Upon the initiation of a financial institution’s regulatory exam, an often overlooked item is the request of the Express Determination Letter (EDL). The EDL is not required to be issued by the regulatory examiners, but can pose serious tax consequences when not secured.
Under Treasury Regulation §1.166-2(d)(3), a bank may make the “Conformity Election.” Under the rules of the conformity election, if the bank regulators conclude there is a presumptive worthlessness for charged off debts, the charge-off is also valid for federal income tax purposes. In addition to maintaining conformity of the presumptive worthlessness of debts charged off, any interest accrued on non-accrual loans are eligible for tax conformity (meaning the change in non-accrual interest balances are not treated as a book to tax accounting adjustment). This adjustment can lead to the tax deduction of all non-accrual interest in the year of election.
If a bank is examined by the Internal Revenue Service, the EDL can be presented to the IRS examiners to substantiate the worthlessness of the debts that were charged off, which relieves the bank of the burden of proving the charged off loan was worthless for income tax purposes. However, the IRS will request a copy of the EDL during an examination, and if the EDL was not secured, can revoke the conformity election that was made.
In order for an EDL to be considered valid, it must be secured for the last federal examination before the last day of the year for which the election is made (for example, if you have the conformity election in place for a 2016 return, the IRS’s position is that the EDL is needed for the last federal examination before January 1, 2016). The initial Conformity Election is made by filing Form 3115 – Application for Change in Accounting Method, which is an automatic change granted by the IRS.
If the IRS revokes the Conformity Election due to the bank not securing the EDL, an accounting method change will not be granted automatic approval by the IRS and a user fee must be paid to secure the accounting method change.
There is no downside to requesting an EDL for the regulatory examiners. This request should be made part of a permanent request list to the examiners and made prior to the start of the regulatory examination. The regulators typically will not issue the EDL if it is not requested at the start of the examination, and retrospective issuance of an EDL is almost never considered.
Please contact Ryan Kilpatrick if you have any questions about the importance of securing Express Determination Letters for your institution.