After the Tax Cuts and Jobs Act passed, one of the first questions it created in the financial institutions industry was about choice of entity. Many S corporation banks are weighing the pros and cons of switching to a C corporation. Eide Bailly sat down with Justin Horst, CFO of Pinnacle Bancorp Inc. of Nebraska, the second largest S corporation financial holding company in the United States, to talk about what his bank was experiencing and his thoughts on the impact of tax reform.
Eide Bailly: Has your organization re-evaluated its S corporation election since tax reform was passed?
Justin: About 67 times (laughs). We went through different iterations as the various House and Senate bills came out and had a model for each to help us know which one to cheer for. We kept track as best we could but it was difficult sometimes to remember what points were in what bill. We’re the second biggest S corporation in the industry, so our numbers get pretty big fairly quickly, and a step in the wrong direction can cost a lot of money. We have a September year-end, so we have until almost the end of the year to decide if we will stay an S corporation. We’re waiting to see how things end up in the instructions and guidance to ensure we understand everything before we make a final decision.
Eide Bailly: What was it like going through the process of watching the different bills unfold and seeing the final product?
Justin: We had some conversations with some Senate aides about the initial pass-through language and how it didn’t work. We offered feedback on what was usable and what could be better, and comparing it with what was in the Senate bill. It was interesting to see the process at that level. Some of the stuff that moved around a lot, like corporate AMT, were big deals for C corporations because all your tax-exempt interest was possibly at risk. Thankfully that didn’t survive. But I think this will be the year of the technical correction, given how quickly it seemed to go through the approval process.
Eide Bailly: How has tax reform impacted your bank’s overall operating strategy?
Justin: We’ve had to look at a lot of what we’re invested in because there are winners and losers in everything that we’re doing. For example, tax exempt bond portfolios were certainly not winners in this with the lower effective federal rate and a worse net yield. We’ve also looked closely at our low-income housing credits, which were also negatively impacted because your investment returns aren’t as good as they were previously. But overwhelmingly, the majority of the items in the bill are positive.
Eide Bailly: How do you think tax reform will impact your growth?
Bill: In terms of growth, we think we’ll save about nine percentage points as an S corporation with the current rates, and we may get another nine points if we switch to a C corporation, relative to taxable income. Those get to be big numbers. We’re a highly acquisitive bank, so that allows more capital to be available, but sellers are figuring that out too because their after-tax return is better. That’s driving higher than expected prices from some sellers, though I’m not sure who has gotten those prices. It certainly will increase the multiples on the banks. It has in the public markets, and we’re starting to see that in private as well.
Eide Bailly: While the C corporation rate changes do not have an expiration date, there is an expiration date of 2025 for the 20 percent qualified business income deduction and the individual rate decreases. Does that give you or your shareholders any apprehension?
Justin: That really weighs heavily on our mind. If those rates were not renewed you’d find it very hard not to switch to a C corporation. And the other side of that is we have a two-year window to switch where there are some benefits in terms of future dividends and rolling in changes to accounting. Our biggest fear is we’d wait to 2025 and then be forced to switch and miss out on the benefits of switching now.
Eide Bailly: What have your conversations with regulators been like so far regarding tax reform?
Justin: One thing we’ve learned as we’ve talked to regulators, they still don’t quite understand our bank’s situation. We’re in a peer group of $10 billion to $50 billion, and there are only two S corporation banks in that group. We told the regulators they are going to see a lot of earnings hits from the other banks in our peer group, that their capital includes deferred tax assets as well, but they don’t seem to understand that as well as they should. It’s a complicated topic, and when you put the words “deferred tax” into it, the general public doesn’t understand what you’re talking about.
Eide Bailly: How much do you weigh the ability to book a deferred tax asset when you look at switching to a C corporation?
Justin: It would add to pure common equity if we switched and give us a tier 1 capital boost, plus the savings in each quarterly estimate. But the loss of deductibility of state taxes plays a big role, too. In Nebraska, we have a financial institution tax as a C or S corporation that the bank pays, and for this purpose that actually is beneficial. Other states have something similar as well. Deductibility of those taxes has a big impact on effective rate.
Eide Bailly: How do you feel tax reform will impact the industry overall?
Justin: Financial institutions will probably fare better than most other sectors because we had such high effective tax rates to begin with. Lots of other industries have the ability to shift money in a way that we don’t. There are certainly winners and losers in this, but overall, I think our industry is a big winner.
One question that is beginning to surface is what does the individual shareholder see themselves doing over the next five to 10 years? Do they see themselves selling their shares or the whole company selling? That really has an impact on your decision making. Also, there are better estate planning options as an S corporation than a C corporation. If you’re looking at doing substantial estate planning or a sale in the next five to 10 years, tax reform will have a strong impact on any decision to switch. Additionally, if you have a lot of operating losses from another company, when your bank income offsets your losses from other investments, you lose that netting if you switch to a C corporation.
So it’s important for every shareholder to look into the future and try to have a strategic plan, which is uncomfortable for many shareholders to talk about, because if you tell someone you might sell your shares in 10 years, you can’t unring that bell. It’s bringing some difficult conversations to the table.
Eide Bailly: How do you think that compares to when banks could first become S corporations in the 1990s?
Justin: Back then, the rates were the same as the federal rate, and when you look at it through that lens, it was easier because you weren’t signaling a sale by switching to a S corporation. You were just looking to get the same rate and get basis, too, or potentially pay of distributions tax-free. It’s different now that there is such a different tax rate. If you’re not considering some of those personal goals and planning, then a C corporation is the clear answer, but unfortunately there’s more to the story. And it’s probably not going to be unanimous in a shareholder group because everyone has different goals and plans.
Eide Bailly: Do you think tax reform will affect lending decisions?
Justin: I think tax reform combined with the rollback in regulations that is happening will make banking more attractive and ultimately more competitive, because I think we’re going to see more entries into the industry. Tax and regulatory burdens were pushing people out of the market and creating consolidation. It will be interesting to see if we have less consolidation now, or if banks that can now stay in the business will still want to sell even if they can get high prices.
About Justin Horst
Justin Horst, CPA, CGMA, is chief financial officer of Pinnacle Bancorp, Inc., a multi-state bank privately owned S corporation financial holding company headquartered in Omaha, Neb., with approximately $10.5 billion in assets. Pinnacle is currently the second largest S corp financial holding company in the United States and has locations across seven states. His responsibilities include working closely with the banking subsidiaries in merger and acquisitions, financial accounting and tax issues, regulatory issues, strategic planning, technology and operational issues, and budgeting.