[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.585-2]

[Page 317-325]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.585-2  Addition to reserve.

    (a) In general--(1) Maximum addition. For taxable years beginning 
before January 1, 1988, the maximum reasonable addition to the reserve 
for losses on loans as defined in paragraph (e)(2) of this section is 
the amount allowable under the percentage method provided by paragraph 
(b) of this section or the experience method provided by paragraph (c) 
of this section, whichever is greater. For taxable years beginning after 
December 31, 1987, the maximum reasonable addition to the reserve for 
losses on loans is the amount determined under the experience method 
provided by paragraph (c) of this section.
    (2) Minimum addition. For taxable years beginning after December 31, 
1976, and before January 1, 1988, a taxpayer to which this section 
applies shall make a minimum addition to the reserve for losses on loans 
as defined in paragraph (e)(2) of this section. For purposes of this 
subparagraph, the term minimum addition means an addition to the reserve 
for losses on loans in an amount equal to the lesser of (i) the amount 
allowable under section 585 (b)(3)(A) and paragraph (c)(1)(ii) of this 
section, or (ii) the maximum amount allowable under section 585 (b)(2) 
and paragraph (b) of this section. For taxable years beginning after 
December 31, 1987, a taxpayer to which this section applies shall make a 
minimum addition to the reserve for losses on loans for each taxable 
year in an amount equal to the amount allowable under section 585 
(b)(3)(A) and paragraph (c)(1)(ii) of this section.
    (b) Percentage method--(1) In general--(i) Maximum addition. Except 
as limited under subparagraph (2) of this paragraph, the maximum 
reasonable addition to the reserve for losses on loans under the 
percentage method for a taxable year is the amount determined under 
paragraph (b)(1) (ii), (iii), or (iv) of this section, whichever is 
applicable. For purposes of this paragraph, the term allowable 
percentage means 1.8 percent for taxable years beginning before 1976; 
1.2 percent for taxable years beginning after 1975 but before 1982; 1.0 
percent for taxable years beginning in 1982; and 0.6 percent for taxable 
years beginning after 1982 and before 1988. This paragraph does not 
apply for taxable years beginning after 1987.
    (ii) Reserve less than allowable percentage of eligible loans. (A) 
If the reserve for losses on loans as of the close of the base year is 
less than the allowable percentage for the taxable year multiplied by 
the eligible loans outstanding at the close of the base year, the amount 
determined under this subdivision for the taxable year is the amount 
necessary to increase the balance of the reserve for losses on loans as 
of the close of the taxable year to an amount

[[Page 318]]

equal to the allowable percentage for the taxable year multiplied by the 
eligible loans outstanding at the close of that year, except that the 
amount determined with respect to the reserve deficiency shall not 
exceed one-fifth of the reserve deficiency. For purposes of this 
section, the term reserve deficiency means the excess of the allowable 
percentage for the taxable year multiplied by the eligible loans 
outstanding at the close of the base year over the reserve forlosses on 
loans as of the close of the base year. Where a taxpayer has recoveries 
of bad debts for a taxable year which exceed the bad debts sustained for 
such year, the taxpayer is not required to reduce its otherwise 
permissible current addition by the amount of the net recovery. A 
reasonable addition attributable to an increase in eligible loans 
outstanding at the close of the taxable year over eligible loans 
outstanding at the close of the base year may be made only for the 
portion of such increase which does not exceed the excess of eligible 
loans outstanding at the close of the taxable year over the sum of the 
amount of eligible loans outstanding at the close of the base year and 
the amount of previous increases in such loans for which an addition was 
made in taxable years ending after the close of the base year. For 
purposes of this subdivision, the order in which the factors which make 
up the annual reserve addition shall be claimed is:
    (1) An amount equal to one-fifth of the reserve deficiency;
    (2) Net bad debts charged to the reserve; and
    (3) An amount attributable to an increase in the amount of eligible 
loans outstanding.
    (B) For its first taxable year, a newly organized financial 
institution to which Sec. 1.585-1 and this section apply shall be 
considered to have no reserve deficiency. For example, a new financial 
institution would compute its annual reserve addition by including in 
such addition an amount not in excess of the sum of (1) the amount of 
its net bad debts charged to the reserve for the taxable year, and (2) 
the allowable percentage of the increase in its eligible loans 
outstanding at the close of the taxable year over the amount of its 
loans outstanding (zero) at the end of the year preceding its first 
taxable year. Such amount would be subject to the 0.6 percent 
limitations provided in subparagraph (2) of the paragraph.
    (C) The application of the rules provided by this subdivision may be 
illustrated by the following example:

