Recently enacted tax reform legislation – informally called the Tax Cuts and Jobs Act – contains substantial changes to the taxation of businesses. Some of the Act’s changes will affect accruals of income tax expense for financial statement (Call Report) purposes and require changes to tax accrual worksheets used by many banks.
Here’s what banks need to be aware of when it comes to tax reform.
For the largest banks – those with total consolidated assets in excess of $10 billion – all or a portion of the FDIC premium will be non-deductible.
Entertainment and Meals Expenses
After 2017 the Act eliminates deductions for entertainment, amusement or recreation expenses, membership dues for any club organized for business, pleasure, recreation, or other social purposes and facilities used in connection with these items (such as an airplane).While the 50 percent deduction remains in place for meals associated with business activities, such as meals during employee travel, the Act extends the 50 percent deduction limitation to employer-operated eating facilities through 2025 (after 2025, the costs will be fully non-deductible).
Banks may want to revise their internal accounting procedures and general ledger accounts to capture those expenses that may have been fully, or partially, deductible prior to the Act, but now are subject to new limitations.
Here’s what you need to know about the deductibility of meal and entertainment expenses.
Excessive Executive Compensation
Corporations treated as publicly held face stricter limitations on the deductibility of compensation paid to certain officers. The Act repeals exemptions that previously applied for performance-based compensation for executive and highly paid officers and expands the definitions of a “covered employee” and a “publicly held corporation.”
For these, and – potentially – other deductions limited by the Act, banks should modify their tax accrual worksheets to provide add-backs increasing taxable income if appropriate.
S Corporation Banks
While S corporations are not generally subject to corporate level income taxes, Act provisions will affect the calculation of taxable income allocated to shareholders and other income tax related computations.
For example, most S corporation banks make special dividend distributions to shareholders that reflect the anticipated income tax expense shareholders will incur on their respective shares of the bank’s taxable income. The lower individual tax rates and limitations on deductions, such as the state income taxes, may warrant changes to the calculations supporting these distributions.
Is an S corporation still right for your bank?
For S corporation banks, tax reform 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.
The federal corporate income tax rate was changed to a flat 21 percent rate for C corporations. The maximum rate had been 35 percent, with a lowest bracket of 15 percent. C corporations should be sure to use the new 21 percent federal corporate tax rate on their tax accrual calculations.
S corporations, when computing tax distribution amounts for 2018 and beyond, should take into account the new individual tax rate schedule (top marginal bracket is now 37 percent, down from 39.6 percent) and consider the new 20 percent of QBI deduction. The net investment income tax, applicable for certain passive owners of S corporations, is still in place. The Tax Cuts & Jobs Act did not change the net investment income tax rules at all.
The opportunity to defer taxable income for C corporation banks has been enhanced by the Act by making available the use of the cash method of accounting for tax purposes for C corporations that have average annual gross receipts of $25 million or less for the prior three years. The prior limitation for C corporations was average gross receipts of $5 million or less for the prior three years and for every year since 1985.
The new $25 million threshold will provide an opportunity for many more C corporation banks to defer taxation on accrued interest receivable until the year it is collected. Likewise, accrued interest payable and accrued expenses payable (including accrued bonuses and salaries) are not deducted until the year paid. Careful analysis will need to be done to determine whether this is a change that would benefit a C corporation bank.
It’s important to note this method change would not necessarily have an immediate impact on a bank’s income statement; the deferred income and expenses from using the cash method become components of a deferred tax asset or liability calculation.
The cash method of accounting remains available for all S corporation banks, and the change to the cash method is an automatic change for S corporation banks with average annual gross receipts of $50 million or less. This has been the case since the IRS released Revenue Procedure 2011-14 (although it is possible the IRS could change the gross receipts threshold for the automatic change in the future). For S corporation banks with average annual gross receipts in excess of $50 million, the bank can still change to the cash method, but would need advance consent from the IRS to do so.
What to do about tax reform at your bank
The Act includes many provisions, including lower tax rates and limitations on certain deductions, affecting the taxation of banks and their shareholders that may require changes to accounting procedures and internal worksheets used for estimating income tax expense. The changes needed can vary depending on each bank’s facts and circumstances.
Tax reform is impacting your financial institution. We’ve created resources to help you make sense of it.