For nearly a decade, talk about rising interest rates stayed largely in the background for banks. When rates did increase in 2022 to levels not seen since 2007, it caused more urgency for banks to focus their attention on the tax implications. Besides a larger tax savings due to the increase in expenses, what else does a rise in the cost of funds mean for tax purposes?
The Internal Revenue Code provides banks with the ability to deduct only a portion of their interest expense when they have investments in tax-exempt securities or municipal loans. The haircut is commonly referred to as the TEFRA adjustment, with TEFRA short for the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The law allows only banks to deduct 80% of their interest expense when investing in bank-qualified, tax-exempt securities. If the entity is not a bank, then the taxpayer is not allowed to take an interest expense deduction when they use debt-to-purchase, tax-exempt investments.
TEFRA impact grows
When the cost of funds was low for so long, the TEFRA adjustment didn’t have a significant impact on a bank’s fully tax equivalent yields. However, it has become more meaningful when evaluating the yield on your tax-exempt bonds. When you are evaluating the yield on the tax-exempt securities, don’t forget to include the TEFRA impact.
The Internal Revenue Code allows small taxpayers to be on the cash basis for the tax return. Until the Tax Cut and Jobs Act (TCJA) of 2017, the definition of a small taxpayer was those entities with three-year average gross receipts of less than $5 million. TCJA increased the threshold to $25 million and it is indexed for inflation. The threshold for 2023 is now $29 million.
The cash basis of accounting is normally advantageous for banks as it provides the biggest opportunity to defer income. The deferral happens because the accrued interest receivable on loans and securities is usually greater than the accrued interest on deposits. As banks reprice the rates on their loans, the amount of revenue will increase, and the additional gross receipts will need to be monitored to ensure the small taxpayer definition can be maintained. In addition, the accrual to cash adjustment could be greater if loans are repriced quicker than the deposits.
Bond sale rule
In addition to the TEFRA adjustment for banks, another special rule is Internal Revenue Code 582(c)(1) which allows the sale of bonds, debentures or certificates held by banks to be considered ordinary assets and not capital assets.
If the bank were to sell a bond at a loss, it does not have to offset the loss against capital gain income. The loss will reduce its regular taxable income. If the bank must incur the loss, at least the loss can be used to offset other operating income.
The Internal Revenue Code has several items that are tied to interest rates. One of those tests is Internal Revenue Code Section 382, which limits the net operating-loss (NOL) carryforwards of a corporation when there is a change in ownership. The ownership change needs to be greater than 50% for shareholders that own more than 5% of the company over a three-year period.
The rules limit the amount of NOL that can be used each year going forward based on the value of the company at the change of ownership multiplied by the adjusted federal long-term, tax-exempt rate. The rate has gone from 1.51% in April 2021 to 3.04% as of April 2023. The increase in the interest rate means that the acquirer of a bank which has net-operating-loss carryforwards will get to use more of the target’s NOLs each year.
How Wipfli can help
Amid rising interest rate increases, your tax strategy may change. Wipfli’s team has the experience to ensure your financial institution is taking full advantage of tax savings in the current environment. Contact Wipfli to learn how we can help your financial institution navigate the challenges ahead through our proactive tax services.
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