IRS Issues Audit Directive on Worthless Debt Deductions for Banks and Bank Affiliates: LBI Directs Its Auditors Not to Challenge Certain Worthless Debt Deductions

Sullivan & Cromwell LLP - October 29, 2014

The Large Business and International Division (“LBI”) at the IRS issued an audit directive (the “Directive”) to its revenue agents relating to bad debt deductions claimed by banks and regulated bank affiliates.  The Directive clarifies the application of the presumption rules for these bad debt deductions which, the IRS admitted, were out of date.  Pursuant to the Directive, LBI examiners are instructed not to challenge worthless debt deductions claimed by banks and regulated bank affiliates (including a partnership wholly owned by a bank and its affiliates) satisfying the parameters described below.  Under the Directive, credit-related loan charge-offs (including estimates of certain selling costs) reported on financial statements filed with the SEC or bank regulator will generally be treated as sufficient evidence that a debt is worthless.  Furthermore, LBI examiners are not to challenge worthless debt deductions taken by banks or regulated bank affiliates in excess of such credit-related loan charge-offs if the bank or bank affiliate applies the conclusive presumption rule in the regulations and certain other requirements are satisfied.

The Directive reflects an effort by LBI to make the audit process more efficient by liberalizing the requirements under the presumption rules and by extending their application to bank affiliates that are not corporations.  The Directive is an internal instruction to IRS employees; it is not an official pronouncement of law and cannot be used, cited or relied on by a taxpayer.  The Directive does not apply to small banks that use the reserve method of accounting for loan losses.

The Directive only applies to audits of taxable years beginning in 2010 through 2014.