COMMUNITY BANK
TAX & ADMINISTRATIVE RELIEF
OPTIONS
APRIL 1999
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COMMUNITY BANK |
EXECUTIVE SUMMARY Independent community banking institutions have always played a special role in America's rural and urban communities and in thousands of neighborhoods. For generations, community-based banks have been the underpinning for millions of consumers, family-owned businesses, family farms, local merchants, and small manufacturers. These are the banks that know their customers by name and help finance their communities' growth, prosperity, and jobs. Many people experience firsthand the significant role community banks play in the economy on both local and national levels. Unfortunately, at the same time, federal laws passed without considering the full impact on Main Street can result in significant hurdles for community banks that hinder their ability to best serve their communities. Burdensome regulations and distorted and unfair tax policies threaten the viability of community-based banks and the consumers and businesses they serve. When tax policies and regulations put community banks at a competitive disadvantage, they lose customers to tax-free rivals. Congress requested the United States Treasury to prepare a detailed report containing recommendations that will preserve the viability and growth of small banking institutions in America. The Independent Bankers Association of America (ICBA) commissioned Grant Thornton LLP, a leading global accounting and management consulting firm, to compile a comprehensive study to identify, and to provide Treasury and Congress with, a suggested menu of tax policy recommendations that respond to many of community bankers' key concerns. Clearly, Congress recognized that the tax burden and regulations imposed on community banks are hindering the banks' ability to serve their communities and even, in some instances, their ability to survive. With the Congressional passage and Presidential signing into public law of the "Credit Union Membership Access Act," (H.R. 1151), the U.S. Treasury was given a concise mandate. The Secretary shall, not later than 1 year after the date of enactment of this Act, submit a report to the Congress containing-- (1) recommendations for such legislative and administrative action as the Secretary deems appropriate, that would reduce and simplify the tax burden for-- (2) any other recommendations that the Secretary deems appropriate that would preserve the viability and growth of small banking institutions in the United States. (P.L. 105-219) Community banks are an essential component of this country's financial structure, despite the consolidation trend, which has reduced the number of banks from almost 14,000 ten years ago to fewer than 9,000 banks today. Community banks are the principal source of credit for small business, which is vital to the growth of our economy. Community banks are the financial backbone of small town America and an essential part of this nation's rural economy. Community banks serve millions of consumers nationwide with a degree of personal service that is not available from the huge financial conglomerates that are dominating our financial services world. As the only trade association that exclusively represents the nation's community banks, the ICBA respectively submits this report detailing recommendation for legislative and administrative tax relief that will help assure the continued vitality and growth of small banking institutions in the United States. For example, the report includes an important recommendation that will encourage Americans to save more if enacted. The proposal provides for exclusion of the first $200 ($400 for joint returns) of interest income from personal income tax. At a time when the national savings rate has declined, the adequacy of personal retirement savings is in question, and banks find it difficult to attract and retain core deposits which are the principal source of funding, this simple tax change makes sense for both individuals and for community banks. This report identifies a menu of tax policy options that reduce community bank tax burdens and compliance costs. The proposals were selected to reflect items that will best relieve the most often cited causes of harm to community banks. Enacting these changes will help to preserve community banks as an important option for financial services for millions of consumers, family-owned businesses, family farms, local merchants, and small manufacturers throughout America. We trust that this report will serve as a key aid to the Treasury and the Congress. Respectfully,
This comprehensive document contains recommendations that, if enacted or adopted, the ICBA believes would improve the viability of community banking and thereby benefit the nation's small businesses and rural economy. Community banks remain an essential component of this country's financial structure, despite the consolidation trend, which has reduced the number of banks from almost 14,000 ten years ago to less than 9,000 banks today. Community banks are the principal source of credit for small business, which is vital to the growth of our economy. Community banks are the financial backbone of small-town America and an essential part of this nation's rural economy. Community banks serve millions of consumers nationwide with a degree of personal service that is not available from the huge financial conglomerates that are dominating our financial services world. Community banks' competitiveness has been undercut by the onslaught of competitors that do not face the same laws and tax responsibilities. Losing customers to tax-free competitors has hurt the economic vitality of community banks. ICBA's recommendations for tax relief level the playing field for community banks and allow the banks to better serve their communities. To prepare this report, the ICBA retained Grant Thornton LLP, a leading global accounting and management consulting firm that specializes in serving community banks, to assist in its efforts to determine the effect of the current tax code on community banks. The first step in the preparation of the ICBA report was an informal survey of a diverse group of community bankers on a broad range of tax topics. The survey results were used to identify tax relief recommendations that would enhance the competitiveness of community banks. The report is structured by tax relief topic. Each chapter contains an overview of the existing law, its effect on community banks, the recommended relief and the projected benefits of the relief. The following is a synopsis of the recommendations contained in each chapter. Chapter One: Estate Tax Relief for Closely-Held Community Banks Family ownership is an integral part of community banking. Today, the estate tax threatens the continued viability of family-owned community banks. Chapter One of the report offers recommendations that would ensure estate taxes are not the deciding factor leading to the demise of the family-owned bank.
