As the end of 2019 approaches, banks should consider their tax situation and evaluate potential planning opportunities. The Tax Cuts and Jobs Act (TCJA) introduced several new planning considerations, and other previously existing strategies are still relevant.
Depending on the outcome of the 2020 presidential and congressional elections, there is a possibility that the 21 percent corporate tax rate may increase. In addition, most of the individual tax law changes made by the TCJA, including the 37 percent top marginal rate and the 20 percent deduction for qualified business income under Internal Revenue Code Section 199A, will sunset after 2025 unless further legislation is enacted. These potential changes may create opportunities for “reverse” tax planning (accelerating income and deferring deductions) in the near future. While this should be closely monitored, most banks’ tax strategies for 2019 still involve accelerating deductions and deferring income.
Overall Accounting Method – Cash vs. Accrual
Prior to 2018, C corporation banks generally did not qualify to use the cash method of accounting unless their prior three years’ average annual gross receipts were less than $5 million. The TCJA increased this threshold to $25 million, allowing many previously ineligible banks to qualify.
Under the cash method, income is generally taxed when cash is received and expenses are deducted when cash is paid. Therefore, banks with accrued interest receivable exceeding payables may benefit from a net deferral of income under the cash method, and a potentially significant tax deduction in the year of change. Taxpayers qualifying under the $25 million gross receipts test can convert to the cash method by filing an automatic accounting method change (Form 3115) with the IRS. If the bank exceeds the $25 million average gross receipts threshold in the future, the unfavorable adjustment can be spread over four years.
S corporation banks generally qualify to use the cash method of accounting regardless of size (the gross receipts threshold does not apply).
For tax purposes, banks are subject to a special rule requiring them to allocate a portion of their interest expense to tax-exempt municipal bonds held. Depending on the type of bond, the allocated interest expense is either 20 or 100 percent nondeductible. Banks can avoid this disallowance by forming a nonbank investment subsidiary to hold municipal bonds. The investment sub is included in the consolidated federal tax return filed by the bank, and there is no effect on bank capital or the call report because it is a wholly owned bank subsidiary. There also may be tax savings in some states that levy a tax on the bank as a separate entity and do not require the inclusion of the investment subsidiary (such as the Missouri bank franchise tax).
Several other common tax planning strategies may present opportunities for banks:
- Fixed Asset Acquisitions: The TCJA provided generous fixed asset expensing opportunities, including 100 percent first-year bonus depreciation through 2022 and §179 expense of up to $1 million annually (adjusted for inflation). Under these provisions, most property purchased by banks will qualify for immediate expensing for tax purposes. If planning to make fixed asset purchases, banks should consider placing them in service before year-end to accelerate the tax deduction.
- Prepaid Expenses: Taxpayers may elect to deduct rather than capitalize qualifying prepaid expenses, such as certain insurance and maintenance contracts, that do not extend beyond 12 months. The cumulative balance of qualifying prepaids may be deducted in the year of change.
- Cost Segregation Studies: A cost segregation study is an engineering-based study that breaks out the components of a building in order to take advantage of shorter depreciable lives and first-year bonus depreciation, if applicable. Taxpayers may undertake a study on existing buildings and file an accounting method change to implement the new asset treatments, with the cumulative difference in accumulated depreciation taken as a deduction in the year of change.
- State Nexus Planning: Many states now impose economic nexus standards, which may require an entity to pay tax on income derived from a state even if it does not have a physical presence there. A nexus study analyzes the bank’s activity and identifies each state where there may be exposure. If there is exposure for previous years, most states have voluntary disclosure agreement (VDA) programs in which the taxpayer can come forward—often anonymously—and agree to file returns and remit taxes owed for prior years. In return, the state agrees to limit the lookback to a certain number of years and waive penalties for late filing.
As the year draws to a close, banks should consult their tax advisor to discuss their specific tax situation and whether they may benefit from any of the planning opportunities covered above. While tax deferral strategies may be appropriate for the time being, banks should re-evaluate each year with the possibility of further tax law changes in the future.