On December 22, 2017, President Trump signed into law the tax reform legislation known simply as “H.R. 1” and now designated Public Law 115-97.
Due to budget reconciliation rules in the Senate, it was determined that the name given the tax reform legislation by Congress, the “Tax Cuts and Jobs Act,” could not be used. Therefore, the official title of H.R. 1 is “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018;” however, we will refer to it simply as H.R. 1. If you’re interested, you can read the entire legislation [not recommended] by clicking here; or, get a summary of the changes by clicking here. But, there is an item discussed below that should be of interest to those in the banking industry operating as an S corporation.
Lower Tax Rates
Bankers will find a number of provisions in H.R. 1 potentially of interest including new limitations on various deductions that will affect their banks and customers. The most notable changes will likely be the lower tax rates.
For calendar year regular corporations, H.R. 1 reduces the current 35 percent top corporate tax rate to 21 percent beginning on January 1, 2018. The 21 percent rate is a “flat” tax that will apply regardless of a regular corporation’s income. For a fiscal year regular corporation, with a tax year ending in 2018, the new flat 21 percent rate will be “blended” with the tax rates in place prior to January 1, 2018.
For S corporation banks, H.R. 1 reduces the top shareholder individual income tax bracket from 39.6 percent to 37 percent starting in 2018. In addition, it introduces a special 20 percent deduction, subject to various potential limitations, that will generally be available to individuals, trusts and estates owning S corporations and other “pass-through” type business entities. Due to procedural constraints in the Senate, both of these changes are temporary; they are slated to expire after 2025, although it is possible Congress during 2026, a mid-term election year, could choose to extend expiring provisions.
In those instances where the full 20 percent deduction is available, the top tax bracket for S corporation owners essentially drops from 37 percent to 29.6 percent. Thus, the gap between the top federal tax rates applicable to regular corporations, at 21 percent, as compared to the top individual S corporation rate, at 29.6 percent, has increased under H.R. 1, to 8.6 percent from the current, and long-standing, 4.6 percent, which was 35 percent compared to 39.6 percent.
This 4 percent increased spread provides an incentive to revisit the advantages and disadvantages of a bank’s current business structure. In particular, banks operating as S corporations should reassess the benefits of their S corporation election. Many banks will likely choose to retain their S corporation status due, in part, to the continuing additional shareholder level income tax on dividends paid by regular corporations. However, others may find that the 21 percent tax rate changes the analysis enough to make a switch to regular corporation status. Under either scenario, the potential for a change in individual rates 8 years down the road also needs to be factored into the planning.
If an S corporation’s owners, after considering the pros and cons of a change, decide to revoke the S election, the effective date of the change needs to be planned. Generally, the effective date of the S corporation revocation is a specified date, one that is on or after the date the revocation is filed with the IRS. However, a revocation filed on or before the 15th day of the third month of the tax year can specify that the termination of the S election is retroactive to the beginning of the tax year.
In light of this opportunity to select a retroactive effective date for revocation, S corporations that view a change to regular corporation status as potentially beneficial should immediately consult with their tax advisers to model the financial implications of the conversion and analyze the consequences of operating as a regular corporation. In that way, they can make their decision soon enough to file the revocation documents by March 15, 2018, so that the termination can be effective as of January 1, 2018, if desired.
Of course, there are many issues to consider when determining the most advantageous business and tax structure for a bank.
Please contact your Eide Bailly professional if you have questions related to reviewing your bank’s tax status or other tax reform issues.