[Code of Federal Regulations]
[Title 26, Volume 2]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.166-2]

[Page 912-916]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.166-2  Evidence of worthlessness.

    (a) General rule. In determining whether a debt is worthless in 
whole or in part the district director will consider all pertinent 
evidence, including the value of the collateral, if any, securing the 
debt and the financial condition of the debtor.
    (b) Legal action not required. Where the surrounding circumstances 
indicate that a debt is worthless and uncollectible and that legal 
action to enforce payment would in all probability not result in the 
satisfaction of execution on a judgment, a showing of these facts will 
be sufficient evidence of the worthlessness of the debt for purposes of 
the deduction under section 166.
    (c) Bankruptcy--(1) General rule. Bankruptcy is generally an 
indication of the worthlessness of at least a part of an unsecured and 
unpreferred debt.
    (2) Year of deduction. In bankruptcy cases a debt may become 
worthless before settlement in some instances; and in others, only when 
a settlement in bankruptcy has been reached. In either case, the mere 
fact that bankruptcy proceedings instituted against the debtor are 
terminated in a later year, thereby confirming the conclusion that the 
debt is worthless, shall not authorize the shifting of the deduction 
under section 166 to such later year.
    (d) Banks and other regulated corporations--(1) Worthlessness 
presumed in year of charge-off. If a bank or other corporation which is 
subject to supervision by Federal authorities, or by State authorities 
maintaining substantially equivalent standards, charges off a debt in 
whole or in part, either--

[[Page 913]]

    (i) In obedience to the specific orders of such authorities, or
    (ii) In accordance with established policies of such authorities, 
and, upon their first audit of the bank or other corporation subsequent 
to the charge-off, such authorities confirm in writing that the charge-
off would have been subject to such specific orders if the audit had 
been made on the date of the charge-off,

then the debt shall, to the extent charged off during the taxable year, 
be conclusively presumed to have become worthless, or worthless only in 
part, as the case may be, during such taxable year. But no such debt 
shall be so conclusively presumed to be worthless, or worthless only in 
part, as the case may be, if the amount so charged off is not claimed as 
a deduction by the taxpayer at the time of filing the return for the 
taxable year in which the charge-off takes place.
    (2) Evidence of worthlessness in later taxable year. If such a bank 
or other corporation does not claim a deduction for such a totally or 
partially worthless debt in its return for the taxable year in which the 
charge-off takes place, but claims the deduction for a later taxable 
year, then the charge-off in the prior taxable year shall be deemed to 
have been involuntary and the deduction under section 166 shall be 
allowed for the taxable year for which claimed, provided that the 
taxpayer produces sufficient evidence to show that--
    (i) The debt became wholly worthless in the later taxable year, or 
became recoverable only in part subsequent to the taxable year of the 
involuntary charge-off, as the case may be; and,
    (ii) To the extent that the deduction claimed in the later taxable 
year for a debt partially worthless was not involuntarily charged off in 
prior taxable years, it was charged off in the later taxable year.
    (3) Conformity election--(i) Eligibility for election. In lieu of 
applying paragraphs (d)(1) and (2) of this section, a bank (as defined 
in paragraph (d)(4)(i) of this section) that is subject to supervision 
by Federal authorities, or by state authorities maintaining 
substantially equivalent standards, may elect under this paragraph 
(d)(3) to use a method of accounting that establishes a conclusive 
presumption of worthlessness for debts, provided that the bank meets the 
express determination requirement of paragraph (d)(3)(iii)(D) of this 
section for the taxable year of the election.
    (ii) Conclusive presumption--(A) In general. If a bank satisfies the 
express determination requirement of paragraph (d)(3)(iii)(D) of this 
section and elects to use the method of accounting under this paragraph 
(d)(3)--
    (1) Debts charged off, in whole or in part, for regulatory purposes 
during a taxable year are conclusively presumed to have become 
worthless, or worthless only in part, as the case may be, during that 
year, but only if the charge-off results from a specific order of the 
bank's supervisory authority or corresponds to the bank's classification 
of the debt, in whole or in part, as a loss asset, as described in 
paragraph (d)(3)(ii)(C) of this section; and
    (2) A bad debt deduction for a debt that is subject to regulatory 
loss classification standards is allowed for a taxable year only to the 
extent that the debt is conclusively presumed to have become worthless 
under paragraph (d)(3)(ii)(A)(1) of this section during that year.
    (B) Charge-off should have been made in earlier year. The conclusive 
presumption that a debt is worthless in the year that it is charged off 
for regulatory purposes applies even if the bank's supervisory authority 
determines in a subsequent year that the charge-off should have been 
made in an earlier year. A pattern of charge-offs in the wrong year, 
however, may result in revocation of the bank's election by the 
Commissioner pursuant to paragraph (d)(3)(iv)(D) of this section.
    (C) Loss asset defined. A debt is classified as a loss asset by a 
bank if the bank assigns the debt to a class that corresponds to a loss 
asset classification under the standards set forth in the ``Uniform 
Agreement on the Classification of Assets and Securities Held by Banks'' 
(See Attachment to Comptroller of the Currency Banking Circular No. 127, 
Rev. 4-26-91, Comptroller of the Currency, Communications Department, 
Washington, DC 20219) or similar guidance issued by the Office of

