Planning opportunities for community banks.

Along with loan quality and asset growth, minimization of tax liabilities ranks high on the list of priorities for community bankers. Although opportunities to permanently avoid taxes are limited, opportunities for deferring taxes are abundant. Deferring taxes into the future allows bankers the luxury of using funds that would otherwise not be available.

Estimated Tax Payments

In a perfect world, tax planning for the current year would be a continuous process that would begin well before its start. In the early stages of planning, nonrecurring transactions that may have an impact on earnings in the coming year should be identified. The purpose of identifying these transactions is to determine the most advantageous annualization periods to use in determining estimated tax payments for the current year. This often overlooked planning tool can affect cash flow significantly.

To avoid underpayment penalties, Sec. 6655(d)(1)(B) requires corporations to make estimated tax payments equal to the lesser of 100% of the current years tax liability or 100% of the prior years tax. The prior year tax exception is unavailable to corporations that had no tax liability in the preceding year or are considered large corporations (generally, corporations with taxable income in excess of $1 million in any of the three tax years immediately preceding the current year).

Unless the taxpayer elects otherwise, each installment is determined by computing the tax on annualized taxable income for the first three months of the current year for both the first and second required installments, the first six months for the third required installment and the first nine months for the fourth required installment. Sec. 6655(e)(2)(C) provides the taxpayer with an opportunity to elect, annually, different annualization periods to compute the required installments, Corporate taxpayers may elect to use one of the following additional annualization periods to determine the first, second, third and fourth installments respectively: the first two months, four months, seven months and 10 months, or the first three months, five months, eight months and 11 months. The election is made on Form 8842, Election To Use Different Annualization Periods for Corporate Estimated Tax, and is due on or before the due date of the taxpayers first installment. Once made, the election is irrevocable for that year.

The ability to elect different annualization periods provides opportunities to select the most advantageous periods for computing estimated tax payments. Example: Community bank XYZ, a calendar-year taxpayer, anticipates paying a large settlement in August of the current year. Electing to determine estimated payments based on three-, five-, eight- and 11-months, income allows the bank to deduct the settlement in determining its third-quarter estimated payment. Similarly, if the bank will recognize large gains in April of the current year because of the sale of one or more branches, using the standard three-, three-, six- and nine-months' income avoids inclusion of the gain in determining the banks second-quarter estimate. The key to planning estimated tax payments is to identify nonrecurring transactions and to project the likelihood and timing of their occurrence.

Secs. 179 and 167

A taxpayer may elect to expense up to $17,500 of the cost of Sec. 179 property additions in the current year. Sec. 179(d)(1) defines Sec. 179 property as any tangible property that is Sec. 1245 property and which is acquired by purchase for use in the active conduct of a trade or business, thus, real property additions do not qualify. Further, Sec. 179(b)(2) provides that the deduction begins to phase out when tangible personal property additions for the year exceed $200,000 and no deduction is allowed if total personal property additions exceed $217,500.

Many community banks never come close to the $200,000 cost limitation of Sec. 179(b)(2). Assuming a 34% tax bracket and at least $17,5000 of tangible property additions, electing the provisions of Sec. 179, results in an annual Federal tax deferral of $4,760 on five-year property and $5,100 on seven-year property. For those banks that are a member of a controlled group of corporations asset additions of all members must be combined for purposes of the Sec. 179(b)(2) limitation. In addition, only $17,500 may be expensed for, the group and allocated accordingly among its members.

Although computer software additions do not qualify for the expense election of Sec. 179, die Revenue Reconciliation Act of 1993 reduced the allowable amortization period of software from 60 months to 36 months (Sec. 167(f)(1), provided the software was not acquired in a transaction involving the acquisition of assets constituting a trade or business or substantial portion thereof (Sec. 197(e)(3)(A)(ii)). Many banks with the capability to compute tax depreciation internally still assign a 60-month life to software that would otherwise quality for a 36-month life. One explanation offered for this phenomenon is that when system upgrades are made to both hardware and software, an invoice is received that lists one lump sum for both hardware and software. By requesting a breakout of the cost of the upgrade between hardware and software, or even separate invoices for each component of the upgrade, a shorter life can be assigned to computer software.

Minimum Reserve Addition

Banks are afforded great flexibility in determining bad debt deductions. For years in which a bank is in a low tax bracket or in a loss position, the bad debt deduction should be postponed to future years when the bank is in a higher tax bracket and each dollar of deduction is worth more in terms of tax savings. Although the regulations speak of a minimum reserve addition, there seems to be ample support to allow taxpayers latitude m determining a reasonable addition to the reserve.

