In general, a deduction is allowed under IRC 166 for any debt which becomes worthless within the taxable year. However, no precise test exists for determining whether a debt is worthless. In many situations, no single factor or identifiable event clearly demonstrates whether a debt has become worthless. Instead, a series of factors or events in the aggregate establishes whether the debt is worthless.

For tax years ending on or after December 31, 1991, a bank, within the meaning of IRC 581 (see 26 CFR 1.166-2(d)(4)(i)), may obtain a conclusive presumption of worthlessness for bad debts that it owns by making a conformity election under 26 CFR 1.166-2(d)(3). Under this election, a debt charged off for regulatory purposes is conclusively presumed to be worthless, in whole or in part, if either

26 CFR 1.166-2(d)(3)(ii)(C) defines the term “loss asset” as a debt that the bank has assigned to a class that corresponds to a loss asset classification under the standards set forth by the “Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks” or similar guidance issued by the bank’s supervisory authority.

Rev. Rul. 2001-59, published on December 17, 2001 in I.R.B. 2001-51, provides clarification of the classification of a loan as a “loss asset” in order to meet the bad debt conformity election. Following an analysis of the applicable legal authorities, the Revenue Ruling concludes that a bank’s board of directors’ resolution authorizing charge-offs of only “loss asset” loans is sufficient to demonstrate classification of the loans as loss assets for purposes of 26 CFR 1.166-2(d)(3). The Revenue Ruling also provides examples of the other procedures a bank can use to classify loans (or loan portions) as loss assets.

Furthermore, Rev. Rul. 2001-59 addresses the situation where a bank erroneously charged off loans for regulatory purposes, but the error was not substantial enough for the Commissioner to revoke the bank’s conformity election under 26 CFR 1.166-2(d)(3)(iv)(D). In such a situation, the revenue ruling concludes that even the erroneously charged off loans are entitled to the conclusive presumption of worthlessness and an adjustment is not warranted.

I. GUIDELINES FOR AUDITING CONFORMITY ELECTION REQUIREMENT

When auditing a bank under the conformity method of accounting, the examiner must confirm that four requirements have been met for the conclusive presumption of worthlessness to apply to loans owned by the bank. Those four requirements are:

If a bank fails to meet either the conformity election or the express determination letter requirements, the bank will not be entitled to utilize the conformity method.

The two remaining requirements of book charge-off and loss asset classification apply to each loan separately. A bank’s failure to meet either of these two remaining requirements for a specific loan will not result in an adjustment, unless this failure or a pattern of failures is substantial enough to result in a determination to revoke the bank’s conformity election under 26 CFR 1.166-2(d)(3)(iv)(D).

To determine whether a bank has met the above four requirements of the conformity election and is entitled to a conclusive presumption of worthlessness for its charge off loans, it is recommended that the examiner initially request the following information:

A Valid Conformity Election

One of the initial documents an examiner must obtain is the bank’s Form 3115, Application for Change in Accounting Method, electing conformity. A Form 3115 must be filed by an existing bank to elect the conformity method of accounting. This election must be made on a bank-by-bank basis and could have been made for years as early as 1991. New banks adopt the conformity method by filing a statement with their initial tax return.

Express Determination Letter

In addition, the examiner must also obtain the bank’s Express Determination Letter(s) (EDL) covering the years under audit. Pursuant to 26 CFR 1.166-2(d)(3)(iii)(D), every bank under the conformity method must obtain an EDL from its Federal supervisory authority verifying the bank maintains and applies loan loss classification standards consistent with the supervisory authority’s regulatory standards. The necessary language for an EDL can be found in Rev. Proc. 92-84, 1992-2 C.B. 489.

At the end of each regulatory examination by its supervisory authority, the bank must request and receive a new EDL. Retroactive EDLs covering earlier regulatory examination periods are not acceptable. Banks are generally examined by their regulator every 18 months.

If a bank fails to obtain the required EDL, the conformity election is automatically revoked as of the beginning of the tax year that includes the date as of which the supervisory authority conducts its examination.

Book Charge-Off Required

It is also recommended that the examiner obtain from the bank a reconciliation of the bank’s charge-offs to its bad debt deductions, since a loan must be charged off on the books and records of the bank for the conclusive presumption of worthlessness to apply. Discussions of books in this context refer to the bank’s Regulatory Accounting Principles (RAP) books.

Under the conformity election, the bad debt deduction is limited to the year of the book charge-off. Accordingly, the examiner should compare the book charge-offs and bad debt deductions to see if there are any obvious inconsistencies, which should be reconciled.

For book purposes, a savings & loan (S&L) may establish a specific allowance for loans classified as either substandard, doubtful, or loss. Pursuant to 26 CFR 1.166-2(d)(4)(ii), for banks regulated by the Office of Thrift Supervision (OTS), the term "charge-off" includes the establishment of a specific allowance for loan losses in the amount of 100 percent of the portion of a debt classified as a loss. This section was added to clarify that the term "charge-off," as it pertains to S&Ls, includes the establishment of specific allowances for loan losses.

Although the establishment of a specific allowance will satisfy the charge-off requirements of the conformity election, the loans charged to a specific allowance must also meet the standards of a loss asset to qualify for a conclusive presumption of worthlessness. A loan classified as substandard or doubtful and charged to a specific allowance by an S&L will not meet the standards of a loss asset.

Loan Must be Classified as a Loss Asset

A loan must also be classified as a "loss asset" by the bank for the conclusive presumption of worthlessness to apply, unless the loan was charged off pursuant to a regulator’s specific order. 26 CFR 1.166-2(d)(3)(ii)(C) defines the term "loss asset" as a debt that the bank has assigned to a class that corresponds to a loss asset classification under the standards set forth by the bank’s supervisory authority. Therefore, it is recommended that the examiner obtain the bank’s policies and procedures on loan classification.

Rev. Rul. 2001-59 provides various procedures for a bank to classify loans, in whole or in part, as loss assets. This evidence could include the board of directors’ resolution referred to in the Revenue Ruling, credit committee reports or notations on loan files.

Bank’s Reports and Filings

Finally, it is recommended that the examiner obtain the bank’s annual reports, call reports to its regulator and SEC filings. The examiner should analyze these filings to determine whether the bank’s charge-offs and recovery rates warrant further review. For SEC registrants, the quarterly and annual Management Discussion and Analysis (MD&A) reports should provide information about the bank’s loan loss methodologies, policies, and procedures.

The examiner should use professional judgement to determine whether the bank’s charge-off and recovery rates warrant further review. Some of the factors to be considered include the rate of charge-offs and recoveries in prior years and the change to charge-offs in comparison to prior year(s). The regulatory and SEC filings may help to determine the bank’s historical recovery rates for applicable loan categories.

If the bank has met the conformity election requirements and its charge-off and recovery rates appear reasonable, no further audit steps are warranted.

However, if the bank’s charge-off and recovery rates do not initially appear reasonable, the examiner should then consider the charge-off and recovery rates experienced by the bank in relation to its peers. Peer groups are often determined with reference to the bank’s asset size, lines of business and/or geographic location. Federal studies (such as the Federal Reserve Bank of New York's publication "Current Issues in Economics and Finance") that track current industry charge-off averages may be useful in this analysis.

A bank’s experience with recoveries, as compared to its peers, may also reflect a charge-off in excess of reasonable business judgement. For example, if a bank were recovering 25 percent or more of the charged-off loans for a particular loan category, while peer data would indicate that 12 percent recover rate was more common, a material deviation may exist. The examiner should then question the bank as to why its recovery rate appears to be out of line with the industry.

If the bank is unable to adequately explain the above deviations, it may be appropriate to sample the loan files to see if the data supports the bank's charge-offs. A bank’s failure to meet the loan loss classification or charge-off requirements for a specific loan, generally will not result in an individual loan adjustment. If the pattern of failures is substantial enough, however, it may result in a determination to revoke the bank’s conformity election.

If the review of the loan files leads to the determination that the charge-offs were substantially in excess of reasonable business judgement, revocation of the election may be warranted. It should be noted that revocation of the conformity election is an extraordinary step when the procedural requirements have been met.

II. REVOCATION OF CONFORMITY ELECTION

As stated previously, if a bank fails to meet either the conformity election or the Express Determination Letter requirements, the bank will not be entitled to utilize the conformity method. However, a bank’s failure to meet either the book charge-off and loss asset classification requirements for a specific loan will not result in an adjustment, unless this failure or a pattern of failures is substantial enough to result in a determination to revoke the bank’s conformity election under 26 CFR 1.166-2(d)(3)(iv)D).

Pursuant to 26 CFR 1.166-2(d)(3)(iv)(D), the Commissioner may revoke a bank’s election to use the conformity method, if an electing bank fails to follow the conformity method of accounting to determine when debts become worthless, or if the bank’s charge-offs are substantially in excess of those warranted by reasonable business judgement in applying the regulatory standards of the bank’s supervisory authority. Accordingly, if an examination of a bank's books and records reveals that there is a pattern of charge-offs in the wrong year or under all the facts and circumstances the charge-offs were substantially in excess of reasonable business judgment in applying the regulatory standards of the bank's supervisory authority, the conformity election may be revoked.

In addition, as stated above, a bank’s failure to meet the loan loss classification or charge-off requirements for a specific loan, generally will not result in an individual loan adjustment. If the pattern of failures is substantial enough, however, it may result in a determination to revoke the bank’s conformity election.

Finally, in the case of an S&L where the creation of a specific reserve for loan losses results in a tax deduction for 100 percent of the portion of the debt classified as loss assets, electing conformity is not intended to allow a double deduction. Such a double deduction could result from the fluctuation in the specific reserve from one reporting period to the next. The examiner should compare the prior specific reserves per the Thrift Financial Reports to ensure that the same specific reserve for a particular loan does not result in a duplication of the tax deduction. If this duplication becomes a pattern, the examiner should consider revocation.

