Community Banking Advisor: What’s the Impact of the Tax Cuts and Jobs Act on Community Banks?

Last year’s tax reform legislation — the Tax Cuts and Jobs Act (TCJA) — represents the most significant overhaul of the Internal Revenue Code in decades. Here’s a summary of the provisions that are most relevant to community banks.

Corporate Tax Rate Reduction

The TCJA lowers the corporate income tax to a flat 21% rate for tax years beginning after December 31, 2017. Previously, the corporate rate was 35% for the highest income bracket, with rates spiking as high as 39% at certain income levels. The act also repeals the corporate alternative minimum tax.

While it’s important to note that the TCJA will substantially reduce tax expenses for 2018 and future years, for many banks the act had a negative impact on earnings and regulatory capital for 2017. Why? The sharp reduction in corporate tax rates required these banks to reduce the values of their deferred tax assets at the end of the year.

S Corporation Benefits

For tax years beginning after December 31, 2017, and before January 1, 2026, the TCJA benefits banks structured as S corporations in two ways:

  1. It lowers individual income tax rates (the top rate is now 37%, down from 39.6%), thus reducing most owners’ taxes on their shares of pass-through income.
  2. It allows shareholders (including trusts and estates) to deduct 20% of their qualified business income (QBI) from the bank, subject to certain limitations.

Generally, QBI is a shareholder’s distributive share of the bank’s net income, excluding certain investment income and reasonable compensation paid to shareholders. The deduction is generally limited to 50% of W-2 compensation paid by the bank. But this limit doesn’t apply to owners with taxable income less than $157,500 ($315,000 for joint filers). Above those income levels, the W-2 wage limitation is phased in over a $50,000 range ($100,000 range for joint filers).

S Election Second Thoughts

Many community banks operate as S corporations, primarily to avoid the double taxation of C corporation profits: once at the corporate level and a second time when paid out as dividends to shareholders. But now that the gap between individual and corporate tax rates has substantially widened, it’s time to re-evaluate that strategy.

If your bank is currently organized as an S corporation, whether you would benefit by converting to a C corporation depends on your particular circumstances. Factors to consider include:

  • Your shareholders’ tax brackets,
  • The value of the 20% QBI deduction, and
  • Your dividend-paying practices.

In general, unless you’re contemplating a sale in the foreseeable future that would create substantial capital gains, there’s a good chance that converting to a C corporation would be less expensive (particularly if Congress doesn’t extend lower individual income tax rates and the 20% QBI deduction after 2025).

Limited Deduction for Interest

The TCJA imposes a new limit on net business interest expense deductibility: For 2018 to 2021, it’s generally capped at 30% of “adjusted taxable income,” which is similar to earnings before interest, taxes, depreciation and amortization (EBITDA). Beginning in 2022, adjusted taxable income will be similar to earnings before interest and taxes (EBIT).

Disallowed interest expense can be carried forward indefinitely. Businesses, including banks, with average annual gross receipts of $25 million or less are exempt from the new limit and may continue to deduct their interest expense in full. Some other taxpayers are also exempt. For example, some real estate businesses may opt out of the new limit in exchange for less favorable depreciation deductions.

Because the 30% limit applies to net interest expense, most banks won’t be affected directly. But the limit may have an indirect impact on a bank’s lending business — if its borrowers are unable to fully deduct interest payments on their loans.

Banks also might be affected by new limits on mortgage interest deductions. Previously, taxpayers could deduct interest on up to $1 million in acquisition debt on a first or second residence, plus up to $100,000 in home equity debt. For 2018 through 2025, the TCJA reduces the first limit to $750,000 (though it grandfathers in acquisition debt that originated before December 15, 2017) and eliminates the home equity interest deduction (though such interest might still be deductible in certain instances, depending on how the borrowed funds are used).

Phased-Out Deduction for FDIC Premiums

The TCJA phases out the FDIC premium deduction for banks with total consolidated assets between $10 billion and $50 billion, and eliminates the deduction for banks with assets of $50 billion or more. Banks with less than $10 billion in assets may continue to fully deduct FDIC premiums, however, so most community banks won’t be affected.

TCJA Impacts

These and other provisions of the TCJA will affect community banks — either directly or indirectly. Your Elliott Davis tax advisor can help you determine the act’s impact on your tax-planning efforts.

Sidebar: What Hasn’t Changed?

The Tax Cuts and Jobs Act also is noteworthy for what it didn’t change. Key proposals that didn’t make it into the final bill include:

  • Deferred compensation. Many community banks use nonqualified deferred compensation plans to enhance key employees’ retirement benefits. A provision that would have effectively eliminated the benefits of these plans was excluded from the final bill.
  • Bond interest. The House bill would have repealed the tax exemption for newly issued private activity bonds, but the final bill preserves the exemption.

In addition, despite intensive lobbying by community banking industry groups, the act preserves the tax exemption for credit unions and Farm Credit System lenders. But, fortunately for community banks, lower tax rates weaken the competitive advantage that these tax exemptions provide to credit unions and Farm Credit System lenders.