As the U.S. presidential election wraps up, potential changes in legislative power and other factors will have a direct impact on your bank.
Although immediate sweeping tax changes are not anticipated, a change in the White House provides an incentive for longer-term tax planning. In addition, having the ability to react and implement strategies in response to changing external factors, including the COVID-19 pandemic and its effect on your bank’s customers, needs to be a focus in coming weeks and months.
Congressional Gridlock Could Stall Tax Proposals
Control of the U.S. Senate will not be decided until January when Georgia holds run-off elections for its two Senate seats. Republicans will hold the Senate majority unless both Democratic candidates prevail in the Georgia run-offs. If both Democratic candidates in Georgia win and the two incumbent Independent party Senators continue to vote with Democrats, the Senate will be evenly divided, and Vice President-elect Kamala Harris would be able to break a 50-50 tie. Democrats have retained control in the U.S. House of Representatives, although it is by a smaller margin than their current majority.
The election results and projections suggest a difficult road for significant changes in the federal income tax system. Republican control of the Senate will allow them to block any changes they oppose, and even if the Democrats win both Georgia run-off elections, their ability to enact significant tax changes will be limited by 1) a majority that depends on the vote of every Democrat and Independent Senator plus the Vice President and 2) Senate rules that require some Republican support for votes requiring more than a simple majority.
President-elect Joe Biden’s campaign proposals to increase tax rates on corporations and high-income individuals (income greater than $400,000) are not expected to be on the table in the near future. This includes Biden’s proposal to phase-out the 20% deduction for Qualified Business Income (QBI) that currently benefits many S corporation bank shareholders.
CARES Act Considerations
The CARES Act not only provided assistance to taxpayers affected by COVID-19; it also presents several new tax planning opportunities:
- The Employee Retention Credit is a payroll tax credit, but there is limited applicability for community banks. There is still time to review whether your bank is eligible to claim this credit.
- Qualified Improvement Property (QIP) put in service during 2018 and 2019 now has a shorter 15-year tax depreciation life and qualifies for bonus depreciation. If your bank placed any assets into service that meet the definition of this type of property, action will need to be taken. Recently, the IRS released new guidance giving taxpayers flexibility in claiming additional depreciation on assets previously placed in service.
Here’s how the CARES Act Impacts Community Banks
PPP Loan Processing Fee Income
The tax treatment for Paycheck Protection Program (PPP) loan processing fees received by banks from the Small Business Administration (SBA) during 2020 may vary from bank to bank depending on the particular facts and circumstances.
In general, regulatory and financial accounting guidelines indicate that for book purposes, the PPP loan fees should be included in earnings over the life of the underlying loan. Thus, if the PPP loan is not forgiven at the end of 2020, the related fees may not be fully realized into book earnings.
For tax purposes, loan fees can generally be recognized in one of two ways based on the nature of the fees received:
- Service fees – If the fees are considered paid for administrative duties performed by the bank in underwriting and closing the loan, such as appraisal fees and other tasks performed by the bank, the fee income will be taxable in the year received for cash basis taxpayers, or the year earned for accrual basis taxpayers. For both cash and accrual basis taxpayers, that year would likely be 2020 for all, or a vast majority, of the PPP fees received.
- Points – If, on the other hand, the PPP loan fees are considered a yield adjustment and treated as interest income for tax purposes, taxpayers should be able to include the “points” (i.e., the loan fees) in taxable income over the life of the underlying loan.
In determining the tax treatment of PPP loan fees, the nature of the fees—whether a “service fee” or “points”—must be determined. There are characteristics of each that may arguably apply to PPP loan fees:
- The SBA refers to the fee as a “processing fee,” which would indicate it may be intended to compensate the bank for services performed in writing, closing and funding the loan. This suggests a service fee, which would be currently taxable.
- However, the fee is calculated as a percentage of loan principal amount, and the loan bears an interest rate that is below market rate compared to other loans typically offered by the bank. These factors suggest the loan fees may be more in the nature of a yield adjustment and, thus, classified as “points” reported as taxable income over the life of the loan.
The IRS has not yet provided guidance as to how it interprets the above factors and the tax treatment of PPP loan fees. It would appear that a case could be made for either “service fee” or “points” treatment. If PPP loans are largely forgiven and/or paid off during 2021, “points” treatment offers a potential one-year deferral of a portion of the related fee income.
Common Year-End Planning Opportunities
Despite uncertainties over the outcome of the Georgia run-off elections in January, it appears a divided government, and the resulting gridlock, may make it difficult for a Biden administration to quickly get its tax proposals enacted.
With that in mind, many banks will most likely pursue the usual tax planning strategy for 2020 of deferring income and accelerating deductions. However, should developments indicate there is a reasonable chance of Democrats taking control of the Senate—increasing the likelihood of higher tax rates and phased-out deductions in 2021 or 2022—tax planning may need to go into “reverse” (accelerating income and deferring deductions for 2020). So, stay flexible!
