[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: 26CFR1.585-7]

[Page 336-339]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.585-7  Elective cut-off method of changing from the reserve 
method of section 585.

    (a) General rule. Any large bank (as defined in Sec. 1.585-5(b)) 
that maintained a reserve for bad debts under section 585 for the 
taxable year immediately preceding its disqualification year (as defined 
in Sec. 1.585-5(d)(1)) may elect to use the cut-off method set forth in 
this section. Any such election must be made at the time and in the 
manner prescribed by Sec. 1.585-8. If a bank makes this election, the 
bank must maintain its bad debt reserve for its pre- disqualification 
loans, as prescribed in paragraph (b) of this section, and the bank must 
include in income any excess balance in this reserve, as required by 
paragraph (c) of this section. The bank may not deduct, for its 
disqualification year or any subsequent taxable year, any amount allowed 
under section 166(a) for pre-disqualification loans (as defined in 
paragraph (b)(2) of this section) that become worthless in whole or in 
part, except as allowed by paragraph (b)(1) of this section. However, 
except as provided in paragraph(d)(3) of this section, the bank may 
deduct, for its disqualification year or any subsequent taxable year, 
amounts allowed under section 166(a) for loans that the bank originates 
or acquires on or after the first day of its disqualification year and 
that become worthless in whole or in part. If a bank makes the election 
allowed by this paragraph (a), its change to the specific charge-off 
method of accounting for

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bad debts in its disqualification year does not give rise to a section 
481(a) adjustment.
    (b) Maintaining reserve for pre-disqualification loans--(1) In 
general. A bank that makes the election allowed by paragraph (a) of this 
section must maintain its bad debt reserve for its pre-disqualification 
loans (as defined in paragraph (b)(2) of this section). Except as 
provided in paragraph (d)(3) of this section, the bank must charge 
against the reserve the amount of any losses resulting from these loans 
(including losses resulting from the sale or other disposition of these 
loans), and the bank must add to the reserve the amount of recoveries 
with respect to these loans. In general, the reserve must be maintained 
in the manner provided by former section 166(c) of the Internal Revenue 
Code and the regulations thereunder. However, after the balance in the 
reserve is reduced to zero, the bank is to account for any losses and 
recoveries with respect to outstanding pre-disqualification loans under 
the specific charge-off method of accounting for bad debts, as if the 
bank always had accounted for these loans under this method.
    (2) Definition of pre-disqualification loans. For purposes of this 
section, a pre-disqualification loan of a bank is any loan that the bank 
held on the last day of its taxable year immediately preceding its 
disqualification year (as defined in Sec. 1.585-5(d)(1)). If the amount 
of a pre-disqualification loan is increased during or after the 
disqualification year, the amount of the increase is not treated as a 
pre-disqualification loan.
    (c) Amount to be included in income when reserve balance exceeds 
loan balance. If, as of the close of any taxable year, the balance in a 
bank's reserve that is maintained under paragraph (b) of this section 
exceeds the balance of the bank's outstanding pre-disqualification 
loans, the bank must include in income the amount of the excess for the 
taxable year. The balance in the reserve is then reduced by the amount 
of this excess. See paragraph (d) of this section for rules on the 
application of this paragraph (c) when a bank disposes of loans.
    (d) Effect of disposing of loans--(1) In general. Except as provided 
in paragraphs (d)(2) and (d)(3) of this section, if a bank that makes 
the election allowed by paragraph (a) of this section sells or otherwise 
disposes of any of its outstanding pre-disqualification loans, the bank 
is to reduce the balance of its outstanding pre-disqualification loans 
by the amount of the loans disposed of, for purposes of applying 
paragraph (c) of this section.
    (2) Section 381 transactions. If a bank that makes the election 
allowed by paragraph (a) of this section transfers outstanding pre-
disqualification loans to another corporation in a transaction to which 
section 381(a) applies, the acquiring corporation (the acquiror) must 
follow the rules of paragraph (d)(2)(i) or (ii) of this section.
    (i) Acquiror completes cut-off method of change. Except as provided 
in paragraph (d)(2)(ii) of this section, the acquiror steps into the 
shoes of the transferor in the section 381(a) transaction with respect 
to using the cut-off method of change. Thus, the transferor's bad debt 
reserve immediately before the section 381(a) transaction carries over 
to the acquiror, and the acquiror must complete the cut-off method begun 
by the transferor. For purposes of completing the transferor's cut-off 
method, the acquiror's balance of outstanding pre-disqualification loans 
immediately after the section 381(a) transaction is the balance of these 
loans that it receives in the transaction, and the acquiror assumes all 
of the transferor's rights and obligations under this section.
    (ii) Acquiror uses reserve method. If the acquiror is not a large 
bank (within the meaning of Sec. 1.585-5(b)) immediately after the 
section 381(a) transaction and uses a reserve method of accounting for 
bad debts attributable to the pre-disqualification loans (and any other 
loans) received in the transaction, the acquiror does not step into the 
shoes of the transferor with respect to using the cut-off method of 
change. The transferor's bad debt reserve immediately before the section 
381(a) transaction carries over to the acquiror, but the acquiror does 
not continue the cut-off method begun by the transferor. If the six-year 
moving average amount (as

