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IRS Guidance May Provide Avenue for Reduction of Taxable Income Recognition Relating to Non-Accrual Loans

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Financial institutions may be impacted in a favorable way by new Internal Revenue Service guidance regarding the treatment of non-accrual interest for income tax purposes.

Generally, accrual-basis financial institutions would include interest in their income for both book and tax purposes when all the events have occurred which fix the right to receive the interest and the amount can be determined with reasonable certainty.

Generally, accrual-basis financial institutions would include interest in their income for both book and tax purposes when all the events have occurred which fix the right to receive the interest and the amount can be determined with reasonable certainty. However, for regulatory financial statement purposes, unless a loan is both well-secured and in the process of collection, federal banking rules may require that a bank suspend the recognition into income of uncollected accrued interest on a loan and reverse any previously recognized uncollected interest income. A common example of this situation is when payment of principal or interest has been in default for a period of 90 days or more.

Even if accrued interest is no longer being recognized, the loan is still a bankable asset (i.e., it is not written off; it is only non-performing). The entity's financial statements will contain a disclosure of the amount of interest that would have been accrued had the loan not been in non-accrual status.

Although the bank is not permitted to recognize accrued interest related to a loan on non-accrual status as income for regulatory financial statement purposes, federal banking rules do not control the federal income tax treatment. The financial institution would continue to accrue the interest income in its tax filings unless there was substantial uncertainty as to its collection.

The mere fact that the borrower is experiencing temporary financial difficulty is not sufficient to support the non-recognition of the income for tax purposes. If the bank reasonably expects a borrower to continue making payments, there is a presumption of a reasonable expectation of repayment. If the principal is subsequently charged off for regulatory purposes, the interest accrued for tax purposes is charged off as part of the bank's bad debt computation. If the interest is actually collected in a future period, it will be either (a) not included in taxable income if the underlying loan has not been charged off or (b) a recovery for tax purposes if the principal had been written off (Rev. Rul. 2007-32, 2007-21 IRB).

The IRS notes that substantiation of uncollectible interest using a loan-by-loan facts and circumstances methodology can be administratively burdensome and impractical, particularly for unsecured loans. In Revenue Procedure 2007-33, the IRS identifies a "safe harbor" method to identify the amount of non-collected interest for which there is a reasonable expectation of payment based on its five-year average experience of collections on all loans. The ratio of total payments received by the bank on all loans (including principal and interest) during the five preceding years to the total amounts that were due and payable to the bank on loans during the same period would represent the amount of non-accrual interest the bank could reasonably expect to collect. This is the amount that would be included in the bank's taxable income.

Proper documentation of the bank's experience with collection of non-accrual loans is essential to substantiate the safe-harbor treatment. Depending on the bank's history of collecting on its loans, it may be able to reduce its taxable income by not including the entire amount of non-accrual interest. The result will be that banks that qualify for the new treatment will not be required to accelerate the recognition of taxable income for this item.

About Morrison, Brown, Argiz & Farra, LLP

Morrison, Brown, Argiz & Farra, LLP, is ranked as the largest independent public accounting firm in Florida, 10th in the Atlantic/Southeast region, and 51st in the nation. The firm has been ranked on "Best of the Best," the list of the top 25 performing firms in the country, for 11 years. MBAF has an impeccable reputation for providing accounting, assurance, tax, litigation, and business valuation support, technology, and consulting services to a wide variety of individuals, entrepreneurs, and corporations across a broad range of industries. For more information, visit

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