Dec. 19, 2016
By Sophia R. Schneider, CPA, and David A. Thornton, CPA
Throughout his campaign, President-elect Donald Trump emphasized the need to reduce U.S. corporate income tax rates in order to make America more competitive internationally. Within the past week, he announced several key appointments to the Department of the Treasury and other financial regulatory positions. These appointees, along with several key Republicans, have begun to discuss the prospects of enacting corporate tax reform legislation that would include reducing the current 35 percent top corporate tax rate to as low as 15 percent, with several other rates in between being considered. The House Ways and Means committee’s tax blueprint is similar in many regards to Trump’s campaign proposals. While there may be a great deal to overcome to see these proposals through to enactment, banks might want to consider the prospects of a 2017 corporate tax rate change as they consider their year-end 2016 tax planning.
The obvious tax planning consideration is that deductions claimed in 2016 will provide a 35 percent tax benefit, while those claimed in 2017 and later possibly could provide a benefit as low as 15 percent if the tax rate change is enacted next year. Likewise, income taxed in 2016 will generate a tax liability at 35 percent, while income taxed in 2017 and later possibly could be taxed at a rate as low as 15 percent. As a result, tax planning strategies aimed at accelerating deductions into 2016 and deferring taxable income into later years should be considered in light of the prospect of a 2017 corporate tax rate reduction.
Impact on Deferred Taxes
Tax rate changes often cause an immediate impact on the net deferred tax assets and liabilities presented in financial statements. The deferred tax inventory generally represents items of deferred taxable income and deferred tax deductions that have yet to be recognized on the tax return. These items are carried at the currently enacted corporate tax rate to be applied in the year these items are expected to settle and affect the then current tax liability. If a corporate tax rate reduction is enacted, the deferred tax inventory that currently is carried at 35 percent is immediately adjusted to be carried at the new rate, which is proposed to be as low as 15 percent.
For banks, the adjustment to the deferred tax inventory that would result from a corporate tax rate reduction likely would be recorded as a financial statement loss because most banks have fairly sizable deferred tax assets from the deferral of tax deductions represented by the financial statement allowance for loan losses. When deferred tax assets currently recorded at 35 percent are reduced to be carried at a lower enacted tax rate, a loss is recorded through income tax expense. This is so even for deferred tax assets that originally were recorded through other comprehensive income. The loss from the remeasurement of deferred tax assets at a lower rate may have a direct impact on the bank’s regulatory capital.
Planning for the Change
The basic tax planning used with income deferral and accelerated deductions is the same strategy used to mitigate the loss of accumulated deferred tax assets when a tax rate reduction is enacted. If deferred tax assets are monetized or deferred tax liabilities are increased prior to the effective date of the tax rate reduction, the financial statement benefit of the higher tax savings will be preserved. The available planning strategies generally can be segregated into two categories: 1) those that must be executed before year-end and 2) those that can be executed after year-end but before the tax return for that year is timely filed.
There are two drawbacks associated with tax planning strategies that must be executed prior to year-end in order to take advantage of a potential 2017 tax rate reduction. First, the execution of these strategies might result in some level of recognized financial statement losses that would need to be weighed against the tax benefit of the accelerated deduction. Second, the prospect of a corporate tax rate reduction in 2017 still is highly tentative, so there is risk that any large-scale tax maneuvering might be premature if the tax rate change occurs in later years or not at all.
Tax planning strategies that must be executed before year-end include:
- Selling loans, securities, other real estate owned, and other assets at a loss (provided the loss is not substantially limited by an IRC Section 382 limitation)
- Accelerating loan charge-offs (however, there is no net financial statement tax benefit if the allowance for loan losses is replenished through additional provision)
- Modifying the bonus plan for the current year to ensure that the bonus is fixed at year-end and not subject to post year-end approval or forfeiture (but watch for any impact of such a change on the exemption of the bonus payment from the IRC Section 162(m) limitation)
Additionally, several highly effective tax planning strategies are based on tax return elections that can be made all the way up until the timely filing date for the tax return, which can be as late as the 15th day of the ninth month after the close of the year if the tax return is properly extended. The benefits of these strategies are twofold. First, these strategies rarely produce any negative impact on financial statement income because they deal primarily with the timing of income or loss for tax return purposes. Second, the extended time period for considering these strategies offers more time to determine the likelihood of successful tax reform legislation being passed before the strategies are executed.
Tax planning strategies that can be executed after year-end but before the tax return for that year is timely filed include:
- Claiming bonus depreciation and accelerated tax depreciation
- Performing a cost segregation analysis of current-year construction projects or those completed in recent years to currently or retroactively accelerate tax depreciation on those assets
- Making payment on 2016 accrued contributions to qualified pensions and benefit plans
- Adopting the bad-debt conformity election if doing so would enable a reduction to the otherwise taxable amount of nonperforming loan interest
- Adopting a favorable tax accounting method to currently deduct loan origination costs if one is not already in place
- Adopting a favorable tax accounting method to currently deduct qualified short-term prepaid expenses if one is not already in place
Another potential tax pitfall of a corporate income tax rate reduction that banks should consider is the reduced benefit of tax-exempt municipal securities and loans that likely would result. The value of these assets likely will fall if their coupon rate does not adjust with reductions to the corporate income tax rate. Losses on sales of municipal securities held by nonbank affiliates (such as bank subsidiaries and holding companies) generally are capital losses and therefore the tax benefit of these losses might be difficult to realize unless readily identified sources of offsetting capital gains are available. This challenge could result in valuation allowances recorded against the tax benefit associated with the losses through the income statement.
Preparation Is the Secret to Success
While the incoming administration has expressed an interest in reducing the current 35 percent top corporate income tax rate to as low as 15 percent, those discussions are only tentative at this point. Nevertheless, it is not too early for banks to begin planning for the prospects of such a rate reduction and analyzing its impact. Every taxpayer is unique and needs to evaluate its available planning opportunities in conjunction with other nontax considerations.