Financial Statement Impact
While a tax rate reduction is beneficial long term, the immediate impact will likely be a charge to the income statement for most banks. This is because a net deferred tax asset (“DTA”) carried on the balance sheet must be re-measured to carry the DTA at the lower enacted tax rate that will be in place when the DTA is realized.
- Banks often have a sizeable net DTA due to the allowance for loan losses. The re-measurement of either a net DTA, or a net deferred tax liability (“DTL”), is recorded through income tax expense in the quarter that the rate reduction is enacted.
- DTAs and DTLs originally recorded through Other Comprehensive Income are also re-measured through income tax expense (not through OCI).
- For most banks, the initial hit to equity from a net DTA reduction will eventually be offset by the benefit of lower taxes on future income. If the enacted tax rate reduction is only temporarily (i.e., sunsets after a number of years), the financial statement impact is more complicated.
- Requires the timing of the DTA and DTL reversals to be forecasted and the deferred taxes to be carried at the enacted tax rate in effect for the year of the forecasted reversal.
Tax Planning Strategies – Overview
If a legislated reduction in tax rates is expected, the general planning strategy is to:
- Accelerated tax deductions and claim them when tax rates are higher; and
- Defer taxable income into future years when tax rates are lower
- No tax benefit unless the planning results in a reduction to a pre-change tax liability (i.e., no benefit if it creates or increases an NOL carryforward)
Defer Gain Transactions
- These transactions may result in the deferral of pre-tax income in the financial statements. However, if these transactions are planned to take place in the near term anyway, it may be beneficial to defer them into the post-change year.
- Selling loans at a gain
- Selling securities at a gain
- Selling fixed assets at a gain
- Any other large taxable gain transactions
Accelerate Loss Transactions
- These transactions may result in the accelerated recognition of pre-tax loss in the financial statements. However, if these transactions are planned to take place in the near term anyway, it may be beneficial to accelerate them into the pre-change year.
- Selling loans, securities and fixed assets at a loss.
- Payout of special compensation.
- Accelerating charitable contributions up to 10% taxable income limitation.
Accelerate Recognition of Deferred Deductions
- These strategies require action to be taken before the end of the pre-change year and may be possible to implement without financial statement income impact.
- Charging off loans (but financial statement impact is nullified if the allowance is restored)
- Selling OREO properties that have been further marked down to FMV after foreclosure
- Securing current deduction for accrued employee bonuses
- For many, this may require modification of the existing bonus plan
- Public companies need to consider potential IRC 162(m) issues
Generate Advance Deductions
- It may be possible to accomplish these strategies with no impact to pre-tax income. Some permit action as late as the extended due date of the return and some require a formal request for change in tax accounting method (form 3115).
- Claim the maximum bonus depreciation and IRC Sec. 179 deduction available for fixed assets.
- Perform a “cost segregation analysis” of new and historical fixed asset construction projects to enable the cumulative effect of accelerated depreciation (Sec. 481 adjustment) to be recognized in the pre-change year.
- Maximize deductions for qualifying repairs.
- Make the maximum deductible pension/qualified plan contribution for the year by the time the tax return is filed
Impact of Rate Reduction on Municipals
- A tax rate reduction will likely decrease the relative value of existing fixed-rate tax-exempt municipals compared to existing fixed rate taxable bonds. A tax rate reduction will result in re-pricing of tax-exempt bond yields compared to taxable yields.
- Current investment decisions involving tax-exempt municipal bonds should consider the potential for a tax rate reduction.
Impact of Rate Reduction on BOLI
- A tax rate reduction will not necessarily impair the value of BOLI investments, as the underlying securities within the BOLI ncontract are often taxable obligations. However, the comparative benefit of BOLI related to other taxable investment alternatives may be diminished with a reduction in tax rates.
- Current investment decisions involving BOLI should consider the potential for a tax rate reduction.
Impact of Rate Reduction on LIHTC Investments
- A tax rate reduction will not impair the value of low-income housing tax credits (“LIHTC”) or other tax credits, as a tax credit is a dollar-for-dollar reduction in tax liability. However, many of these tax credit partnership investments are priced based upon a combination of the yield from tax credits and the tax benefit of operating losses.
- A tax rate reduction will diminish the tax benefit of operating losses going forward.
- A tax rate reduction could potentially result in some amount of immediate impairment of investment.
- Current investment decisions involving LIHTC and other tax credit partnerships should consider the potential for a tax rate reduction.
This is an excerpt from our 2017 Annual Community Bank Industry Tax Update.
About the Author
David joined YHB in 1999 after graduating from West Virginia University with a B.S.B.A. degree. A tax specialist who works in depth with his clients, his focus is on banks and closely held businesses of any size.