Tax Aspects of Nonperforming Assets

The recent turmoil in the financial markets has sparked a renewed interest in the tax rules covering nonperforming assets. For insurance companies, the rules take on added significance because of the interplay between statutory accounting and tax. This is an appropriate time for a brief review and comparison of the statutory and tax accounting rules.

Accrual of Investment Income

On the investment income side, SSAP No. 34 requires a two-step process for the accrual of income when collection is in doubt. First, investment income must be written off if it is probable that it will not be collected. The “probable” standard is derived from SSAP No. 5. As used in SSAP No. 5, “probable” refers to “that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved.” (SSAP No. 5, fn. 1.) Second, SSAP No. 34 requires that investment income over 90 days (or 180 days for mortgages) past due must be treated as a non-admitted asset on the balance sheet. Because the second step has no effect on income, the relevant standard for comparison with the tax rules is the “probable” standard under the first step.

How does the “probable” standard compare with the tax standard for accrual of income? For income tax purposes, Treas. Reg. § 1.451-1(a) applies the accrual method to interest income, requiring an income inclusion when all events have occurred that fix the right to receive the interest income and the amount can be determined with reasonable accuracy. The accrual standard for the income inclusion is satisfied when the interest is economically earned, payment is due or payment is received. An exception applies, however, if there is a “reasonable doubt as to collectibility” at the time the accrual standard otherwise would be satisfied. The “reasonable doubt as to collectibility” standard is a lesser standard than the wholly worthless standard for the write-off of principal discussed below. Although there is little or no guidance comparing the statutory and tax standards, the Internal Revenue Service (IRS) can be expected to apply the “reasonable doubt as to collectibility” standard in a more stringent manner than the statutory accounting “probable” standard. In Rev. Rul. 2007-32,3 applicable to banks, the IRS strictly construed the exception from accrual, holding that the uncertainty as to collection must be “substantial.” The IRS also reiterated case law providing that a temporary financial difficulty of the debtor is not sufficient to avoid accrual of income and that it is the taxpayer’s burden to demonstrate substantial uncertainty as to collection. Thus, it is up to the taxpayer to accumulate and preserve the evidence regarding the debtor’s nancial instability to substantiate the nonaccrual of interest and avoid an IRS audit adjustment. Furthermore, the IRS appears to have designated this as a Tier II issue under its Issue Focus Program, meaning that the issue may draw increased attention and some level of coordination from the IRS National Office.