Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

amount of worthless bad debts claimed on the return was not substantially in excess of the amount that would be warranted by the exercise of reasonable business judgment in applying the loan loss standards of ABC’s supervisory authority.

LAW AND ANALYSIS

Section 166(a)(1) of the Internal Revenue Code allows a deduction for a debt that becomes worthless during the taxable year. In addition, § 166(a)(2) permits a deduction for “partially worthless debts” if the taxpayer charges off an appropriate amount on the taxpayer’s books and records and the Internal Revenue Service is satisfied that the debt is recoverable only in part.

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. Among the factors indicating worthlessness are: a debtor’s serious financial reverses, insolvency, lack of assets, continued refusal to respond to demands for payment, ill health, death, disappearance, abandonment of business, and bankruptcy. Additionally, a debt’s unsecured or subordinated status and expiration of the statute of limitations can provide an indication that the debt is worthless. Conversely, availability of collateral or third party guarantees, a debtor’s earning capacity, payment of interest, a creditor’s failure to press for payment, and a creditor’s willingness to make further advances are factors suggesting that the debt is not worthless. Accordingly, § 1.166–2 of the regulations requires consideration of all pertinent evidence and provides that a deduction is warranted if the surrounding circumstances indicate that the debt is uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment.

In the case of a “bank” (as defined in § 1.166–2(d)(4)(i) of the regulations) or other corporation subject to supervision by Federal authorities, or by State authorities maintaining substantially

Section 166.—Bad Debts

26 CFR 1.166–2: Evidence of worthlessness.

Bank bad debts; clarification of the conformity method. A bank has classified loans as loss assets under the conformity election if the loans are charged off pursuant to a board of director’s resolution authorizing the charge-offs only if required under regulatory standards. Also, the conclusive presumption of worthlessness under the conformity election applies to loans erroneously charged off for regulatory purposes, if the bank’s charge-offs are not substantially in excess of those warranted by reasonable business judgment.

Rev. Rul. 2001–59

ISSUES

1. What steps are necessary to record or memorialize the assignment of a loan (or loan portion) as a “loss asset” for purposes of the conformity method of accounting for worthless bad debts?

2. Does the conclusive presumption of worthlessness under the conformity method apply to loans erroneously classified as loss assets?

FACTS

ABC corporation is a “bank” (as defined in § 1.166–2(d)(4)(i) of the Income Tax Regulations) and is subject to supervision by Federal authorities. ABC has elected under § 1.166–2(d)(3) to use the conformity method of accounting to determine when debts owed to ABC become worthless bad debts.

Under a resolution adopted by ABC’s board of directors, ABC’s officers and employees are authorized to charge off loans (or portions of loans) only when the charge-off is required under the loan loss classification standards issued by the bank’s supervisory authority. Thus, when ABC’s officers and employees charge off a loan for regulatory purposes, they do not take any additional steps to record or memorialize whether, in their judgment, the charge-off is required by the loan loss

standards that have been issued by ABC’s supervisory authority.

The loan loss standards require ABC to charge off “loss assets.” Loss assets are loans (or portions of loans) determined to be uncollectible and of such little value that their continuance as bankable assets is not warranted. In the case of a consumer loan or credit card debt, regardless whether there is specific adverse information about the borrower, ABC is required to charge off the asset when its delinquency exceeds certain established thresholds. Thus, ABC must charge off installment loans that are 120 days, or five payments, past due and credit card debts that are 180 days past due after seven zero billings. In addition, if ABC receives specific adverse borrower information (for example, the borrower’s death or bankruptcy) confirming a loss before the applicable 120 day or 180 day threshold date has passed, then an immediate charge-off is required. See Comptroller of the Currency, “Allowance for Loan and Lease Losses,” Comptroller’s Handbook 10, 19 (June 1996); “Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks,” Attachment to Comptroller of the Currency Banking Circular No. 127, Rev. 4–26–91. ABC’s supervisory authority, in connection with its most recent examination of the bank’s loan review process, made an express determination that ABC maintains and applies loan loss standards that are consistent with the regulatory standards issued by the Comptroller of the Currency.