    Example. The X Bank is a commercial bank which has a calendar year 
as its taxable year. X adopted the reserve method of accounting for bad 
debts in 1950. On December 31, 1969, X has $1,000,000 of outstanding 
eligible loans and a balance of $13,000 in its reserve for losses on 
loans. The base year is 1969 and, consequently, X has a reserve 
deficiency of $5,000 ((1.8% x $1,000,000) - $13,000).
    (a) During 1970, X has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1970, X has $1,050,000 of 
outstanding eligible loans. The maximum reasonable addition under the 
percentage method is $2,900 which consists of $1,000 of reserve 
deficiency (\1/5\ x $5,000), the $1,000 in net bad debts charged to the 
reserve for losses on loans, and $900 attributable to the increase in 
the balance of eligible loans (1.8% x ($1,050,000 - $1,000,000)). 
Assuming that X makes an addition to the reserve for losses on loans of 
$2,900 for the year, the balance of the reserve as of December 31, 1970 
is $14,900 ($13,000 - $1,000 + $2,900).
    (b) During 1971, X has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1971, X has $800,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $14,400 (1.8% x $800,000). The maximum reasonable addition under the 
percentage method is $500 which is a portion of one-fifth of the reserve 
deficiency. Assuming that X makes an addition to the reserve for losses 
on loans of $500 for the year, the balance of the reserve as of December 
31, 1971, is $14,400 ($14,900 - $1,000 + $500).
    (c) During 1972, X has net bad debts of $600 charged to the reserve 
for losses on loans. On December 31, 1972, X has $850,000 of outstanding 
eligible loans. The allowable percentage of eligible loans is $15,300 
(1.8% x $850,000). The maximum reasonable addition under the percentage 
method is $1,500 which consists of $1,000 of reserve deficiency (\1/5\ x 
$5,000) and $500 of the net bad debts charged to the reserve for losses 
on loans in 1971. Even though the full addition with respect to the 
reserve deficiency in 1971 was not made, the amount of the addition that 
can be made in 1972 with respect to the reserve deficiency is limited to 
one-fifth of such deficiency. Assuming that X makes an addition to the 
reserve for losses on loans of $1,500 for the year, the balance of the 
reserve as of December 31, 1972, is $15,300 ($14,400 - $600 + $1,500).

[[Page 319]]

    (d) During 1973, X did not have any net bad debts charged to the 
reserve for losses on loans. On December 31, 1973, X has $1,000,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $18,000 (1.8% x $1,000,000). The maximum reasonable addition under 
the percentage method is $2,100 which consists of $1,000 of reserve 
deficiency (\1/5\ x $5,000), $500 of net bad debts charged to the 
reserve for losses in 1971, and $600 of net bad debts charged to the 
reserve in 1972. Although outstanding eligible loans increased from 
$850,000 in 1972 to $1,000,000 in 1973, no addition is permitted with 
respect to the increase because the amount of eligible loans outstanding 
at the close of 1973 ($1,000,000) does not exceed the sum of the amount 
of such loans at the close of the base year ($1,000,000) and the amount 
of previous increases in such loans for which an addition was made in 
taxable years ending after the close of the base year ($50,000 loan 
increase in 1970). Assuming that X makes an addition to the reserve for 
losses on loans of $2,100, the balance of the reserve as of December 31, 
1973, is $17,400 ($15,300 + $2,100).

