision by Federal authorities, or by by a corporation or by a government or State authorities maintaining substan- political subdivision thereof, with in- tially equivalent standards, charges off terest coupons or in registered form. a debt in whole or in part, either—

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(i) In obedience to the specific orders method of that establishes of such authorities, or a conclusive presumption of worthless- (ii) In accordance with established ness for debts, provided that the bank policies of such authorities, and, upon meets the express determination re- their first audit of the bank or other quirement of paragraph (d)(3)(iii)(D) of corporation subsequent to the charge- this section for the taxable year of the off, such authorities confirm in writing election. that the charge-off would have been (ii) Conclusive presumption—(A) In subject to such specific orders if the general. If a bank satisfies the express audit had been made on the date of the determination requirement of para- charge-off, graph (d)(3)(iii)(D) of this section and then the debt shall, to the extent elects to use the method of accounting charged off during the taxable year, be under this paragraph (d)(3)— conclusively presumed to have become (1) Debts charged off, in whole or in worthless, or worthless only in part, as part, for regulatory purposes during a the case may be, during such taxable taxable year are conclusively presumed year. But no such debt shall be so con- to have become worthless, or worthless clusively presumed to be worthless, or only in part, as the case may be, during worthless only in part, as the case may that year, but only if the charge-off re- be, if the amount so charged off is not sults from a specific order of the bank’s claimed as a deduction by the taxpayer supervisory authority or corresponds at the time of filing the return for the to the bank’s classification of the debt, taxable year in which the charge-off in whole or in part, as a loss asset, as takes place. described in paragraph (d)(3)(ii)(C) of (2) Evidence of worthlessness in later this section; and taxable year. If such a bank or other (2) A bad debt deduction for a debt corporation does not claim a deduction that is subject to regulatory loss clas- for such a totally or partially worth- sification standards is allowed for a less debt in its return for the taxable taxable year only to the extent that year in which the charge-off takes the debt is conclusively presumed to place, but claims the deduction for a have become worthless under para- later taxable year, then the charge-off graph (d)(3)(ii)(A)(1) of this section dur- in the prior taxable year shall be ing that year. deemed to have been involuntary and (B) Charge-off should have been made the deduction under section 166 shall be in earlier year. The conclusive presump- allowed for the taxable year for which tion that a debt is worthless in the claimed, provided that the taxpayer year that it is charged off for regu- produces sufficient evidence to show latory purposes applies even if the that— bank’s supervisory authority deter- (i) The debt became wholly worthless mines in a subsequent year that the in the later taxable year, or became re- charge-off should have been made in an coverable only in part subsequent to earlier year. A pattern of charge-offs in the taxable year of the involuntary the wrong year, however, may result in charge-off, as the case may be; and, revocation of the bank’s election by (ii) To the extent that the deduction the Commissioner pursuant to para- claimed in the later taxable year for a graph (d)(3)(iv)(D) of this section. debt partially worthless was not invol- (C) Loss asset defined. A debt is classi- untarily charged off in prior taxable fied as a loss asset by a bank if the years, it was charged off in the later bank assigns the debt to a class that taxable year. corresponds to a loss asset classifica- (3) Conformity election—(i) Eligibility tion under the standards set forth in for election. In lieu of applying para- the ‘‘Uniform Agreement on the Classi- graphs (d)(1) and (2) of this section, a fication of Assets and Securities Held bank (as defined in paragraph (d)(4)(i) by Banks’’ (See Attachment to Comp- of this section) that is subject to super- troller of the Currency Banking Cir- vision by Federal authorities, or by cular No. 127, Rev. 4–26–91, Comptroller state authorities maintaining substan- of the Currency, Communications De- tially equivalent standards, may elect partment, Washington, DC 20219) or under this paragraph (d)(3) to use a similar guidance issued by the Office of

