How Does CECL Affect Taxes?

Members of the banking industry know all about the Financial Accounting Standard’s Board’s (FASB) recent issuance of the current expected credit loss (CECL) standards.

What is not as well known is how the new CECL standards impact taxes.

What Is CECL?

CECL standards mandate the use of historical, current and anticipated information to forecast expected losses over the life of a loan.

It is vital that the banking industry have a firm grasp of the impact of CECL’s adjustment to loan losses, the tax implication of bad debt charge-offs and capital in order to help banks to proactively manage their taxes.

One of the most likely results of the CECL standard will be a boast in the allowance for loan losses, which will not directly result to an increase in the number of charge-offs.  That is because bad debts, in and of themselves, are not usually tax deductible.  Instead, the deduction is put off until the debt is charged-off, meaning that the bank “gives up” on collecting the bad debt.

On the borrower side, the event of the charge-off results in a Form 1099-C, which then creates taxable income for the borrower who didn’t pay.

You can see, then, that the bad debt becomes a tax write-off for the bank at the same time it becomes taxable income to the borrower.

The new CECL standards change the way banks will view this matter.

More Bank Charge-Offs, or Fewer?

One of the biggest changes CECL will bring to your allowance calculations is to use “life of loan” loss methods, instead of a more traditional 1-yr charge-off ratio.

IRS Code (IRC) does permit a tax deduction for a wholly worthless debt in the year it becomes worthless. 

The new CECL standards provide more flexibility and “interpretation” on the bank’s side, as to when the loan actually becomes worthless.

At the same time, the IRC allows a tax deduction for a partially worthless debt up to the charged off amount, the Generally Accepted Accounting Principles (GAAP) reserve.

Keep in mind that the IRC does not mandate that the IRS follow charge-offs that are reported for either financial or legal purposes.  This had led to many conflicts over the years between the IRS and banking industry institutions that are under examination.  In order to lessen the conflict, regulations state that worthlessness is presumed when a charge-off occurs as a result of instruction or in accordance with established policy.

The Fine Print Is Still Being Interpreted

Another portion of the IRC green lights loss deductions for partially or wholly worthless debts that follow loan loss standards in line with the bank’s regulatory standards.  It also permits a deduction for the estimated selling costs of the loan and requires the bank to obtain a letter stating that regulatory standards were followed.

There are many tax methods that are currently available to determine both the amount and timing of bad debt tax deductions that financial institutions can use.

Bankers should thoroughly evaluate each method and discuss with their institution’s tax team which would be the most beneficial to use.

Borrowers who have defaulted on a debt also should work to understand how a bank’s “forgiveness” of debt can create a tax liability.

The fine print on the new CECL will affect the tax implications for both lenders and borrowers in ways we don’t fully understand yet.

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