Community banks could benefit in the long run from lower tax rates, but first need to navigate the short-term effect on deferred taxes and investment portfolios.
With the 2016 presidential election behind us, our new Republican-controlled Congress and White House are pushing for tax reform in 2017. However, it is not clear how quickly this could occur, or the extent to which the tax changes will conform to the campaign promises of President-elect Donald Trump or the proposals of the House GOP Tax Reform Task Force.
For most community banks, the hope of lower tax rates for the corporation and/or its shareholders comes as a welcome relief. But institutions should consider the short- and long-term impact of these proposals — including the effect on deferred taxes, earnings, regulatory capital, distributions, or bank investments — and prepare for impending changes.
Key proposals
Trump’s proposal would reduce the corporate tax rate from 35 percent to 15 percent and limit the tax rate paid by individuals on pass-through businesses, including S Corporations, to 15 percent. The Republican House Task Force proposals vary slightly from Trump’s, but also promise a significant reduction in tax rates.
| Trump proposals | House task force proposals | |
|---|---|---|
| C Corporation tax rate | 15% | 20% |
| S Corporation pass-through tax rate | 15% | 25% |
| Corporate alternative minimum tax | Repealed | Repealed |
| Net investment income tax of 3.8% | Repealed | Repealed |
| Capital gains and dividends rate | 0%, 15%, and 20% maximum | 6%, 12.5%, and 16.5% maximum |
Banks may need to revalue deferred taxes and liabilities
All C Corporation banks, as well as some S Corporations, are required to record deferred tax assets and liabilities representing the amount by which taxes payable or receivable are expected to change in the future due to timing differences between the financial statements and the tax return. Deferred tax assets and liabilities are calculated by applying the tax rate that is expected to be in effect in the periods in which the deferred tax assets or liabilities are expected to be realized or paid.
If the corporate tax rate falls from 35 percent to as low as 15 percent, community banks would be forced to revalue their deferred tax assets and liabilities. For example, a community bank with $1 million in net positive timing differences could go from recording a $350,000 federal deferred tax asset to a $150,000 deferred tax asset after the tax reforms. This change in estimate would need to be recognized immediately through the income statement in the year of the tax rate change, resulting in a $200,000 decrease in earnings.
Though the impact of this change would eventually be offset by lower annual income tax expense, the immediate impact of this adjustment could strain institutions with currently recorded large deferred tax assets or banks that are tight on regulatory capital.
Standardizing S Corporation tax rates
S Corporations do not pay tax at the corporate level. Instead, they pass their income tax liability to their shareholders. Historically, this tax liability has been paid at each shareholder’s personal marginal tax rate, meaning that some bank shareholders could end up paying a federal tax rate of over 40 percent on their S Corporation earnings, while others may pay lower taxes.
The most recent proposals seek to put S Corporations on closer parity with C Corporations by standardizing the tax rate shareholders pay at either 15 or 25 percent. Though this is good news for shareholders that have historically been in higher tax brackets, it will mean S Corporation banks may need to reconsider their dividend policies.
Many S Corporation banks have shareholder agreements requiring that they pay tax distributions equal to the maximum personal tax rate paid by shareholders (currently 39.6 percent plus 3.8 percent for net investment income tax plus state income tax). This has resulted in high distribution payout rates as a percentage of annual taxable income. For those shareholders in lower personal tax brackets, this practice puts additional cash in their pockets — the full amount received is more than what is needed to meet their tax payments.
If the tax rate is standardized and lowered as proposed, S Corporation banks will need to determine if they should continue to pass the additional cash on to shareholders through dividends, or if the capital would be better used for growth or other purposes.
Bank investments may become less attractive
Investments in tax-exempt municipal bonds and bank-owned life insurance (BOLI) have traditionally been popular with community banks because of the potential tax savings. With the proposed decrease in tax rates, banks will need to reevaluate the inherent rate of return these investments are earning.
Currently, if a C Corporation invests in a tax-exempt bond earning a 2 percent coupon rate, it may be earning a tax equivalent yield of around 3 percent after considering the tax savings from the bond. If corporate tax rates were to decrease from 35 percent to 15 percent, the tax equivalent yield on that bond would decline to 2.35 percent, making it less attractive as a long-term investment. The tax equivalent rate of return on BOLI would be similarly impacted, leaving banks largely locked into their lower earning BOLI investments due to the tax and penalties associated with cancelling many of the policies.
These changes could lead community banks to reconsider their overall investment strategies. The impact on the municipal bond market nationally may also be significant, as tax-exempt bonds become less desirable across the market as a whole.
How we can help
It is still unknown whether Democrats will be able to curtail or modify the Republican-led tax reforms, but it is clear that banks should start planning for these possible scenarios. Community banks should consider preemptively meeting with their tax advisors and auditors to give thoughtful consideration to the opportunities and challenges proposed by the tax reforms.