[[Page 914]]

the Comptroller of the Currency, the Federal Deposit Insurance 
Corporation, the Board of Governors of the Federal Reserve, or the Farm 
Credit Administration; or for institutions under the supervision of the 
Office of Thrift Supervision, 12 CFR 563.160(b)(3).
    (iii) Election--(A) In general. An election under this paragraph 
(d)(3) is to be made on bank-by-bank basis and constitutes either the 
adoption of or a change in method of accounting, depending on the 
particular bank's facts. A change in method of accounting that results 
from the making of an election under this paragraph (d)(3) has the 
effects described in paragraph (d)(3)(iii)(B) of this section.
    (B) Effect of change in method of accounting. A change in method of 
accounting resulting from an election under this paragraph (d)(3) does 
not require or permit an adjustment under section 481(a). Under this 
cut-off approach--
    (1) There is no change in the Sec. 1.1011-1 adjusted basis of the 
bank's existing debts (as determined under the bank's former method of 
accounting for bad debts) as a result of the change in method of 
accounting;
    (2) With respect to debts that are subject to regulatory loss 
classification standards and are held by the bank at the beginning of 
the year of change (to the extent that they have not been charged off 
for regulatory purposes), and with respect to debts subject to 
regulatory loss classification standards that are originated or acquired 
subsequent to the beginning of the year of change, bad debt deductions 
in the year of change and thereafter are determined under the method of 
accounting for bad debts prescribed by this paragraph (d)(3);
    (3) With respect to debts that are not subject to regulatory loss 
classification standards or that have been totally charged off prior to 
the year of change, bad debt deductions are determined under the general 
rules of section 166; and
    (4) If there was any partial charge-off of a debt in a prechange 
year, any portion of which was not claimed as a deduction, the deduction 
reflecting that partial charge-off must be taken in the first year in 
which there is any further charge-off of the debt for regulatory 
purposes.
    (C) Procedures--(1) In general. A new bank adopts the method of 
accounting under this paragraph (d)(3) for any taxable year ending on or 
after December 31, 1991 (and for all subsequent taxable years) when it 
adopts its overall method of accounting for bad debts, by attaching a 
statement to this effect to its income tax return for that year. Any 
other bank makes an election for any taxable year ending on or after 
December 31, 1991 (and for all subsequent taxable years) by filing a 
completed Form 3115 (Application for Change in Accounting Method) in 
accordance with the rules of paragraph (d)(3)(iii)(C)(2) or (3) of this 
section. The statement or Form 3115 must include the name, address, and 
taxpayer identification number of the electing bank and contain a 
declaration that the express determination requirement of paragraph 
(d)(3)(iii)(D) of this section is satisfied for the taxable year of the 
election. When a Form 3115 is used, the declaration must be made in the 
space provided on the form for ``Other changes in method of 
accounting.'' The words ``ELECTION UNDER Sec. 1.166-2(d)(3)'' must be 
typed or legibly printed at the top of the statement or page 1 of the 
Form 3115.
    (2) First election. The first time a bank makes this election, the 
statement or Form 3115 must be attached to the bank's timely filed 
return (taking into account extensions of time to file) for the first 
taxable year covered by the election. The consent of the Commissioner to 
make a change in method of accounting under this paragraph (d)(3) is 
granted, pursuant to section 446(e), to any bank that makes the election 
in accordance with this paragraph (d)(3)(iii)(C), provided the bank has 
not made a prior election under this paragraph (d)(3).
    (3) Subsequent elections. The advance consent of the Commissioner is 
required to make any election under this paragraph (d)(3) after a 
previous election has been revoked pursuant to paragraph (d)(3)(iv) of 
this section. This consent must be requested under the procedures, 
terms, and conditions