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defined in Sec. 1.585-2(c)(1)(ii)) for all of the loans received in the 
transaction exceeds the balance of the reserve that carries over to the 
acquiror, the acquiror increases this balance by the amount of the 
excess. Any such increase in the reserve results in a negative section 
481(a) adjustment that is taken into account as required under section 
381.
    (3) Dispositions intended to change the status of pre-
disqualification loans. This paragraph (d)(3) applies if a bank that 
makes the election allowed by paragraph (a) of this section sells, 
exchanges, or otherwise disposes of a significant amount of its pre-
disqualification loans (as defined in paragraph (b)(2) of this section) 
and a principal purpose of the transaction is to avoid the provisions of 
this section by increasing the amount of loans for which deductions are 
allowable under the specific charge-off method. If this paragraph (d)(3) 
applies, the District Director may disregard the disposition for 
purposes of paragraphs (b)(1) and (d)(1) of this section or treat the 
replacement loans as pre-disqualification loans. If loans are so treated 
as pre-disqualification loans, no deductions are allowable under the 
specific charge-off method for the loans, except as provided in 
paragraph (b)(1) of this section, and the disposition that causes the 
loans to be so treated may be disregarded for purposes of paragraphs 
(b)(1) and (d)(1) of this section. If a bank sells pre-disqualification 
loans and uses the proceeds of the sale to originate new loans, this 
paragraph (d)(3) does not apply to the transaction.
    (e) Examples. The following examples illustrate the principles of 
this section:

    Example 1. Bank M is a bank that properly elects to use the cut-off 
method set forth in this Sec. 1.585-7. M's disqualification year is its 
taxable year beginning on January 1, 1987. On December 31, 1986, M had 
outstanding loans of $700 million (pre-disqualification loans), and the 
balance in its bad debt reserve was $10 million. M must maintain its 
reserve for its pre-disqualification loans in accordance with Sec. 
1.585-7(b), and it may not deduct any addition to this reserve for 
taxable year 1987 or any later year. For these years, M may deduct 
amounts allowed under section 166(a) for loans that it originates or 
acquires after December 31, 1986, and that become worthless in whole or 
in part.
    Example 2. Assume the same facts as in Example 1. Also assume that 
in 1987 M collects $150 million of its pre- disqualification loans, M 
determines that $2 million of its pre-disqualification loans are 
worthless, and M recovers $1 million of pre-disqualification loans that 
it had previously charged against the reserve as worthless. On December 
31, 1987, the balance in M's bad debt reserve is $9 million ($10 million 
- $2 million + $1 million), and the balance of its outstanding pre-
disqualification loans is $548 million ($700 million - $150 million - $2 
million).
    Example 3. Assume the same facts as in Examples 1 and 2. Also assume 
that on December 31, 1990, the balance in M's bad debt reserve is $5 
million and the balance of its outstanding pre-disqualification loans is 
$25 million. In 1991 M collects $21 million of its outstanding pre-
disqualification loans and determines that $1 million of its outstanding 
pre-disqualification loans are worthless. Thus, on December 31, 1991, 
the balance in M's bad debt reserve is $4 million ($5 million - $1 
million), and the balance of its outstanding pre-disqualification loans 
is $3 million ($25 million - $21 million - $1 million). Accordingly, M 
must include $1 million ($4 million - $3 million) in income in taxable 
year 1991, pursuant to Sec. 1.585-7(c). On January 1, 1992, the balance 
in M's reserve is $3 million ($4 million - $1 million).
    Example 4. Assume the same facts as in Examples 1 through 3. Also 
assume that in 1992 M transfers substantially all of its assets to 
another corporation (N) in a transaction to which section 381(a) 
applies, and N is treated as a large bank under Sec. 1.585-5(b)(2) for 
taxable years ending after the date of the transaction. Pursuant to 
Sec. 1.585-7(d)(2)(i), N steps into M's shoes with respect to using the 
cut-off method. M's bad debt reserve immediately before the section 
381(a) transaction carries over to N, and N must complete the cut-off 
procedure begun by M. For this purpose, N's balance of outstanding pre-
disqualification loans immediately after the section 381(a) transaction 
is the balance of these loans that it receives from M.
    Example 5. Assume the same facts as in Examples 1 through 4, except 
that N is not treated as a large bank after the section 381(a) 
transaction. Also assume that N uses the reserve method of section 585 
and plans to use this method for all of the loans it acquires from M 
(including loans that were not pre-disqualification loans). Pursuant to 
Sec. 1.585-7(d)(2)(ii), M's bad debt reserve immediately before the 
section 381(a) transaction carries over to N in the transaction; 
however, N does not continue the cut-off procedure begun by M and does 
not treat any loan as a pre-disqualification loan. If the six-year 
moving average amount (as defined in Sec. 1.585-2(c)(1)(ii)) for all of 
N's newly acquired loans exceeds the balance of the reserve that carries 
over to N, N increases this balance by

[[Page 339]]

the amount of the excess. Any such increase in the reserve results in a 
negative section 481(a) adjustment that is taken into account as 
required under section 381.

[T.D. 8513, 58 FR 68762, Dec. 29, 1993; 59 FR 15502, Apr. 1, 1994]