Historically, banks have used the reserve method of accounting to determine their tax deductions for loan losses. Sec. 585(c) prohibits "large banks" from using the reserve method, those banks with average assets in excess of $500 million or part of a parent-subsidiary controlled group with average assets in excess of $500 million must instead use the specific charge-off method under Sec. 166(a) in determining their bad debt deduction. Similar rules for thrifts are found in Sec. 593 except that this Code section does not contain a "large thrift" prohibition against die reserve method.

Sec. 585(b)(1) provides that the reasonable addition to die reserve "shall be an amount determined by the taxpayer which shall not exceed...." However, Regs. Sec. 1.585-2(a)(2) requires a minimum reserve addition for commercial banks. For tax years beginning after Dec. 31, 1987, a bank using the reserve method must make a minimum addition to the reserve in an amount equal to the six-year moving average amount allowable under the experience method. Similar regulations were proposed for thrifts under Sec. 593 but were never adopted. Prior to die adoption of the minimum addition regulations the IRS stated in Rev. Rul. 66-26 that" ...[a] bank is not required to take as a tax deduction its maximum permissible annual reserve addition for each taxable year, and unused portions ... may be used in a subsequent year." Also, Letter Rulings (TAMs) 8009003 and 8031062 held that a $1 addition to the reserve was permissible in years prior to the effective date of the minimum addition rules, even though a much larger deduction was allowable.

With respect to Sec.593 the Tax Court held, in The Home Group, Inc., 91 TC 265 (1988), that Sec 593 "grants wide latitude and complete discretion to taxpayers to decide the amount of available reserves they wish to claim in any year, not to exceed the statute's limits." The Tax Courts decision in Home Group challenges the validity of the minimum addition rule under Regs. Sec. 1.585-2(a)(2) and gives banks the ammunition to determine a reasonable addition to the reserve for bad debts.

Tax-Exempt Investment Securities

Sec. 291(a)(3) disallows a deduction for interest expense related to holding tax-exempt securities. If qualified tax-exempt obligations are acquired by a financial institution, only 20% of the interest expense attributable to the obligations is disallowed. Qualified tax-exempt obligations include any obligation not a private activity bond and issued by an issuer that reasonably anticipates not issuing more than $10 million of tax-exempt obligations during the year.

If the bank is owned by a holding company that is debt free, consideration should be given to having the holding company purchase the tax-exempt obligations for purposes of avoiding the Sec. 291 disallowance. (this planning technique was validated by the Clinton Administration's failed balanced budget plan late last year, which attempted to extend the disallowance to all corporations owning municipal securities.) From a regulators viewpoint, the fact that a holding company owns municipal securities should not be a concern, as long as die capital levels of the bank are not adversely affected.

ESOP Loan Interest Income

Sec. 133(a) allows a bank to exclude from gross income 50% of the interest received on loans to leveraged employee stock ownership plans (ESOPs) or their sponsoring corporations, to the extent that the loan proceeds are used to acquire employer securities for the plan. Because of this exclusion, banks can generally offer a lower rate on ESOP loans than conventional loans. For example, an ESOP loan at 6.5% yields roughly the same after-tax cash flow as a conventional loan at 8% (assuming a 34% tax rate).

For ESOP loans made after July 10, 1989, Sec. 133(b) imposes additional requirements for this exclusion. The exclusion is available only if the ESOP owns either more than 50% of each class of outstanding stock of die corporation issuing the employer securities or more than 50% of die total value of all of die corporation's outstanding stock. In addition, die loan term cannot exceed 10 years. It should be noted that the Revenue Reconciliation Act of 1995 would have eliminated this loans made after Oct. l3, l995.

Low-Income Housing Tax Credits 

Banks with high taxable income and regular tax liabilities in excess of alternative minimum tax liabilities are excellent candidates for die low-income housing credit authorized by Sec. 42. Each dollar of credit win offset one dollar of tax liability.

The typical investment is made through a limited partnership in which the bank is the limited partner, and is generally entered into with a real estate developer with which the bank has an established relationship. Alternatively, an investment can be made via a pooled approach that combines funds from several corporate investors. Because a partnership operates the project, the banks share of partnership income or loss will flow through to it along with its share of the credit.

Sec. 42 contains many eligibility requirements to claim die credit. Generally, the credit is equal to 9% of the project basis for new buildings and 4% for existing buildings. The credit is claimed over a 10-year period, but remains subject to recapture over 15 years. Recapture is required if die project fails to meet the rent and income tests provided in Sec. 42(g), if the building is sold or if a partner's interest in the partnership is sold.