    (iii) Reserve equal to or greater than allowable percentage and 
eligible loans have not declined. If the reserve for losses on loans as 
of the close of the base year is equal to or greater than the allowable 
percentage for the taxable year multiplied by the eligible loans 
outstanding at the close of the base year and if the amount of eligible 
loans outstanding at the close of the taxable year is equal to or 
greater than the amount of eligible loans outstanding at the close of 
the base year, the amount determined under this subdivision is the 
amount necessary to increase the reserve to the greater of (A) the 
allowable percentage for the taxable year multiplied by the eligible 
loans outstanding at the close of the year, or (B) the balance of the 
reserve as of the close of the base year. The application of the rule 
provided by this subdivision may be illustrated by the following 
example:

    Example. The M Bank is a commercial bank which has a calendar year 
as its taxable year. M adopted the reserve method of accounting for bad 
debts in 1950. On December 31, 1969, M has $1,000,000 of outstanding 
eligible loans and a balance of $20,000 in its reserve for losses on 
loans.
    (a) During 1970, M has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1970, M has $1,100,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $19,800 (1.8% x $1,100,000). The maximum reasonable addition under 
the percentage method is $1,000 which is the amount sufficient to 
increase the balance of the reserve as of the close of the taxable year 
to the balance of the reserve as of the close of the 1969 base year 
($20,000). Assuming that M makes an addition to the reserve for losses 
on loans of $1,000 for the year, the balance of the reserve as of 
December 31, 1970, is $20,000 ($20,000 - $1,000 + $1,000).
    (b) During 1971, M has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1971, M has $1,300,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $23,400 (1.8% x $1,300,000). The maximum reasonable addition under 
the percentage method is $4,400 which is the amount sufficient to 
increase the balance of the reserve to the allowable percentage of 
eligible loans outstanding at the close of the taxable year. Assuming 
that M makes an addition to the reserve for losses on loans of $4,400 
for the year, the balance of the reserve as of December 31, 1971, is 
$23,400 ($20,000 - $1,000 + $4,400).
    (c) During 1972, M has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1972, M has $1,200,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $21,600 (1.8%x$1,200,000). No reasonable addition may be made under 
the percentage method because the reserve for losses on loans ($22,400, 
i.e., $23,400-$1,000) is greater than the allowable percentage of 
eligible loans outstanding at the close of the taxable year ($21,600) 
and the balance of the reserve as of the close of the base year 
($20,000). Assuming that no amount is added under the experience method 
provided by paragraph (c) of this section, the balance of the reserve 
for losses on loans as of December 31, 1972, is $22,400 ($23,400-
$1,000).
    (d) During 1973, M has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1973, M has $1,200,000 of 
outstanding eligible loans. The allowable percentage of eligible loans 
is $21,600 (1.8%x$1,200,000). The maximum reasonable addition under the 
percentage method is $200 which is the amount sufficient to increase the 
reserve for losses on loans to the allowable percentage of eligible 
loans outstanding at the close of the taxable year. Assuming that M 
makes an addition to the reserve for losses on loans of $200 for the 
year, the balance of the reserve as of December 31, 1973, is $21,600 
($22,400-$1,000+$200).

    (iv) Reserve greater than allowable percentage and eligible loans 
have declined. If the reserve for losses on loans as of the close of the 
base year is equal to or greater than the allowable percentage of 
eligible loans outstanding at such time and if the amount of eligible

[[Page 320]]

loans at the close of the taxable year is less than the amount of 
eligible loans outstanding at the close of the base year, the amount 
determined under this subdivision is the amount necessary to increase 
the balance of the reserve to the amount which bears the same ratio to 
eligible loans outstanding at the close of the taxable year as the 
balance of the reserve as of the close of the base year bears to the 
amount of eligible loans outstanding at the close of the base year. The 
application of the rule provided by this subdivision may be illustrated 
by the following example:

    Example. The N Bank is a commercial bank which has a calendar year 
as its taxable year. N adopted the reserve method of accounting for bad 
debts in 1950. On December 31, 1969, N has $1,000,000 of outstanding 
eligible loans and a balance of $20,000 in its reserve for losses on 
loans.
    (a) During 1970, N has net bad debts of $3,000 charged to the 
reserve for losses on loans. On December 31, 1970, N has $900,000 of 
outstanding eligible loans. The maximum reasonable addition under the 
percentage method is $1,000, which is the amount necessary to increase 
the balance of the reserve to the amount ($18,000) which bears the same 
ratio to eligible loans outstanding at the close of the taxable year 
($900,000) as the balance of the reserve as of the close of the base 
year ($20,000) bears to the amount of the eligible loans outstanding at 
the close of the base year ($1,000,000). Assuming that N makes an 
addition to the reserve for losses on loans of $1,000 for the year, the 
balance of the reserve as of December 31, 1970, is $18,000 ($20,000-
$3,000+$1,000).
    (b) During 1971, N has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1971, N has $1,100,000 of 
outstanding eligible loans. The maximum reasonable addition under the 
percentage method, determined under subdivision (iii) of this 
subparagraph, is $3,000 which is the amount necessary to increase the 
balance of the reserve to the greater of the allowable percentage of 
eligible loans outstanding at the close of the taxable year ($19,800) or 
the balance of the reserve at the close of the base year ($20,000). 
Assuming that N makes an addition to the reserve for losses on loans of 
$3,000 for the year, the balance of the reserve as of December 31, 1971 
is $20,000 ($18,000-$1,000+$3,000).

    (2) Limitations. Notwithstanding any other provision of this 
paragraph, the maximum reasonable addition to the reserve for losses on 
loans under the percentage method shall not exceed the greater of:
    (i) Six-tenths of 1 percent of the eligible loans outstanding at the 
close of the taxable year, or
    (ii) An amount sufficient to increase the reserve for losses on 
loans at the close of the taxable year to six-tenths of 1 percent of the 
eligible loans outstanding at the close of the taxable year.
    The application of the rules provided by this subparagraph may be 
illustrated by the following example:

    Example. The Y Bank begins business as a commercial bank on July 1, 
1974. Y adopts the calendar year as its taxable year and the reserve 
method of accounting for bad debts.
    (a) During 1974, Y has net bad debts of $1,000. On December 31, 
1974, Y has $1,000,000 of outstanding eligible loans. Under subparagraph 
(1)(ii)(B) of this paragraph, because Y is a newly-organized financial 
institution, there is no reserve deficiency. Except for the limitations 
of this subparagraph, the maximum reasonable addition under subparagraph 
(1)(ii)(A) of this paragraph would be the amount of net bad debts 
charged to the reserve for losses ($1,000) plus the allowable percentage 
of outstanding eligible loans at the close of the taxable year $18,000 
(1.8%x$1,000,000). However, because of the limitations of this 
subparagraph, the maximum reasonable addition to the reserve for losses 
on loans under the percentage method is an amount sufficient to increase 
the balance of the reserve for losses on loans to $6,000 which is 0.6 
percent of the eligible loans outstanding at the close of the taxable 
year. Assuming that Y makes an addition to the reserve for losses on 
loans of $7,000 for the year, the balance of the reserve as of December 
31, 1974, is $6,000 ($7,000-$1,000). The $7,000 consists of the $1,000 
in net bad debts and $6,000 attributable to the increase in eligible 
loans outstanding.
    (b) During 1975, Y has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1975, Y has $1,000,000 of 
outstanding eligible loans. Except for the limitations of this 
subparagraph, the maximum reasonable addition under subparagraph 
(1)(ii)(A) of this paragraph would be the amount of net bad debts 
charged to the reserve for losses ($1,000) plus an amount attributable 
to the increase in the amount of eligible loans outstanding with respect 
to which no reasonable addition was allowed in 1974 ($12,000, i.e., 
$18,000-$6,000). However, because of the limitations of this paragraph, 
the maximum reasonable addition to the reserve for losses on loans under 
the percentage method is $6,000 which is an amount

[[Page 321]]

