Tax reform could be a net positive for the banking industry, with an expected long-term boost to profits due to a significant cut in the corporate tax rate, from 35 percent to 21 percent. Its proponents believe that it will fuel the broader economy as well.
But despite the anticipated net gains, boards and management teams need to look at how tax reform will impact their organizations. Certain areas will be negatively impacted or warrant discussion to ensure the bank’s making the most of these changes. With that in mind, here are some of the topics your board should tackle in light of tax reform, and how it could affect your bank.
Initial Tax Hit
Tax reform just passed in late December, but many banks are already aware of its short-term downside, as the deferred tax assets on bank balance sheets, calculated based on a higher tax rate, have resulted in write downs on fourth quarter 2017 earnings. (Some banks have deferred tax liabilities on their balance sheets, which will positively impact earnings.)
These losses are expected to be recouped rather quickly. Kristine Hoeflin, a partner at Moss Adams LLP, recommends that banks quickly communicate this to shareholders and other stakeholders, so they understand that this is a one-time loss.
Impact on Compensation Plans
Under the new tax law, companies can no longer deduct executive pay above $1 million—a shift from the old law, which allowed companies to deduct performance-based pay in excess of $1 million. In another change, companies can’t deduct compensation surpassing $1 million for a departed named executive—the CEO, chief financial officer and three highest paid officers. “You can’t beat it by paying it out after they step down,” says Doug Faucette, a partner with the law firm Locke Lord LLP.
Banks still need to provide their executives with competitive compensation, so for most entities this will likely become just another cost of doing business—and with a lower tax rate, the scales still tip in the industry’s favor. However, a review of compensation plans is still warranted, and acquisitive banks will also want to determine the potential impact in a deal.
Another note: Banks are expected to earn more in 2018 as a result of the new tax code. Make sure the bank is truly rewarding the executive’s performance, not improved metrics that resulted from the tax cut.
Impact on Organizational Structures
Banks should also look at their own organizational structures following tax reform, particularly if the bank is a Subchapter S corporation, which has 100 or fewer shareholders and is taxed as a partnership while enjoying the benefits of being a corporation. Management should make a presentation to the board outlining the impact of tax reform on the bank, along with an analysis of how the bank would be affected in a conversion from a Sub S to a C Corporation and management’s recommendation on the best choice for the organization, says Robert Klingler, a partner at the law firm Bryan Cave.
How the bank wants to deploy its profits will factor into this decision, says Hoeflin. For banks that prefer to continually reinvest profits into the company, “the C Corp set-up, with this low tax rate, would present some favorable circumstances,” she explains. For banks that want to share those profits directly with shareholders, the Sub S structure will continue to make more sense, as Sub S shareholders avoid the double taxation that occurs with a C Corporation.
Shareholder agreements should be reviewed regularly, and will outline how the board can proceed if it wants to change the bank’s structure. “Many times it will involve the consent of the holders of two-thirds of your shares,” says Jonathan Hightower, a Bryan Cave partner, but that threshold differs with each bank. Sometimes the board has the discretion to change the structure without shareholder approval.
Subchapter S banks will still benefit from tax reform—but your bank could benefit even more as a C Corporation, depending on its strategic goals. A current analysis will make that clear to the board.
Another item to note: Banks below $10 billion assets will still qualify for the same deduction for premiums paid to the Federal Deposit Corp. that they have been receiving, but banks between $10 billion and $50 billion will qualify for a partial deduction for these premiums, and banks above $50 billion will no longer qualify for any deduction.
Impact on Local Markets
The mortgage interest deduction is now capped at a principal balance of $750,000, down from $1 million. “That could reduce demand for new home purchase mortgages if folks decide not to move because of the inability to deduct their interest going forward,” says Michael Giammalvo, a partner at Crowe Horwath LLP. Demand could dampen in certain markets more than others. For example, the average home price in California is $697,539, according to Trulia, compared to an average $230,000 for a home in Nebraska.
If your bank has a significant market presence in a state with higher real estate taxes, the cap on itemized deductions at $10,000 for state and local income and property taxes could throw additional cold water on the decision to purchase a new home. “It’s not as tax-advantaged as it used to be, to be a homeowner in an expensive market, says Giammalvo.
Interest is also no longer deductible for home equity lines of credit, so demand could be diminished there as well, adds Giammalvo.
Companies can no longer deduct entertainment expenses—taking a client out for dinner, for example—that were previously deductible at 50 percent of the money spent. That’s a potential pain point for commercial lenders. “I’m hearing from a lot of banks that the inability to deduct entertainment expenses going forward is a problem,” says Giammalvo.
Banks serving businesses with average gross receipts over $25 million should understand that interest expense deductions are now limited for these businesses. “Would we start to see in the banking industry a decrease in demand for lending, because [companies] would find equity for the financing rather than debt sources?” asks Hoeflin.
Take care not to overestimate the positive impact of tax reform on loan demand. While many in the industry expect a wave of commercial loans as companies earn more money, Bill Demchak, CEO of PNC Financial Services Group, has expressed skepticism on this front, as reported in The Wall Street Journal. He believes that companies with more money in their pockets as a result of tax reform will have less need to borrow from banks, dampening rather than fueling demand.
Since each bank’s markets and competitive niches will differ, a strategic discussion around how the impact will be felt will benefit the board and management. “A tailored and careful conversation for each bank, particularly for smaller community banks, makes sense,” says Hightower.
Making the Most of Earnings Gains
Perhaps the biggest question for boards to consider is how to invest the gains derived from a lower rate. Many banks have already announced that they’re spreading the wealth to employees and communities, through one-time donations to a community fund, for example, and hourly wage increases and bonuses for employees.
This a good public relations move for the industry, as the tax cuts were seen by some Americans as a favor to corporate America. “Banks need to make sure that the benefit they’re getting from tax reform really works for the country at large,” says Hightower.
Further, investors will be expecting banks to deploy excess capital to fuel improvements and growth. For banks slow to use that capital for M&A, or to provide share repurchases or dividends to shareholders, “we may actually see activist pressure accelerate and those [banks] may become potential targets,” says Sharon Dogonniuck, senior managing director at Ernst & Young Capital Advisors LLC. Investment in technology is another way to deploy that capital, and could provide a much needed-boost to banks that have struggled with the financial industry’s digital evolution. Smart investment in technology will define community banking’s winners and losers, says Dogonniuk. “Technology costs money, and [banks] need technological scale.”
The discussions occurring now in boardrooms spurred by tax reform could be a once in a lifetime occurrence for the banking industry and businesses at large. “I’ve doing this for 24 years, and we’ve never seen anything like this, where there’s such a transformation in the business tax world,” says Giammalvo.