The examiner should use professional judgement in determining whether to pursue the extraordinary step of revoking a bank’s conformity election. Based on the data collected, the team manager and team coordinator should determine the extent of resources to devote to this issue. Conversations with the taxpayer and the banking technical advisors may assist the examiner in setting the scope and depth for examining this issue and help minimize the audit burden on both the taxpayer and the examination team.

III. EXAMPLES OF LOANS NOT SUBJECT TO CONFORMITY ELECTION

Bad debt deductions for loans not subject to regulatory loss classification standards are determined under the general rules of IRC 166.

It should also be remembered that not all loans of a bank are entitled to the conclusive presumption of worthlessness under the conformity election. For example, the examiner should confirm the bank owns the worthless loans for both book and tax purposes. Loans not owned for book purposes are not subject to regulatory loan loss classification standards and thus are outside the scope of the conformity election. In addition, the examiner should be aware that the bank’s bad debt tax basis might be affected by the mark to market provisions under IRC 475.

The following are examples of some loans or portions of loans not subject to the conformity election because they are not subject to regulatory loan loss classification standards.

Securitized Loans - Many securitizations are treated as sale for book purposes (see Statement of Financial Accounting Standards 125 and 140), but are treated as financing arrangements for tax purposes. In these circumstances, if the bank does not own the loans for book/regulatory purposes, the loans cannot be charged off on the bank's books under the loss classification standards and, therefore, the conformity election cannot apply to the securitized loans. For example, credit card, installment and auto loan securitizations have generally been treated as sales for book purposes, but financing transactions for tax purposes. The determination of sale versus financing is highly fact intensive and requires a case-by-case analysis of the benefits and burdens of ownership.

Restructured Loans - A loan may be significantly modified for tax purposes. This significant modification requires the tax recognition of gain or loss, which may not exist for book purposes. See 26 CFR 1.1001-3.

Interest on Non-Performing Loans - A bank may cease to accrue interest income for book purposes, even though it continues to accrue the interest for tax purposes. Thus, there is no loan on the books for this unpaid interest.

Loans Accounted for on a Cost Recovery Basis - A bank with a loan that is considered delinquent or non-performing may still receive cash payments from the borrower. The bank may apply these payments first to principal for book purposes. However, for tax purposes, these payments may be recognized as interest income, based upon the terms of the loan document.

Interest Accrual Reversals - For book purposes, a bank may be required to reverse previously accrued interest income, when a loan is impaired or non-performing. However, interest income cannot be reversed for tax purposes. Thus, there is no loan of this interest for tax purposes.

In-Substance Foreclosures - In-Substance Foreclosures (ISF) represent the physical possession of the collateral property by a bank. An ISF is recorded as Other Real Estate Owned (OREO) for book purposes, even though a technical foreclosure has not taken place. In an ISF circumstance, the loan no longer exists for book purposes, but it still exists for tax purposes.

IV. PREVIOUSLY PUBLISHED DETERMINATIONS CONCERNING THE CONFORMITY ELECTION

Prior published determinations by the Chief Counsel’s office in the conformity election area are being provided for informational purposes only. Please note that pursuant to IRC 6110(k)(3), Chief Counsel Advice may not be used or cited as precedent. Such advice generally involves specific taxpayers based on specific facts and represents the thinking of Chief Counsel’s office at the time of issuance.

FSA 199912005, Released March 26, 1999:

In response to a request for Field Service Advice, Counsel concluded that only loans classified as "loss assets” for regulatory purposes qualify as deductible bad debts under a valid conformity election, while loans classified as "substandard" or "doubtful" do not.

FSA 200018017, Released May 5, 2000:

On the facts presented, Counsel recommended in this Field Service Advice that Exam consider revoking the taxpayer’s conformity election in the earliest open year under examination in accordance with 26 CFR 1.166-2(d)(3)(iv)(D). Also, any such revocation must be handled as a cut-off method with no attendant adjustment under IRC 481(a) with respect to loan amounts previously charged off for book purposes.

ITA 200027036, Released July 7, 2000:

In response to a request for Technical Assistance concerning the revocation of the conformity election under 26 CFR 1.166-2(d)(3), Counsel concluded the IRS may audit a bank that has made the conformity election. The audit determines whether the bank complied with the requirements of the accounting method in particular, as well as the requirements for a bad debt deduction in general.

This advice also discusses instances in which the conformity election may be revoked.

The case of United States v. U.S. Bancorp, 12 F. Supp. 2d 982 (D. Minn. 1998) is cited as a footnote in this advice. In this summons enforcement case, the bank argued that under a valid conformity election, the information sought by the IRS was irrelevant, since the election provides a conclusive presumption of worthlessness for bad debts. The court concluded that the conclusive presumption does not make information regarding those debts irrelevant to the legitimate determination of the bank’s tax liabilities and the accuracy of the bank’s tax return. Accordingly, the bank was required to comply with the summons.

CCA 200045030, Released November 9, 2000:

In response to a request for Technical Assistance concerning the conformity election under 26 CFR 1.166-2(d)(3), Counsel concluded, in part:

FSA 200129003, Released July 20, 2001:

In this Field Service Advice dealing with whether a building and loan association’s treatment of bad debt losses was an accounting method change, Counsel stated that the conformity election under 26 CFR 1.166-2(d)(3) can apply equally to banks using the reserve method of accounting for bad debts and to banks using the specific charge-off method.

BACKGROUND

IRC 166(a)(2) provides “[w]hen satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.”

Insurance companies are required by state law to file Annual Statements using the accounting principles set out in the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual which have been adopted by the states. SSAP 43R provides accounting rules that must be followed when loan-backed and other structured securities are impaired and subject to a charge-off. SSAP 43R became effective on September 30, 2009, and applies for all reporting periods ending on or after September 30, 2009.

DEFINITIONS

EXAMINATION GUIDANCE

A. IN GENERAL

LB&I examiners should not challenge an insurance company’s partial worthlessness deduction under IRC 166(a)(2) for eligible securities if the company complies with the following:

1. First Year Adjustment

For the first taxable year in which an insurance company applies this guidance (the "Adjustment Year"), which can be no earlier than the company's 2009 and no later than the company's 2012 taxable years, the company's partial worthlessness deduction under IRC 166(a)(2) for eligible securities is the same amount as the company’s SSAP 43R credit-related impairment charge-offs for the same securities as reported on its Annual Statement except that the company reduces or increases its deduction by a positive or negative adjustment. The positive or negative adjustment is determined on December 31 of the Adjustment Year and is the difference between (i) the tax basis of eligible securities over (ii) the statutory carrying value of the same securities increased by any non-credit-related portion of any charge-off not allowed as deductible under this guidance. In no event may the tax basis of eligible securities be less than the post-charge-off statutory carrying value under SSAP 43R as adjusted for any non-credit impairment. The Adjustment Year partial worthlessness deduction may be negative depending on the size of a negative adjustment, and therefore may be an income item; and

2. SSAP 43R Credit-Related Charge-Off Conformity

For taxable years beginning after the Adjustment Year, the insurance company’s partial worthlessness deduction under IRC 166(a)(2) for eligible securities is the same amount as the company’s SSAP 43R credit-related impairment charge-offs for the same securities as reported on its Annual Statement. In no event may the tax basis of eligible securities be less than the post-charge-off statutory carrying value under SSAP 43R as adjusted for any non-credit impairment.

If an insurance company complies with both (1) and (2) above, LB&I examiners should not challenge an insurance company’s partial worthlessness deduction under IRC 166(a)(2) for eligible securities as reported on its Federal income tax returns for all open years ending before the Adjustment Year.

B. IMPLEMENTATION

1. Under Examination

If an insurance company is under examination and wants to apply the provisions of this guidance, LB&I examiners, in consultation with the company, will decide whether the most appropriate way to implement this guidance is to change the amount of the company's partial worthlessness deduction for eligible securities for the taxable year(s) under examination to be consistent with this guidance or allow the company to file amended Federal income tax returns. See paragraph A1 for the period in which an insurance company may choose to implement this guidance.

2. Not Under Examination

If an insurance company is not under examination, it may choose to implement the provisions of this guidance by filing amended Federal income tax returns, or by first applying this guidance for the company's current taxable year. In either case, the insurance company must attach a statement to its Federal income tax return for the Adjustment Year (either an amended return or the current taxable year return) stating that it is implementing the provisions of this guidance beginning in that Adjustment Year. See paragraph A1 for the period in which an insurance company may choose to implement this guidance. For a consolidated Federal income tax return, a separate statement should be attached for each insurance company.

C. CONSISTENCY REQUIREMENT

For this guidance to apply, an insurance company must use SSAP 43R credit-related impairment charge-off amount for all eligible securities that are partially worthless.

D. CERTIFICATION STATEMENT

Upon examination, if an insurance company has used its SSAP 43R credit-related impairment charge-offs of eligible securities reported on its Annual Statement as the amount of a partial worthlessness deduction under IRC 166(a)(2), it must sign and complete Exhibit 4.30.2-3, Certification Statement for Section 166 Partial Worthlessness Deduction (“Certification Statement”).

An insurance company must complete all sections of the Certification Statement, have the statement signed by an authorized individual, and provide the statement to the LB&I examiner within 30 days of a request for the statement. A separate Certification Statement may be requested for each taxable year under audit. For a consolidated Federal income tax return, a separate Certification Statement may be requested for each insurance company. An LB&I examiner will consider any insurance company not in compliance with these requirements ineligible for this guidance and subject to regular audit procedures.

The Certification Statement must be signed by an individual who is authorized to execute the insurance company's Federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit, the taxpayer's SSAP 43R credit-related impairment charge-off for eligible securities reported on its Annual Statement are consistent with the section IRC 166(a)(2) partial worthlessness deduction claimed for the same eligible securities. Insurance companies should retain the underlying accounting documentation that would permit the LB&I examiner to reconcile the companies' Annual Statement with their partial worthlessness deductions for eligible securities reported on the Federal income tax return. If an insurance company fails to properly and timely submit the requested documentation that would permit the examiner to reconcile the company's statutory accounting impairment with its Federal income tax deductions for eligible securities, then the director of field operations may determine that this guidance does not apply to the insurance company.

