INTEGRATION OF DISTRESSED THRIFT'S BAD DEBT RESERVE INTO ACQUIRING COMMERCIAL BANK'S RESERVE RESULTS IN ACCOUNTING CHANGE AND MUST BE ADJUSTED
Rev. Rul. 85-171; 1985-2 C.B. 148
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Jurisdictions
- LanguageEnglish
- Tax Analysts Electronic Citation85 TNT 212-47
Rev. Rul. 85-171
ISSUE
Does the integration under section 381(c)(4) of the Internal Revenue Code of a distressed thrift institution's bad debt reserve, computed under section 593, into an acquiring commercial bank's bad debt reserve, computed under section 585, result in a change in method of accounting, thereby necessitating a section 481(a) adjustment?
FACTS
BK is a commercial bank to which section 585 of the Code applies. BK maintains a bad debt reserve for its mortgage and other loans in accordance with section 585, making annual additions to the reserve as permitted by that section. T is a thrift institution to which section 593 applies. T maintains a bad debt reserve for its mortgage and other loans in accordance with section 593, making annual additions to the reserve as permitted by that section. On January 2, 1984, T merged into BK. The merger of T into BK qualified as a reorganization under section 368(a)(1)(G) and (a)(3)(D)(ii). After the reorganization, BK's original business and that acquired from T were operated by BK as an integrated commercial bank business.
LAW AND ANALYSIS
Section 446(a) of the Code provides the general rule for methods of accounting. Section 1.446-1(a)(1) of the Income Tax Regulations states that the term "method of accounting" includes not only the over-all method of accounting of the taxpayer but also the accounting treatment of any item. Section 1.446-1(e)(2)(ii)(a) states that a change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. Section 1.446-1(e)(2)(ii)(a) provides further that a "material item" is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Section 1.446-1(e)(2)(ii)(b) states that a change in the method of accounting does not include an adjustment with respect to the addition to a reserve for bad debts.
Section 166(a) of the Code allows a deduction for any debt that becomes worthless during the taxable year. Section 166(c) states that in lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary) a deduction for a reasonable addition to a reserve for bad debts. Section 166(g)(3) provides a cross reference to section 593 with respect to special rules for bad debt reserves of certain mutual savings banks, domestic building and loan associations, and cooperative banks, and section 166(g)(4) provides a cross reference to section 585 with respect to special rules for bad debt reserves of banks.
Section 585(b)(1) of the Code provides that, for purposes of section 166(c), the reasonable annual addition to the reserve for bad debts of any financial institution to which such section applies is computed by either the percentage method provided by section 585(b)(2) or the experience method provided by section 585(b)(3). The percentage method is based on "eligible loans" (as defined in the Code and regulations); the experience method is based on "loans outstanding" as so defined. For purposes of computing the reserve addition, there is no maximum reserve balance under the experience method; however, under the percentage method the maximum reserve is 1.2 percent of eligible loans in taxable years beginning after 1975 but before 1982; 1 percent of eligible loans for 1982; and .6 percent thereafter through 1987 (when use of the percentage method ceases).
Section 593(b) of the Code provides that, for purposes of section 166(c), the reasonable annual addition to the bad debt reserve shall be an amount equal to the sum of a reserve for nonqualifying loans plus a reserve for qualifying real property loans. Section 593(b)(1)(A) provides that the allowable annual addition to the bad debt reserve for nonqualifying loans (loans other than qualifying real property loans) is determined under the experience method for banks provided by section 585(b)(3). The addition for qualifying real property loans, as defined in section 593(d), may be computed under either the experience method for banks provided by section 585(b)(3), the percentage method for banks provided by section 585(b)(2) as adjusted by section 593(b)(3), or the percentage of taxable income method for thrift institutions provided by section 593(b)(2). While section 593(b)(2)(A) provides that the applicable percentage for the percentage of taxable income method for 1979 and later years is 40 percent, section 593(b)(2)(D) provides that the maximum reserve balance under such method is 6 percent of qualifying real property loans outstanding at the close of the taxable year.
