SECTION 2. LAW

Section 166(a)(1) permits a deduction for any debt that becomes worthless in the taxable year. Section 166(a)(2) authorizes the Secretary to issue guidance on deducting debt that becomes partially worthless within the taxable year, with the deduction not to exceed the amount charged off.

Generally, whether a debt has become worthless within the taxable year is determined by examining all pertinent evidence, including objective circumstances such as the value of the collateral and the financial condition of the debtor. Section 1.166–2(a). Additionally, worthlessness is generally associated with identifiable events demonstrating the worthlessness of the debt and justifying the abandonment of hope of recovery. Cole v. Commissioner, 871 F.2d 64, 67 (7th Cir. 1989). Section 1.166–2 includes two alternative rules that, if met, provide banks and other regulated corporations with a conclusive presumption that a debt is worthless. Section 1.166–2(d)(1) provides that

[i]f a bank or other corporation which is subject to supervision by Federal authorities, or by State authorities maintaining substantially equivalent standards, charges off a debt in whole or part, either—

(i) In obedience to the specific order of such authorities, or

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

then the debt shall, to the extent charged off during the taxable year, be conclusively presumed to have become worthless, or worthless only in part, as the case may be, during such taxable year. The conclusive presumption rule set forth in section 1.166–2(d)(1) is referred to herein as the “Specific Order Method.”

Section 1.166–2(d)(3) provides an alternative method of accounting for banks that make a conformity election (the “Book Conformity Method”). If a bank regulator issues an express determination letter stating that a bank electing to use the Book Conformity Method maintains and applies loan loss classification standards that are consistent with the regulatory loan loss classification standards of the bank regulator, then loans classified by the bank as loss assets and charged off are conclusively presumed to have become worthless in whole or in part. The regulations define a loss asset as one that is classified as such under the standards set forth in

the “Uniform Agreement on the Classification of Assets and Securities Held by Banks” (See Attachment to Comptroller of the Currency Banking Circular No. 127, Rev. 4–26–91...) or similar guidance issued by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve, or the Farm Credit Administration; or for institutions under the supervision of the Office of Thrift Supervision, 12 CFR 563.160(b)(3).

Section 1.166–2(d)(3)(ii)(C).