equal to 0.6 percent of the eligible loans outstanding at the close of 
the taxable year. This amount consists of net bad debts of $1,000 and 
$5,000 attributable to a portion of the increase in eligible loans in 
1974 with respect to which no reasonable addition was allowable for 
1974. Assuming that Y makes an addition to the reserve for losses on 
loans of $6,000 for the year, the balance of the reserve as of December 
31, 1975, is $11,000 ($6,000-$1,000+$6,000).
    (c) During 1976, Y has net bad debts charged to the reserve for 
losses on loans of $1,000. On December 31, 1976, Y has $1,000,000 in 
outstanding eligible loans. At the close of 1975 (Y's base year for 
1976), the amount of outstanding eligible loans was also $1,000,000. 
Consequently, there is a reserve deficiency of $1,000 
((1.2%x$1,000,000)--$11,000). The maximum reasonable addition to the 
reserve for losses under subparagraph (1)(ii)(A) of this paragraph is 
$1,200 which consists of one-fifth of the reserve deficiency ($1,000x\1/
5\=$200) and the net bad debts charged to the reserve for losses on 
loans for the year ($1,000). Because that amount is less than 0.6 
percent of the eligible loans outstanding at the close of the taxable 
year (0.6%x$1,000,000=$6,000), the limitations of this subparagraph do 
not apply. Assuming that Y makes an addition to the reserve for losses 
on loans of $1,200 for the year, the balance of the reserve as of 
December 31, 1976, is $11,200 ($11,000-$1,000+$1,200).

    (c) Experience method--(1) In general--(i) Maximum addition. The 
amount determined under this paragraph for a taxable year is the amount 
necessary to increase the balance of the reserve for losses on loans (as 
of the close of the taxable year) to the greater of the amount 
determined under subdivision (ii) or (iii) of this subparagraph. For 
special rules for a new financial institution, see subparagraph (2) of 
this paragraph.
    (ii) Six-year moving average amount. The amount determined under 
this subdivision is the amount which bears the same ratio to loans 
outstanding at the close of the taxable year as (A) the total bad debts 
sustained during the taxable year and the 5 preceding taxable years (or, 
with the approval of the Commissioner, a shorter period), adjusted for 
recoveries of bad debts during such period, bears to (B) the sum of the 
loans outstanding at the close of such 6 (or fewer) taxable years. For 
purposes of applying this subdivision, a period shorter than 6 years 
generally would be appropriate only where there is a change in the type 
of a substantial portion of the loans outstanding such that the risk of 
loss is substantially increased. For example, if the major portion of a 
bank's portfolio of loans changes fromagricultural loans to industrial 
loans which results in a substantial increase in the risk of loss, a 
period shorter than 6 years may be appropriate. Similarly, a bank which 
has recently altered its lending practices to include in its portfolio 
of loans consumer-installment loans, when it had previously made only 
commercial loans, may also qualify to use a period shorter than six 
years. A decline in the general economic conditions in the area, which 
substantially increase the risk of loss, is a relevant factor which may 
be considered. In any case, however, approval to use a shorter period 
will not be granted unless the taxpayer supplies specific evidence that 
the loans outstanding at the close of the taxable years for the shorter 
period requested are not comparable in nature and risk to loans 
outstanding at the close of the six taxable years. The fact that a 
bank's bad debt experience has shown a substantial increase is not, by 
itself, sufficient to justify use of a shorter period. If approval is 
granted to use a shorter period, the experience for those taxable years 
which are excluded shall not be used for any subsequent year. A request 
for approval to exclude the experience of a prior taxable year shall not 
be considered unless it is sent to the Commissioner at least 30 days 
before the close of the first taxable year for which such approval is 
requested.
    (iii) Base year amount. The amount determined under this subdivision 
is the lower of (A) the balance of the reserve as of the close of the 
base year, or (B) if the amount of loans outstanding at the close of the 
taxable year is less than the amount of loans outstanding at the close 
of the base year, the amount which bears the same ratio to loans 
outstanding at the close of the taxable year as the balance of the 
reserve as of the close of the base year bears to the amount of loans 
outstanding at the close of the base year.
    (2) Special rules for new financial institutions--(i) In general. In 
the case of any taxable year preceded by less than 5 authorization years 
(as defined in

