New NOL rules may hurt some profitable banks.

The Taxpayer Relief Act of 1997 (TRA '97) reduced the net operating loss (NOL) carryback period to two years and increased the NOL carryforward period to 20 years. Even in the midst of the current economic expansion, this change in the NOL carryback period is already causing some problems for banks getting ready to prepare their 1997 financial statements. The reduced carryback period may even result in a charge to the earnings and capital of profitable banks, because of the possible need to establish a financial statement deferred tax asset valuation allowance.

New NOL Carryback and Carryforward Periods

Under prior law, an NOL could be carried back three years and forward 15 years. These new carryback and carryforward periods are effective for NOLs generated in tax years beginning after Aug. 5, 1997.

The new NOL carryback period is especially rough on banks because regulators impose limitations more stringent than those contained in Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109), for purposes of determining the amount of deferred tax assets that a bank can include as Tier I capital.

SFAS 109: Accounting for Deferred Tax Assets

The Financial Accounting Standards Board (FASB) issued SFAS 109 in February 1992. Under the standard, a bank reports deferred tax assets arising from tax carryforwards and deductible temporary differences (i.e., future deductions or income taxed but not booked).

Tax carryforwards are deductions or credits that a bank cannot use for current tax purposes, but may carry forward to reduce taxable income or taxes payable in a future period. Temporary differences arise when a bank records transactions in one period on the bank's books and recognizes them in another period (or periods) on its income tax return.

A bank may only realize deferred tax assets arising from deductible temporary differences by:

* Recovering taxes paid in prior years;

* Offsetting taxable temporary differences; or

* Earning sufficient future taxable income.

SFAS 109 allows a bank to record deferred tax assets that are dependent on future taxable income. The bank must, however, also establish a reserve to adjust the recorded asset to the amount that will more likely than not be realized.

Regulatory Treatment of Deferred Tax Assets

The banking agencies adopted the provisions of SFAS 109 for reporting in quarterly Consolidated Reports of Condition and Income beginning Jan. 1, 1993. The regulatory policy originally prohibited the inclusion of deferred tax assets dependent on future taxable income, but was subsequently relaxed in certain situations.

For regulatory purposes, the final rules on the regulatory treatment of deferred taxes as capital (effective April 1, 1995) limit the amount of deferred tax assets dependent on future taxable income to the lesser of the following amounts:

* The amount of deferred tax assets expected to be realized within one year of the quarter-end report date, based on a bank's projection of future taxable income (exclusive of carryforwards and reversals of existing temporary differences) for that year; or

* 10% of Tier 1 capital, net of good-will and all identifiable intangible assets other than purchased mortgage servicing rights and purchased credit card relationships, and before any disallowed deferred tax assets are deducted.

For purposes of determining whether a deferred tax asset is realizable, the temporary differences are deemed to be recognized as of the end of the period ending one year after the quarter-end report date.

The final rules provide for a number of special adjustments that may be made when computing the capital limitation related to deferred tax assets. in general, these adjustments serve to remove deferred tax assets or deferred tax liabilities associated with items not included in regulatory capital.

Increased Earnings Volatility

As a result of the reduced NOL carryback period, losses related to a downturn in the quality of a bank's loan portfolio may be magnified if it becomes necessary to establish a deferred tax asset valuation allowance. The improvement in a bank's condition may also be magnified when the quality later improves if the deferred tax asset valuation allowance is no longer needed.

It is uncertain whether Congress fully understands the effect the reduced NOL carryback period will have on banks. The fact that most banks are currently recording record profits partially masks the damaging effect of the reduced carryback period. Undoubtedly, a number of calendar year--end banks will determine (to their dismay) that they need to establish a deferred tax asset valuation allowance at the end of 1997.

Banks need to monitor the size of their deferred tax asset relative to their carryback potential, in light of the reduced NOL carryback period. A slight downturn in the economy, for instance, could result in the need for a deferred tax asset valuation allowance.

The new NOL rules generally make it even more important for banks to accelerate tax deductions or defer income to the earliest tax year possible. Although it may not have any effect on the financial statements for the current year, accelerating deductions or deferring income may result in additional carryback potential in future years.

Accelerating losses in years in which an NOL is expected to be generated may prove to be especially beneficial. This is because the current-year NOL may be carried back to a year that is about to expire (i.e., a tax year to which future NOLs will not be able to be carried back).

RELATED ARTICLE: Addendum

Reprinted below form the Tax Clinic article, "Effects of Dividends and Son-offs on Stock," by Russell H. Hereth and John C. Talbott, ITA, Dec. 1997, is the chart on page 757 at bottom right. The original version contained incorrect total.

                                       Sears   Allstate   Morgan
                                                          Stanley

Per-share tax basis                   $15.83   $14.66     $ 13.56
Market price on 8/1/97                 62.52    79.375     48.625
Potential gain per share              $46.42   $64.715    $35.065
  Number of shares                       100        92         78
  Total gain                          $4,642   $ 5,954    $ 2,735
Total sale price                      $6,225   $ 7,303    $ 3,793
Less 20% capital gains tax               928     1,191        547
Cash received
  (sale price -- capital gains tax)   $5,297   $ 6,112    $ 3,246

From John Ziegelbauer, CPA, Washington, D.C.