Annual Statement Information:

Relevant Period of the Annual Statement: __________

CERTIFICATION

By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalty of perjury, that for the taxable year to which this certification statement applies: (A) the taxpayer’s credit-related impairment amounts of eligible securities reported on the Annual Statement are the same as the amounts of partial worthlessness deductions claimed with respect to the same securities on the taxpayer’s Federal income tax return for the relevant taxable year; and (B) the tax basis of eligible securities reported on the Annual Statement is not less than the post-charge-off statutory carrying value of the same securities under SSAP 43R as adjusted for any non-credit impairment.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

Signature: ____________________

Date: ____________________

Title: ____________________

For corporations, the certification must be signed by an individual authorized under IRC 6062.

I. INTRODUCTION

This guidance is for Large Business & International (LB&I) examiners regarding bad debt deductions claimed under IRC 166 by a Bank or Bank Subsidiary. In addition, this guidance clarifies that LB&I examiners will not challenge the inclusion of certain estimated selling costs in a Bank or Bank Subsidiary’s bad debt deduction.

Independently determining worthlessness amounts under IRC 166 imposes a significant burden on Banks, Bank Subsidiaries, and LB&I examiners. Moreover, changes in bank regulatory standards are processes have created concerns about how to comply with the conclusive presumption under IRC 166.

Pending any further guidance modifying or superseding this, this guidance provides an administrative resolution generally based on accepting charge-off amounts reported by Banks and Bank Subsidiaries for GAAP and regulatory purposes as sufficient evidence of worthlessness. This guidance is intended to provide an efficient manner of resolving many bad debt deduction issues for Banks and Bank Subsidiaries and to more efficiently manage LB&I’s audit resources until further guidance under IRC 166 is issued.

This guidance does not apply to small banks that use the reserve method of accounting for loan losses under IRC 585, but is available to small banks that do not use the reserve method of accounting for loan losses. LB&I may consider issuing separate guidance for determining the amount and timing of charge-offs under IRC 585.

II. DEFINITIONS

III. IRC 166 DEDUCTIONS FOR ELIGIBLE DEBT AND ELIGIBLE DEBT SECURITIES

A. Background

IRC 166 (a)(1) provides that “[t]here shall be allowed as a deduction any debt which becomes worthless within the taxable year.”

IRC 166(a)(2) provides that "[w]hen satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction."

Treas. Reg. 1.166-2(a) provides that “[i]n 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.”

Banks can determine their bad debt deduction in one of four ways. First, they may apply the general facts and circumstances test under Treas. Reg. 1.166-2(a) to determine whether a debt is worthless in the same manner as other types of taxpayers. In the alternative, Banks may use one of two special rules provided in Treas. Reg. 1.166- 2(d)(1) and (3). Finally, small banks are entitled to apply the reserve method of accounting for loan losses. See IRC 585.

Treas. Reg. 1.166-2(d)(1) provides a “conclusive presumption rule” under which worthlessness is generally presumed to occur in the same year that a bank, or other regulated corporation, charges off a debt in whole or in part pursuant to Federal or state bank regulatory rules and established policies, or pursuant to a specific order by a bank regulator.

Treas. Reg. 1.166-2(d)(3) provides a “conformity election” under which worthlessness is conclusively presumed if a Bank’s Bank Regulator makes an express determination that the bank maintains and applies loan loss classification standards that are consistent with regulatory standards.

Many Banks have subsidiaries that are not themselves Banks, but are facilitative of the Banks’ banking and lending businesses. In general, a Bank’s controlled subsidiaries are subject to the same supervision and oversight by Bank Regulators as the Bank, and a Bank Regulator generally applies identical standards to a Bank’s controlled subsidiaries as they do to the Bank, where the controlled subsidiaries conduct any business that can be conducted by the Bank.

B. Issue Tracking

Any cases having this issue should use the following Uniform Issue List (UIL) number: UIL 166.07-00 - Bad Debt Deductions for Eligible Debt and Eligible Debt Securities - Banks and Bank Subsidiaries.

C. Examination Guidelines

LB&I examiners should not challenge a Bank or Bank Subsidiary’s bad debt deduction for eligible debt or eligible debt securities as follows:

1. Bank or Bank Subsidiary using the general facts and circumstances test of Treas. Reg. 1.166-2(a)

Do not challenge a Bank or Bank Subsidiary’s bad debt deduction for eligible debt and eligible debt securities if the deduction is the same amount as the amount of the credit-related impairment portion of its charge-off of eligible debt and the amount of the credit-related impairment portion of its charge-off of eligible debt securities as reported on its applicable financial statement.

In no event, however, may the post-deduction tax basis of eligible debt be less than the post-charge-off book basis of the eligible debt as increased by any portion of the charge-off not related to credit impairment, nor may the post- deduction tax basis of eligible debt securities be less than the post-charge-off carrying amount of the eligible debt securities as increased by any portion of the charge-off not related to credit impairment.

In addition, do not challenge the inclusion in the Bank or Bank Subsidiary’s bad debt deduction for eligible debt of estimated selling costs to the extent such estimated selling costs are included in the charge-off reported in the Bank or Bank Subsidiary’s applicable financial statement.

2. Bank or Bank Subsidiary using the conclusive presumption rule of Treas. Reg. 1.166-2(d)(1)

Do not challenge a Bank or Bank Subsidiary’s bad debt deduction for eligible debt and eligible debt securities if the deduction is the sum of: (1) the amount of the credit-related impairment portion of its charge-off of eligible debt and the amount of the credit-related impairment portion of its charge-off of eligible Debt Securities as reported on its Applicable Financial Statement; and (2) the portion of the charge-off of eligible debt and eligible debt securities in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. 1.166-2(d)(1)) by a Bank Regulator as reported on its Applicable Financial Statement.

Do not challenge regardless of whether or not a Bank or Bank Subsidiary presents a specific order by Bank Regulators or confirmation in writing as described in Treas. Reg. 1.166-2(d)(1). However, a signed Certification Statement from the Bank or the Bank Subsidiary is required.

In no event, however, may the post-deduction tax basis of eligible debt be less than the post-charge-off book basis of the eligible debt as increased by any portion of the charge-off not related to credit impairment and reduced by any amount of the charge-off in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. 1.166-2(d)(1)) by a Bank Regulator, nor may the post-deduction tax basis of eligible debt securities be less than the post-charge-off carrying value of the eligible debt securities as increased by any portion of the charge-off not related to credit impairment and reduced by any amount of the charge-off in excess of the credit-related impairment that was taken pursuant to a specific order or written confirmation (as described in Treas. Reg. 1.166-2(d)(1)) by a Bank Regulator.

In addition, do not challenge the inclusion in the Bank or Bank Subsidiary’s bad debt deduction for eligible debt of estimated selling costs to the extent such estimated selling costs are included in the charge-off reported in the Bank or Bank Subsidiary’s Applicable Financial Statement.

3. Bank using the conformity election under Treas. Reg. 1.166-2(d)(3)

Do not challenge a Bank’s bad debt deduction for eligible debt and eligible debt securities if a Bank made a proper conformity election under Treas. Reg. 1.166-2(d)(3) regardless of whether or not the express determination requirement as described in Treas. Reg. 1.166-2(d)(3)(iii)(D) is satisfied.

In addition, do not challenge the inclusion in the Bank bad debt deduction for eligible debt of estimated selling costs to the extent such estimated selling costs are included in the charge-off reported in the Bank Applicable Financial Statement.

D. Implementation

1. In General

This guidance applies on an entity-by-entity basis. A Bank or Bank Subsidiary may apply this guidance no earlier than its 2010 taxable year and no later than a taxable year that begins in 2014. Pending any future guidance modifying or superseding this guidance, once a Bank or Bank Subsidiary chooses to apply this guidance, it must apply it consistently going forward from year to year.

If a Bank or Bank Subsidiary chooses to follow the provisions of this guidance, it may implement any applicable changes by filing amended returns or making the changes in its current taxable year. If a Bank or Bank Subsidiary is under examination, LB&I examiners, in consultation with the taxpayer, may decide whether it is appropriate to change the amount of bad debt deduction for the eligible debt and eligible debt securities for the open taxable year(s) under examination to be consistent with this guidance or to allow the taxpayer to file amended returns.

2. First Year Adjustment

If a Bank or Bank Subsidiary described in C.1 or C.2 above chooses to follow the provisions of this guidance, its first taxable year in which changes are made is the “Adjustment Year.” For the Adjustment Year, LB&I Examiners should not challenge a Bank or Bank Subsidiary’s bad debt deduction if the amount of the deduction is determined as provided in C.1, and, where applicable, in C.2 above, reduced or increased by a positive or negative adjustment, determined on December 31 of the Adjustment Year (or the last day of the Adjustment Year, if different from December 31) as set out below. The overall Adjustment Year bad debt deduction may be negative, and, depending on the size of the adjustment, may be an income item.

A. Bank or Bank Subsidiary described in C.1 for Eligible Debt and Eligible Debt Securities

B. Bank or Bank Subsidiary described in C.2 for Eligible Debt and Eligible Debt Securities

3. Charge-Off Conformity in Subsequent Years

For each taxable year beginning after the Adjustment Year, the amount of the bad debt deduction under IRC 166 for eligible debt and eligible debt securities should be determined as provided in C.1 for Banks and Bank Subsidiaries described in section C.1, and as provided in section C.2 for Banks and Bank Subsidiaries described in section C.2.

IV. CERTIFICATION STATEMENT

If the taxpayer has claimed a bad debt deduction under IRC 166 in compliance with the provisions of this guidance, then upon examination, the taxpayer must sign and complete Exhibit 4.30.2-5, Certification Statement for Section 166 Eligible Debt and eligible debt securities.

