Mark to market accounting

Transcription

1 Mark to market accounting Understanding an often overlooked benefit for specialty finance companies Prepared by: Scott Ruby, Director, McGladrey LLP Jaymeson Morris, Tax Associate, McGladrey LLP February 2014 Specialty finance companies operate in a tough environment. Their subprime customers are, by definition, poorer credit risks than those served by most banks. The industry rule of thumb holds that such companies will typically write off loans at a much higher rate than prime rate lenders. For financial accounting purposes, specialty finance companies must estimate the bad debts incurred in their loan portfolio and record this estimate by providing an adequate allowance for loan losses. Generally, these losses will be realized the following year or shortly thereafter, depending on the nature and form of the underlying portfolio. Prior to a tax law change in 1986, taxpayers, including specialty finance companies, were allowed to deduct reasonable additions to the

2 allowance for loan losses. Under the 1986 change, the allowance for loan losses is not deductible for tax purposes. This generally creates a significant unfavorable book-to-tax accounting temporary difference. However, specialty lenders often overlook a useful tax-planning opportunity. Companies that originate or purchase loans have an option that effectively allows them to accelerate the deduction for the bad debts they will incur based upon market conditions. This article discusses the opportunities of the mark to market tax accounting option and gives examples of how it can work to create tax-planning advantages for specialty lenders. Understanding mark to market accounting The mark to market tax rules found in section 475 are well-defined and straightforward. The rules apply to any taxpayer who originates or purchases securities, including specialty lenders who originate or purchase loans. Such companies can be direct lenders that originate loans or indirect lenders that purchase retail installment sales contracts (i.e., loans). The term security encompasses direct loans, as well as installment sales contracts (except installment sales contracts acquired from a related party). The rules are mandatory if the company routinely buys and sells (or originates and sells) loans. Because the sales of loans by portfolio lenders are rare or infrequent, the mark to market rules are generally not mandatory. Those taxpayers are not required to use the mark to market accounting method for tax purposes, but may elect to do so. This election is an often overlooked benefit for specialty finance companies. Under the mark to market rules, a taxpayer is treated as having sold its loan portfolio on the last day of the year. If the assumed sales price is less than the tax basis in the loans, the taxpayer recognizes a loss. If the loans have appreciated, the taxpayer recognizes a gain. For taxpayers that originate subprime loans or purchase subprime installment sales contracts shortly after origination, the value of their subprime loan pool is generally less than the amount paid for the loans. A third-party buyer would discount the price of the loan pool for the anticipated future writeoffs and other market factors related to that loan pool. It would work something like this. Assume that a newly formed company purchases subprime automobile loans from a network of dealers and that the loans are purchased at the same time as, or shortly after, the cars are sold. The indirect lender purchases the loans with a discount. At the end of the company s first year, the unpaid principal balance of the loan portfolio is $15,500,000, and the unamortized discount on those loans is $325,000. Based upon market conditions, pools of similar subprime auto loans are selling at 90 percent of unpaid principal at the end of the year. This example shows the math: Fair market value of the loans at Dec. 31 $15,500,000 x 90% $13,950,000 Less: Tax basis in the loans (Face value of $15,500,000 unamortized discount of $325,000) (15,175,000) Loss on hypothetical year-end sale $(1,225,000) Assumed tax rate 40% Benefit of the tax deduction (note that this is a timing difference) $490,000 As a result of using mark to market, this indirect lender would increase its cash flow by $490,000 money it can then use for other purposes, such as growing the business. 2

3 Once elected, the loan portfolio continues to undergo mark to market valuation in subsequent years. Assume that the company grows its loan portfolio the unpaid principal balance is $17,500,000 at the end of year 2, and the unamortized discount on those loans is $375,000. Due to changing market conditions, pools of similar subprime auto loans are selling at 87 percent of unpaid principal at the end of the year. The math would look like this: Fair market value of the loans at the end of year 2 $17,500,000 x 87% $15,225,000 Less: Tax basis in the loans (Face value $17,500,000 unamortized discount of $375,000) (17,125,000) Loss on hypothetical year-end sale $(1,900,000) Less: Loss previously deducted in year 1 $(1,225,000) Loss deductible for Year 2 $(675,000) Assumed tax rate 40% Benefit of the tax deduction $270,000 Benefit for the two years $760,000 This indirect lender would increase its cash flow by $270,000 for year 2 for a cumulative two-year benefit of $760,000. If loan prices stay stable, but the loan pool increases year over year, then the benefit increases year over year. But remember, this is a timing difference it will reverse as the portfolio is liquidated or if buyers begin to pay more for similar loan pools, depending on the valuation assigned at disposition. Election If this sounds promising, the next question might be, What s the process of actually getting started with mark to market? It s a simple matter: a company that holds the loans that it originates or purchases can adopt the mark to market accounting method by filing for an Application for Change in Accounting Method (Form 3115). It is important to note that a company cannot claim a deduction for any change in value that took place prior to the date of the accounting change. However, the company must consider the subsequent change in value for any loans that were held on the date the election was made. For newly formed companies, the election is made with the initial return and applies to all loans acquired or originated by the company. (The election will also generally apply to any other security that the company holds.) Advantages of the election Historically, the market value of a seasoned loan pool is lower than the tax basis in that pool. Because a company is not able to deduct the allowance for loan losses on a historical basis, the mark to market method is generally favorable for subprime lenders. In many cases, applying the mark to market method serves to ameliorate the book-to-tax difference caused by the tax treatment of the allowance for loan losses. Changing to the mark to market method is an automatic change, which can be filed with the Internal Revenue Service (IRS) on the earlier of the date the return is filed or the date the return is due, including extensions. By comparison, non-automatic changes must be requested by the end of the tax year, well before the return is due. Because the mark to market change is automatic, a calendar-year corporation that extends its return could file the application electing the mark to market method for the 2013 tax year as late as Monday, Sept. 15, 2014 (provided the company does not file its income tax return prior to that date). 3