[[Page 322]]

paragraph (e)(5) of this section), subparagraph (1) of this paragraph 
shall be applied with the adjustments provided by subdivision (ii) of 
this subparagraph.
    (ii) Adjustments. (A) The total bad debts for the 6-year period 
computed under subparagraph (1)(ii)(A) of this paragraph shall be the 
sum of:
    (1) The bad debts sustained by the taxpayer during its authorization 
years, adjusted for recoveries of bad debts for such years, and
    (2) That fraction of the total bad debts sustained by a comparable 
bank (as defined in paragraph (e)(7) of this section) during the 
comparison years (as defined in paragraph (e)(6) of this section), 
adjusted for recoveries of bad debts for such years, which bears the 
same ratio to such total as the average loans outstanding of the 
taxpayer during the authorization years bears to the average loans 
outstanding of the comparable bank during the comparison years.
    (B) The total amount of loans outstanding during the 6-year period 
computed under subparagraph (1)(ii)(B) of this paragraph shall be six 
times the average loans outstanding of the taxpayer during the 
authorization years.
    (d) Change in accounting method from specific charge-off method to 
reserve method of treating bad debts--(1) In general. If a bank is 
granted permission in accordance with Sec. 1.446-1(e)(3) to change its 
method of accounting for bad debts from a method under which specific 
bad debt items are deducted to the reserve method of treating bad debts, 
the taxpayer shall effect the change as provided in subparagraphs (2) 
and (3) of this paragraph.
    (2) Initial balance of the reserve. The initial balance of the 
reserve at the close of the year of change shall be no less than the 
minimum addition as described in paragraph (a)(2) of this section and 
shall be no larger than the greater of:
    (i) The allowable percentage of eligible loans outstanding at the 
close of the taxable year of change, or
    (ii) The amount which bears the same ratio to loans outstanding at 
the close of the taxable year as the total bad debts sustained during 
the taxable year and the 5 preceding taxable years (or, with the 
approval of the Commissioner, a shorter period), adjusted for recoveries 
of bad debts during such period, bears to the sum of the loans 
outstanding at the close of such 6 or fewer taxable years.

In the case of taxable years beginning after 1987, the initial balance 
of the reserve at the end of the year of change shall be the amount 
specified in subdivision (ii) of this subparagraph.
    (3) Deduction with respect to initial balance. The deduction with 
respect to the initial balance of the reserve at the close of the 
taxable year of change, determined under subparagraph (2) of this 
paragraph, is allowable ratably over a period of 10 years commencing 
with the taxable year of change (or a shorter period as may be approved 
by the Commissioner). Thus, the bad debt deduction under section 166 for 
the taxable year of change will consist of the amount of debts 
determined to be wholly or partially worthless and charged-off during 
such taxable year plus one-tenth (if a 10-year period is used) of the 
amount of the reserve determined under subparagraph (2) of this 
paragraph. For each of the 9 taxable years following the taxable year of 
change, the bad debt deduction will consist of the reasonable addition 
to the reserve for bad debts for each such year as provided by section 
585, as otherwise determined, plus one-tenth of the amount determined to 
be theinitial balance of the reserve under subparagraph (2) of this 
paragraph. The amount established as a bad debt reserve for the taxable 
year of change under subparagraph (2) of this paragraph shall be 
considered as the balance of the reserve for purposes of determining the 
amount of subsequent additions to such reserve, even though the entire 
amount of the reserve may not have been deducted under section 585(a)(1) 
or former section 166(c) because of the requirement that it be deducted 
over a number of years.
    (e) Definitions--(1) Base year--(i) Percentage method. For purposes 
of paragraph (b) of this section (relating to the percentage method), 
the term base year means: For years beginning before 1976, the last 
taxable year beginning on or before July 11, 1969; for taxable years 
beginning after 1975 but before

[[Page 323]]

1983, the last taxable year beginning before 1976; and, for taxable 
years beginning after 1982, the last taxable year beginning before 1983. 
However, for purposes of section 585(b)(2)(A) the term base year means 
the last taxable year before the most recent adoption of the percentage 
method, if later than the base year as determined under the preceding 
sentence.
    (ii) Experience method. For purposes of paragraph (c) of this 
section (relating to the experience method), the term base year means 
(A) the last taxable year before the most recent adoption of the 
experience method, or (B) the last taxable year beginning on or before 
July 11, 1969, which ever is later; and for taxable years beginning 
after 1987, the last taxable year beginning before 1988.
    (iii) Example. The application of the rules provided by this 
subparagraph may be illustrated by the following example:

    Example. The T Bank is a commercial bank which has a calendar year 
as its taxable year. T adopted the reserve method of accounting for bad 
debts in 1950. On December 31, 1969, T has $1,000,000 of outstanding 
eligible loans and a balance of $19,300 in its reserve for losses on 
loans.
    (a) During 1970, T has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1970, T has $1,050,000 of 
outstanding eligible loans. T elects the percentage method. The base 
year is 1969. The maximum reasonable addition under the percentage 
method of $1,000 which is the amount sufficient to increase the balance 
of the reserve as of the close of the taxable year to the balance of the 
reserve as of the close of the base year 1969 ($19.300). Assuming that T 
makes an addition to the reserve for losses on loans of $1,000 for the 
year, the balance of the reserve for losses on loans as of December 31, 
1970, is $19,300 ($19,300-$1,000+$1,000).
    (b) During 1971, T has net bad debts of $8,000 charged to the 
reserve for losses on loans. On December 31, 1971, T has $1,100,000 of 
outstanding eligible loans. T elects the experience method. The base 
year is 1970. The maximum reasonable addition under the experience 
method is $8,000 which is the amount sufficient to increase the balance 
of the reserve as of the close of the taxable year to the balance of the 
reserve as of the close of the 1970 base year ($19,300). Assuming that T 
makes an addition to the reserve for losses on loans of $8,000 for the 
year, the balance of the reserve for losses on loans as of December 31, 
1971, is $19,300, ($19,300-$8,000+$8,000).
    (c) During 1972, T has net bad debts of $1,000 charged to the 
reserve for losses on loans. On December 31, 1972, T has $1,200,000 of 
outstanding eligible loans. T elects the percentage method. The base 
year is 1971 and there is a reserve deficiency of $500 
((1.8%x$1,100,000)-$19,300). The maximum reasonable addition under the 
percentage method is $2,900 which consists of $100 of reserve deficiency 
(\1/5\x$500), the $1,000 in net bad debts charged to the reserve for 
losses on loans, and $1,800 attributable to the increase in the balance 
of eligible loans (1.8%x($1,200,000-$1,100,000)). Assuming that T makes 
an addition to the reserve for losses on loans of $2,900 for the year, 
the balance of the reserve for losses on loans as of December 31, 1972, 
is $21,200 ($19,300-$1,000+$2,900).

    (2) Loan--(i) General rule. For purposes of this section and 
Sec. Sec. 1.585-1, 1.585-3, and 1.585-4, the term loan means debt as 
the term debt is used in section 166 and the regulations thereunder. The 
term loan includes (but is not limited to) the following items:
    (A) An overdraft in one or more deposit accounts by a customer in 
good faith whether or not other deposit accounts of the same customer 
have balances in excess of the overdraft;
    (B) A bankers acceptance purchased or discounted by a bank; and
    (C) A loan participation to the extent that the taxpayer bears a 
risk of loss.
    For purposes of (B) of this subdivision (i), a bankers acceptance 
shall be considered as a loan made by the bank which purchased or 
discounted the bankers acceptance and not a loan made by the originating 
bank.
    (ii) Exceptions. Notwithstanding the provisions of subdivision (i) 
of this subparagraph, the term loan does not include the following 
items:
    (A) Discount or interest receivable reflected in the face amount of 
an outstanding loan, which discount or interest has not been included in 
gross income;
    (B) For taxable years beginning after December 31, 1976, commercial 
paper, however acquired by the bank, including, for example, short-term 
promissory notes which may be purchased on the open market;
    (C) For taxable years beginning after December 31, 1976, a debt 
evidenced by a security (as defined in section 165(g)(2)(C) and the 
regulations thereunder);

