Reverse Tax Planning for C Corporation Financial Institutions
As financial institutions look to provide their shareholders the best return of capital, a potential tax rate increase under President Biden is looming. Before examining the effects of the Biden tax proposals, let’s revisit the effects of the Tax Cuts and Jobs Act (TCJA) under the Trump administration.
The passage of the TCJA brought a reduction in the corporate income tax rate. Many taxpayers, including financial institutions, implemented various tax planning strategies for tax year 2017 to accelerate deductions and defer income taxed at a higher income tax rate. For corporations that saw the top corporate rate of 35 percent move to a flat rate of 21 percent, the revalue of deferred taxes for some institutions was a significant one-time tax expense. By accelerating certain deductions into 2017, banks were able to soften the blow to their earnings.
The Biden administration seeks to undo some of the favorable provisions of the TCJA. The Biden tax proposal originally included a corporate income tax rate increase to 28 percent. Most recently, the House Ways and Means Committee proposed the return of a graduated corporate tax structure as follows:
- 18 percent rate on taxable income not over $400,000
- 21 percent rate on taxable income over $400,000 but not over $5 million
- 26.5 percent rate for taxable income over $5 million
To phase out the benefit of the lower rates, the proposal includes an additional 3 percent surtax for taxpayers with taxable income greater than $10 million (up to a maximum additional surtax of $287,000).
The potential tax rate increase now provides the inverse of the tax planning strategies that were considered for 2017. This brings about reverse tax planning as an opportunity for financial institutions.
Reverse tax planning provides for recognition of income now at the lower tax rate and deferring deductions into tax years where the tax rate is higher. This type of planning affects the corporation’s net income, as recognizing more taxable income currently will increase an institution’s deferred tax asset (or decrease its deferred tax liability). Since deferred tax assets and liabilities are calculated using the future tax rate, this will provide a one-time boost to the income statement via an income tax benefit to record.
Although there are multiple ways to achieve the objective of reverse tax planning, some are administratively easier than others, while others require the filing of Form 3115 to report a change in accounting method to the IRS. Below is a brief summary of several considerations.
- Electing out of bonus depreciation: Electing out of bonus depreciation will increase taxable income and defer the depreciation deduction on fixed assets placed in service into future years when the tax rate is higher.
- Cost segregation studies: Cost segregation studies allow for taxpayers to carve out components of a newly acquired or constructed building or renovations into shorter tax lives than that of the building (39 years). Banks may want to consider delaying the completion of a cost segregation study to deduct the additional tax depreciation in a tax year with a higher tax rate. Form 3115 is required to deduct this additional depreciation.
- Electing out of the accelerated prepaid deduction: For institutions currently accelerating the deduction of eligible prepaid expenses, electing out of this treatment will defer the deduction into future years. Form 3115 is required in order to change this accounting method.
- Recognition of loan fees: Banks may defer loan origination fees over the life of the loan for tax purposes. The bank may consider changing its method of accounting to cash basis and recognize these fees when received. Form 3115 may be required to be filed, under advance consent procedures, to take advantage of this opportunity.
- Accrued expenses: Institutions may want to consider delaying payment of certain accrued expenses that are typically paid within two and a half months of the end of the fiscal year. Delaying payment will increase taxable income and provide a higher deduction in future years. In the first tax year with higher tax rates, the bank may want to consider accelerating these same payments or ensuring certain payments are fixed and determinable at year-end, which would allow for deductibility of two payments in one year. An area of consideration is revisiting bonus policies.
As financial institutions consider various tax positions, it’s important to understand how these may affect deferred taxes and the related revalue in the event of an income tax rate change. By considering certain tax strategies, financial institutions may see a direct effect to improve their bottom line.
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