Republican Tax Reform Bill Lacks Details on Issues Affecting Community Banks
On September 27, 2017, the Trump administration and Congressional GOP leaders unveiled their much-anticipated tax reform plan, the “Unified Framework for Fixing Our Broken Tax Code.” This framework cuts corporate tax rates, lowers the individual tax brackets, changes tax deductions, and makes sweeping changes to how S corporations would be taxed.
At this time, the bill’s framework remains a broad proposal and no formal legislation has been revealed. And as with earlier proposals issued by President Trump in April 2017, the plan remains sparse on details. But as specifics continue to emerge, bankers should consider the potential impact of these changes on their organizations, as well as their customers.
Reducing the corporate tax rate to 20 percent
The Republican proposal would reduce the corporate tax rate from 35 percent to 20 percent and eliminate the alternative minimum tax. The provisions would also affect how S corporation shareholders are taxed on pass-through income.
In addition, personal income tax brackets would be reduced, and many of the deductions currently available to individuals would be eliminated. One important element yet to be decided is how Republicans will pay for the proposed tax cuts.
|Business Tax Reforms||Current||Proposed|
|C Corporation tax rate||35% maximum||20%|
|Corporate Alternative Minimum Tax (AMT)||20%||Repealed|
|S Corporation pass-through rate||Taxed at the shareholder’s personal tax rate||25% maximum|
|Individual Tax Reforms||Current||Proposed|
|Personal tax rates||7 brackets with a 39.6% maximum rate||3 brackets with a 35% maximum rate|
|Standard deduction||$6,350 single
$12,700 married filing jointly
$24,000 married filing jointly
|Personal exemption||$4,050 per taxpayer or dependent||Eliminated|
|Estate tax||Up to 40% on estates over $5.49 million||Repealed|
Any tax changes made will likely be temporary
Though Republicans have proposed making at least portions of the tax reform plans retroactive to January 2017 to spur economic growth, given the recent challenges in Congress, we believe it is unlikely that legislation will be finalized before year end.
It is likely that the tax reform package will move in Congress under the reconciliation rules, which require only a simple majority in the Senate to pass. But under these rules, the tax cuts would likely sunset after 10 years. Though Republicans would certainly prefer permanent reforms, Treasury Secretary Steven Mnuchin has said, “If we have it for 10 years, that’s better than nothing.” So the long-term impact of lower tax rates and the repeal of the estate tax will be difficult to predict.
Community banks have expressed concern about how their loan portfolios may be affected by these proposals. Here’s how the bill, if passed, could affect areas of your community bank:
Home mortgage interest
Under the new proposals, most itemized deductions would be eliminated, including those for medical expenses, state and local income taxes, and property taxes, leaving taxpayers with the ability to only itemize home mortgage interest and charitable contributions. In addition, the framework includes a dramatic increase in the standard deduction from $12,700 to $24,000 for married couples filing jointly.
According to IRS data, around 30 percent of households itemize their deductions today. With these proposed changes, we anticipate that far fewer households would be able to itemize in the future. The inherent subsidy created historically by the home mortgage interest deduction will effectively be eliminated for a large section of American families, especially for the middle-class in parts of the country where home prices have remained affordable. The impact of this change on home ownership and mortgage lending cannot be predicted, but it is certainly a risk that banks should begin to consider.
Businesses may begin searching for alternative financing
Addressed only briefly in the framework, Republicans have proposed that the tax deduction for net interest expense incurred by a C corporation businesses be eliminated. The framework leaves open the opportunity to limit the deduction of interest paid by non-corporate taxpayers.
If businesses are not able to deduct interest expense, they may search for alternative financing, such as equity investments, rather than borrowing to make large purchases.
Immediate expensing of capital investments could increase lending
The framework allows businesses to immediately expense the cost of new investments in depreciable assets, other than buildings and similar structures, for a five-year period beginning in 2017. This effectively allows 100 percent bonus depreciation on these investments. The bonus depreciation rate has fluctuated wildly over the last 15 years, from zero percent up to 100 percent. While it is seen as an incentive to spur equipment purchases, many believe this type of incentive only speeds up the purchase of assets businesses would have purchased anyway.
This provision, if enacted, could increase some commercial, industrial, and agribusiness production lending. However, many small to mid-size businesses will likely not be affected, as they are already able to take up to $500,000 in annual Section 179 deductions on equipment purchases, which amply covers their needs in many cases.
S corporation shareholders face uncertainty
As previously addressed, the tax reform plans may initially challenge C corporation community banks because of the potential impact on deferred tax assets and capital. But over the long run, it is clear that most C corporation banks would appreciate lower corporate tax rates, even if those rates are temporary.
For S corporations, there is more uncertainty in these new proposals. The framework limits the maximum tax rate applied to the business income of small and family-owned businesses, including S corporations, to 25 percent. This is a much different than the current system where S corporation shareholders pay taxes on their share of S corporation income at individual ordinary income tax rates, resulting in some bank shareholders paying at rates of up to 39.6 percent.
On the surface, this proposal sounds like great news for wealthier shareholders investing in S corporation banks, but it isn’t clear if the 25 percent rate will apply to S corporations of all sizes, or if it will be limited to businesses below a certain size threshold, which could exclude certain institutions. In addition, there are provisions in the framework that indicate Congress may adopt measures to prevent the re-characterization of personal income (such as wages) into business income to prevent wealthy individuals from avoiding the top personal tax rate.
Furthermore, the proposed repeal of the estate tax, which will also likely be temporary, could leave some shareholders struggling to plan how they will pass on their shares to the next generation. Speculation also remains as to how the gift tax will be structured if the estate tax is repealed.
How we can help
While it is still unknown how these tax reform proposals will play out, it is clear that the Republican Party is committed to working towards major changes to the tax code. We anticipate that these topics will be hotly debated in the fall of 2017 and into the new year. In the meantime, your management team should be ready to act when the time comes. Leaders of community banks should consider preemptively meeting with their tax advisors to carefully consider how these changes may impact your bank’s future plans.