Rev. Rul. 66-26

The purpose of this Revenue Ruling is to assist banks in computing their bad debt reserves under the provisions of Revenue Ruling 65-92, C.B. 1965-1, 112. There follows a series of guidelines which supplement Revenue Ruling 65-92, and which clarify many of the questions which have been raised concerning the application of the formula provided in that Ruling.

(1) With respect to the establishing of the bad debt reserve on the books, the reserve should be shown on the bank's books or records on a basis consistent with its income tax returns. However, it is not required that the reserve be actually placed on the books by the close of the year. Ordinarily the amounts deducted and the reserve shown in the returns should be shown on the books as soon as practicable after the close of the taxable year.

When an addition to the bad debt reserve as originally set up is adjusted or corrected upon audit in a later year, the revenue agent's adjustments should not be reflected for the year in which the audit is made, but should be reflected in the computation of the annual addition for the year to which such adjustments relate.

(2) Bad debts and recoveries on bad debts must be recorded in the reserve account except as hereinafter provided. Bad debts should be charged to the reserve for the year in which they occur, and recoveries on bad debts which have been previously charged against the reserve should be credited to the reserve for the taxable year of recovery.

Recoveries on bad debts which were charged off prior to the time that the bank adopted the reserve method should not be credited to the reserve, but should be treated as taxable income subject to the provisions of section 111 of the Internal Revenue Code of 1954.

(3) The term `net bad debts' as used in section 4 of Revenue Ruling 65-92 means all bad debts charged to the reserve account for the current taxable year less any recoveries realized during the current taxable year on bad debts charged to the reserve account in prior years.

(4) If, as a result of net recoveries during the taxable year, the reserve balance exceeds the prescribed limitations, a bank is not required to report the excess as taxable income. Any recoveries on bad debts previously charged to the reserve account must be credited to the reserve even though the limitations relating to the permissible amount of the reserve are exceeded. In such a case the excess over the otherwise permissible balance in the reserve account precludes current deductible additions to the reserve, and may affect future deductible additions.

Where a bank subject to section 4 of Revenue Ruling 65-92 (i.e., a bank with a reserve less than the 2.4-percent uniform ratio) has recoveries for the year which exceed bad debts for that year, the bank is not required to reduce its otherwise permissible current annual additions by the amount of the net recovery. The amount of the addition to the reserve is, however, subject to the applicable limitations prescribed in sections 4, 5, and 6 of the Ruling.

(5) Circumstances under which an addition in excess of 0.8 percent of eligible loans might be made to the reserve would exist if net bad debts charged to the reserve during the taxable year exceed the reserve balance as of the beginning of the taxable year. In such a case, an amount could be added which would result in a final balance of 0.8 percent of eligible loans, provided, however, that the limitations of section 4 of Revenue Ruling 65-92 are not exceeded.

(6) Concerning the meaning and application in section 4 of Revenue Ruling 65-92 of the term `end of the year preceding the year of change' as that term relates to increases in yearend outstanding loans, the term represents the base yearend date for determining any increases in yearend loan balances in future years. For example, a bank whose taxable year is the calendar year would have a base yearend of either:

1. December 31, 1964, in a situation where the bank was on the reserve method as of that date; or,

2. December 31, of the year preceding the year of change in method for a bank which changed from the specific chargeoff method to the reserve method of treating bad debts after December 31, 1964.

In the case of a newly organized bank, there would be no outstanding loan balance as of the end of the year preceding its first taxable year, and the loan balance base to be used for determining future increases in yearend outstanding loand would, therefore, be zero. Thus, in the case of a new bank whose first taxable year ends after December 31, 1964, there would be no reserve deficiency (as that term is used in Revenue Ruling 65-92) and the new bank would compute its annual reserve addition by including in such addition the amount of its net bad debts for the taxable year, plus 2.4 percent of the increase in its loans outstanding at the end of the year over the amount of its loans outstanding (zero) at the end of the year preceding its first taxable year. The foregoing amounts would represent the bank's tentative reserve addition subject to the limitations of section 4 (other than the one-tenth limitation) and the maximum limitations of section 6 of Revenue Ruling 65-92. (The term `newly organized bank' as used here does not include a bank organized as a result of a transaction to which section 381(a) of the Internal Revenue Code of 1954 applied.)