4 Disadvantages of the election Valuations are the source of IRS exam exposure with respect to the mark to market accounting method. Case law makes it clear that the company must meet a very high standard and must show that it has properly and accurately demonstrated fair market value. Thus, subjective valuations can draw the attention of the IRS. A company should obtain an appraisal from an independent, qualified valuation specialist each year. Even with a valuation report, an IRS agent might challenge the valuation. In these cases, the matter may go to IRS appeals before it is resolved. The issues are inconvenience to the lender and the increased costs of an IRS exam. Any securities acquired after the date of the election are generally subject to mark to market. However, the company can designate a security as held for investment and not subject to mark to market. This designation must be made on the day the security is acquired. Lenders must also view mark to market in light of their loan portfolios and business models. While in some years the method may result in a tax deduction, in other years some previous benefits may reverse. Consider the previous indirect lender example. Assume that the lender s loan portfolio decreases the unpaid principal balance is $17,000,000 at the end of year 3, and the unamortized discount on those loans is $355,000. Pools of similar subprime auto loans are still selling at 87 percent of unpaid principal at the end of the year. The math would look like this: Fair market value of the loans at the end of year 3 $17,000,000 x 87% $14,790,000 Less: Tax basis in the loans (Face value $17,000,000 unamortized discount of $355,000) (16,645,000) Loss on hypothetical year-end sale $(1,855,000) Less: Loss previously deducted in years 1 and 2 $(1,900,000) Unfavorable adjustment (increase in taxable income) for year 3 $45,000 Assumed tax rate 40% Tax cost of the adjustment $18,000 The cumulative loss deducted in the first two years exceeds the loss on the hypothetical yearend sale for year 3. In this instance, rather than a deduction, the valuation results in an increase in income for tax purposes. Over the three years, the cumulative benefit is still $742,000. Other circumstances that may cause previous benefits to reverse include shifting a loan portfolio from deep subprime to near-prime and improving market conditions (i.e., buyers are paying more for pools of seasoned loans), both of which would cause a portfolio to be valued more highly in the market, resulting in a smaller loss on the hypothetical sale. The impact Mark to market accelerates the deduction for most subprime lenders lenders considering its use should realize that the acceleration is a timing difference and not a reduction in taxes. A specialty lender will still recognize losses on charged-off loans when they occur. Use of mark to market simply means the deduction can be taken earlier and, as a result, frees up cash for other purposes. Is the benefit of shifting the deduction to an earlier tax year worth the costs, which involve the valuation work and the possibility of an IRS challenge? The decision requires a clear cost-benefit analysis and a realistic calculation of the lender s internal rate of return (IRR) on how it would use funds freed up by the earlier deduction. 4

5 Specialty lenders should also understand that the election to use mark to market valuation applies to all securities that they hold. Before making the election, a company should identify all securities and determine the impact of the election on that security. For example, an interest rate hedge might be a security for purposes of section 475. Additionally, because the IRS might challenge the valuation of the portfolio, a company might consider including a disclosure statement (Form 8275) with its return to minimize or eliminate exposure to valuation penalties. The disclosure statement is not mandatory, and some taxpayers are reluctant to include a protective disclosure statement because they believe that a protective disclosure might increase the likelihood of an IRS examination. It is unclear whether this is the case. However, we can offer this observation. For most specialty lenders, the book-to-tax difference for mark to market will be reported on Schedule M-3. Schedule M-3 has a specific line for reporting the mark to market difference. Thus, the IRS knows a company uses mark to market and knows the amount of the deduction. If the deduction is large, the IRS might choose to examine the return. Accordingly, some audit risk exists based solely on the size of the mark to market adjustment, regardless of the inclusion of a disclosure. This view suggests that a protective disclosure does not affect the possibility of examination. Summary: weighing risks and benefits As 2014 begins, specialty lenders can benefit from enhancing their knowledge of mark to market and seeing whether this accounting method works for their portfolio and business model. The election involves costs, but the benefits can be substantial. Since rules governing the use of mark to market are quite clear, an election can be a simple matter. However, disadvantages involve annual costs of third-party valuations, other securities held by the company, and the possibility of IRS examinations. The bottom line learn the rules, run the numbers, assess your portfolio, calculate your IRR and see if a mark to market valuation can make a positive impact. 5

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