What the new Wisconsin tax exemption means for your bank's deferred tax asset
On July 5, 2023, the Wisconsin 2023-2025 budget was approved. It includes an exemption from taxation on commercial and agricultural loan income for banks doing business in Wisconsin.
Under the new rule — which is effective for tax years beginning after December 31, 2022 — banks are allowed to exempt from state taxation loan income from commercial and agricultural loans of $5 million or less where the borrower resides or is located in Wisconsin.
While there remain unanswered questions related to the eligibility of certain loans, the impact of the new rule could be significant for many Wisconsin-based banks. From preliminary discussions, it appears that many Wisconsin banks believe the impact of the rule will eliminate state taxable income in 2023 and in subsequent years. Although this is good news overall, given the potential for no future state taxable income, banks will need to analyze the realizability of the state portion of their deferred tax asset.
Below are some common questions Wipfli has received from Wisconsin banks on the accounting implications related to the new tax rule and the answers as of the date of this article:
Can you give me a quick reminder on accounting for the deferred tax asset (DTA)?
A DTA represents the estimated future tax benefit impacts that are related to temporary timing differences between reporting for book and tax purposes. The DTA is recorded at the tax rate that is expected to be in effect when the DTA will be utilized, which is generally based on current federal and state rates in effect. DTAs must be evaluated for impairment considering positive and negative evidence. A DTA is considered impaired when it is unlikely that the company will be able to fully realize the associated tax benefits.
Our bank has evaluated the new tax rule and believes our taxable state income will be zero this year and in future years. Do we need to record impairment against the state portion of our DTA?
Yes. If you do not anticipate generating state tax income in future years, the recorded DTA will not have value, and the bank should recognize a valuation allowance for the amount that is not expected to be realized.
If you don’t believe the rule will fully eliminate state tax income in future years, the impairment analysis may be different.
If we believe our state DTA has suffered impairment, when should the impairment be recorded?
According to ASC 740-10-25-47, “The effect of a change in tax laws or rates shall be recognized at the date of enactment.” While it’s certainly reasonable to take your time to evaluate the expected impact of the new tax rule, the evaluation should be performed as of the date of the change in tax law (which in this case is July 2023).
The same is true for the calculation of the current state tax liability. Many calendar year-end Wisconsin banks likely overaccrued for current state expense during the first half of 2023. It would be appropriate to reevaluate the state tax accrual, considering the expected benefit from the new tax rule.
If our DTA is impaired, how does that impact our financial statements?
According to ASC 740-10-45-15, “When deferred tax accounts are adjusted … for the effect of a change in tax laws or rates, the effect shall be included in income from continuing operations ….” In other words, the valuation allowance for the DTA is recognized through income tax expense in the current period.
We have a DTA related to unrealized losses on AFS securities. Do we recognize the impairment on this portion of the DTA differently?
No. As detailed in the previous question, ASC 740-10-45-15 applies to all deferred tax accounts, including the DTA related to unrealized losses on AFS securities (even though unrealized losses on AFS securities run through other comprehensive income, rather than through net income). This means any write down of the state DTA related to unrealized losses will need to be recognized through income tax expense.
This is consistent with happened back in 2017 and 2018 when many banks had to reevaluate the deferred tax asset in light of the Tax Cuts and Jobs Act reducing the corporate federal income tax rate. You may recall that the FASB issued Accounting Standard Update 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, to provide relief for “stranded tax effects” that would have otherwise arisen in accumulated other comprehensive income (AOCI).
This standard was issued to address some of the reporting challenges that resulted from the need to write down the DTA related to unrealized losses through income tax expense specifically as a result of the Tax Cuts and Jobs Act. However, this accounting standard does not provide the same relief for other tax law changes that result in stranded tax effects, including the Wisconsin tax law change.
What is a stranded tax effect, and how does it “go away?”
One example of a stranded tax effect results when changes to DTAs are recognized in net income even though the underlying temporary differences generating the DTA are recognized in other comprehensive income.
In the above example, the recognition of a DTA valuation allowance for the Wisconsin income tax benefit is charged to income tax expense (net income), while the change in unrealized gain or loss on securities available for sale was previously recognized in other comprehensive income. This amount will become a reconciling difference when comparing the calculated after-tax unrealized loss remaining in AOCI to what is actually recognized in the trial balance.
In practice, banks can elect one of two methods to release the stranded tax effects through an offsetting entry to income tax expense: 1) release the amount of the stranded tax effect allocated to each applicable security when the security is disposed of (the “security-by-security approach”) or 2) release all of the stranded tax effect when all available-for-sale securities are disposed of (the “portfolio approach”).
Contact your accountant to determine the impact this accounting may have on your specific situation.
How Wipfli can help
Wisconsin banks should evaluate the expected impact of the new tax rule and recognize appropriate valuation allowances to the DTA during the period when the law became effective. Any DTA impairment, including the portion related to unrealized losses on AFS securities, should run through current year income tax expense.
If you need assistance in evaluating the impact on your bank, contact Wipfli for help. Our accounting professionals are experienced in this area and can help.
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