[[Page 915]]

prescribed under the authority of section 446(e) and Sec. 1.446-1(e) 
for requesting a change in method of accounting.
    (D) Express determination requirement. In connection with its most 
recent examination involving the bank's loan review process, the bank's 
supervisory authority must have made an express determination (in 
accordance with any applicable administrative procedure prescribed 
hereunder) that the bank maintains and applies loan loss classification 
standards that are consistent with the regulatory standards of that 
supervisory authority. For purposes of this paragraph (d)(3)(iii)(D), 
the supervisory authority of a bank is the appropriate Federal banking 
agency for the bank, as that term is defined in 12 U.S.C. 1813(q), or, 
in the case of an institution in the Farm Credit System, the Farm Credit 
Administration.
    (E) Transition period election. For taxable years ending before 
completion of the first examination of the bank by its supervisory 
authority (as defined in paragraph (d)(3)(iii)(D) of this section) that 
is after October 1, 1992, and that involves the bank's loan review 
process, the statement or Form 3115 filed by the bank must include a 
declaration that the bank maintains and applies loan loss classification 
standards that are consistent with the regulatory standards of that 
supervisory authority. A bank that makes this declaration is deemed to 
satisfy the express determination requirement of paragraph 
(d)(3)(iii)(D) of this section for those years, even though an express 
determination has not yet been made.
    (iv) Revocation of Election--(A) In general. Revocation of an 
election under this paragraph (d)(3) constitutes a change in method of 
accounting that has the effects described in paragraph (d)(3)(iv)(B) of 
this section. If an election under this paragraph (d)(3) has been 
revoked, a bank may make a subsequent election only under the provisions 
of paragraph (d)(3)(iii)(C)(3) of this section.
    (B) Effect of change in method of accounting. A change in method of 
accounting resulting from revocation of an election under this paragraph 
(d)(3) does not require or permit an adjustment under section 481(a). 
Under this cut-off approach--
    (1) There is no change in the Sec. 1.1011-1 adjusted basis of the 
bank's existing debts (as determined under this paragraph (d)(3) method 
or any other former method of accounting used by the bank with respect 
to its bad debts) as a result of the change in method of accounting; and
    (2) Bad debt deductions in the year of change and thereafter with 
respect to all debts held by the bank, whether in existence at the 
beginning of the year of change or subsequently originated or acquired, 
are determined under the new method of accounting.
    (C) Automatic revocation--(1) In general-- A bank's election under 
this paragraph (d)(3) is revoked automatically if, in connection with 
any examination involving the bank's loan review process by the bank's 
supervisory authority as defined in paragraph (d)(3)(iii)(D) of this 
section, the bank does not obtain the express determination required by 
that paragraph.
    (2) Year of revocation. If a bank makes the conformity election 
under the transition rules of paragraph (d)(3)(iii)(E) of this section 
and does not obtain the express determination in connection with the 
first examination involving the bank's loan review process that is after 
October 1, 1992, the election is revoked as of the beginning of the 
taxable year of the election or, if later, the earliest taxable year for 
which tax may be assessed. In other cases in which a bank does not 
obtain an express determination in connection with an examination of its 
loan review process, the election is revoked as of the beginning of the 
taxable year that includes the date as of which the supervisory 
authority conducts the examination even if the examination is completed 
in the following taxable year.
    (3) Consent granted. Under the Commissioner's authority in section 
446(e) and Sec. 1.446-1(e), the bank is directed to and is granted 
consent to change from this paragraph (3)(1) method as of the year of 
revocation (year of change) prescribed by paragraph (d)(3)(iv)(C)(2) of 
this section.

