On September 30, 2008, the Internal Revenue Service (“IRS”) issued Notice 2008-83, which provides a favorable treatment of a bank’s bad debts after an ownership change. This notice is good news for banks acquiring targets with troubled loan portfolios.

Banks generally must treat bad debts (e.g., losses on loans) by taking a specific deduction (“charge-off”) for the debt. Certain smaller banks can choose to deduct additions to bad debt reserves.

If a corporation undergoes a more than 50% change of ownership, net operating loss carryforwards are subject to specific limitations on deductibility. Special rules apply the same limitations for certain built-in losses or built-in deductions of the corporation attributable to the period before the change of ownership but are claimed within 5 years after the ownership change.

So what happens when a bank makes a loan on Day 1, is acquired on Day 2, and takes a bad debt deduction on Day 3? Many tax practitioners were concerned that some or all of the bad debt deduction might be a built-in loss or built-in deduction attributable to the period before the acquisition for purposes of the loss limitation rules on change of ownership.

Enter a kindler and gentler IRS in Notice 2008-83. The notice concludes that any bad debt deduction properly allowed after an ownership change to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) will not be a built-in loss or a deduction that is attributable to periods before the change date, and thus not subject to the loss limitation rules. This favorable rule will permit an acquiring bank to obtain the maximum Federal income tax benefit from troubled loan portfolios of targets.

This notice is aimed specifically at banks, so it is unclear how this rule would apply to other taxpayers.