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the Comptroller of the Currency, the charge-off of the debt for regulatory Federal Deposit Insurance Corporation, purposes. the Board of Governors of the Federal (C) Procedures—(1) In general. A new Reserve, or the Farm Adminis- bank adopts the method of accounting tration; or for institutions under the under this paragraph (d)(3) for any tax- supervision of the Office of Thrift Su- able year ending on or after December pervision, 12 CFR 563.160(b)(3). 31, 1991 (and for all subsequent taxable (iii) Election—(A) In general. An elec- years) when it adopts its overall meth- tion under this paragraph (d)(3) is to be od of accounting for bad debts, by at- made on bank-by-bank basis and con- taching a statement to this effect to stitutes either the adoption of or a its income tax return for that year. change in method of accounting, de- Any other bank makes an election for pending on the particular bank’s facts. any taxable year ending on or after De- A change in method of accounting that cember 31, 1991 (and for all subsequent results from the making of an election taxable years) by filing a completed under this paragraph (d)(3) has the ef- fects described in paragraph Form 3115 (Application for Change in (d)(3)(iii)(B) of this section. Accounting Method) in accordance (B) Effect of change in method of ac- with the rules of paragraph counting. A change in method of ac- (d)(3)(iii)(C)(2) or (3) of this section. counting resulting from an election The statement or Form 3115 must in- under this paragraph (d)(3) does not re- clude the name, address, and taxpayer quire or permit an adjustment under identification number of the electing section 481(a). Under this cut-off ap- bank and contain a declaration that proach— the express determination requirement (1) There is no change in the § 1.1011– of paragraph (d)(3)(iii)(D) of this sec- 1 adjusted basis of the bank’s existing tion is satisfied for the taxable year of debts (as determined under the bank’s the election. When a Form 3115 is used, former method of accounting for bad the declaration must be made in the debts) as a result of the change in space provided on the form for ‘‘Other method of accounting; changes in method of accounting.’’ The (2) With respect to debts that are words ‘‘ELECTION UNDER § 1.166– subject to regulatory loss classifica- 2(d)(3)’’ must be typed or legibly print- tion standards and are held by the ed at the top of the statement or page bank at the beginning of the year of 1 of the Form 3115. change (to the extent that they have (2) First election. The first time a not been charged off for regulatory bank makes this election, the state- purposes), and with respect to debts ment or Form 3115 must be attached to subject to regulatory loss classifica- the bank’s timely filed return (taking tion standards that are originated or into account extensions of time to file) acquired subsequent to the beginning for the first taxable year covered by of the year of change, bad debt deduc- the election. The consent of the Com- tions in the year of change and there- missioner to make a change in method after are determined under the method of accounting under this paragraph of accounting for bad debts prescribed (d)(3) is granted, pursuant to section by this paragraph (d)(3); (3) With respect to debts that are not 446(e), to any bank that makes the subject to regulatory loss classifica- election in accordance with this para- tion standards or that have been to- graph (d)(3)(iii)(C), provided the bank tally charged off prior to the year of has not made a prior election under change, bad debt deductions are deter- this paragraph (d)(3). mined under the general rules of sec- (3) Subsequent elections. The advance tion 166; and consent of the Commissioner is re- (4) If there was any partial charge-off quired to make any election under this of a debt in a prechange year, any por- paragraph (d)(3) after a previous elec- tion of which was not claimed as a de- tion has been revoked pursuant to duction, the deduction reflecting that paragraph (d)(3)(iv) of this section. partial charge-off must be taken in the This consent must be requested under first year in which there is any further the procedures, terms, and conditions

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prescribed under the authority of sec- (1) There is no change in the § 1.1011– tion 446(e) and § 1.446–1(e) for requesting 1 adjusted basis of the bank’s existing a change in method of accounting. debts (as determined under this para- (D) Express determination requirement. graph (d)(3) method or any other In connection with its most recent ex- former method of accounting used by amination involving the bank’s the bank with respect to its bad debts) review process, the bank’s supervisory as a result of the change in method of authority must have made an express accounting; and determination (in accordance with any (2) Bad debt deductions in the year of applicable administrative procedure change and thereafter with respect to prescribed hereunder) that the bank all debts held by the bank, whether in maintains and applies loan loss classi- existence at the beginning of the year fication standards that are consistent with the regulatory standards of that of change or subsequently originated or supervisory authority. For purposes of acquired, are determined under the new this paragraph (d)(3)(iii)(D), the super- method of accounting. visory authority of a bank is the appro- (C) Automatic revocation—(1) In gen- priate Federal banking agency for the eral— A bank’s election under this bank, as that term is defined in 12 paragraph (d)(3) is revoked automati- U.S.C. 1813(q), or, in the case of an in- cally if, in connection with any exam- stitution in the Farm Credit System, ination involving the bank’s loan re- the Farm Credit Administration. view process by the bank’s supervisory (E) Transition period election. For tax- authority as defined in paragraph able years ending before completion of (d)(3)(iii)(D) of this section, the bank the first examination of the bank by does not obtain the express determina- its supervisory authority (as defined in tion required by that paragraph. paragraph (d)(3)(iii)(D) of this section) (2) Year of revocation. If a bank makes that is after October 1, 1992, and that the conformity election under the tran- involves the bank’s loan review proc- sition rules of paragraph (d)(3)(iii)(E) of ess, the statement or Form 3115 filed this section and does not obtain the ex- by the bank must include a declaration press determination in connection with that the bank maintains and applies the first examination involving the loan loss classification standards that bank’s loan review process that is after are consistent with the regulatory October 1, 1992, the election is revoked standards of that supervisory author- ity. A bank that makes this declara- as of the beginning of the taxable year tion is deemed to satisfy the express of the election or, if later, the earliest determination requirement of para- taxable year for which tax may be as- graph (d)(3)(iii)(D) of this section for sessed. In other cases in which a bank those years, even though an express de- does not obtain an express determina- termination has not yet been made. tion in connection with an examina- (iv) Revocation of Election—(A) In gen- tion of its loan review process, the eral. Revocation of an election under election is revoked as of the beginning this paragraph (d)(3) constitutes a of the taxable year that includes the change in method of accounting that date as of which the supervisory au- has the effects described in paragraph thority conducts the examination even (d)(3)(iv)(B) of this section. If an elec- if the examination is completed in the tion under this paragraph (d)(3) has following taxable year. been revoked, a bank may make a sub- (3) Consent granted. Under the Com- sequent election only under the provi- missioner’s authority in section 446(e) sions of paragraph (d)(3)(iii)(C)(3) of and § 1.446–1(e), the bank is directed to this section. and is granted consent to change from (B) Effect of change in method of ac- this paragraph (3)(1) method as of the counting. A change in method of ac- year of revocation (year of change) pre- counting resulting from revocation of scribed by paragraph (d)(3)(iv)(C)(2) of an election under this paragraph (d)(3) this section. does not require or permit an adjust- ment under section 481(a). Under this cut-off approach—