[[Page 916]]

    (4) Requirements. A bank changing its method of accounting under the 
automatic revocation rules of this paragraph (d)(3)(iv)(C) must attach a 
completed Form 3115 to its income tax return for the year of revocation 
prescribed by paragraph (d)(3)(iv)(C)(2) of this section. The words 
``REVOCATION OF Sec. 1.166-2(d)(3) ELECTION'' must be typed or legibly 
printed at the top of page 1 of the Form 3115. If the year of revocation 
is a year for which the bank has already filed its income tax return, 
the bank must file an amended return for that year reflecting its change 
in method of accounting and must attach the completed Form 3115 to that 
amended return. The bank also must file amended returns reflecting the 
new method of accounting for all subsequent taxable years for which 
returns have been filed and tax may be assessed.
    (D) Revocation by Commissioner. An election under this paragraph 
(d)(3) may be revoked by the Commissioner as of the beginning of any 
taxable year for which a bank fails to follow the method of accounting 
prescribed by this paragraph. In addition, the Commissioner may revoke 
an election as of the beginning of any taxable year for which the 
Commissioner determines that a bank has taken charge-offs and deductions 
that, under all facts and circumstances existing at the time, were 
substantially in excess of those warranted by the exercise of reasonable 
business judgment in applying the regulatory standards of the bank's 
supervisory authority as defined in paragraph (d)(3)(III)(D) of this 
section.
    (E) Voluntary revocation. A bank may apply for revocation of its 
election made under this paragraph (d)(3) by timely filing a completed 
Form 3115 for the appropriate year and obtaining the consent of the 
Commissioner in accordance with section 446(e) and Sec. 1.446-1(e) 
(including any applicable administrative procedures prescribed 
thereunder). The words ``REVOCATION OF Sec. 1.166-2(d)(3) ELECTION'' 
must be typed or legibly printed at the top of page 1 of the Form 3115. 
If any bank has had its election automatically revoked pursuant to 
paragraph (d)(3)(iv)(C) of this section and has not changed its method 
of accounting in accordance with the requirements of that paragraph, the 
Commissioner will require that any voluntary change in method of 
accounting under this paragraph (d)(3)(iv)(E) be implemented 
retroactively pursuant to the same amended return terms and conditions 
as are prescribed by paragraph (d)(3)(iv)(C) of this section.
    (4) Definitions. For purposes of this paragraph (d)--
    (i) Bank. The term bank has the meaning assigned to it by section 
581. The term bank also includes any corporation that would be a bank 
within the meaning of section 581 except for the fact that it is a 
foreign corporation, but this paragraph (d) applies only with respect to 
loans the interest on which is effectively connected with the conduct of 
a banking business within the United States. In addition, the term bank 
includes a Farm Credit System institution that is subject to supervision 
by the Farm Credit Administration.
    (ii) Charge-off. For banks regulated by the Office of Thrift 
Supervision, the term charge-off includes the establishment of specific 
allowances for loan losses in the amount of 100 percent of the portion 
of the debt classified as loss.

[T.D. 6500, 25 FR 11402, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7254, 38 FR 2418, Jan. 26, 1973; T.D. 8396, 57 FR 6294, 
Feb. 24, 1992; T.D. 8441, 57 FR 45569, Oct. 2, 1992; T.D. 8492, 58 FR 
53658, Oct. 18, 1993]