Section 381(c)(4) of the Code provides that the acquiring corporation in a reorganization to which section 368(a)(1) applies shall use the method of accounting used by the transferor corporation unless several transferors or the acquiring corporation and a transferor used different methods. In that event, the method or combination of methods shall be prescribed by regulations. Section 1.381(c)(4)-1(b)(2) of the regulations provides that if, after a reorganization, the businesses of the parties to the transaction are operated as separate and distinct businesses, then the method of accounting employed by each business shall be continued. But if, after the reorganization, any of the businesses is not operated as a separate and distinct business, to the extent that different methods of accounting were employed on the date of the reorganization, the principal method of accounting employed shall be used, provided it can be used and clearly reflects income. See section 1.381(c)(4)-1(b)(3) and (c).
Section 1.381(c)(4)-1(a)(1)(ii) of the regulations states that the acquiring corporation shall take into its accounts the dollar balances of those accounts of the transferor corporation that represent reserves in respect of which the transferor has taken a deduction. However, this same paragraph of the regulations also states that the amount of the adjustments necessary to reflect a change of accounting method, the manner in which they are to be taken into account, and the tax attributable thereto shall be determined under section 481 of the Code.
In the present situation, prior to the reorganization BK maintained a bad debt reserve in accordance with section 585 of the Code and T maintained a bad debt reserve in accordance with section 593. After the reorganization, BK continued to operate its business and that acquired from T as an integrated commercial bank business. Since BK is not qualified to conduct business as a thrift institution, BK is not permitted to use the bad debt reserve method provided by section 593. Hence, for the mortgage and other loans acquired from T, BK will be required, because of the change of business, to shift from computing bad debt reserves and additions under section 593 of the Code to computing them under section 585.
Section 1.381(c)(4)-1(c)(1) of the regulations provides that when an acquiring corporation must use a different method of accounting for an acquired business than its transferor did, the adjustments necessary to reflect such change and any resulting increase or decrease in tax are determined as if the transferor had initiated a change of accounting method, and any consequent increase or decrease in tax is taken into account by the acquiring corporation.
Rev. Rul. 75-445, 1975-2 C.B. 74, concludes that changing from the percentage method to the experience method within section 585 of the Code is not a change in method of accounting, but that the reserve method described in section 585 is a method of accounting. Rev. Rul. 79-123, 1979-1 C.B. 215, concludes that changing from the percentage of loans method to either the percentage of taxable income method or the experience method within section 593 of the Code are not changes in methods of accounting. However, the reserve method described in section 593 is a method of accounting.
Section 1.446-1(e)(2)(ii)(a) of the regulations provides that a change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. This same regulation defines a "material item" as any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.
A change from the method of estimating a reasonable addition to a bad debt reserve under section 593 of the Code (thrift) to the method of estimating that addition under section 585 (bank) is a change in the treatment of a material item and therefore is a change in method of accounting because it affects the proper time of taking a deduction. See section 1.446-1(e)(2)(ii) of the regulations. It affects the proper time of taking a deduction because it determines the amount of the deduction, both in the current year and in future years, and the amounts deductible under the two methods are not the same.
Section 1.446-1(e)(2)(ii)(b) of the regulations, which provides that a change of accounting method does not include an adjustment with respect to the addition to a reserve for bad debts, is not applicable in the present situation. That statement is made in the context of changes that do not alter the method of accounting itself (such as a change in the useful life of a depreciable asset) and relates only to an adjustment in computing the annual addition for bad debts that corrects differences between prior estimates of bad debt experience and actual bad debt experience. Such corrections have traditionally been treated as self-adjusting in the current year. See section 1.166-4(b)(2).
HOLDING
The integration under section 381(c)(4) of the Code of a distressed thrift institution's bad debt reserve computed under section 593 of the Code into an acquiring commercial bank's bad debt reserve computed under section 585 results in a change in method of accounting, thereby necessitating a section 481(a) adjustment.
EFFECT ON OTHER DOCUMENTS
Rev. Rul. 75-445 and Rev. Rul. 79-123 are distinguished.
- Institutional AuthorsInternal Revenue Service
- Code Sections
- Jurisdictions
- LanguageEnglish
- Tax Analysts Electronic Citation85 TNT 212-47