The taxpayer must complete all sections of the certification statement, have the statement signed by an authorized individual, and provide the statement to the LB&I examiner within 30 days of a request for the certification statement. A separate certification statement may be requested for each taxable year under audit. For a consolidated federal income tax return, a separate certification statement may be requested for each bank and bank subsidiary applying the terms of this guidance. A LB&I examiner will consider any taxpayer not in compliance with these requirements ineligible for this guidance and subject to regular audit procedures.

The certification statement must be signed by an individual who is authorized to execute the taxpayer’s federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit:

For taxpayers described in C.1 and C.2:

For taxpayers described in C.2:

In addition, the taxpayer should retain the underlying accounting documentation that would permit the LB&I examiner to reconcile the taxpayer’s Applicable Financial Statement with the amount of its bad debt deduction for eligible debt and eligible debt securities reported on the taxpayer’s federal income tax return. If a taxpayer fails to properly and timely submit the requested documentation, then the director of field operations or his/her delegate may determine that this guidance does not apply to the taxpayer.

Please provide the following information for taxpayers described in the guidance under C.1, C.2, and C.3:

A. Amount of the Charge-off reported on the Applicable Financial Statement for:

B. Amount of the IRC 166 bad debt deduction reported on Federal income return for:

C. Post Charge-off:

D. Post-deduction tax basis for:

Please provide the following information for taxpayers described in the guidance under C.1 and C.2:

E. Portion of the Charge-off not related to credit impairment, if any:

F. First-Year Adjustment determined on December 31 of the Adjustment Year (or the last day of the Adjustment Year, if different):

Please provide the following information for taxpayers described in the guidance under C.2:

G. Portion of the Charge-off charged-off pursuant to a specific order or written confirmation by a Bank Regulator:

CERTIFICATION

By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalties of perjury, that for the taxable year under audit:

For taxpayers described in C.1 and C.2 -

For taxpayers described in C.2, if the bad debt deduction claimed in the taxpayer’s federal income tax return is in excess of the credit-related impairment portion of the charge-offs reported on the taxpayer’s applicable financial statement, then such excess amount was charged-off pursuant to a specific order or written confirmation (as described in Treas. Reg. 1.166-2(d)(1)) by a bank regulator as reported on its applicable financial statement.

Signature: ____________________

Title: ____________________

Date: ____________________

For corporation, the certification must be signed by an individual authorized under IRC 6062.

CERTIFICATION

By signing this Certification Statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records under IRC 6001 to establish to the satisfaction of the IRS the statements made in this Certification Statement are true, correct, and complete.

(A) For purposes of IRC 199, the taxpayer has determined it had benefits and burdens over the Qualifying Property when the Qualifying Activities were performed and filed its Federal Income Tax return(s) consistent with this determination.

(B) The Contract to which this Certification Statement applies was not governed by the rules applicable to

(C) The Qualifying Activities occurred in whole or in significant part within the United States.

The taxpayer certifies under penalty of perjury that it has examined this Certification Statement, and to the best of its knowledge and belief, it is true, correct, and complete.

Taxpayer’s Signature:

Date (Taxpayer):

Title (Taxpayer):

For corporations, the certification must be signed by an individual authorized under IRC 6062.

CERTIFICATION

The counterparty did not claim, and will not claim, the IRC 199 deduction for any taxable year covered by the Contract pursuant to which the same Qualifying Activities were performed.

The Counterparty certifies under penalty of perjury that it has examined this Certification Statement, and to the best of its knowledge and belief, it is true, correct, and complete.

Counterparty’s Signature:

Date (Counterparty):

Title (Counterparty):

For corporations, the certification must be signed by an individual authorized under IRC 6062.

This guidance provides instructions to LB&I examiners in determining whether a taxpayer’s method for allocating Mixed Service Costs (MSC) to certain self-constructed tangible personal property(self-constructed property) is appropriate and should not be challenged. This guidance applies to examination activity relating to electric utilities, natural gas utilities, and combined electric and natural gas utilities.

BACKGROUND

Utility industry taxpayers may not use the Simplified Service Cost Method (SSCM) to allocate MSC to self-constructed property that is not mass-produced or does not have a high degree of turnover. See Treas. Reg. 1.263A-1(d)(1), (h)(1), (h)(2)(i)(D); see also Rev. Rul. 2005-53, 2005-2 C.B. 425.

For property that is not eligible for the SSCM, utility industry taxpayers should allocate MSC based on a reasonable allocation method such as the "facts and circumstances" method. See Treas. Reg. 1.263A-1(f)(1), (f)(4), (g)(4).

EXAMINATION GUIDANCE

1. Examiners should not challenge the reasonableness of the following MSC allocation method used by a utility industry taxpayer:

A. Step 1 - A consistent headcount ratio - The taxpayer allocates MSC among (i) transmission and distribution (T&D) and other departments, and between (ii) capital (i.e., production or resale) and non-capital activities within a T&D department based on an annually determined headcount ratio that is calculated in the following manner:

B. Step 2 - A production cost ratio with a limited reduction for purchased electricity and purchased natural gas - The taxpayer allocates capitalizable MSC among capital activities according to a production cost ratio that is computed as follows:

2. This guidance does not apply if the taxpayer includes any of the following elements in its MSC allocation methods:

3. This guidance does not address the following threshold issues:

Contacts:

If you have any questions, please contact the Inventory & 263A Practice Network.

BACKGROUND

Insurance companies are required by state law to file Annual Statements using the accounting principles set out in the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual, Statement of Statutory Accounting Principles (SSAP), or equivalent accounting standards mandated by insurance regulators.

Several Actuarial Guidelines (AGs) adopted by the NAIC provide standards for the valuation of reserves for VA contracts involving Guaranteed Minimum Benefit (GMxB). Insurance companies follow these AGs for the purposes of tax reserve calculations. AG 34 values reserves for guaranteed minimum death benefits (see Definitions, below). AG 39 values reserves for guaranteed living benefits (see Definitions, below).

Variable annuities have features of both life insurance and investment products. VA contracts generally are regulated by the State insurance regulators and the Securities and Exchange Commission. The sale of VA contracts is overseen by the Financial Industry Regulatory Authority. Current VA contracts often provide one or more GMxB. For example, a single contract may provide a Guaranteed Minimum Death Benefit and Guaranteed Minimum Living Benefit.

A VA contract with GMxB subjects insurance companies to the risk of incurring liabilities that exceed the value of segregated account assets for the contract. Insurance companies typically hedge the risks associated with GMxB obligations.

DEFINITIONS

The following table reflects terms and definitions.

ISSUE TRACKING

Any cases having this issue should use UIL 446.33-01 Hedging Transactions – Variable Annuity Contracts.

EXAMINATION GUIDANCE

LB&I examiners should not challenge the method of accounting for eligible GMxB Hedges described below in section A of this guidance. This guidance applies only to the eligible GMxB Hedges related to the VA contracts issued before December 31, 2009. Eligible GMxB Hedges related to the VA contracts issued on or after December 31, 2009 should be accounted for using a method consistent with the matching requirements in Treas. Reg. 1.446-4(e)(1).

A. In General

The following is required:

Step 1. MTM Valuation of Eligible GMxB Hedges:

Step 2. Determine Aggregate Net Hedge Gain or Loss on all Eligible GMxB Hedges for the Taxable Year

Aggregate net hedge income, deduction, gain or loss is determined by adding:

Step 3. Allocate Aggregate Net Hedge Gain or Loss Between --

Only the portion of the aggregate net hedge gain or loss allocable to VA contracts issued before December 31, 2009, is taken into account in Step 4 below. Hedge gain or loss allocable to VA contracts issued on or after December 31, 2009, should be accounted for using a method consistent with the matching requirement in Treas. Reg. 1.446-4(e)(1).

Step 4. Accounting for the Portion of Aggregate Net Hedge Gain or Loss Allocable to VA Contracts Issued Before December 31, 2009.

Net Hedge Gain

Net Hedge Loss

B. Implementation

If insurance companies under examination want to apply the provisions of this guidance, LB&I examiners will make the change in method of accounting. This change will be made whether the existing method of accounting is permissible or impermissible, and whether the issue is under exam or not. The change will be made under the principles and requirements of Rev. Proc. 2002-18, 2002-1 C.B. 678 generally for the earliest open year under examination, except that, 1) if the parties agree (and notwithstanding section 5 of Rev. Proc. 2002-18), the year of change may be a taxable year other than the earliest open taxable year under examination, and 2) a positive 481(a) adjustment shall be taken into account over four taxable years under the rules of section 7 of Rev. Proc. 97-27, 1997-1 C.B. 680, as modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696.

Insurance companies not under examination may apply the provisions of this guidance by filing a Form 3115, Application for Change in Accounting Method, under Rev. Proc. 2015-13.

C. Consistency Requirement

For this to apply, an insurance company must

D. Certification Statement

To be eligible for this guidance, an insurance company must sign and complete the attached Exhibit 4.30.2-10, Certification Statement for IRC 446: Related to Hedging of Variable Annuity Guaranteed Minimum Benefits Certification Statement ("certification statement"). An insurance company must complete all sections of the certification statement, have the statement signed by an authorized individual, and provide the statement to the LB&I examiner within 30 days of a request for the statement. A separate certification statement may be requested for each taxable year under audit. For a consolidated federal income tax return, a separate certification statement may be requested for each insurance company. An LB&I examiner will consider any insurance company not in compliance with these requirements ineligible for this guidance and subject to regular audit procedures.

E. Contact

Questions concerning this guidance should be directed to the Financial Institutions & Products Practice Network.

