Tax Cuts & Jobs Act Implications for Banking Institutions

Polsinelli PC. In California, Polsinelli LLP
Tax Cuts & Jobs Act Implications for
Banking Institutions
Presented by Polsinelli PC
April 12, 2018
1

real challenges. real answers. sm
Presenters
Bill Sanders
Shareholder and
Practice Chair of
the Tax Group
(Kanas City)
Philip Feigen
Shareholder and
Practice Chair of
the Banking and
Financial
Institutions Group
(Washington, D.C.)
Erik Edwards
Of Counsel in the
Tax Group (Kanas
City)
2

Federal Legislative Update
 Congress orders Dodd-Frank cost review
 State of play: Banking regulatory overhaul
3

Overview of the Major Tax Act Provisions
Affecting the Banking Industry
 Rate Reductions including Choice of Entity and Deferred Tax Asset
Account Impacts
 Qualified Business Income (“QBI”) Deduction
 Interest Expense Deduction Limitation
 Changes to Depreciation and Expensing
 Dividends Received Deduction Decrease
 NOL Limitations
 Excise Tax on Wages over $1 million (Section 162(m))
 Limitation on Deductibility of State Taxes
 Further Limits on Deductibility for Meals, Entertainment and
Employee Parking
 Choice of Entity – To be and S or not to be an S – That is the
question
4

Rate Reductions
 37% Top Individual Rate (40.8% including net
investment income tax)
• Prior maximum was up to 45%
 29.6% Effective Rate on Business Income From Pass-
Throughs Eligible for Full 20% Deduction (33.4%
including net investment income tax)
 21% C Corporation Tax Rate Reduced to Flat 21%
• Qualified Dividends still subject to shareholder
level tax of up to 23.8%
• Overall effective federal tax rate of 39.8% for
earnings if distributed (down from 50%)
 23.8% Capital Gains Tax Rate Did Not Change
5

Impact on Deferred Tax Asset Account
 U.S. Bank’s suffered a 40.9% drop in profits
during the fourth quarter of 2017 compared to
the same quarter a year ago
 The FDIC indicated this drop was due largely to
one-time changes from the new tax law
 Revaluations of Deferred Tax Asset Accounts
due to the C Corporation rate reduction and the
new mandatory repatriation tax on income from
foreign subsidiaries
6

Qualified Business Income (“QBI”)
Deduction
 20% deduction for flow-through income
 Limited to the greater of:
– 50% of W-2/wages paid or
– 25% of W-2/wages paid plus 2.5% of the cost of
tangible depreciable property for qualifying
businesses
 Subject to certain limitations and phase-outs
 Aggregation issues
7

Deduction, cont’d
 Allows individual taxpayers to deduct 20% of domestic
“qualified business income” (QBI) from a partnership, S
corporation, or sole proprietorship (“qualified
businesses”) subject to certain limitations and
thresholds.
 “Qualified businesses” do not include “specified service
trade or businesses” (accounting, law, health, several
other professions, service businesses related to
investing, and financial services) but engineering and
architecture trades are not excluded.
8

Deduction, cont’d
 “Financial services” versus “banking”
 “specified services” are explicitly defined under IRC
Section 1202(e)(3)(A), and include:
– “…any trade or business involved the performance of services in the
fields of health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage services, or any trade
or business where the principal asset of such trade or business is the
reputation or skill of 1 or more of its employees…”
 IRC Section 1202(e)(3)(B) addresses “any banking,
insurance, financing, leasing, investing, or similar
business”
9

Interest Expense Deduction Limitation
 Across the board limitations on the deductibility
of business interest expense.
 Real property and farming trades or businesses
can make an irrevocable election out of the
business interest deduction limitation. These
businesses must then use the alternative
depreciation system to depreciate property with
a recovery period of 10 years or more.
10

Interest Expense Deduction
Limitation, cont’d
 In common parlance, this limitation is described as
limiting the deduction of net interest expense to the
extent of 30% of “adjusted taxable income” where:
– For the first four years, “adjusted taxable income” is EBITDA
(computed on a tax basis); and
– Later, “adjusted taxable income” is 30% of EBIT.
11

Interest Expense Deduction
Limitation, cont’d
 While there is no bank-related exception to this limitation, Code
Section 163(j)(1) contains a bank-friendly provision. Section
163(j)(1) sates that the amount allowed as a deduction for
any taxable year for business interest shall not exceed the sum of:
– the business interest income of such taxpayer for such taxable year,
plus
– 30 percent of the adjusted taxable income of such taxpayer for such
taxable year, plus
– Certain floor plan financing interest .
 “Business interest income” is the amount of interest includible in the
taxpayer’s gross income for the taxable year which is properly
allocable to a trade or business. “Trade or business,” for this
purpose excludes certain specific items, none of which relate to
banking.
12

Immediate Expense Deduction and
Section 179
 Immediate expensing of tangible property placed in
service between September 27, 2017 through 2022.
 5 year phase-out: 80% expensing in 2023, 60% in 2024,
etc.
 Applies to new and used property so long as it is
purchaser’s first use of the property.
 Applies to tangible property with 20 year depreciation or
less.
– Cost segregation worth more
– Asset purchases more valuable
– Purchase price allocations more important
13

