IRS Should Stop Stalling Deductions for Bad Loans

If it looks like a duck, waddles like a duck, and quacks like a duck, it must be a duck. So goes the old saw.

Unfortunately, the banking industry today must dispose of quite a few dead ducks. And barring a resurrection, they have no hope of future life.

The dead ducks are uncollectible loans that banks have charged off only to be challenged by the Internal Revenue Service.

A Change in Policy

From the 1950s until the 1970s, tax reserve allowances to banks for loan losses were based on the experience of the Great Depression.

Since losses were relatively light in the later period, the reserve allowances were relatively generous. This was fortunate, because the industry hit the real estate problems of the early and mid-1970s, those reserves probably spared the Federal Deposit Insurance Corp. significant problems with major institutions.

Beginning with the Tax Reform Act of 1969, however, the amount allowed for loss reserves was slashed. And the 1986 Tax Reform Act ended reserves for large banks. Banks with assets exceeding $500 million or those in holding companies with combined assets exceeding $500 million were assigned a "chargeoff" method for tax purposes.

Chargeoff Before Deduction

Basically, this method required that a loan be charged off before a tax deduction could be claimed.

By the late 1980s, steep losses were clearly developing in bank portfolios. Regulators were aggressively and perhaps appropriately demanding higher reserves or chargeoffs.

The 1986 Tax Reform Act mandated a Treasury study to determine when a loan should be considered "bad" for Federal income tax purposes. This study is unfinished; the Treasury is supposedly consulting with regulators in order to thoroughly describe when a duck should be declared dead.

Meanwhile, there's more controversy with the Internal Revenue Service about when a loan is a proper chargeoff. Examining agents are challenging deductions in many cases where the evidence supporting a chargeoff appears adequate.

Bankers universally dread the loss of interest or principal. They loathe bad loans, with their taint of failure.

The position of many IRS agents suggests they doubt this.

When regulators say a loan is uncollectible and should be written down; when the auditors agree; when the loan remains unpaid; when the bankers, ever averse to premature writeoffs, agree to record a loss -- still the IRS demurs, clinging to the belief that the chargeoff is improper or premature.

What's the Secret?

Perhaps the IRS has a magic formula to bring dead ducks back to life; if so, many bankers would welcome a copy. Maybe the IRS would take an assignment of the debt in lieu of taxes.

We are optimistic that tax policy in this area will be revisited to align it with marketplace realities. The reasoned positions of those closest to the loans -- those who make the unpleasant but necessary decisions on chargeoffs -- should carry weight.

So let's avoid counterproductive autopsies of indisputably dead ducks.

Mr. Howard L. Wright, a partner with Arthur Andersen & Co., and director of regulatory matters in its Washington office.

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