The Internal Revenue Service is scrutinizing at least a handful of banks that sought large tax refunds for charging off bad loans last year.
The inquiries, if they turn into full-blown audits, could have significant implications for community and regional banks. If the IRS denies a refund, the bank would lose the ability to count it as much-needed capital.
"It could wipe out $1 million to $2 million in capital" for a community bank, said Bill Massey, a shareholder and CPA at Saltmarsh, Cleaveland & Gund in Pensacola, Fla.
After writing off soured loans and taking a net loss, many banks sought refunds on their 2009 tax returns, a technique known as loss carry-backs. Some banks are facing audits because by law, refunds that exceed $2 million trigger an IRS examination of any business.
While that trigger has been on the books for years, many banks posted the worst chargeoffs and net losses in their history last year, so the IRS is conducting more audits and paying close attention to charged-off loans.
The situation is a Catch-22 for banks whose regulators demanded they write off more nonperforming credits. Massey pointed to a recent case where the IRS challenged a loan that a bank charged off because it was still trying to foreclose on the collateral. If the bank hadn't charged off the loan "they could get criticized by their regulators," he said.
Only 25% to 30% of U.S. banks may seek refunds in excess of $2 million, Massey said. Yet accountants whose clients include banks worry that the IRS could also look at institutions that claimed smaller refunds. And once an audit begins, its scope could widen.
"Whenever a company's tax liability goes way down, it is not surprising that there's an audit … and the administration said they were going to be more aggressive in the corporate tax world," said Kip Weissman, a partner at the law firm Luse Gorman Pomerenk & Schick. "The bad thing is when they're going in for one thing and they find something else."
The IRS would not comment for this story.
Federal law requires certain refunds in excess of $2 million that result from carry-backs from credit losses be approved by the Joint Committee on Taxation. An IRS auditor could scrutinize these returns even more thoroughly than in a general audit because the agency must report its findings to the committee to secure refund approval, said Bob McCahill, a director in the New York office of McGladrey, an accounting firm.
"And certainly, the more [chargeoffs] you have, the more likely it is going to be challenged," he said.
The real estate market's collapse, coupled with changes to accounting rules, have caused more banks to charge off loans, producing larger losses and leading them to file for larger refunds on their tax returns.
"The larger banks, they get audited every single year," McCahill said. "But some of the smaller banks haven't been audited in decades."
In 2009, the stimulus legislation allowed small businesses with net operating losses in 2008 to carry back the loss five years instead of the previous two-year limit. The change was intended to provide relief to businesses, including banks, that were profitable before the recession and could use the refund for income and capital.
"For our clients, it was a pretty significant thing," said Frank Gonzalez, a partner in charge of financial institutions at Morrison, Brown, Argiz & Farra LLP in Miami. "Every institution was pretty much at a loss position in 2009 because of the market."
Gonzalez said while nearly all of his clients took advantage of the loss carry-back changes, he does not have banking clients that sought refunds of more than $2 million. The IRS has, however, made inquiries because a few banks deducted a loss based on reserves and not chargeoffs.
Massey said three of his bank clients filed for refunds of more than $2 million for the 2008 tax year and four for 2009 as a result of the loss carry-back changes. He expects more banks to seek higher refunds as chargeoffs and net losses rise.
Among the 50 Southeast banks with assets of less than $10 billion that had the highest provisions for loan losses, only eight were profitable in 2009 before tax adjustments, according to SNL Financial LC. Net chargeoffs rose at 47 of those banks, often 50% or more from 2008 to 2009.
Despite relief from the loss carry-back changes, "there are still institutions where it is not enough and they are still looking for additional capital," Gonzalez said. "It has helped a lot or it has helped enough in order for some banks to stay on their feet."