Here’s a summary of common tax planning strategies banks should consider for year-end:
- Revisit the S corporation versus C corporation analysis in light of the Biden tax proposals. Determine the optimal long-term strategy for your bank and its ownership group.
- Project year-end capital ratios and determine the impact if S corporation tax distributions might be needed for shareholders. Regulators offered some relief for S corporation banks that may have fallen into their Basel III “buffer zones” and below the 9% Community Bank Leverage Ratio level, specifically as it relates to tax distributions.
- While tax rates may increase in future years, many banks are experiencing inflated balance sheets and corresponding pressure on regulatory capital ratios. For S corporation banks, the risk of increasing tax rates may be less important than lowering taxable income in 2020 and reducing tax distribution needs in order to preserve capital and support regulatory capital ratios.
- S corporation banks should also review the potential 20% QBI deduction available to shareholders to determine if any changes in business operations or record keeping could increase the benefit of this deduction.
- Review the bank’s loan watch list and classified loans to determine if any additional charge-offs would be appropriate prior to year-end.
- For cash basis banks, consider the tax impact of any customer loan interest that was capitalized as part of loan principal in a workout situation. The capitalized interest is not considered “collected” for tax purposes; adjustments to the bank’s taxable income may be necessary.
- For “other real estate” or “other personal property” repossessed during the year, make sure the property has been written down to fair market value. Keep in mind, the initial write-down should be booked to the allowance for loan losses and is generally deductible as a loan charge-off. Subsequent write-downs to the property due to declines in value are not deductible for tax purposes until the property is eventually sold.
- Consider the availability of bonus depreciation and Section 179 expensing elections for 2020 fixed asset additions. If higher tax rates are expected in the near future, determine whether forgoing bonus depreciation is optimal for 2020, or if the current tax benefit of the bonus depreciation outweighs any potential tax savings from deferring the deduction. And, as mentioned above, review fixed asset additions in 2018 and 2019 to determine if there may be opportunities to claim additional depreciation on QIP assets.
- Cost segregation studies could provide significant current-year (2020) deductions on buildings that may have been in service for several years. These studies can support a cumulative “catch-up” deduction for prior year depreciation and move future tax depreciation deductions to 2020. Again, consideration should be given to the prospects of future higher income tax rates.
- For cash basis banks, consider payment of accrued liabilities and paying certain short-term prepaid expenses that are qualified for accelerated deduction before year-end.
- Accrual basis banks may also prepay and deduct in 2020 some prepaid expenses, but the types available for deduction are more limited. Items such as taxes, insurance, and warranty contracts would qualify for this deduction.
- Generally, an accrual basis bank is allowed a current deduction for accrued bonuses if they are paid within the first 2 ½ months of the following tax year. However, there are tax deduction limitations if the bonus plan allows the bank to retain any amounts forfeited by employees.
- With significant differences in state rates of taxation, make sure loans, deposits, loan interest income, payroll and property are properly identified in bank records for apportionment calculations and allocation to the appropriate states. Review applicable state tax filing requirements.
- Review your bank’s tax depreciation schedule for assets that are no longer in service and may have been disposed of by the bank. If any tax basis remains for these assets, it may be deductible as a loss on disposal.
- It would be a good practice prior to year-end to review the dollar expensing threshold included in the banks capitalization policy and determine if that amount still makes sense. In addition, review your bank’s repairs and maintenance expense accounts and current year fixed asset additions to ensure all items follow the bank’s capitalization policy.
- A review of the bank's available-for-sale investment security portfolio should be made and securities with unrealized losses should be considered for sale in order to recognize the ordinary loss (or gain, depending on the bank’s applicable planning strategy) before year-end.
- Reviewing your bank’s expenses for meals and entertainment may uncover potential deductions. While entertainment expenses are not generally deductible, there are exceptions. Also, consider whether your accounting and expense reimbursement procedures separately track categories such as business meals, entertainment, employee recreation, dues for business trade associations and other types of expenses distinguishable from entertainment.
- Review hiring practices to identify new employees and prospective employees that may qualify for the Work Opportunity Tax Credit.
- If your bank has employees working remotely during the COVID-19 pandemic, it is a good time to review reimbursement policies for employee expenses.
- The IRS is currently assessing substantial penalties on applicable large employers for failures related to compliance with Affordable Care Act (ACA). Banks subject to the ACA should review their reporting and identify any potential risks due to noncompliance.
- For S corporation banks and holding companies, year-end tax planning provides a good time to perform some S corporation due diligence functions to ensure that all S corporation eligibility requirements are still being met. If shares were transferred during the year or new shareholders were added, it is important to review compliance with S corporation requirements, particularly if shares were transferred into trusts during the year. Care must be taken to be sure that IRS requirements, as well as Federal Reserve Bank rules, are complied with.