By Debra CopeMore than 600 participants joined a recent American Bankers Association webinar on how tax reform legislation affects Subchapter S corporations, underscoring that many banks are weighing tax strategy decisions.
Nearly 2,000 U.S. banks have elected Subchapter S tax treatment as a way of passing through tax liability directly to shareholders, avoiding a double tax hit on the bank and its shareholders. Banks that elect Subchapter S status generally strive to distribute enough cash to shareholders in the form of dividends to enable them to satisfy the tax liability.
Kevin Powers, a tax partner with Crowe Horwath in Hartford, Conn., walked participants through examples of how banks can evaluate all the variables that affect whether Subchapter S treatment makes sense for them as the 2017 tax reform law takes effect.
The tax reform bill reduced the maximum federal corporate income tax rate from 35 percent to 21 percent for tax years beginning after Dec. 31, 2017. It also reduced the maximum income tax rate on individuals from 39.6 percent to 37 percent for taxable years 2018 through 2025. Income tax rates on capital gains for non-corporate taxpayers were unchanged at 15 percent or 20 percent.
Significantly, Powers noted, the bill also created a 20 percent deduction for so-called “qualifying income” of businesses conducted through pass-through entities or as sole proprietorships. This has the potential in some cases to reduce the maximum effective federal income tax rate on such income from 37 percent to 29.6 percent, he noted.
ABA’s Curtis Dubay and John Kinsella have been working with policymakers and other trade associations to make sure the intent of Congress with respect to S-corporation banks comes through in the definition of “qualifying income.” Income qualifies for the deduction as long as the business is not engaged in a “specified service trade or business.” The specified services, trades and businesses are defined in the law; however, the Treasury Department is working now to issue interpretative regulations that further define which types of business lines will be excluded from the deduction.
The presenters said that the upshot of these and other tax changes — including limits on deduction of state and local income taxes and property taxes and the elimination of miscellaneous itemized deductions — is that banks may need to reassess whether being treated as a corporation or a pass-through is more advantageous.
William “Dub” Sutherland, a partner with the San Antonio law firm of Kennedy Sutherland, said key advantages of Subchapter S corporations remain in place, particularly the avoidance of double taxation. By applying the 20 percent deduction, taxpayers could see their effective income tax rates lowered. “And if you are an active investor, you have the benefit of avoiding a 3.8 percent tax on net investment income,” he added.
“S-corporations don’t have quite the same advantage over a C-corporation as we had before,” Sutherland said. “But if you are paying dividends and plan to continue to do so, it is tough to come up with a scenario where converting to a C-corporation makes sense.”
Patrick Kennedy, managing partner with Kennedy Sutherland, said the enactment of tax reform presents an opportunity for banks to “step back and analyze your individual situation.” For example, “if you are in a slow-growth mode, capital accumulation may not be a significant issue,” making S-corp status viable. But, “If you are in a high-growth mode, you may not want to have the pressure of paying dividends that you would in an S-corporation regime,” Kennedy said.
The bottom line, the presenters said, is to do the analysis and not rush the decision. “Really analyzing individual shareholder positions is very important,” Kennedy said.