Taxpayer Name:

Taxpayer EIN:

Tax Year:

Relevant Period of the Annual Statement:

Annual Statement Information:

A. Mark-to market value of all Eligible GMxB Hedges reported as of December 31:

B. Mark-to-market value of all Eligible GMxB Hedges related to variable annuity contracts issued:

C. Total net mark-to-market amounts reported for the taxable for:

Certification

By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalty of perjury, that for the tax year to which this certification statement applies, the taxpayer used the method of accounting set forth in the examination guidance of this IRM to recognize Eligible GMxB hedge income, deductions, gains, and losses for VA contracts issued before December 31, 2009 for federal income tax purposes.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

Signature:

Date:

Title:

For corporations, the certification must be signed by an individual authorized under IRC 6062.

BACKGROUND

Insurance companies are generally required, by state law, to file annual statements using statutory accounting principles set by the National Association of Insurance Commissioners (NAIC) as adopted by state insurance regulators. The Standard Valuation Law, which was promulgated by the NAIC and has been adopted by every state in some form, provides the basic rules for determining the minimum amount of reserves that must be held by a company. The Commissioner’s Reserve Valuation Method (CRVM) (for life insurance contracts) and the Commissioner’s Annuity Reserve Valuation Method (CARVM) (for annuity contracts) are in the Standard Valuation Law. The Standard Valuation Law is interpreted by the model regulations and actuarial guidelines, which are also promulgated by the NAIC. The NAIC’s Valuation Manual is intended to consolidate into one document the minimum reserve requirements for insurance contracts.

IRC 805(a)(2) allows an insurance company to take a deduction for increases in certain life insurance reserves. More, specifically, IRC 807(b) provides that if, for any taxable year, the closing balance of "the items described in subsection (c)" (which includes life insurance reserves) exceeds the opening balance, the excess is taken into account as a deduction under IRC 805(a)(2). By contrast, IRC 807(a) provides that if the opening balance exceeds the closing balance, the excess is included in gross income under section 803(a)(2).

Under IRC 807(d)(3), the tax reserve method that applies to a variable annuity contract is the CARVM prescribed by the NAIC that is in effect on the date the contract was issued. Similarly, the tax reserve method that applies to a life insurance contract is the CRVM prescribed by the NAIC that is in effect on the date the contract was issued.

CARVM for variable annuities is interpreted in AG 43, which clarifies the assumptions and methodologies that comply with the intent of the Standard Valuation Law. AG 43 became effective on December 31, 2009, for all variable annuity contracts issued on or after January 1, 1981. AG 43 was effectively incorporated in part 21 of the Valuation Manual (VM-21) adopted by the NAIC on December 2, 2012. VM-21 is effective for all variable annuity contracts issued on or after January 1, 2017.

In Notice 2010-29, 2010-1 C.B. 547, the IRS provided interim guidance to issuers of variable annuity contracts as a result of the NAIC’s adoption of AG 43. Under the Notice, for a contract falling within the scope of AG 43 and issued on or after December 31, 2009, the tax reserve method, with respect to such a contract under IRC 807(d)(2)(A) and (d)(3), is the method prescribed in AG 43 for determining the Standard Scenario Amount (SSA) (applied using the appropriate valuation interest rate under IRC 807(d)(2)(B) and certain other adjustments). The provisions for determining the Conditional Tail Expectation Amount (CTEA) are not taken into account.

Part 20 of the Valuation Manual (VM-20) prescribes minimum reserve valuation standards for individual life insurance contracts. VM-20 incorporates a principle based reserve standard similar in concept to the AG 43 standard for variable annuity contracts. The requirements of VM-20 constitute the CRVM requirements effective for certain life insurance contracts issued on or after January 1, 2017.

The method of determining life insurance reserves for use in computing an insurance company’s taxable income is prescribed in IRC 807(d). For this purpose, the reserve for a contract is generally equal to the greater of

In no event may the reserve for any contract exceed the amount taken into account with respect to that contract as of that time in determining the statutory reserves (reduced by any deferred and uncollected premiums taken into account in determining the statutory reserves). IRC 807(d)(1) (flush language); see also IRC 811(c).

IRC 807(d)(2) provides that the reserve for any contract must be determined using (i) the tax reserve method applicable to that type of contract,(ii) the greater of the applicable federal interest rate or the prevailing state assumed interest rate, and (iii) the prevailing commissioner’s standard tables for morbidity or mortality adjusted as appropriate to reflect the risks (such as substandard risks) incurred under the contract that are not otherwise taken into account.

DEFINITIONS

The following table reflects terms and definitions relative to this guidance.

ISSUE TRACKING

Any cases having this issue should use UIL Code 807.03-02.

EXAMINATION GUIDANCE

A. In General

1. Guidance Regarding Eligible VA Contracts & Eligible Life Insurance Contracts

For tax years 2010 through 2016, LB&I examiners should discontinue any current examination of the federally prescribed reserve for eligible VA contracts if the insurance company timely provides a copy of the certification statement for eligible VA contracts described in this guidance. If an insurance company implements this guidance, LB&I examiners should not make any adjustments to taxable income reported on an insurance company’s original returns (such as allowing claims for refunds and affirmative adjustments) for tax years 2010 through 2016 that are based on adjustments to the federally prescribed reserve for eligible VA contracts unless the adjustments are processable adjustments.

For the tax year 2017, LB&I examiners should not challenge the federally prescribed reserve for eligible VA contracts or eligible life insurance contracts reported on the insurance company’s return if the method used is described in this guidance and the insurance company provides the certification statement described in this guidance. An insurance company’s compliance with this guidance may be examined in connection with an examination of the 2017 tax year.

For tax years after 2017, LB&I examiners also should not challenge any ten-year spread resulting from implementation of the methods described in this guidance that is taken into account as described in this guidance if the insurance company timely provides a copy of the certification statement for eligible VA contracts described in this guidance.

Please contact the LB&I Insurance Practice Network for guidance.

2. Guidance Regarding Eligible AG 39 VA Contracts

For tax years 2010 through 2016, LB&I examiners should discontinue any current examination of the federally prescribed reserve for eligible AG 39VA contracts if the insurance company timely provides a copy of the certification statement for eligible AG 39 VA contracts described in this guidance. If an insurance company implements this guidance, LB&I examiners should not make any adjustments to taxable income reported on an insurance company’s original returns (such as allowing claims for refunds and affirmative adjustments) for tax years 2010 through 2016 that are based on adjustments to the federally prescribed reserve for eligible AG 39 VA contracts unless the adjustments are processable adjustments.

For the tax year 2017, LB&I examiners should not challenge the federally prescribed reserve for eligible AG 39 VA contracts reported on the insurance company’s return if the method used is described in this guidance and the insurance company provides the certification statement described in this guidance. An insurance company’s compliance with this guidance may be examined in connection with an examination of the 2017 tax year.

For tax years after 2017, LB&I examiners also should not challenge any ten-year spread resulting from implementation of the method described in this guidance that is taken into account as described in this guidance if the insurance company timely provides a copy of the certification statement for eligible AG 39 VA contracts described in this guidance.

Please contact the LB&I Life Insurance Practice Network for guidance.

3. Additional Sections of this Guidance

Section B of this guidance describes the accepted methods for computing the federally prescribed reserves for eligible VA contracts and eligible life contracts. Section C describes how these accepted methods should be implemented. Section D describes the accepted method for computing the federally prescribed reserve for eligible AG 39 VA contracts and how this method should be implemented. Section E requires that certain values used in computing the federally prescribed reserve be those used on the annual statement and provides other rules for implementing this guidance. Section F describes the manner in which the TCJA transition rule for life insurance reserves should be implemented by insurance companies adopting this guidance. Section G describes the certification that an insurance company must provide to be subject to this guidance.

B. Accepted Methods for Determining the Federally Prescribed Reserve

1. Accepted Method for Eligible VA Contracts

The federally prescribed reserve for an eligible VA contract will be treated as the sum of:

The life insurance reserve for an eligible VA contract under IRC 807(d) is equal to the greater of:

In no event may the reserve for any contract exceed the amount taken into account with respect to that contract as of the time in determining the statutory reserves (reduced by any deferred and uncollected premium taken into account in determining the statutory reserves). IRC 807(d)(1) (flush language).

2. Accepted Method for Eligible Life Insurance Contracts

The federally prescribed reserve for an eligible life insurance contract will be treated as the sum of:

The life insurance reserve for an eligible life insurance contract under IRC 807(d) is equal to the greater of:

In no event may the reserve for any contract exceed the amount taken into account with respect to that contract as of that time in determining the statutory reserves (reduced by any deferred and uncollected premiums taken into account in determining the statutory reserves). IRC 807(d)(1) (flush language).

C. Implementation of the Accepted Methods

1. Implementation for Eligible VA Contracts

The implementation of the accepted method for eligible VA contracts depends on whether a ten-year spread is required. For purposes of this guidance, a ten-year spread is required to implement the accepted method for eligible VA contracts as described in this guidance unless one of these apply:

No Ten-Year Spread Required. If a ten-year spread is not required (as described above), then the federally prescribed reserve for an eligible VA contract as of the close of 2017, is computed with the accepted method for VA contracts. Accordingly, the increase or decrease in the balance of life insurance reserves for eligible VA contracts for 2017 is the difference between:

Ten-Year Spread Required. If a ten-year spread is required (as described above), then the insurance company may implement the accepted method for eligible VA contracts and the associated ten-year spread under either of the following two options; provided, however, that if an insurance company has a tax year that is not an open year after the earliest open year that is a VM-21/AG 43 year tax, then Option 1 must be used.

Option 1 - Adjustments are computed as if an insurance company implemented the accepted method for eligible VA contracts in 2016.

(a) The ten-year spread is computed as if the accepted method for eligible VA contracts had been implemented in 2016, and the computation of the ten-year spread included contracts issued in 2016. Accordingly, the ten-year spread for eligible VA contracts is the difference between:

The ten-year spread amount is taken into account in equal amounts over 10 tax years starting in 2017.

(b) The increase or decrease in the balance of life insurance reserves for eligible VA contracts for 2017 is the difference between:

Option 2 - Adjustments are computed as if an insurance company implemented the accepted method for eligible VA contracts in each open year, but the aggregate amount of such adjustments is taken into account on the 2017 tax return.