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    (D) Any loan which is entered into or acquired for the primary 
purpose of enlarging the otherwise available bad debt deduction;
    (E) Loans which have been contractually committed to the extent that 
funds have not been disbursed to the borrower or disbursed on behalf of 
the borrower; and
    (F) Any transaction which is in violation of a Federal or State 
statute that governs the activities of the financial institution.
    (3) Eligible loan--(i) General rule. For purposes of this section 
and Sec. Sec. 1.585-3 and 1.585-4, the term eligible loan means a loan 
(as defined in subparagraph (2) of this paragraph) which is incurred in 
the course of the normal customer loan activities of a financial 
institution and which is not a loan described in subdivision (ii) of 
this subparagraph. Nothing within the preceding sentence will be 
construed to exclude from the term eligible loan a bona fide loan in a 
new market or under a novel repayment arrangement if the likelihood of 
nonrepayment is at least as great as that of other customer loans of the 
financial institution.
    (ii) Exceptions. Loans which do not constitute eligible loans 
include:
    (A) A loan to a bank (as defined in section 581 and the regulations 
thereunder) or to a domestic branch of a foreign corporation to which 
Sec. 1.585-1 applies, including a repurchase transaction or other 
similar transaction;
    (B) Bank funds on deposit in any bank (foreign or domestic) such as 
a deposit represented by a certificate of deposit or any other form of 
instrument evidencing the deposit of a sum of money with the issuing 
bank that will be available on or after a stated date or period of time;
    (C) A sale or loan of Federal funds irrespective of the purchaser or 
borrower;
    (D) A loan, to the extent that it is directly or indirectly made to, 
guaranteed by, or insured by the United States, a possession or 
instrumentality thereof, or a State or political subdivision thereof; 
and
    (E) A loan which is secured by a deposit in the lending financial 
institution or in a bank as defined in section 581 or a domestic branch 
of a foreign corporation to which this section applies to the extent 
that the financial institution has control over withdrawal of such 
deposit.
    (iii) Definition of loan which is secured by a deposit. For purposes 
of subdivision (ii)(E) of this subparagraph:
    (A) A loan is considered secured if the loan is on the security of 
any instrument which makes the deposit specific security for the payment 
of the loan, provided that such instrument is of such a nature that in 
the event of default the deposit could be subjected to the satisfaction 
of the loan;
    (B) A deposit includes a guarantee deposit in the form of a 
holdback, pledged collateral that has been reduced to cash, and loan 
payments that are maintained in a separate account; and
    (C) Control over the withdrawal of a deposit is evidenced by 
possession of a passbook, certificate of deposit, note, or other similar 
instrument the possession of which is normally required to permit 
withdrawal. The lending financial institution does not have control over 
withdrawal of the deposit if the deposit can be withdrawn without 
consent of the lending financial institution. Thus, the lending 
financial institution normally does not have control over the withdrawal 
of a deposit in an account merely because the borrower agrees to 
maintain a minimum, average, or compensating balance.
    (4) Predecessor. For purposes of this section, the term predecessor 
means (i) any taxpayer which transferred more than 50 percent of the 
total amount of its assets to the taxpayer and is described in Sec. 
1.585-1, or (ii) any predecessor of such predecessor.
    (5) Authorization years. For purposes of this section, the term 
authorization years means the number of years, containing 12 complete 
months, between (i) the first day of the first full taxable year of the 
taxpayer for which it (or any predecessor) was authorized to do business 
as a financial institution described in Sec. 1.585-1, and (ii) the 
taxable year.
    (6) Comparison years. For purposes of this section, the term 
comparison years means those consecutive taxable years containing 12 
complete months of a comparable bank, the last of which

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ends within 12 months immediately preceding the beginning of the first 
taxable year of the taxpayer, which are equal in number to six minus the 
number of authorization years of the taxpayer.
    (7) Comparable bank. For purposes of this section, the term 
comparable bank means all the financial institutions described in Sec. 
1.585-1 located within the same Federal Reserve district.
    (8) Average loans outstanding. For purposes of this section, the 
term average loans outstanding means the sum of the loans outstanding at 
the close of each taxable year of a period divided by the number of 
taxable years in such period.
    (9) Adjusted for recoveries of bad debts. For purposes of this 
section, the term adjusted for recoveries of bad debts means an 
adjustment for the full amount recovered with respect to bad debts 
previously charged to the reserve during any of the applicable taxable 
years.

(Sec. 585(b)(4), of the Internal Revenue Code of 1954 (83 Stat. 618; (26 
U.S.C. 585(b)(4))))

[T.D. 7532, 43 FR 3109, Jan. 23, 1978, as amended by T.D. 7835, 47 FR 
42342, Sept. 27, 1982; T.D. 8513, 58 FR 68757, Dec. 29, 1993]