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(4) Requirements. A bank changing its requirements of that paragraph, the method of accounting under the auto- Commissioner will require that any matic revocation rules of this para- voluntary change in method of ac- graph (d)(3)(iv)(C) must attach a com- counting under this paragraph pleted Form 3115 to its income tax re- (d)(3)(iv)(E) be implemented retro- turn for the year of revocation pre- actively pursuant to the same amended scribed by paragraph (d)(3)(iv)(C)(2) of return terms and conditions as are pre- this section. The words ‘‘REVOCATION scribed by paragraph (d)(3)(iv)(C) of OF § 1.166–2(d)(3) ELECTION’’ must be this section. typed or legibly printed at the top of (4) Definitions. For purposes of this page 1 of the Form 3115. If the year of paragraph (d)— revocation is a year for which the bank (i) Bank. The term bank has the has already filed its income tax return, meaning assigned to it by section 581. the bank must file an amended return The term bank also includes any cor- for that year reflecting its change in poration that would be a bank within method of accounting and must attach the meaning of section 581 except for the completed Form 3115 to that the fact that it is a foreign corpora- amended return. The bank also must tion, but this paragraph (d) applies file amended returns reflecting the new only with respect to the method of accounting for all subse- on which is effectively connected with quent taxable years for which returns the conduct of a banking business have been filed and tax may be as- within the United States. In addition, sessed. the term bank includes a Farm Credit (D) Revocation by Commissioner. An System institution that is subject to election under this paragraph (d)(3) supervision by the Farm Credit Admin- may be revoked by the Commissioner istration. as of the beginning of any taxable year (ii) Charge-off. For banks regulated for which a bank fails to follow the by the Office of Thrift Supervision, the method of accounting prescribed by term charge-off includes the establish- this paragraph. In addition, the Com- ment of specific allowances for loan missioner may revoke an election as of losses in the amount of 100 percent of the beginning of any taxable year for the portion of the debt classified as which the Commissioner determines loss. that a bank has taken charge-offs and [T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR deductions that, under all facts and 14021, Dec. 31, 1960, as amended by T.D. 7254, circumstances existing at the time, 38 FR 2418, Jan. 26, 1973; T.D. 8396, 57 FR 6294, were substantially in excess of those Feb. 24, 1992; T.D. 8441, 57 FR 45569, Oct. 2, warranted by the exercise of reasonable 1992; T.D. 8492, 58 FR 53658, Oct. 18, 1993] business judgment in applying the reg- ulatory standards of the bank’s super- § 1.166–3 Partial or total worthless- visory authority as defined in para- ness. graph (d)(3)(III)(D) of this section. (a) Partial worthlessness—(1) Applica- (E) Voluntary revocation. A bank may ble to specific debts only. A deduction apply for revocation of its election under section 166(a)(2) on account of made under this paragraph (d)(3) by partially worthless debts shall be al- timely filing a completed Form 3115 for lowed with respect to specific debts the appropriate year and obtaining the only. consent of the Commissioner in accord- (2) Charge-off required. (i) If, from all ance with section 446(e) and § 1.446–1(e) the surrounding and attending cir- (including any applicable administra- cumstances, the district director is sat- tive procedures prescribed thereunder). isfied that a debt is partially worth- The words ‘‘REVOCATION OF § 1.166– less, the amount which has become 2(d)(3) ELECTION’’ must be typed or worthless shall be allowed as a deduc- legibly printed at the top of page 1 of tion under section 166(a)(2) but only to the Form 3115. If any bank has had its the extent charged off during the tax- election automatically revoked pursu- able year. ant to paragraph (d)(3)(iv)(C) of this (ii) If a taxpayer claims a deduction section and has not changed its method for a part of a debt for the taxable year of accounting in accordance with the within which that part of the debt is

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