(a) The ten-year spread is computed as if the accepted method for eligible VA contracts had been implemented in the earliest open year that is a VM-21/AG 43 year (without regard to any eligible VA contracts issued in the such year) and allocated equally to the ten tax years beginning immediately after such year.

(b) Aggregate adjustments to life insurance tax reserves previously determined and reported on an original return (adjusted as appropriate to reflect any processable adjustments) that otherwise would have been required to reflect implementation of the accepted method for eligible VA contracts in the earliest open year that is a VM-21/AG 43 year are taken into account in 2017.

2. Implementation for Eligible Life Insurance Contracts

For insurance companies that adopted VM-20 in 2017, the accepted method for eligible life insurance contracts is implemented by computing the federally prescribed reserve for 2017 for an eligible life insurance contract using the accepted method for eligible life insurance contracts.

D. Accepted Method and Implementation for Certain Variable Annuity Contracts Issued Before December 31, 2009

The accepted method for eligible AG 39 VA contracts may be implemented for eligible AG 39 VA contracts in the same manner as the accepted method for eligible VA contracts is implemented for eligible VA contracts with references to VM-21/AG 43 years considered as references to AG 39 years and references to eligible VA contracts considered as references to eligible AG 39 VA contracts.

E. Additional Provisions

In implementing the accepted method for eligible VA contracts and/or the accepted method for eligible AG 39 VA contracts, an insurance company must use the standard scenario amount and conditional tail expectation amount reported under AG 43 and VM-21 in the company’s annual statement, including all accompanying notes, schedules, and exhibits.

In implementing the accepted method for eligible life insurance contracts, an insurance company must use the net premium reserve, deterministic reserve, and stochastic reserves reported under VM-20 in the company’s annual statement, including all accompanying notes, schedules, and exhibits.

If an insurance company implements the accepted method for eligible VA contracts, it must also implement the accepted method for life insurance Contracts for any Eligible Life Insurance Contracts. If an insurance company implements the Accepted Method for Eligible VA Contracts or the Accepted method for eligible life insurance contracts, such methods (and any adoption of either option 1 or option 2 in section C.1. of this guidance) must also be implemented by all members of any consolidated group of which such insurance company is a member at any time during the taxable year.

An insurance company will be considered to have properly implemented this guidance if it attempts in good faith to implement this guidance and subsequently and in good faith provides any necessary corrections or additional information.

F. Coordination with Pub. L. No. 115-97 (TCJA)

For purposes of implementing the transition relief under section 13517(c)(3) of the TCJA for insurance companies that follow this guidance, the reserve referenced in section 13517(c)(3)(A)(ii) must take into account the determination of the reserve in accordance with this guidance.

G. Certification Statement

To be eligible for this guidance, an insurance company must sign and complete in good faith (and timely provide any necessary corrections) the attached Exhibit 4.30.2-12, Certification Statement for IRC 807 Principle Based Reserves for Variable Annuity Contracts (AG 43/VM-21) and Life Insurance Contracts (VM-20) ("Certification Statement"). An insurance company must complete all sections of the certification statement, have it signed by an authorized individual, and attach it to its 2017 return. If the insurance company is under exam for any tax year, the insurance company must provide a copy of the certification statement to the LB&I examiner within 30 days of a request for such statement. For a consolidated federal income tax return, a separate certification statement may be requested for each insurance company. An LB&I examiner will consider any insurance company not in compliance with these requirements to be ineligible for this guidance and subject to regular audit procedures.

The certification statement must be signed by an individual who is authorized to execute the insurance company’s federal income tax return. The individual must certify, under penalty of perjury, that the insurance company and any consolidated group of which it is a member:

Insurance companies should retain the underlying accounting documentation that would permit the LB&I examiner to verify the insurance company’s compliance with the requirements of this guidance. If an insurance company fails to properly and timely submit the requested documentation, then the LB&I examiner may determine that this guidance does not apply to the insurance company (or any member of the consolidated group of which the insurance company is a member).

H. Contact

Questions concerning this guidance should be directed to the LB&I Life Insurance Practice Network.

Insurance Company Name:

EIN:

Tax Year:

Relevant Period of the Annual Statement:

This Certification Statement must be completed for each insurance company, without regard to whether it is a member of a Consolidated Group.

If the insurance company is a member of a Consolidated Group, please provide:

Name of the Parent of the Consolidated Group:

EIN of the Parent of the Consolidated Group:

A. Indicate for which of the following types of contracts the 2017 tax return reflects the adjustment described in this guidance:

[ ] Eligible VA Contracts

[ ] Eligible AG 39 VA Contracts

[ ] Eligible Life Insurance Contract

B. Information for Implementing the Accepted Method when there is no ten-year spread required:

*Opening life insurance reserve tax balance for 2017, as previously determined and reported on a return (adjusted as appropriate to reflect any Processable Adjustment).

**Closing life insurance reserve tax balance for 2017 computed under the Accepted Method.

C. If a ten-year spread is required, please choose Option 1 or Option 2 as described in the guidance and provide the information below:

CERTIFICATION

By signing this certification statement, the insurance company agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalty of perjury, that for the tax year to which this certification statement applies, the insurance company and each member of the consolidated group of which the insurance company is a member:

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

Signature:

Date:

Title:

For corporations, the certification must be signed by an individual authorized under IRC 6062.

Taxpayer Name:

Taxpayer EIN:

Tax Year:

Qualified Financial Statement:

Relevant Period of the Qualified Financial Statement:

CERTIFICATION

By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

I certify, under penalty of perjury, that for the tax year to which this certification statement applies, the taxpayer's mark-to-market values reported on its qualified financial statements are consistent with the IRC 475 values for the same securities and/or commodities reported on the taxpayer's federal income tax return for the relevant tax year for all entities included in the consolidated tax return that use the IRC 475 mark-to-market method of accounting.

I certify, under penalty of perjury, that no tax return Schedule M adjusting entries or other book to tax adjusting entries were made regarding the IRC 475 mark-to-market values.

I certify, under penalty of perjury, that no deferred tax assets, deferred tax liabilities, or valuation allowances were reported for U.S. GAAP (FAS 109/ASC 740) purposes regarding any IRC 475 mark-to-market values.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

Signature:

Date:

Title:

For corporations, the certification must be signed by an individual authorized under IRC 6062. For partnerships, the certification must be signed by an individual authorized under IRC 6063. All certifications must be signed under penalty of perjury.

Taxpayer Name:

Taxpayer EIN:

Tax Year:

CERTIFICATION

By signing this certification statement, the taxpayer agrees to readily provide (upon request of the IRS) all relevant data and records required under IRC 6001 to establish to the satisfaction of the IRS that the statements made in this certification statement are true, correct and complete.

(A) the taxpayer’s qualified research expenses (QREs) are computed in accordance with IRC 41(b),

(B) in computing the QREs, the taxpayer excluded the activities listed in IRC 41(d)(4); and

(C) in computing the IRC 41 credit, the taxpayer included QREs relating to stages 1 and 2 of the pharmaceutical drug and Therapeutic Biologics Development Process and clinical trials required by the FDA related to accelerated approvals in the amount of $_______.

I certify, under penalty of perjury, that I have examined this certification statement, and to the best of my knowledge and belief, it is true, correct, and complete.

Signature:

Date:

Title:

For corporations, the certification must be signed by an individual authorized under IRC 6062.

Please click here for the text description of the image.

* Column A total must equal Line 19 in Appendix C

Please click here for the text description of the image.

Instructions for Appendix C (2017)

Step 1:

Line 1 Report the amount of research and development costs currently expensed pursuant to ASC 730 for U.S. GAAP purposes which amount is shown as a line item on taxpayer’s income statement included in its certified audited financial statements or which amount is shown separately stated in a note to its certified audited financial statements for the same year/period as the tax return.

Step 2:

Line 2 Subtract all Book/GAAP ASC 730 R&D amounts for any foreign entities, i.e. non- U.S. entities such as controlled foreign corporations.

Line 3 Line 1 - line 2, this figure should include GAAP R&D ASC 730 expenses for only U.S. entities.

Line 3a The figure reported here should be the same amount as reported on: Form 1120, Sch. M-3, Part III, column (a), line 35; Form 1120S, Sch. M-3, Part III, column (a), line 29; or Form 1065, Sch. M-3, Part III, column (a), line 29 (collectively the “Schedule M3 amount”). Provide an explanation, if the Schedule M-3 amount is different than the amount on Line 3.

Step 3: Line 4 Subtractions from U.S. ASC 730 Financial Statement R&D.

Line 5 All U.S. ASC 730 Financial Statement R&D GL accounts specifically excluded from section 174 such as: (i) quality control testing; (ii) efficiency surveys; (iii) management studies; (iv) consumer surveys; (v) advertising of promotions; (vi) the acquisition of another's patent, model, production or process; or (vii) research in connection with literary, historical, or similar projects.

Line 6 All U.S. ASC 730 Financial Statement R&D GL accounts that are non-wage, non-supply and non-contract research such as depreciation, amortization, shipping, travel, training, rent, overhead, general and administrative expenses and all other items not eligible for section 41 QREs.

Line 7 All U.S. ASC 730 Financial Statement R&D costs incurred for all agreements/contracts pursuant to which the taxpayer performed ASC 730 research in order to comply with the terms of the agreements/contracts. These costs are to be subtracted regardless of whether incurred in connection with funded research.

Line 8 All U.S. ASC 730 Financial Statement R&D costs incurred for all persons other than the taxpayer’s employees who performed ASC 730 research on behalf of the taxpayer.

Line 9 All wages and related expenses for U.S. ASC 730 Financial Statement R&D for U.S. employees who leave the U.S. and perform research services outside of the U.S. Also, the wages and stock options associated with these individuals for ASC 730 research performed outside the U.S. should not be included on lines 13 & 14, below. A similar adjustment for non-inclusion of ASC 730 research performed outside the U.S. is also required to be made to taxable W-2 wages captured on lines 15, 16 & 17, below.

