Conformity Election – To Elect or Not

2/17/2011

By Robert L. Hamby, CPA

The conformity election is a tax election to help determine whether a loan charge off is appropriate as a tax deduction and whether the interest income waived for book purposes on non-accrual loans should also be excluded for tax purposes. Many times the IRS will argue with the taxpayer on an individual loan-by-loan basis whether a charge off is appropriate for tax purposes. For book purposes, a loan charge off is deemed adequate if full recovery of the bank’s investment is not practical. For tax purposes a loan charge off is appropriate if the loan is determined to be of worthless value. The conformity election avoids disparate treatment from the different government agencies.

For loans that are placed on non-accrual status, the accrual of interest is stopped and the amount of accrued interest is reversed or charged off at the time of being placed on non-accrual status. For tax purposes, the non-accrued interest may be reported as taxable income depending on the status of each loan. The IRS position on whether the interest is taxable or not comes down to this: is the interest collectible or merely delinquent? This is a determination that the IRS makes. Some of the general guidelines in making the determination that loans are not necessarily uncollectible involve:

• Passage of time (loans that are placed on non-accrual status under the 90-day rule)
• Multiple loans to the same borrower (loans placed on non-accrual status for all loans to the same borrower rather than reviewing collectability on an individual basis)
• Loans with inconsistent payments

Under the conformity election, a loan charge off, whether partial or full is deemed of worthless value and the accrual of interest waived on non-accrual loans is determined to be uncollectible.

Although the conformity election would appear to make life easier under an IRS audit, the difficulty is maintaining the election. In order to make the election and maintain a valid election, an express determination letter must be obtained and signed by the bank’s federal regulator after each examination. Otherwise the election is voided. The express determination letter is a statement from the federal regulator stating in general terms that the bank maintained and applied loan loss classification standards in regard to charge offs within the regulatory standards for the timeframe covered under the regulatory examination. For actual requirements and wording of the express determination letter, please refer to IRS Revenue Procedure 92-84. Failure to obtain the express determination letter voids the election, which may cause tax returns to be filed incorrectly.