Section 179, cont’d
 There were four categories of improvements to the interior of
nonresidential buildings: leasehold improvements, retail
improvement property, restaurant property, and qualified
improvement property.
 Now, there is only one general definition, “qualified improvement
property.”
– Includes most interior improvements made after real property is place in
service
– Supposed to get 15 year depreciation, but may have been inadvertently
left out.
– Qualified improvement property: normal is 15 years, ADS should be 20
years, but may have been erroneously omitted. Result unclear
 Error means property could be subject to lengthy depreciation, and
could also disqualify this property from immediate expensing
14

Section 179, cont’d
 Prior law allowed immediate deduction of $510,000 in
purchases of qualified property in 2017, so long as total
purchases did not exceed $2,030,000
– Qualified property is tangible personal property (not real estate,
except as described below)
 New Law increases the deduction to $1,000,000 with
purchase limit of $2,500,000 (both indexed for inflation)
 Includes Qualified Improvement Property, roofs, HVAC,
fire and security
15

Dividends Received Deduction Decrease
 Corporations may still deduct 100% of dividends
received from a corporation that is part of an affiliated
group (generally where the taxpayer owns 80% of the
corporation paying the dividend).
 Deduction is reduced to 65% (from 80%) where the
taxpayer owns at least 20% (but less than 80%) of the
corporation paying the dividend.
 Deduction is reduced to 50% (from 70%) where the
taxpayer owns less than 20%.
16

NOL Limitations
 Corporate net operating loss carrybacks are eliminated.
 Net operating losses carryforward indefinitely but are
limited to 80% of taxable income.
 Technical Correction Possible:
– The new 80% deduction limit is effective for losses arising in tax
years beginning after Dec. 31, 2017 but the Tax Act made the
changes to carrybacks and carryforwards effective for tax years
ending after that date.
– For fiscal year companies with 2017 taxable years ending after
Dec. 31, 2017, this results in an unexpected problem if they have
incurred significant losses they were hoping to carryback.
17

Excise Tax on Wages over $1 million
 All compensation paid to a “covered employee” (with a broader
definition) in excess of $1 million would be nondeductible,
including post-termination and post-death payments, severance,
deferred compensation and payments from nonqualified plans.
 Expanded from just public companies to certain privately-held
corporations not publicly traded but with public debt and foreign
companies publicly traded through American Depository
Receipts.
 The Section 162(m) exception under for qualified performance-
based compensation and commissions is eliminated. This is a
significant change for companies that have traditionally had
compensation programs designed in a manner to meet the
requirements of the performance-based exception.
18

Limitation on Deductibility of State Taxes
 Individuals are limited to state and local tax deductions
at $10,000 (property plus choice of income or sales
taxes, as under old law).
 Taxable entities are not subject to these limitations.
 Implications for flow through state and local income
taxes.
19

Further Limits on Deductibility for Meals,
Entertainment and Employee Parking
 No deduction for entertainment expenses
 Meals provided for convenience of
employer are now only 50% deductible
even if excludible from employees’ gross
income as de minimis fringe benefits
 Employee parking costs no longer
deductible
20

Choice of Entity – To be and S or not to be
an S – That is the question
 Historical role of S and C corporations in the Banking
Industry
 Cumulative Impact of New Tax Law Changes on the
Choice of Entity
 Analysis and Case Study of an Community Bank and its
Decision on Conversion
 The 10 year Hang Over Effect of Converting From an S
corporation to a C corporation
 Washington and the Dilemma of Future Uncertainty
21

Historical Role of S and C Corporations in
the Banking Industry
 As of September 20, 2017, about 1/3rd of all banks
throughout the US were S corporations
 A vast majority of these are banks with assets under $1
Billion.
22

Cumulative Impact of New Tax Law
Changes on the Choice of Entity
 Historically, the tax code has been biased
toward operating in pass-through form, but the
Tax Act significantly reduced the disparity in
effective tax rates.
23

Changes on the Choice of Entity, cont’d
 Examples of businesses that may want to incorporate:
– Businesses that reinvest most of their earnings. Corporate tax
rate is now 21% whereas pass-through income is taxed at 29.6%
to owner if a full QBI deduction is available, and 37% if no
deduction is available.
 E.g., assets light and labor light businesses; high tech
business
– Business whose shares may qualify as Section 1202 “Qualified
Small Business Stock”
– Businesses that can make use of nonqualified deferred
compensation.
– C Corporations with foreign sales or who own foreign
subsidiaries.
24

 CAVEAT: Once a business chooses to incorporate,
changing back to pass-through form may cause gain
recognition.
– Corporation to partnership (legal partnership or LLC taxed as
partnership): Gain recognized as if assets sold at fair value.
– C Corporation to S Corporation:
– All shareholders must be eligible shareholders.
– One class of stock rule.
– Corporate tax is levied on asset sales within 5 years of the
election to the extent that unrealized built-in gains existed on the
election date.
– Accumulated earnings remain subject to double tax.
25