Line 10 The amount of prototype overhead, patent costs and severance pay included in U.S. ASC 730 Financial Statement R&D.

Line 11 Total subtractions step 3, (add lines 5 through 10).

Line 11a Subtotal U.S. ASC 730 Financial Statement R&D after subtractions (Line 3 - Line 11)

Step 4: Line 12 W-2 Wages for employee compensation added to U.S. ASC 730 Financial Statement R&D in this step should not include any amounts relating to the above subtractions. Further, the W-2 wages should only relate to wage costs that are charged to U.S. ASC 730 Financial Statement cost centers.

Line 13 Subtract U.S. ASC 730 Financial Statement R&D wage and wage related accounts not already subtracted in the lines, above.

Line 14 Subtract U.S. ASC 730 Financial Statement R&D stock-based compensation not already subtracted in the lines, above.

Note: Amounts on lines 15, 16 & 17 are calculated using Appendix D - Adjusted ASC 730 Financial Statement R&D Wage Detail. These wages represent taxable W-2 wages (base wages and stock options) for employees whose wage costs are charged to U.S. ASC 730 Financial Statement cost centers

Line 15 Add 95% of W-2 wages for qualified individual contributors.

Line 16 Add 95% of W-2 wages for 1st level supervisor managers.

Line 17 Add upper level managers’ limit.

Line 18 Total step 4

Step 5:Line 19 Adjusted ASC 730 Financial Statement R&D (line 11a + line 18)

Note: for lines 20 through 22, breakdown the amount of QREs reported on line 19 to the appropriate lines on Form 6765. Record theses costs in Appendix B - column headed “Adjusted ASC 730 Financial Statement R&D.”

Line 20 Wages for qualified services (Form 6765 line 5 or 24)

Line 21 Cost of supplies (Form 6765 line 6 or 25)

Line 22 Rental or lease costs of computers (Form 6765 line 7 or 26)

The total of lines 20 through 22, Adjusted ASC 730 Financial Statement R&D QRE amounts (Form 6765 line 9 or 28). This amount should equal line 19 above.

Please click here for the text description of the image.

Instructions for Appendix C - 2020

Step 1: Financial Statement R&D amounts reduced by foreign R&D

Line 1 Report the amount of research and development costs currently expensed for U.S. GAAP purposes, which amount is shown as a line item on the taxpayer’s income statement included in its Certified Audited Financial Statements or is separately stated in a note to its Certified Audited Financial Statements for the same year/period as the tax return.

Line 1a Subtract all Book/GAAP R&D amounts for any foreign entities, i.e. non-U.S. entities such as Controlled Foreign Corporations.

Line 1b Subtract all the Book/GAAP R&D amounts for any U.S. entities not included in the taxpayer’s consolidated U.S. Federal Income Tax return.

Line 2 Subtract Line 1a and 1b from Line 1. This figure should include GAAP R&D expenses for only U.S. entities included in the taxpayer’s consolidated U.S. Federal Income Tax return.

Line 2a The figure reported here should be the same amount as reported on: Form 1120, Sch. M-3, Part III, column (a), Line 35; Form 1120S, Sch. M-3, Part III, column (a), Line 29; or Form 1065, Sch. M-3, Part III, column (a), Line 29 (collectively the “Schedule M- 3 amount”). Provide an explanation, if the Schedule M-3 amount is different than the amount on Line 2.

Step 2:Line 3 Adjustments to U.S. Financial Statement R&D. Remove all GAAP internal use software and non ASC 730 expenditures reported in the Financial Statement R&D amount.

Line 3a For any software development activities performed and which costs are included in U.S. Financial Statement R&D, remove all software development costs for software that is not for sale, lease, or otherwise marketed by the taxpayer. Software sold to related parties or as part of a cost sharing arrangement for internal use is not software for sale, lease or otherwise marketed.

Line 3b Subtract any expenses identified under ASC 730-10-55-2 or any other Non ASC 730 expenditure that is included in the U.S. Financial Statement R&D. If these expenses are not included in the U.S. Financial Statement R&D, taxpayer must explain the methodology used to determine these expenses were not included in the taxpayer’s Financial Statement R&D.

Line 4 Subtract Lines 3a and 3b from Line 3. This is the U.S. ASC 730 Financial Statement R&D amount.

Step 3: Subtractions (not previously adjusted in steps 1 & 2 above) from U.S. ASC 730 Financial Statement R&D

Line 5 All U.S. ASC 730 Financial Statement R&D GL accounts or items specifically excluded from section 174 including but are not limited to (i) Quality Control Testing; (ii) efficiency surveys; (iii) management studies; (iv) consumer surveys; (v) advertising or promotions; (vi) the acquisition of another's patent, model, production or process; or (vii) research in connection with literary, historical, or similar projects.

Line 6 All U.S. ASC 730 Financial Statement R&D GL accounts and expenditures such as depreciation, amortization, shipping, travel, training, rent, overhead, general and administrative expenses and all other items not eligible for section 41 QREs.

Line 7 All U.S. ASC 730 Financial Statement R&D costs incurred for all agreements/contracts pursuant to which the taxpayer performed ASC 730 research in order to comply with the terms of the agreements/contracts. These costs are to be subtracted regardless of whether incurred in connection with funded research.

Line 8 All U.S. ASC 730 Financial Statement R&D costs incurred for all persons other than the taxpayer’s employees who performed ASC 730 research on behalf of the taxpayer.

Line 9 All wages and related expenses for U.S. ASC 730 Financial Statement R&D for U.S. employees who leave the U.S. and perform research services outside of the U.S. Also, the wages and stock options associated with these individuals for ASC 730 research performed outside the U.S. should not be included on Lines 13 & 14, below. A similar adjustment for non-inclusion of ASC 730 research performed outside the U.S. is also required to be made to taxable W-2 wages captured on Lines 15, 16 & 17, below.

Line 10 The amount of prototype overhead, patent costs and severance pay included in U.S. ASC 730 Financial Statement R&D.

Line 11 Total subtractions step 3 (total of lines 5 through 10).

Line 11a Subtract Line 11 from Line 3. This is the U.S. ASC 730 Financial Statement R&D after subtractions subtotal.

Step 4:Line 12 U.S. ASC 730 Financial Statement R&D wage adjustment. W-2 Wages for employee compensation added to U.S. ASC 730 Financial Statement R&D in this step should not include any amounts relating to the above subtractions. Further, the W-2 wages should only relate to wage costs that are charged to U.S. ASC 730 Financial Statement cost centers.

Line 13 Subtract U.S. ASC 730 Financial Statement R&D wage and wage related accounts not already subtracted in the lines above.

Line 14 Subtracts U.S. ASC 730 Financial Statement R&D stock-based compensation not already subtracted in the lines above.

For lines 15 - 17, complete appendix D - ASC 730 Financial Statement R&D wage detail. These wages represent taxable W-2 wages (base wages and stock options) for employees whose wage costs are charged to U.S. ASC 730 Financial Statement cost centers.

Line 15 Add 95% of W-2 wages for qualified individual contributors.

Line 16 Add 95% of W-2 wages for 1st level supervisor managers.

Line 17 Add upper level managers’ limit.

Line 18 Total Step 4. Total of Lines 13 through 17.

Step 5:Line 19 Add Lines 11 and 18. This is the Adjusted ASC 730 Financial Statement R&D amount.

For lines 20 - 22, breakdown the amount of QREs reported on line 19 to the appropriate lines on the Form 6765. Record these costs in appendix B - column headed “Adjusted ASC 730 Financial Statement R&D”.

Line 20 Wages for qualified services (Form 6765 line 5 or 24).

Line 21 Cost of supplies (Form 6765 line 6 or 25).

Line 22 Rental or lease costs of computers (Form 6765 Line 7 or 26).

The total of lines 20 through 22, Adjusted ASC 730 Financial Statement R&D QRE amounts (Form 6765 line 9 or 28). This amount should equal line 19 above.

Instructions for Appendix D - Adjusted ASC 730 Financial Statement R&D Wage Detail

Line 1 95% of the base W-2 wages for qualified individual contributors which wage costs are charged to U.S. ASC 730 Financial Statement cost centers.

Line 2 95% of the W-2 stock option wages for qualified individual contributors which wage costs are charged to U.S. ASC 730 Financial Statement cost centers.

Line 3 Total of lines 1 and 2.

Line 4 95% of the base W-2 wages for 1st level supervisor managers which wage costs are charged to U.S. ASC 730 Financial Statement cost centers.

Line 5 95% of the W-2 stock option wages for 1st level supervisor managers which wage costs are charged to U.S. ASC 730 Financial Statement cost centers.

Line 6 Total of lines 4 and 5

Line 7 The upper level managers’ limit is the lesser of: (a) 10% of the sum of lines 3 and 6, above; or (b) 100% of the W-2 wage and W-2 stock option costs for upper level managers, which are charged to U.S. ASC 730 Financial Statement cost centers. If the taxpayer wants to include more than the upper level managers’ limit in QREs, 100% of the W-2 wage and W-2 stock option costs for upper level managers is considered to be $0 and any amount claimed for upper level managers will be subject to risk analysis and examination.

The following terms and definitions apply solely for the purposes of the directive issued in 2017:

The following terms and definitions apply solely for the purposes of the directive issued in 2020:

ISSUE

What are the legal requirements for valuing timber property that is damaged or destroyed by casualty, for purposes of claiming a casualty loss under IRC 165(a)?

BACKGROUND

Under IRC 165(a) a deduction is allowed for any loss sustained during the taxable year. Business casualty losses are determined by reference to the single, identifiable property damaged or destroyed. Treas. Reg. 1.165-7(b) (2). For timber property the SIP is generally the depletion block. See Revenue Ruling 99-56, 1999-51 IRB 676. Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value of the SIP or its adjusted basis. Treas. Reg. 1.165-7(b) (2). This generally requires that the fair market value of the SIP (block) be ascertained by competent appraisal, immediately before and after the casualty. Treas. Reg. 1.165-7(a) (2).