During the taxable year ending on December 31, 2000, ABC charged off for regulatory purposes certain credit card debts that were not required to be charged off under applicable regulatory loan loss standards. Except for the erroneously charged off credit card debts, ABC charged off only loans required to be charged off under the loan loss standards.

On its Federal income tax return for 2000, ABC deducted as wholly worthless debts all assets that it had charged off for regulatory purposes, including the debts that had been erroneously charged off despite the absence of an applicable regulatory requirement. Even so, the total

2001-51 I.R.B 585 December 17, 2001

by reasonable business judgment in applying the regulatory standards of the bank’s supervisory authority, then the Commissioner may revoke the bank’s election to use the conformity method. Under the facts described above, however, except for the erroneously charged off credit card debts, ABC properly used regulatory loan loss standards to determine its worthless bad debts and did not claim a deduction on its return for bad debts substantially in excess of the amount warranted by reasonable business judgment under the applicable regulatory standards. If the deduction claimed had been substantially in excess of that amount, the Commissioner could have revoked the conformity election.

HOLDINGS

1. ABC’s charge-offs of certain loans (or portions thereof), pursuant to a board of directors’ resolution authorizing the charge-off of a loan (or portion thereof) only if the charge-off is required under applicable regulatory standards issued by the bank’s supervisory authority, are sufficient to demonstrate classification of the loans (or loan portions) as loss assets for purposes of § 1.166–2(d)(3) of the regulations.

2. The conclusive presumption of worthlessness applies to the credit card debts that ABC erroneously charged off for regulatory purposes during the taxable year ending on December 31, 2000. ABC, on its 2000 income tax return, properly deducted the credit card debts as worthless bad debts.

DRAFTING INFORMATION

The principal author of this revenue ruling is Craig Wojay of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Mr. Wojay at (202) 622–3920 (not a toll-free call).

equivalent standards, § 1.166–2(d)(1) provides administrative simplicity by creating a conclusive presumption of worthlessness for loans charged off in whole or in part in obedience to specific orders or in accordance with the established policies of those authorities.

Additional simplification is provided by § 1.166–2(d)(3) of the regulations for tax years ending on or after December 31, 1991. Under the regulation, a bank subject to supervision by Federal authorities, or by State authorities maintaining substantially equivalent standards, may elect to use the conformity method of accounting to determine when a debt becomes worthless. Under the conformity method, a conclusive presumption of worthlessness applies to loans charged off, in whole or in part, for regulatory purposes if the charge-offs correspond to the bank’s classification of the loans, in whole or in part, as loss assets under applicable regulatory standards. Section 1.166–2(d)(3)(ii)(A)(2) provides that a bad debt deduction is allowed for the taxable year in which a debt is conclusively presumed to have become worthless.

For the conclusive presumption of worthlessness to arise, a bank must satisfy the express determination requirement of § 1.166–2(d)(3)(iii)(D) of the regulations and must classify the loan, in whole or in part, as a loss asset as described in § 1.166–2(d)(3)(ii)(C). The express determination requirement is satisfied if the bank’s supervisory authority, in connection with its most recent examination of the bank’s loan review process, has made an express determination that the bank maintains and applies loan loss classification standards that are consistent with the authority’s regulatory standards. See Rev. Proc. 92–84 (1992–2 C.B. 489) (providing the form for the determination letter). Section 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 in 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.

Various procedures can be used by a bank to classify loans (or loan portions) as loss assets. For example, an officer or employee may record or memorialize on a form the determination that a loan (or loan portion) is a loss asset. Loan or credit committee reports or internal credit rating reports also can demonstrate that a loan has been classified as a loss asset. Additionally, if officers and employees are authorized to charge off loans (or loan portions) only if the loans (or loan portions) are loss assets, then the charge-offs of the loans (or loan portions) demonstrate that the loans (or loan portions) have been classified as loss assets.

