Bad Debts

Section 166(a) of the tax code says that "there shall be allowed as a deduction any debt which becomes wholly worthless within the taxable year." However, in the case of a guarantor of another party's debt, a special set of rules operates to determine the time such guarantor is entitled to a "bad debt" deduction (once the guarantor honors the obligation to the creditor).

Sec. 1.166-1 Bad debts.

(a) Allowance of deduction. Section 166 provides that, in computing

taxable income under section 63, a deduction shall be allowed in respect

of bad debts owed to the taxpayer. For this purpose, bad debts shall,

subject to the provisions of section 166 and the regulations thereunder,

be taken into account either as--

(1) A deduction in respect of debts which become worthless in whole

or in part; or as

(2) A deduction for a reasonable addition to a reserve for bad

debts.

The following case study is very useful :

ISSUES

1. What steps are necessary to record or memorialize the assignment of a loan

(or loan portion) as a loss asset for purposes of the conformity method of accounting

for worthless bad debts?

2. Does the conclusive presumption of worthlessness under the conformity

method apply to loans erroneously classified as loss assets?

FACTS

ABC corporation is a bank (as defined in  1.166-2(d)(4)(i) of the Income Tax

Regulations) and is subject to supervision by Federal authorities. ABC has elected

under  1.166-2(d)(3) to use the conformity method of accounting to determine when

debts owed to ABC become worthless bad debts.

Under a resolution adopted by ABC
s board of directors, ABC
s officers and

employees are authorized to charge off loans (or portions of loans) only when the

charge-off is required under the loan loss classification standards issued by the banks

supervisory authority. Thus, when ABC
s officers and employees charge off a loan for

regulatory purposes, they do not take any additional steps to record or memorialize

whether, in their judgment, the charge-off is required by the loan loss standards that

have been issued by ABC
s supervisory authority.

The loan loss standards require ABC to charge off loss assets. Loss assets

are loans (or portions of loans) determined to be uncollectible and of such little value

that their continuance as bankable assets is not warranted. In the case of a consumer

loan or credit card debt, regardless whether there is specific adverse information about

the borrower, ABC is required to charge off the asset when its delinquency exceeds

certain established thresholds. Thus, ABC must charge off installment loans that are

120 days, or five payments, past due and credit card debts that are 180 days past due

after seven zero billings. In addition, if ABC receives specific adverse borrower

information (for example, the borrowers death or bankruptcy) confirming a loss before

the applicable 120 day or 180 day threshold date has passed, then an immediate

charge-off is required. See Comptroller of the Currency, Allowance for Loan and

Lease Losses, Comptrollers Handbook 10, 19 (June 1996); Uniform Agreement on

-2-

the Classification of Assets and Appraisal of Securities Held by Banks, Attachment to

Comptroller of the Currency Banking Circular No. 127, Rev. 4-26-91.

ABC
s