2017 was a year of significant changes for our country. With the start of a new year, one change on everyone’s mind is tax reform. The year 2018 comes with the promise of one of the largest overhauls of our tax system in many years. With the potential for significantly lower tax rates for businesses, there are several planning opportunities to be cognizant of when preparing your 2017 tax returns. This article will touch on a few of those opportunities, namely the following:
• Impact on Municipal Bonds
• Passive Versus Active Shareholder Treatment
• Accounting Method Changes
• Cost Segregation Studies
• Impact on Deferred Tax Inventory – C Corps
• C- Versus S-Corp Status
Impact on Municipal Bonds
Lower tax rates will directly impact a financial institution’s investment analysis of tax-exempt investments and tax-exempt loans, compared to taxable alternatives. Financial institutions should consider these lower tax rates when determining the tax-equivalent yield on these investments in the future. The tax-equivalent yield structure will be different for C corporations (utilizing corporate tax rates) versus S corporations (utilizing personal tax rates). Under either entity structure, the impact of lower tax rates should be considered when making efficient investment decisions.
Passive Versus Active Shareholders
Under the current law in place for 2017 tax filings, pass-through income is generally taxable to shareholders at ordinary income tax rates. Passive shareholders are also currently subject to an additional 3.8% Medicare tax, as well as passive loss limitation rules. In our past tax environment, being an active shareholder was most often preferable.
Tax reform, however, may give rise to a new way of thinking. Depending on what survives between the House and Senate versions of the tax bill, there could be tax breaks available for passive S-corporation shareholders. While the additional 3.8% tax and the passive loss limitation rules will still apply, these potential changes may warrant a closer look at shareholder status. The treatment of active versus passive is generally determined by the “material participation” rules. Any shareholder that may be on the fence should work with their tax advisor to determine if altering their activities in the upcoming years may put them in a more beneficial tax position. Shareholders whose status is determined by the active or passive nature of their trustee should also take a closer look, as well as any shareholders with passive losses from other activities. If the bank produces passive income for those shareholders, this may help to offset suspended losses, which can be a win-win if rates are favorable.
Accounting Method Changes
There are several accounting method changes that may be especially beneficial for your bank to file with your 2017 tax return. With lower tax rates expected, a deduction for these changes on your 2017 tax return could result in permanent tax savings.
If available, consider converting to the overall cash basis method of accounting. To have this method available, a C corporation must have gross receipts less than $5 million under the old tax law (this threshold may increase with tax reform). An S-corporation bank will have the option available, but must have gross receipts less than $50 million to qualify for a non-automatic change in accounting method with the IRS. The cash basis method of accounting allows a tax deduction when payment occurs and is especially favorable for banks. Making the change with your 2017 tax return could result in a large benefit.
Consider a review of your fixed asset schedules. Automatic accounting method changes are allowed by the IRS for several adjustments. The repairs and maintenance regulations that were put into place in 2014 resulted in favorable changes for many taxpayers. Also, it is not uncommon for tax depreciation schedules to have improper tax methods, improper tax lives, missed bonus depreciation, or contain fixed assets that are disposed of or eligible for partial disposition. If a review of your fixed assets has not been done recently, doing so now could have significant benefits. Many changes to your fixed asset schedules can be accomplished by filing an accounting method change (Form 3115) with the IRS while preparing your 2017 tax return. Also, see the discussion below regarding cost segregation studies.
There are several other advantageous accounting methods available to banks that can be explored, including those related to bad debts, nonaccrual loan interest, other real estate, loan origination fees and costs, mortgage servicing rights, and mark to market. Consult with your tax advisor to determine whether you are already taking advantage of these favorable accounting methods. If you are, no additional action is necessary. If you are not, automatic accounting method changes may be available for you to file with your 2017 tax return.
Cost Segregation Studies
A cost segregation study is an in-depth analysis of the costs associated with the acquisition, construction, or renovation of a building. The study generally results in additional accelerated depreciation deductions, thereby reducing income tax obligations and increasing cash flow. A cost segregation study done before your 2017 tax return is filed could result in permanent tax savings for your bank. A building placed into service during 2017 or a prior year may be a candidate for a study. This study can accelerate depreciation expenses by breaking out assets with shorter lives that may also qualify for bonus depreciation or Section 179 expensing. A study may also be done in conjunction with renovations to allow for a tax deduction for the partial disposition of certain components of a building or prior improvements. Often a cost/benefit analysis is available for no charge to determine whether a cost segregation study can benefit your bank.
Deferred Tax Inventory – C Corps
Tax reform may pose a significant risk to deferred tax assets (DTAs). When a rate reduction is enacted, all existing DTAs and DTLs (deferred tax liabilities) need to be adjusted to reflect the lower tax rates. The required adjustment for DTAs would result in a reduction to book income. If the reduction in rates comes with an expiration date, this could create more complication in determining the financial statement impact. We recommend that you consult your tax advisor to assist with this analysis. In the long run, most banks will see a benefit from lower taxes that will offset the initial hit to equity from a net DTA reduction, but be sure to discuss planning opportunities with your tax advisor to help minimize the short-term impact.
C- Versus S-Corporation Status
The status of C versus S corporations generally considers several factors, with tax rates playing a large part. Given the tax law in recent years, it generally made sense to be an S corporation to avoid double taxation. Upcoming changes in both corporate and individual tax rates should now be considered when analyzing the benefits of C versus S status. The changes related to taxation of pass-through income, as well as the treatment of active versus passive status of all shareholders may warrant the need for further analysis for your bank.
Lower tax rates provide a huge opportunity for tax planning. By accelerating tax deductions into years with higher rates and postponing taxable income into years with lower tax rates, permanent tax savings are available. With the potential for permanent tax savings, now is the time to work with your tax advisor to maximize the benefit to your bank. Contact your Wipfli relationship executive to learn more.