ABC has made the conformity election under § 1.166–2(d)(3) of the regulations and has satisfied the express determination requirement described in § 1.166– 2(d)(3)(iii)(D). Additionally, under the resolution adopted by ABC’s board of directors, ABC’s officers and employees are authorized to charge off loans (or portions of thereof) only if the charge-offs are required under applicable loan loss standards issued by ABC’s supervisory authority. Under these circumstances, ABC’s charge-offs of certain loans (or loan portions) are sufficient to demonstrate classification of those loans (or loan portions) as loss assets under standards issued by ABC’s supervisory authority.

Under § 1.166–2(d)(3)(ii) of the regulations, the conclusive presumption of worthlessness applies to loans charged off, in whole or in part, for regulatory purposes if the charge-off corresponds to the bank’s classification of the loans, in whole or in part, as loss assets under applicable regulatory standards. Although the applicable loan loss regulatory standards did not require ABC to charge off certain credit card debts, the conclusive presumption of worthlessness attached to those debts when ABC erroneously charged off the debts for regulatory purposes.

Under § 1.166–2(d)(3)(iv)(D) of the regulations, 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

December 17, 2001 586 2001-51 I.R.B.

useful life of that class of property to the industry or other group.

Rev. Proc. 87–56 (1987–2 C.B. 674) sets forth the class lives of property that are necessary to compute the depreciation allowance under § 168. This revenue procedure establishes two broad categories of depreciable assets: (1) asset classes 00.11 through 00.4 that consist of specific assets used in all business activities; and (2) asset classes 01.1 through 80.0 that consist of assets used in specific business activities.

Asset class 00.3, Land Improvements, of Rev. Proc. 87–56 includes improvements directly to or added to land, whether the improvements are § 1245 or § 1250 property, provided the improvements are depreciable. Examples of these assets might include sidewalks, roads, canals, waterways, drainage facilities, sewers, wharves and docks, bridges, fences, landscaping, shrubbery, or radio and television transmitting towers. Assets included in asset class 00.3 have a recovery period of 15 years for purposes of § 168(a) and 20 years for purposes of § 168(g).

Rev. Rul. 55–290 (1955–1 C.B. 320) concludes that expenditures incurred by a taxpayer in the original construction of golf course greens are capital expenditures that are added to the original cost of the land and are not subject to an allowance for depreciation. The revenue ruling also concludes that subsequent operating expenses for sod, seed, soil, and other sundry maintenance are ordinary and necessary business expenses that are deductible from gross income for federal income tax purposes.

In Edinboro Company v. United States, 224 F. Supp. 301 (W.D.Pa. 1963), the court held that golf course improvements, such as greens, tees, fairways, and traps, were not depreciable under § 167(a) because they are not distinguishable from the land, which is molded and reshaped to form them, and, like the land, they have an unlimited useful life. The court concluded that “[a] golf course is primarily a landscaping proposition[, although]

[o]ccasionally a green or a trap or bunker is altered or rebuilt.” The taxpayer in Edinboro failed to demonstrate a determinable useful life of the golf course improvements, or that the improvements were subject to wear and tear, exhaustion,

Section 167.—Depreciation

26 CFR 1.167(a)–2: Tangible property. (Also § 168.)

Golf course greens land preparation costs. The costs of land preparation undertaken by a taxpayer in the original construction or reconstruction of push-up or natural soil golf course greens are not depreciable, but the costs of land preparation undertaken by a taxpayer in the original construction or reconstruction of modern golf course greens that is so closely associated with depreciable assets, such as a network of underground drainage tiles or pipes, that the land preparation will be retired, abandoned, or replaced contemporaneously with those depreciable assets are depreciable.

Rev. Rul. 2001–60

ISSUE

Are land preparation costs incurred by a taxpayer in the original construction or reconstruction of golf course greens subject to an allowance for depreciation under § 167 of the Internal Revenue Code?

