“Relax!” Famous words from Green Bay Packers quarterback, Aaron Rogers. Although that was a couple of years ago, the Packers were probably legitimately worried last weekend. But you should not worry needlessly. This year, we should focus on this term, RELAX, as it relates to all of the news coverage about banks writing down deferred tax assets, assuming corporate tax rates decrease with the new administration set to take the reins in a few weeks. While this is written in the context of community banks, it applies equally to all C Corporation businesses, and the tax planning ideas apply to all of us.
The impact of a tax rate decrease is two-fold. First, there is the impact on the deferred taxes of an entity. If that entity has more future deductions than deferred income, it is typically in a deferred tax asset (DTA) position. For simplicity, let’s assume a bank has only one temporary difference: its allowance for loan and lease losses (ALLL). In many instances, the ALLL for book purposes is greater than the tax reserve, if any.
Based upon the September 30, 2016 call report data for community banks, the average Return on Assets (ROA) is 1.06%; the average loans to total assets is 69% and the average ALLL to total loans is 1.23%. These numbers are the basis for the calculations below.
Assuming that I have a $1 billion bank, and based upon the assumptions above, the ALLL would be $8.5 million. This amount would also represent the cumulative amount of deferred deductions for tax purposes, as large banks (with assets more than $500 million) are not allowed to use the reserve method for bad debts for tax purposes. Let us also assume a 35% federal tax rate.
The accumulated book ALLL will be deductible for tax, but usually not until the loans are actually charged off, creating a temporary difference of $8.5 million that may be deductible in the future. This disallowed deduction creates more taxes payable today or in recent past years, at the tax rates in place at the time (current taxes payable). So you would pay additional tax on this deferred deduction at 35% as the book expense is not deducted for tax purposes. This would result in a federal deferred tax asset equal to $3 million ($8.5 million at 35%). This asset would be evaluated based upon the company’s expectation to realize this tax benefit in the future. Assuming that it is “more likely than not” to realize this benefit, the company would have a DTA of $3 million based upon today’s enacted rates.
What happens if you paid the tax at a higher rate, but then, before the tax expense becomes deductible, the tax rates decrease? This is not a good deal for taxpayers, as they paid tax on taxable income in a higher tax rate year, and now will recover those deductions at a lower tax rate. Under the accounting codification ASC 740, a company is required to re-assess the value of these future deductions when tax rate decreases are enacted, and write down the deferred tax asset based upon the enacted tax rates. Assuming that the corporate tax rate decreases by 10%, our example company would be facing a deferred tax write-down of $850,000 (the $8.5 million temporary difference now valued at 25%, vs. 35% prior to the enactment of lower tax rates). That is the downside of the tax rate decreases, and much is being made about this impact in articles and other commentaries. See “Trump Tax Cut Means Billion-Dollar Writedowns at Banks”; https://www.bloomberg.com/politics/articles/2016-11-30/trump-s-tax-cut-means-billion-dollar-writedowns-for-u-s-banks.
But, shouldn’t tax rate decreases be a good thing? Indeed. The other part of this story is that companies should enjoy a decrease in their current tax expense prospectively on any taxable earnings. As a company’s earnings are subject to lower tax rates, it will be able to accrue less income tax expense, and enjoy higher earnings. If a company has book income in the first year after the tax rate decrease, adjusted for permanent tax differences (i.e., tax exempt interest) of $16 million (based upon our ROA assumptions above), and that income is taxed at 25% rather than 35%, current tax expense will be $1.6 million less. This is the upside of the lower tax rates. In this example, the bank recovers the initial writedown of its DTA in just over six months. This is the good news about a tax rate decrease. Are you feeling relaxed yet?
- Any institution with significant deferred liabilities, due to purchase accounting adjustments, accelerated depreciation, servicing portfolios, etc. will enjoy the write-down of this deferred tax liability in a rate-decreasing environment, providing at least a much quicker earn-back of the deferred tax asset write-down.
- Each company’s tax situation is unique. In addition to purchase accounting, other significant temporary differences that will impact your deferred taxes include:
- Loan servicing assets
- Depreciable fixed assets
- Lease portfolio
- Available for Sale (AFS) securities
- Deferred compensation accruals
- Book expense for non-qualified stock options or restricted stock awards
Adjustments to deferred taxes through tax rate changes will impact your regulatory capital. Any adjustment to the deferred taxes upon enactment of rate cuts will be an immediate adjustment for financial reporting and likely for regulatory capital calculations. The recoupment of this charge through lower current tax expense will accrue over time as the bank has earnings.
All taxpayers should consider ways to accelerate tax deductions for a lower rate environment, and defer taxable income with the prospect of lower corporate tax rates. A sample of strategies might include:
- Sell AFS securities that have unrealized losses for tax purposes
- Accelerate fixed asset purchases and take advantage of Section 179 deductions and / or bonus depreciation
- Consider benefits of cost segregation for branches and other tangible property
- Deduct expenses as allowed under recurring item exception election (prepaid items)
- Review incentive compensation plans and consider accelerating deductions under “all events” and “economic performance” standards
A tax rate decrease may require an initial charge for writing down your DTA, but the ongoing benefits of the rate decrease will be good in the long run.
The tax impact will only be recorded once legislation is enacted. This said, you should model some scenarios currently, so that you can plan effectively.
It is still too early to know what shape tax reform will take in 2017. Will we see action in the first 100 days? How comprehensive will the tax reform legislation be? We will start to see this legislation take shape in the near future. Some actions may be warranted between now and year end, in contemplation of lower tax rates in either 2017 or 2018. Others (cost segregation) may be available after year end, but before you file your 2016 tax returns.
It is going to be an interesting few months, so try to RELAX.