The Tax Cuts and Jobs Act (TCJA) will significantly alter the tax landscape for financial institutions, and community banks can generally expect to retain more profits for their shareholders under the new rules.
Whether structured as C corporations or S corporations, community banks will need to reassess their tax-planning strategies to account for major changes to the statutory tax rates and other tax provisions. This includes looking at deferred tax asset treatment, changes in permanent differences, such as meals and entertainment, and more.
Here’s an overview of the TCJA’s most relevant provisions and how they could affect financial institutions
Beginning in 2018, the TCJA establishes a flat, permanent 21% corporate rate. Fiscal-year corporations will need to compute tax using a pro rata allocation based on days for the tax year that includes January 1, 2018. Because the law was enacted before the 2017 year-end, companies will also be required to include the effects of the new law in the quarter that ended December 31, 2017.
Banks generally carry significant deferred tax assets, so their quarterly earnings could be adversely impacted by this provision, as we’ve seen reported in numerous press releases throughout January 2018. Deferred tax assets and liabilities previously valued using a federal rate of 35% or 34%, including those originally recorded through other comprehensive income (OCI), will be revalued through a company’s income statement.
Other Comprehensive Income
Disproportionate tax effects lodged in OCI result from recording the revaluation through the income statement. Because many banks have available-for-sale (AFS) securities and pensions, this raised the question of how these disproportionate effects ultimately reverse.
The Financial Accounting Standards Board (FASB) was quick to respond, issuing an exposure draft in early January 2018 with an expedited comment period that closed February 2. The guidance requires a reclassification from accumulated OCI to retained earnings for stranded tax effects resulting from the newly enacted federal corporate income tax rate change.
The proposed update would be effective for fiscal years beginning after December 15, 2018, with early adoption permitted. Regulatory guidance also allowed for early adoption, permitting the application of the guidance with December 31, 2017, call reports.
For banks with unrealized gains, delaying the adoption to the required effective date may provide a planning opportunity to recognize a reduction in tax expense for the disposal of these securities under the item-by-Item approach.
Use of Tax Estimates in Financial Statements
Recognizing that it may be difficult for companies to fully assess and account for the changes in their financial statements by the time they’re due, the SEC released guidance for registrants when tax reform was signed into law. The FASB affirmed this guidance can also be applied by nonpublic entities.
Summary of SEC Guidance
- Companies that are unable to account for certain income tax effects of the new law by the time the financial statements are issued may include a reasonable estimate as a provisional amount.
- The provisional amount would be adjusted during the measurement period, which begins in the reporting period that includes the TCJA’s enactment date and ends when an entity has obtained, prepared, and analyzed the information that was needed to complete the accounting requirements under ASC 740.
- The measurement period can’t extend beyond one year from the TCJA enactment date.
- Any provisional amounts or adjustments to provisional amounts included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense or benefit in the reporting period the amounts are determined.
- If provisional amounts are used, disclosures guidance is provided. Guidance prescribes qualitative disclosures and explanations as well as the impact of measurement period adjustments on the effective tax rate and when the accounting for income tax effects of the TCJA is completed.
Other Corporate Tax Provisions
These are the other most notable tax code changes that could impact banks structured as C corporations:
Alternative Minimum Tax
- The corporate alternative minimum tax (AMT) is repealed.
- AMT credits carry over in their 2018–2021 tax years to offset regular tax liability with 50% of any remaining unused credits being refundable through 2020.
- In 2021, 100% of any remaining AMT credits is refundable.
Business Net Operating Losses
- Using business net operating losses (NOLs) to offset income is limited to 80%. This is only true for NOLs that arise in tax years after December 31, 2017.
- NOLs can no longer be carried back to an earlier tax year. However, they can be carried forward indefinitely. This is also only true of NOLS that arise in tax years after December 31, 2017.
Executive Compensation Deduction
- Exceptions to Section 162(m) executive compensation deduction limitation for commissions and performance-based compensation are repealed.
- Transition rules apply to contracts in effect on November 2, 2017.
S Corporations and Pass-Through Entities
Under previous law, net taxable income from S corporations was passed through to owners and taxed at the owners’ standard rates. Beginning in 2018, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI). This new tax break is available to individuals, estates, and trusts that own interests in pass-through business entities. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
QBI is generally defined as the net amount of qualified items of income, gain, deduction, and loss from any qualified business of the noncorporate owner. The QBI deduction isn’t allowed in calculating the noncorporate owner’s adjusted gross income, but it reduces taxable income. In effect, QBI is treated the same as an allowable itemized deduction.
W-2 Wage Limitation
The QBI deduction generally can’t exceed the greater of the noncorporate owner’s share of either:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year
- The sum of 25% of W-2 wages paid plus 2.5% of the cost of qualified property
Qualified property is the depreciable tangible property—including real estate—owned by a qualified business as of year-end and used by the business at any point during the tax year for the production of qualified business income.
Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 and $315,000 for joint filers. Above those income levels, the W-2 wage limitation is phased in over a $50,000 range and $100,000 range for joint filers.
The following TCJA provisions will impact community banks, regardless of entity type:
- Business-related entertainment—50% deduction is repealed.
- Meals provided on-premises—deduction for expenses is reduced to 50% from 100%.
- Tangible property—certain tangible property placed in service after September 27, 2017, can be fully expensed.
- Section 179—expensing limitations are increased.
- Exclusions from employee income—those related to transportation benefits, parking benefits, and moving expense reimbursements are repealed.
- Deductibility of Federal Deposit Insurance Corporation (FDIC) insurance premiums— there’s a new limitation for banks with assets in excess of $10 billion. The limitation is a ratio that total assets in excess of $10 billion bears to $40 billion. Complete phaseout occurs at $50 billion.
- Cash method of accounting—taxpayers with average gross receipts of less than $25 million are permitted to use this method
- Tax credit bonds—these are repealed, including qualified zone academy bonds and advance refunding bonds. The repeal won’t impact bonds issued before December 31, 2017.
- Rehabilitation tax credits—these are modified, including the repeal of the 10% credit for pre-1936 buildings and changes to the 20% credit for certain historic structures—generally for amounts incurred after 2017.
There are also new limitations on net interest expense deductibility, which may result in implications on customer loan demand in future years. The TCJA limits the deduction of interest expense to the amount of interest income plus 30% of taxable income without regard to depreciation, amortization, or depletion deductions and distributive pass-through income. Interest disallowed carries forward indefinitely. Businesses with average annual gross receipts of $25 million or less are exempt, and real property businesses may elect not to apply provision.
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For more information on how tax reform could affect your financial institution, contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.