FACTS

Two types of golf course greens that are currently in use are “push-up” or natural soil greens and “modern” greens. Push-up or natural soil greens are essentially landscaping that involves some reshaping or regrading of the land. The soil is pushed up or reshaped to form the green. While push-up or natural soil greens may have limited irrigation systems (such as hoses and sprinklers adjacent to the greens), a subsurface drainage system is not utilized.

Modern greens make use of technological changes in green design and construction and contain sophisticated integrated drainage systems. The construction of the modern green occurs after the general earthmoving, grading, and initial shaping of the area surrounding and underneath the green. These greens are constructed with a network of subsurface drainage tiles or interconnected pipes, one or more layers of gravel and/or sand particles, a rootzone layer, and a variety of

turfgrass. Over time, the modern green loses its effectiveness as a drainage system due to tile or pipe deterioration, or sediment blockage. Replacement of the subsurface drainage tiles or pipes requires excavation and replacement of the gravel layer, rootzone layer, and turfgrass above the tiles or pipes. The subsurface drainage tiles or pipes typically are replaced within 20 years.

LAW AND ANALYSIS

Section 167(a) provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion and wear and tear of property used in a trade or business or held for the production of income.

Section 1.167(a)–2 of the Income Tax Regulations provides that in the case of tangible property, the depreciation allowance applies only to that part of the property that is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence. The allowance does not apply to land apart from the improvements or physical development added to it.

The depreciation deduction provided by § 167(a) for tangible property placed in service after 1986 generally is determined under § 168. This section prescribes two methods of accounting for determining depreciation allowances: (1) the general depreciation system in § 168(a); and (2) the alternative depreciation system in § 168(g). Under either depreciation system, the depreciation deduction is computed by using a prescribed depreciation method, recovery period, and convention.

The applicable recovery period for purposes of § 168(a) or § 168(g) is determined by reference to class life. Section 168(i)(1) provides that the term “class life” means the class life (if any) that would be applicable with respect to any property as of January 1, 1986, under former § 167(m) as if it were in effect and the taxpayer had elected under that section. Prior to its revocation, § 167(m) provided that in the case of a taxpayer who elected the asset depreciation range system of depreciation, the depreciation deduction would be computed based on the class life prescribed by the Secretary that reasonably reflects the anticipated

2001-51 I.R.B 587 December 17, 2001

or obsolescence that could not be fully reversed by annual maintenance.

Although the depreciation allowance generally does not apply to land because land has no determinable useful life, land preparation may be depreciable if it is closely associated with depreciable assets so that it is possible to establish a determinable period over which the land preparation will be useful in a particular trade or business. A useful life for land preparation is established if it will be replaced contemporaneously with a related depreciable asset. Whether land preparation will be replaced contemporaneously with a related depreciable asset is a question of fact, but if the replacement of the asset will require the physical destruction of the land preparation, this test will be considered satisfied. Rev. Rul. 68–193 (1968–1 C.B. 79) clarifying Rev. Rul. 65–265 (1965–2 C.B. 52) (costs for a roadway grading that would be retired contemporaneously with a building are depreciable); Rev. Rul. 72–96 (1972–1 C.B. 66) (land preparation costs for a reservoir that would be retired contemporaneously with an electric generating plant are depreciable); Rev. Rul. 74–265 (1974–1 C.B. 56) (the cost of shrubbery immediately adjacent to apartment buildings is depreciable because the shrubbery would be retired contemporaneously with the buildings); Rev. Rul. 80–93 (1980–1 C.B. 50) (costs for excavation and backfilling that would be retired contemporaneously with laundry facilities and a storm sewer system are depreciable).

