How Trump’s Tax Reform Plan May Impact Community Banks
On April 26, 2017, the Trump Administration released its long-awaited federal tax reform plan, the 2017 Tax Reform for Economic Growth and American Jobs. The plan, released as a one-page outline of “core principles,” follows many of the proposals President Trump made on the campaign trail. But the plan, which advertises itself as the “biggest individual and business tax cut in American history,” is short on details.
Unless Trump is able to rally bipartisan support, the tax cuts enacted are likely to be temporary and could sunset after a 10-year period.
For many community banks, the hope of lower tax rates for both the corporation and its shareholders comes as welcome relief, despite the initial challenges that tax reform may bring. But continued uncertainty about the form and substance of the reforms has left bankers watching and waiting for more details.
Trump’s core principles
Trump’s proposal would reduce the corporate tax rate from 35 percent to 15 percent, and also reduce the rate paid by S corporation shareholders on pass-through income. In addition, personal income tax brackets would be reduced and many of the deductions currently available to taxpayers would be eliminated. Trump has also proposed a one-time tax on repatriated foreign corporate profits and the elimination of tax breaks for “special interests.”
|C corporation tax rate||15 percent|
|S corporation pass-through rate||15 percent|
|Corporate alternative minimum tax (AMT)||Repealed|
|Personal tax rates||Reduced to three brackets (10, 25, and 35 percent)|
|Standard deduction||Double the current amount|
|Itemized deductions||Eliminated except for mortgage interest and charitable contributions|
|Net investment income tax of 3.8 percent||Repealed|
Timing and cost of tax reform
Significant concerns have been raised regarding the cost of the proposed tax reform, which is estimated to be around $5.5 trillion over ten years. And though Republicans are currently the majority in Congress and hope to pass these reforms by year end, the Senate’s reconciliation rules will not allow for a simple majority vote if the reforms add to the deficit beyond 10 years.
Unless Trump is able to rally bipartisan support, the tax cuts enacted are likely to be temporary and could sunset after that 10-year period. This creates uncertainty for banks considering their long-term tax structure and for shareholders worried about estate planning.
Impact on corporate structure and shareholders
The Trump proposals seek to put S corporations on parity with C corporations by standardizing the tax rate shareholders pay on their pass-through earnings at 15 percent. This is good news for S corporation shareholders who have historically paid rates as high as 39.6 percent, but the parity may also mean uncertainty for bankers trying to determine the ideal corporate structure for their institutions.
The Trump proposals seek to put S corporations on parity with C corporations by standardizing the tax rate shareholders pay on their pass-through earnings at 15 percent.
Since tax rates paid by C corporations will be substantially lower, the benefits associated with avoiding double taxation are not as profound under the new proposals, particularly for those institutions looking to retain more capital. In addition, banks looking to grow may embrace the opportunity to go back to a C corporation where they can raise capital from a broader variety of shareholders and have the ability to issue preferred stock.
This decision is made more complex by the potential 10-year limit on these reforms. An S corporation that chooses to convert to a C corporation is prohibited from making another S election for five years, so banks need to have a clear plan before they decide to restructure.
The repeal of the estate tax will also not leave shareholders free and clear when determining how their shares will pass to the next generation. Speculation remains as to whether the gift tax will remain in place after the estate tax has been repealed, particularly if the estate tax repeal is temporary. Republicans have also debated whether assets should continue to receive a step up in basis upon death. Shareholders should continue to carefully consider their long-term plans for their bank stock investments.
Investment and lending considerations
Community bankers have also been concerned about how their investment and loan portfolios may be impacted by these proposals.
In March 2017, more than 150 members of Congress asked the House Ways and Means Committee to preserve the tax-exempt status of municipal bond interest. The lawmakers were concerned that Trump and congressional leaders would undermine this popular means of financing the construction of bridges, roads, and other public projects.
Bankers that hold municipal bonds for both investment and Community Reinvestment Act reasons are likewise concerned. With the decline in the corporate tax rates from 35 percent to 15 percent, the tax equivalent yield on these investments will already decline significantly. However, if the tax-exempt treatment of these bonds is eliminated entirely, banks may need to carefully consider their investment strategies and decide if they will continue to invest in municipal bonds.
Home mortgage interest
Trump is promising to retain the home mortgage interest deduction. However, his proposal to double the standard deduction — bringing it to over $25,000 for married couples filing jointly — would substantially reduce the number of taxpayers who itemize.
Furthermore, by eliminating other commonly claimed deductions (such as state income taxes and real estate taxes), itemized deductions would be left to only the highest earning taxpayers and those with the largest home mortgages.
For many middle-class home buyers, the inherent subsidy created historically by the home mortgage interest deduction would effectively be eliminated (although replaced by the increased standard deduction). This has left some bankers concerned about the future of their mortgage lending business.
Though not addressed in Trump’s most recent plan, the House Ways and Means Committee issued proposals in fall 2016 that could also impact business lending. The first would substantially change the existing depreciation rules for taxpayers, allowing businesses to fully and immediately write off the cost of new equipment, buildings, and intangible assets they purchase. The second would eliminate the deduction of interest expense by most taxpayers other than banks and similar companies that generate significant interest income.
The combination of these two provisions could stimulate fixed asset purchases but could also result in taxpayers seeking alternative financing, such as equity investments, rather than borrowing to make those purchases.
How we can help
While it is still unknown how the details of these tax reform proposals will play out, it is clear that the President and the Republican Party are committed to working towards substantial changes to the U.S. tax code.
In the meantime, community banks should consider preemptively meeting with their tax advisors to carefully consider how these changes may impact the bank’s overall tax structure, business operations, and shareholders’ interests so they are ready to act when the time comes.