Implications of a Tax Rate Increase for Your Financial Institution
To say this past year has been a whirlwind for tax legislation and tax planning would be the understatement of the year for the tax practicing community and their clients. We have dealt with sweeping new legislation from the Cares Act and subsequent bills all while trying to plan around an election and what each candidate might bring to the table. Your financial institution may have received more emails and articles from your tax accountants than ever before to explain the Cares Act, the Consolidated Appropriations Act, payroll tax credits, and more. It has become a never-ending world of tax considerations that probably hasn’t been seen to this degree in a long time. And all of this has occurred while trying to navigate life in general during a pandemic. This narrative is a long-winded way of saying that sometimes it is easy to lose sight of planning for the future when focused on the present.
This article will discuss some planning and considerations around a potential future tax rate increase. Note that these thoughts deal primarily with C-Corporations. Financial institutions operating as S-Corporations will have other considerations not addressed here.
The Tax Cuts and Jobs Act was signed in December 2017 and brought the corporate rate down to 21% (from 34-35%). It was a major tax change and most of us recall the frantic pace to revalue deferred tax assets and calculate the income statement impact of a rate change at calendar year-end 2017. Even then we kept saying the rate was not likely to go below 21% and it might just be a matter of time before it goes back up. Here we are almost 4 years later and with a new President and a power shift in Washington the tax rate is front and center again, with President Biden proposing an increase to 28%. While the change could be higher or lower than that (or not take place at all), you likely should be planning ahead and aware of the repercussions of a rate change if it does occur.
Many financial institutions and their accountants have already started to plan for this event. Here at BNN we certainly have been in these discussions for a while and considering things such as timing of depreciation, revenue, or charge-offs, etc. Below let’s first discuss the tax accounting impact before turning to a few tax planning opportunities.
Tax Accounting for a Rate Change
A rising tax rate delivers the inverse of what occurred at the end of 2017. If you can think back to then (even if we don’t want to!) you may recall that revaluing the deferred tax asset impacted your bottom line for the quarter in which the legislation was signed. If you had a deferred tax asset valued at 35%, your deferred tax asset was too high and needed to be brought down to 21% by crediting the deferred tax asset and debiting tax expense. Many banks were in a deferred tax asset position (due primarily to their loan loss allowance) and saw that effect. However, it was a boost to your bottom line if you happened to be in a deferred tax liability position (perhaps due to unrealized gains on investments or depreciation).
This revaluation got even more fun in 2017 if you had a fiscal year-end. In those cases you had more factors to address and ended up with a blended rate tax rate. Certainly this is a distinct possibility again and depending on timing, a blended rate may impact calendar year filers as well. Last time, many institutions needed to look over their entire deferred inventory of temporary differences to see what might reverse at 21% in the future (such as a bad debt allowance) or what might reverse at the blended rate in that same fiscal year. So it was a more multistep approach to first revalue from 35% to the blended rate, determine what will reverse at the blended rate, and then revalue the remaining inventory to 21%.
We also have another scenario potentially with this go round. Last time the bill was signed in the fourth quarter for calendar year-ends, with a 1/1 effective date. What would have occurred if the bill was signed in the third quarter with a 1/1 of the following year effective date? Well, much like the fiscal year scenario above we have a multi-step approach. First we would need to see what the deferred tax asset/liability looks like as of the end of the quarter. Then we would try to determine, to the best of our knowledge, what will reverse at 21% and what will then reverse at the new rate. That revaluation effect would need to be recorded in Q3 and then potentially adjusted for the actual result in Q4. Essentially in Q3 you are trying to estimate what your deferred taxes will be as of year-end and revaluing that amount to the new tax rate and putting it through the income statement in the third quarter.
Example: A bill is signed into law on September 15, 2021 that will change the corporate tax rate to 28% effective 1/1/2022. The total temporary differences for Best Bank in the World is $1,000,000 as of 9/30/2021. At a tax rate of 21% the deferred tax asset is $210,000. Let’s say based on all data available we expected total temporary differences to be $1,500,000 as of 12/31/2021 (the day before the new effective rate). The deferred tax asset at 21% would be $315,000. This needs to be revalued at 28% now since everything would reverse at the new tax rate. So at 28% the deferred tax asset is $420,000. Now you would debit deferred tax asset for $105,000 ($420,000 – $315,000) and credit tax expense for $105,000 as of 9/30/2021. If the actual temporary differences as of 12/31/2021 are say $1,450,000 vs. $1,500,000, there may be a true-up required.
Note that your deferred taxes on other comprehensive income also will need to be revalued in a similar manner. With the Tax Cuts & Jobs Act there was a one-time reclass allowed to retained earnings for this impact, to avoid any “stranded” OCI, and hopefully a similar mechanism will be available again.
Tax planning for rate change
To oversimplify, if you anticipate rates rising, do the opposite of what you did at the end of 2017. As accountants it goes against our nature to try to accelerate income and defer deductions in an attempt to maximize a one year tax liability, but when looking over a multi-year span the tax savings for a deduction at 21% vs. 28% can be significant, overcoming the time value of money.
In December of 2017 we published an article describing ways to create permanent tax savings by using temporary differences. Those thoughts remain useful now, when the situation is reversed.
Examples of ideas include electing out of bonus depreciation or looking at the timing of accrued bonus payments or accrued compensation payments (can these be paid and/or approved later?). Should you be looking at prepaid expenses and perhaps deferring prepayments where applicable? Should you defer pension contributions to a higher tax rate year? These are the discussions that hopefully already are taking place and should continue unless the narrative surrounding the corporate tax rate changes.
The calculation to revalue the deferred tax asset (or liability) is not something to be overlooked. Banks should know what they need to do if and when a tax rate change occurs. Discussions with advisors should be ongoing to consider future tax savings and liquidity needs. While we aren’t predicting what might happen to tax rates, we do think it makes sense to be ready for changes. We have all dealt with a lot over the past year and often the focus was on what needs to be done tomorrow, rather than a year from now. However, a rate change may be inching closer to tomorrow than ever before.
For more information or a discussion on how this may impact your bank, please contact Adam Aucoin or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.