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FEATURE

Yes, CECL Affects

Taxes, Too

KEITH FOSTER

y now, most of the banking indus- es. Since a tax deduction isn’t available would in all probability not result in the
try is aware of the Financial Ac- for the allowance, the deduction for satisfaction of execution on a judgment.”
Bcounting Standards Board’s (FASB) charge offs should be increased where An indicator of poor financial condition
issuance of the current expected credit possible. Over the years, several meth- for an unsecured and preferred debt
loss (CECL) standard. The CECL mod- ods of accounting for the timing of bad would be bankruptcy of the debtor.
el requires the use of historical, current debt worthlessness, i.e., charge offs, have Bad Debt Method #2: The
and forecasted information to estimate been created for tax purposes. Presumption Rule
expected losses over the life of a loan. Bad Debt Method #1: Facts &
While generally accepted accounting Circumstances It’s important to note there isn’t an IRC
principles (GAAP) accounting for CECL requirement for the IRS to follow charge
has been discussed in numerous previ- Internal Revenue Code (IRC) Section offs reported for financial or regulatory
ous articles, the tax effect of the related 166(a)(1) allows for a tax deduction of a purposes. Historically, this has resulted
adjustments has received little attention. wholly worthless debt obligation in the in numerous disagreements between the
Understanding the tax effect of CECL’s year a debt becomes worthless, and IRC IRS and banks under exam. In an effort to
adjustment to loan losses, capital and the §166(a)(2) allows for a tax deduction of relieve discord, regulations were provid-
ed for guidance on what the IRS would
a partially worthless debt obligation up
tax treatment of bad debt charge offs in to the amount charged off, i.e., up to the accept. Reg. §1.166-2(d)(1) provides that
general is essential to help banks avoid GAAP reserve. In general, debt and equi- worthlessness is presumed when a loan
surprises and take advantage of tax plan- ty securities don’t result in a tax deduc- is charged off in obedience to regulators’
ning opportunities to mitigate unwel- tion until they become wholly worthless. specific orders or in accordance with
come results. However, under a special rule for banks in established policies of such authorities,
A probable consequence of a change IRC §582(c), debt securities, e.g., bonds, and upon the first examination after the
to the CECL model is an increase in the may result in a tax deduction when only charge off, the regulators confirm in writ-
allowance for loan losses, which doesn’t partially worthless, up to the amount of ing that the charge off would’ve been
directly result in an increase to charge the charge off. Conversely, there isn’t subject to specific orders for a charge off.
offs. To understand CECL’s tax effect, a special rule for equity securities, i.e., While this method isn’t commonly used
it’s helpful to understand the tax treat- stocks, FNMA, FHLMC, etc. Therefore, a in practice, it’s available.
ment of the allowance for loan losses deduction isn’t allowed until the security
and charge offs. In general, an allowance becomes wholly worthless. Bad Debt Method #3: The
for bad debts isn’t deductible for tax Determining when a debt becomes Conformity Election
purposes. The deduction is delayed until wholly or partially worthless is based on Reg. §1.166-2(d)(3) provides for a con-
there’s a charge off. This means when the facts and circumstances and subject formity election. This election effec-
CECL increases a GAAP allowance, it to a review of each separate debt. Per tively allows loss deductions for partial
will increase expense and reduce capi- Regulation §1.166-2, the IRS “will con- and wholly worthless debts to follow
tal without resulting in a corresponding sider all pertinent evidence, including GAAP, or more technically, to follow
tax deduction. Since the allowance is a the value of the collateral, if any, secur- loan loss standards consistent with the
timing difference for tax purposes, banks’ ing the debt and the financial condition bank’s applicable regulatory standards.
deferred tax assets will increase for C of the debtor.” It goes on to note that In addition, it allows for a deduction of
corporations. As discussed below, the “legal action is not required where the estimated selling costs related to loans,
deferred tax asset and related tax deduc- surrounding circumstances indicate that if those costs are allowed or required by
tion hang on the balance sheet until the the debt is worthless and uncollectible regulators. This election also requires the
debt becomes worthless for tax purpos- and that legal action to enforce payment bank to obtain an express determination

30 The Texas Independent Banker