By Paul Davis
A series of tax cuts that are poised to expire next year should be on the radar of banks of all sizes.
The Tax Cuts and Jobs Act, which was signed into law in December 2017, is largely viewed as the most-sweeping overhaul of the tax code in three decades. It ushered in a series of tax advantages, especially for pass-through entities such as Subchapter S corporations. About a third of all banks are structured as S-corps.
Those advantages are set to expire at the end of 2025. While they could be extended by next year’s Congress, there is considerable uncertainty heading into November’s national election. After the elections, a lot of conversations on Capitol Hill will focus on individual tax rates and how to pay for a potential decrease, industry observers say.
“The interesting thing about tax reform is that there are a lot of built-in things that could cause action in that space,” says Joey Connor, VP for tax policy at the America Bankers Association.
“I think we’ll see a mad dash after the election, when we know what the White House and the chambers of Congress look like.” The TCJA cut the corporate tax rate from 35 percent to 21 percent in a move that would have reduced the tax rate advantage of pass-through entities such as sole proprietorships, partnerships and S-corps from about 10 percent to less than 3 percent.
That prompted legislators to look for an offset to assist pass-through entities.
They settled on the Section 199A qualified business income deduction, which allows owners of pass-through entities to deduct up to 20 percent of their taxable income from those entities.
“While they’re not quite on par with other banks, the QBI gives shareholders of S-corps a little more of a tax break than they otherwise would have received,” says Kevin Powers, Washington national tax partner at accounting firm Crowe.
Another item to watch is the $10,000 U.S. cap on deductions for state and local taxes, or the SALT cap, which includes income from pass-through entities. In response, more than 40 states enacted a pass-through entity tax, or PTET, a workaround that lets S-corps avoid the SALT cap by redefining state and local taxes as an above-the-line business expense. (Otherwise, it would be counted as an individual expense passed on to shareholders.)
As a result, S-corp business owners in those states who opt for the PTET receive a tax credit for their individual state states, which offsets most of the tax paid by the business.
“There is a lot of talk in Congress about extending the SALT cap or raising the amount,” Powers says.
Smaller banks aren’t the only financial institutions that need to pay close attention to next year’s discussions around tax reform. Several items in the TCJA impact large banks — both those domiciled in the U.S. and abroad.
U.S. banks with sizeable foreign operations will need to watch the status of the global intangible low-taxed income, or GILTI, which is a minimum tax tied to international earnings from intellectual property such as patents, trademarks and copyrights.
GILTI, which taxes most active earnings above a 10% return on assets, could be up for discussion during next year’s tax reform negotiations.
“The effective rate for GILTI will increase, barring Congressional intervention,” Connor says.
Banks based outside of the U.S. will need to take note of the tax rate for foreign-derived intangible income, or FDII. The TCJA lowered the rate for FDII from 21 percent to 13.125 percent. It accounts for the sale of services abroad that are attributable to intangible assets based in the U.S.
Finally, multinationals should track the base erosion and anti-abuse, a 10 percent minimum tax directed toward corporations with at least $500 million of gross receipts. The tax was designed to keep companies with operations outside the U.S. from shifting profits to those markets to avoid U.S. tax liability.
While it will be challenging for banks to make concrete plans right now, given Election Day uncertainty, many are starting to have conversations in hopes of developing contingency plans, Powers says.
“The S-corps I am meeting with are just trying to get prepared by planning for a variety of what ifs,” Powers says, adding that it is possible that some S-corps could look to convert to C-corps if it looks like existing provisions will not be extended.
Banks that are worried about the impact of tax reform can go ahead and start engaging with lawmakers to tout the importance of extending the QBI deduction, Connor says, helping to shape the message by sharing information on lending volume and jobs created from S-corp bank activity.
“Banks need to explain the role they play supporting small business,” Connor says. “Now is the time to start having those conversations on Capitol Hill.”
Contributing Editor Paul Davis is the founder of the Bank Slate, a consulting and advisory practice and bank-focused media platform. He was previously a longtime editor and reporter at American Banker.