With respect to the application of the provisions of section 4 of Revenue Ruling 65-92 to a bank which changes from the specific chargeoff method to the reserve method of treating bad debts, the only factor which would distinguish that bank from one which was on the reserve method at December 31, 1964, would be the amount of the reserve deficiency which, in the case of the changing bank, would be a full 2.4 percent of its outstanding loans at the end of the year preceding the year of change.

(7) In order that a bank may add to its reserve an amount attributable to loan balance increases, the loan balance at the end of the year of the proposed reserve addition must exceed the total of (a) the amount of loans which were outstanding at the end of the year preceding the year of change, and (b) the amount of any outstanding loans with respect to which reserve additions for loan increases were taken in years prior to the year of the proposed addition. This limitation is illustrated as follows:

Assume that a bank with a reserve less than the 2.4 percent ceiling had outstanding loans of $1,000,000 on December 31, 1964, had outstanding loans of $2,000,000 on December 31, 1965, and has outstanding loans of $1,750,000 on December 31, 1966. For 1965 the bank elected not to add to its reserve the full amount based upon the $1,000,000 increase in loans, but in making its reserve addition it took into account only 50 percent of the $1,000,000 increase ($500,000). In computing its reserve addition for 1966, the bank would be entitled to a reserve addition attributable only to outstanding loan increases of $250,000, since a reserve addition with respect to $500,000 of the $750,000 outstanding loan increase was taken in the year 1965.

(8) The order in which the factors which make up the annual reserve addition should be claimed is:

1. Net bad debts charged to the reserve;

2. An amount equal to one-tenth of the reserve deficiency; and,

3. An amount attributable to any increase in outstanding loans.

A bank is not required to take as a tax deduction its maximum permissible annual reserve addition for each taxable year, and unused portions of the above factors may be used in a subsequent year. The use of such portions in a later year would, however, be subject to the applicable limitations of Revenue Ruling 65-92 governing the amount of the reserve addition in such later year.

There is no requirement that the reserve deficiency be used up within a 10-year period. The one-tenth additions relating to the deficiency may be taken over a period in excess of 10 years.

(9) The maximum limitations in section 6 of Revenue Ruling 65-92 are overall limitations not to be exceeded under any circumstances. Section 6 would apply only in a situation where the proposed reserve addition as computed under either section 4 or 5 of Revenue Ruling 65-92 is greater than 0.8 percent of outstanding loans. If the reserve addition as determined under either section 4 or 5 of the Ruling is not greater than 0.8 percent of outstanding loans, section 6 of the Ruling is not applicable and the lesser amount must be used.

(10) Losses on worthless securities are not to be charged against the bad debt reserve for loans established under Revenue Ruling 65-92. See G.C.M. 25605, C.B. 1948-1, 38, as modified by Revenue Ruling 65-92. Deductions for losses on securities may be taken either as specific bad debt losses or may be taken through the creation of a separate loss reserve on such securities established without respect to Revenue Ruling 65-92.

(11) Application for permission to change the method of treating bad debts must be made within 90 days after the beginning of the taxable year in which the taxpayer desires to make the change. (Section 1.446(e)(3) of the Income Tax Regulations.)

A bank is not required to adopt the reserve method of accounting for bad debts because of the permission granted it to do so; however, if it does not change, it would be necessary to again obtain permission if a change is desired in a subsequent year.

Revenue Ruling 65-92, C.B. 1965-1, 112, supplemented.

¹ Also released as Technical Information Release 794, dated Jan. 12, 1966.