The major problem in this area arises when taxpayers, contrary to the regulations, do not perform an appraisal of the SIP (i.e., depletion block) before and after the casualty. Instead, these taxpayers seek to extrapolate the loss in value from per-unit FMVs, multiplying that figure by the number of units lost or damaged. In essence, this method consists of determining the volume of lost timber and multiplying that volume by the market price per applicable unit (cord, thousand board feet ("MBF"), etc.). This fragmented, additive approach is sometimes called the gross timber value and does not reflect the reduction in value of the SIP as a unitary whole. In other words, it does not follow that the loss of a specific volume of merchantable timber, whose value is often readily known, necessarily reduces the value of the larger block by the same amount. In some situations, where the loss area is relatively small and the block size is very large, the loss may not reduce the value of the depletion block at all.

This additive approach does not work because larger timber properties often sell at a substantial discount, (reflecting a wholesale price,) compared to their gross retail timber value. Hancock Timber Resource Group 1999. "Analysis of Timberland Transactions Reveals Size Discount." In 1-6 Hancock Timberland Investor. Third Quarter; Hancock Timber Resource Group 2000. "Taking Advantage of the Wholesale Discount for Large Timberland Transactions." February 2000, R-00-1. These studies associate larger discounts with properties that have larger volumes and acreages. For example, a Western sale of 250,000 MBF on 25,000 acres yielded an average discount of 35%, while a sale of 2,000,000 MBF on 200,000 acres yielded an average discount of 48%.

The literature suggests several reasons for the relationship between property size and discounts. The wholesale value typically reflects a price discount, which recognizes that merchantable volume may be too large to cut and market in the immediate future. Even if it were physically and legally possible to harvest all the timber immediately, however, complete liquidation might depress local prices by producing a market glut. Moreover, some of the merchantable timber may be in stands that currently contain too little volume to be economically operable, is too expensive to access, or is in inaccessible riparian zones or buffer areas. The timber harvest must be deferred until later, in some cases indefinitely, so the time value of money is relevant. As the time to harvest increases, risk also increases, because of the volatility in timber prices and future market conditions. Additionally, larger properties attract longer-term investors, who desire sustained yield, not short-term liquidation.

Another factor that tends to diminish liquidity of larger tracts is that the pool of potential buyers declines as the property size increases. Very large timber properties require buyers to have access to large amounts of capital. The lack of potential buyers tends to put downward pressure on the prices of these parcels.

LAW & ARGUMENT

Treas. Reg. 1.165-1(C) provides that the amount of loss allowable as a deduction under Section 165(a) shall not exceed the amount prescribed by Treas. Reg. 1.1011-1 as the adjusted basis for determining the loss from the sale or other disposition of the property involved.

When timber property is damaged or destroyed by a casualty event, the first step in determining the amount of the casualty loss is the identification of the single identifiable property (SIP).

In the case of timber casualty losses, the Court of Appeals for the Federal Circuit has declared that, as a matter of law, the SIP is the timber depletion block "when that property serves for commercial, forest management, and depletion purposes".

Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value (of the SIP) or the adjusted basis (of the SIP). Treas. Reg.1.165-7(b)(2).

Under Treasury Reg. 1.165-7(a)(2), this generally requires that the fair market value of the SIP (block) be ascertained by competent appraisal, immediately before and immediately after the casualty, to determine the amount of the loss deductible.

This formula, including the requirement that the reduction in fair market value be determined with reference to the SIP, has been acknowledged by every Court that concluded that the SIP is the depletion block. As noted above, to determine the allowable loss, a court must take the difference between the fair market value of the SIP before and after the casualty. "No one denies that the 'single identifiable property damaged or destroyed' must be ascertained in order to delineate the casualty loss, the fair market values, the adjusted basis, and, ultimately, to determine the allowable deduction, if any." Westvaco Corp. v. United States, 639 F.2d 700, 708 (Ct.Cl. 1980) (citations omitted). See, Weyerhaeuser Co. v. United States, 39 Fed. Cl. 410, 411 (1997) ("[T]he court must determine plaintiff's allowable casualty loss deduction by reference to each of the depletion blocks affected… For each depletion block so affected, plaintiff's casualty loss deduction is limited to the lesser of (I) the diminution in the fair market value of the depletion block as a result of the casualty event, or (ii) the amount of the adjusted basis of the depletion block.")

Using the additive approach does not necessarily accurately reflect this difference. "[A]n aggregation of the value of destroyed units of merchantable timber, together with the value of the partial losses resulting from nonfatal injuries to merchantable trees, does not necessarily measure the reduction in fair market value of the property." Westvaco, 639F.2d at 707. In a similar case, the court of federal claims followed Westvaco. International Paper Co. v. United States, 39 Fed. Cl. 313 (1996). There, the IRS requested detailed information concerning timber damaged by a hurricane. Claiming that the parties that already agreed to the volumes and types of timber damaged, International Paper refused to provide the requested information. Holding that the IRS was entitled to the requested data, the court noted that, in order to value the loss, "[a]pparently, plaintiff seeks to extrapolate from per-unit FMVs, multiplying that figure by the number of units determined to be lost in each SIP." Id. at 319. This attempt to establish the amount of the loss prior to ascertaining the SIP was "somewhat backwards." Id.

In the one case that did accept the use of the additive method, the Court of Federal Claims noted the method's shortcomings. Weyerhaeuser. There, rather than valuing the entire SIP, Weyerhaeuser valued the tree stands the damaged timber was in. The Court of Federal Claims evaluated the evidence and found that the taxpayer's appraisal yielded a result that was substantially the same as if they had appraised the entire depletion block. But the court cautioned that, absent evidence that the additive approach was equivalent to the decrease in FMV of the SIP, this valuation method was not the best method. "To the contrary, prudence counsels a similarly-situated taxpayer to eschew the fragmented, additive approach and establish its prima facie case by proving the diminution in the fair market value of the SIP, i.e., the timber depletion block viewed as a unitary property." Weyerhaeuser, 39 Fed. Cl. at 412, n. 5 (citations omitted).

Once the SIP has been identified, it must be valued. Even after the unitary method has been selected, it’s still necessary to determine the fair market value using appropriate valuation methodologies.

Fair market value is traditionally defined as the price at which property would have changed hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973), see Treas. Reg. 1.611-1(d) (2). Valuation is based upon the market the property would be sold for in the ordinary course of business. Anselmo v. Commissioner, 757 F.2d 1208 (11th Cir. 1985) (valuing unmounted gems using a wholesale price, rather than the retail price when mounted); Arbini v. Commissioner, T.C. Memo. 2001- 141 (holding that the value of donated newspapers should be determined at the wholesale not retail level). The fair market value of real property is determined with reference to the property as a whole, not by reference to artificially created subdivisions. Akers v. Commissioner, 799 F.2d 243 (6th Cir.1986); Pope & Talbot v. Commissioner, T.C. Memo. 1997-116, 73 T.C.M. (CCH) 2229. This principle is best illustrated by Akers.

In Akers, the Sixth Circuit addressed the valuation of a conservation easement. The Akers contributed an easement on several properties they owned, including a 1,261 acre tract known as the Treanor Tract. The property next to the Treanor Tract had been subdivided into lots of a few acres. In their valuation, the Akers assumed that the Treanor Tract would be subdivided into twenty-four lots of approximately fifty acres. They then valued the various tracts using sales of comparable lots. The Service valued the Treanor Tract as a whole, focusing on comparable sales of tracts over 1,000 acres. To determine which method was appropriate the court looked at applicable definition of fair market value under IRC 170(c), which looked at "the price at which the property would change hands between a willing buyer and a willing seller." Id at 245 (emphasis in original). This language "suggest[s] that the appropriate question is what a hypothetical Malcolm Forbes would have paid for [the Treanor Tract] as one tract, rather than what two dozen hypothetical yuppies would have paid for it as 24 [smaller tracts]." Id.

The Tax Court has applied the same principle to timber properties. In Pope & Talbot v. Commissioner, the court considered the valuation of 79,000 acres of timberland. Pope & Talbot valued the land as a block, while the IRS proposed subdividing the land into six smaller parcels. Rejecting the IRS's valuation, the court held that subdivision was not appropriate because the market was depressed; Pope & Talbot would incur additional costs if the land was subdivided and the available evidence indicated that the most likely buyer was a large, industrial buyer that would purchase the entire tract. As a result, the court valued the property at a 39 percent discount to its gross timber value.

Thus, when valuing timber using a hypothetical sale, it's important to focus on a realistic transaction. If the property or block being valued includes several distinct tracts that are noncontinuous and contain different types of timber, subdivision may be appropriate. See Schapiro v. Commissioner, T.C. Memo. 1991-128 (accepting valuation based on subdivision in a case where an easement was granted specifically to preclude subdivision of the property); Symington v. Commissioner, 87 T.C. 892, 898 (valuing property based on subdivision where there was a strong demand for small lots in the area). If a party suggests subdivision, however, "the taxpayer must establish that there existed a reasonable probability that the land would be so used in the reasonably near future." Stanley Works v. Commissioner, 87 T.C.389, 401 (1986). Absent evidence that subdivision would be expected or reasonable the property should be valued as a whole. Akers, 799 F.2d at 245; Pope & Talbot, 73 T.C.M. at 2236. And if a property is valued based on subdividing it, an allowance must be made for the cost of subdivision including marketing costs and liquidation time. Akers, 799 F.2d at 246; Symington, 87 T.C. at 899.

CONCLUSION

Though there are no hard and fast rules for valuing timber casualty losses, some general guidance can be given. The appropriate SIP for a timber casualty is generally the depletion block. The loss is the difference between the FMV of the SIP before and after the casualty and generally cannot be based upon the retail value of the damaged timber. Moreover, the SIP must be valued as a single property or by using reasonable subdivisions.