Allowance for Loan Loss and the IRS

3/4/2010

By Joseph M. Press, CPA, CFE

Over the past several fiscal quarters, banks have been faced with the need to increase their loan loss reserves to unprecedented levels. In light of this situation, the question has arisen, “At what point will the Internal Revenue Service (IRS) challenge our ALLL as excessive?” The short answer is that the IRS is indifferent with respect to the amount of ALLL at a bank. An understanding of how a bank arrives at its deduction for bad debt losses will show why.

In general, banks, other than large commercial banks (assets over $500,000,000), may use either the specific charge-off method or the reserve method to compute the bad debt deduction.

Under the reserve method, a bank computes the ratio of net bad-debt charge-offs for its most recent six taxable years, including the current taxable year, to the total of loans outstanding at the close of each of the six years. The ratio is applied to the loans outstanding at the close of the current taxable year and the result is the permissible reserve balance. The deduction for a taxable year is the amount required to bring the reserve to the permissible balance.

While there is an alternative calculation available to eligible banks, which involves additions to the reserve to maintain the reserve balance as it existed at the end of the base year, this variation rarely comes into play as the base year for many banks is 1987.

For banks not eligible to use the reserve method, such as large commercial banks, Sub S banks, and for other banks electing not to use the reserve method, the specific charge-off method must be used. Simply put, under the specific charge-off method, a bank’s annual bad debt deduction would equal its annual net charge-offs.

In summary, a bank’s bad debt deduction is determined without regard to the amount of ALLL the bank deems appropriate for regulatory and financial reporting purposes, and accordingly, the IRS would be indifferent with respect to the level of the ALLL.