 Examples of businesses that may wish to be organized
in or remain in pass-through form:
– Businesses that distribute most of their earnings. Effective federal tax
rate to corporate shareholders is 39.8% whereas pass-through effective
rate is 29.6% if a full QBI deduction is available. (E.g., asset intensive
and labor intensive businesses.)
– If no QBI deduction is available, individual rate is 37%, which is still ~
3% lower than effective rate to shareholders, assuming NII tax doesn’t
apply – otherwise rates are about the same (39.8% vs. 40.8%).
– Certain heavily leveraged businesses because it is easier for pass-
throughs (e.g., partnerships) to work around the new limitation on
interest deductions.
– S Corporations with foreign subsidiaries can avoid immediate inclusion
of tax deferred foreign earnings.
26

Analysis and Case Study of an Community
Bank and its Decision on Conversion
S Corporation
Old Law New Law
Corporate Tax
Pre-Tax Income 15,000,000 15,000,000
Corporate Tax - -
Net After Tax Income 15,000,000 15,000,000
Shareholder Tax
Shareholder Income 15,000,000 15,000,000
QBI Deduction - 3,000,000
Net Shareholder Income 15,000,000 12,000,000
Federal Income Tax 5,940,000 4,440,000
Net Investment Income Tax 570,000 570,000
Phase Out - Itemized Deductions 180,000 -
Sate Income Tax (6% assumed) 900,000 720,000
Federal Tax Savings for State Tax Ded'n (356,400) -
Total Income Taxes 7,233,600 5,730,000
Effective Combined Tax Rate 48.2% 38.2%
27

Analysis and Case Study of an Community
Bank and its Decision on Conversion, cont’d
C Corporation
Old Law New Law
Corporate Tax
Pre-Tax Income 15,000,000 15,000,000
Corporate Tax (Federal and State) (6,000,000) (3,900,000)
Net After Tax Cash 9,000,000 11,100,000
Shareholder Tax
Shareholder Income (Dividends) 9,000,000 11,100,000
Income Tax (Federal) 1,800,000 2,220,000
Net Investment Income Tax 342,000 421,800
Phase Out - Itemized Deductions 108,000 -
Sate Income Tax (6% assumed) 540,000 666,000
Federal Tax Savings for State Tax Ded'n (213,840) -
Total Shareholder Tax 2,576,160 3,307,800
Total Income Taxes 8,576,160 7,207,800
Effective Combined Tax Rate 57.2% 48.1%
28

S Corporation and C Corporation
Summary
Old Law New Law Old Law New Law
Pre-Tax Income 15,000,000 15,000,000 15,000,000 15,000,000
Corporate Tax - - (6,000,000) (3,900,000)
Net Corporate After Tax 15,000,000 15,000,000 9,000,000 11,100,000
Shareholder Tax (7,233,600) (5,730,000) (2,576,160) (3,307,800)
Net Individual After Tax 7,766,400 9,270,000 6,423,840 7,792,200
Effective Combined Tax Rates 48.2% 38.2% 57.2% 48.1%
S Corporation C Corporation
29

The 10 year Hang Over Effect of Converting
to a C Corporation
 S corporation to C corporation
– General five year prohibition against re-electing S
corporation status
 C corporation to S corporation
– Five year built in gains period
 S corporation to C corporation to S corporation
– General five year prohibition against re-electing S
corporation status followed by five year built in gains
period
30

Washington and the
Dilemma of Future Uncertainty
 OMB vs. Treasury
 Tax reform 2.0?
31

A Few Key Points
 Choice of Entity is now more complicated – certain provisions of the
tax bill favor corporate form, like the flat 21% tax rate and desire to
reinvest profits, while others, such as the 20% deduction of qualified
business income and distribution of profits, favor pass-throughs.
 M&A is likely to accelerate, and asset sales will be more important
because of new rule allowing immediate expensing of tangible asset
purchases.
 New provisions will require careful planning and coordination – new
limit on interest deductions, 20% deduction from taxable income of
pass-through businesses, new depreciation and immediate
expensing rules, etc.
32

Questions
Bill Sanders
Shareholder and
Practice Chair of
the Tax Group
(Kanas City)
Philip Feigen
Shareholder and
Practice Chair of
the Banking and
Financial
Institutions Group
(Washington, D.C.)
Erik Edwards
Of Counsel in the
Tax Group (Kanas
City)
33

Polsinelli provides this material for informational purposes only. The material
provided herein is general and is not intended to be legal advice. Nothing
herein should be relied upon or used without consulting a lawyer to consider
your specific circumstances, possible changes to applicable laws, rules and
regulations and other legal issues. Receipt of this material does not establish
an attorney-client relationship.
Polsinelli is very proud of the results we obtain for our clients, but you should
know that past results do not guarantee future results; that every case is
different and must be judged on its own merits; and that the choice of a lawyer
is an important decision and should not be based solely upon advertisements.
© 2018 Polsinelli PC. In California, Polsinelli LLP.
Polsinelli is a registered mark of Polsinelli PC
34

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