While § 168 determines the amount of the depreciation allowance provided by § 167(a) for tangible property placed in service generally after 1986, § 167 determines whether the tangible property is depreciable property. Under § 167 and the regulations thereunder, land is not depreciable. Similarly, the costs of general grading or shaping of land are not depreciable because the land preparation is inextricably associated with the land. However, if the land preparation is so closely associated with depreciable assets that it will be retired, abandoned, or replaced contemporaneously with those assets, a useful life for land preparation is established and, therefore, the cost of the land preparation is depreciable.

Push-up or natural soil greens are representative of the type of green com

monly in use when Rev. Rul. 55–290 was issued and Edinboro was decided. Push-up or natural soil greens are essentially landscaping that involves some reshaping or regrading of the land. Accordingly, the Service will continue to follow the holdings in Rev. Rul. 55–290 and Edinboro with respect to push-up or natural soil greens.

Unlike push-up or natural soil greens, the modern green is a sophisticated improvement to the land carefully designed to facilitate drainage. Essential components of the modern green are the underground drainage tiles or interconnected pipes. Because these tiles or pipes deteriorate over time, they have a determinable useful life and, therefore, are depreciable. Asset class 00.3, Land Improvements, of Rev. Proc. 87–56, includes drainage facilities. The gravel layer, rootzone layer, and turfgrass above the network of underground drainage tiles or interconnected pipes are so closely associated with these tiles or pipes that replacement of the tiles or pipes will require the contemporaneous physical destruction of that land preparation. Thus, it is possible to establish a determinable useful life for the land preparation above the underground tiles and pipes.

HOLDINGS

Land preparation undertaken by a taxpayer in the original construction or reconstruction of push-up or natural soil greens is inextricably associated with the land and, therefore, the costs attributable to this land preparation are added to the taxpayer’s cost basis in the land and are not depreciable.

The costs of land preparation undertaken by a taxpayer in the original construction or reconstruction of modern greens that is so closely associated with depreciable assets, such as a network of underground drainage tiles or pipes, that the land preparation will be retired, abandoned, or replaced contemporaneously with those depreciable assets are to be capitalized and depreciated over the recovery period of the depreciable assets with which the land preparation is associated. For purposes of § 168, the modern green described above is includible in asset class 00.3, Land Improvements, of Rev. Proc. 87–56. However, the general earthmoving, grading, and initial shaping

of the area surrounding and underneath the modern green that occur before the construction are inextricably associated with the land and, therefore, the costs attributable to this land preparation are added to the taxpayer’s cost basis in the land and are not depreciable.

Subsequent operating expenses for sod, seed, soil, and other sundry maintenance are ordinary and necessary business expenses that are deductible from gross income for federal income tax purposes.

CHANGE IN METHOD OF ACCOUNTING

Any change in a taxpayer’s treatment of the cost of modern greens to conform with this revenue ruling is a change in method of accounting to which the provisions of §§ 446 and 481 and the regulations thereunder apply. A taxpayer wanting to change the method of accounting for the cost of modern greens owned by the taxpayer at the beginning of the year of change to conform with this revenue ruling must follow the automatic change in method of accounting provisions in Rev. Proc. 99–49 (1999–2 C.B. 725) (or its successor), unless the scope limitations in section 4.02 of Rev. Proc. 99–49 apply.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 55–290 is modified and superseded. Rev. Proc. 99–49 is modified and amplified to include this accounting method change in the APPENDIX.

PROSPECTIVE APPLICATION

A taxpayer may continue to use its present method of treating the cost of modern greens placed in service during any taxable year beginning before November 29, 2001, as a nondepreciable capital expenditure.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mark Pitzer of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mark Pitzer at (202) 622–3110 (not a toll-free call).

December 17, 2001 588 2001-51 I.R.B.

Section 168.—Accelerated Cost Recovery System

If the costs of land preparation undertaken by a taxpayer in the original construction or reconstruction of modern golf course greens are depreciable, what is the classification of these costs under § 168(e)(1) of the Internal Revenue Code? See Rev. Rul. 2001–60, page 587.

2001-51 I.R.B 589 December 17, 2001