The recently enacted Tax Cuts and Jobs Act includes changes designed to simplify accounting methods for “small businesses.” One of these changes in the act presents a unique opportunity for qualifying community banks taxed as C corporations to defer taxable income.
Cash Method of Accounting
Under prior law, a C corporation bank could generally use the cash method of accounting for income tax purposes only if it met a $5 million gross receipts test. To meet this test, the bank’s average annual gross receipts for the prior three tax years, similarly measured for all prior taxable years beginning after December 31, 1985, could not exceed $5 million.
This relatively low $5 million threshold prevented many C corporation banks from using the cash method of accounting. However, this limitation did not apply to S corporation banks. As a result, many S corporation banks defer significant amounts of taxable income by utilizing the cash method of accounting for tax reporting purposes.
Gross Receipts Threshold Increased
The act increases the three-year average gross receipts threshold for using the cash method of accounting to $25 million effective for tax years beginning after December 31, 2017. In addition, the Tax Cuts and Jobs Act drops the previous requirement that the test be met in all prior tax years.
This provides an opportunity for qualifying C corporation banks currently using the accrual method of accounting for income tax purposes to consider making a change to the cash method. Because a bank’s accrued interest income at year-end typically exceeds accrued interest and operating expenses payable, the change generally results in lower amounts of taxable income as a bank grows over time. The future tax liability on the deferred taxable income is recorded in deferred taxes on the balance sheet.
Making the Change
Future IRS guidance will likely address the procedures for making the change to the cash method under the new $25 million average gross receipts threshold. We expect the change to be available without obtaining the IRS’ advance consent and to generate a one-time adjustment to taxable income to effect the change from the accrual method. This adjustment—commonly called a “section 481(a) adjustment” —is computed by netting the accrued income receivable and expenses payable accounts as of the end of the year preceding the change.
Therefore, if the change is made for 2018, the accrual balances as of December 31, 2017, will be used to determine the section 481(a) adjustment. Generally, this adjustment amount will result in a deduction on the bank’s 2018 return. For 2018 and following years, the bank must use the cash method of accounting in its tax returns unless it subsequently fails the $25 million average gross receipts test or otherwise decides to return to the accrual method.
For those banks using the accrual method for tax reporting that can meet the $5 million average gross receipts threshold for 2017, a change to the cash method is still available as long as it is made with the timely filed 2017 tax return. Making the change in 2017 may be advantageous if the section 481(a) adjustment can be deducted at a tax rate higher than 2018’s 21 percent flat tax rate. This results in a permanent tax savings that can be significant.
While the cash method generally allows a bank to defer taxable income, it complicates tax planning by making it more difficult to predict future taxable income. Sometimes this is one of the key factors leading banks to prefer the accrual method of accounting for income tax purposes.
Please contact your Eide Bailly professional for assistance in computing your bank’s average gross receipts and assessing the potential benefit of using the cash method of accounting—should it be available.
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