Chapter Two: S Corporation Relief for Community Banks An S Corporation is a flow-through structure for tax purposes and generally has been an option for small businesses for many years. Beginning in tax years after 1996, banks can also make the S Corporation election. S Corporation status allows closely-held community banks to eliminate the double taxation of corporate income and gain on distributions to the shareholders, making the bank more competitive in the marketplace. Although a significant number of banks have converted to S Corporation status, as many as 1,500 more have expressed interest in the making the election after 1999. Before the S Corporation election can be made, banks must first overcome some difficult obstacles to avoid disrupting their operations or disenfranchising many of their shareholders. Chapter Two contains two groups of solutions for offering community banks S Corporation Relief. The first part contains solutions that, if enacted, will make it easier for community banks to make the S Corporation election. Part 2 identifies various other solutions that will provide relief for community banks that have already made the S Corporation election. Make Conversion to S Corporation Status Easier for Community Banks
Other S Corporation Relief for Community Banks
Chapter Three: Personal Interest Income Exclusion Improving the effective return on personal savings accounts will encourage people to deposit more funds in their local banks. Excluding the first $200 ($400 for joint filers) of interest income from personal taxable income would directly reward consumers for saving. An interest income exclusion would promote increased personal savings, make it easier for community banks to attract and retain core deposits, and result in more funds reinvested in local communities. Chapter Four: Increase Net Operating Loss Carryback Period Net operating loss carryback periods have a direct impact on the viability of community banks. Increasing the net operating loss carryback period from two to five years for community banks with total assets of less than $10 billion will ensure improved stability in Tier 1 capital and allow community banks to better serve their small business and farm customers facing an economic downturn. Chapter Five: Community Reinvestment Act Relief Relief from the Community Reinvestment Act (CRA) would ensure that regulatory burden is not unnecessarily placed on community banks. Chapter Five offers three recommendations to improve the implementation of CRA and reduce the burden imposed on community banks. First a total exemption from CRA for the "smallest" community banks that would help restore regulatory balance and allow them to concentrate their resources on serving their communities. The second recommendation is to define the asset size of community banks eligible for the streamlined examination as $1 billion. The third recommendation is to provide tax credits for CRA loans.
Chapter Six: Reduce Disallowance of Interest Expense Allocable to Targeted Tax-Exempt Obligations Current law restricts community banks' ability to participate in tax-exempt securities issued by entities in their communities. To enhance the ability of community banks to compete in the qualified tax-exempt obligation market, three changes are recommended. Changing the rules regarding the allocation of interest expense on tax-exempt obligations is essential and is important to the economic vitality of community banks.
Chapter Seven: Reduce Tax Rates for Qualified Community Banks Tiered tax rates based on size of bank and level of community lending will enhance the competitiveness of community banks. Reducing the tax rate to 15 percent on the first $1 million of taxable income for "qualified community banks" would preserve the viability and growth of small banking institutions in the United States. A tax reduction for community banks will contribute to increased economic stability and growth in small communities by increasing the funds available for local reinvestment. Chapter Eight: Expand Use of Cash Method of Accounting The cash method of accounting often provides a clear reflection of community bank income flows. Many community banks that originally qualified to use the cash basis method of accounting in 1987 (because they had less than $5 million in average gross receipts) have lost their eligibility or are finding it more difficult to qualify. The effect of the last 12 years worth of inflation on the real value of the $5 million average gross receipts threshold has made it difficult for many community banks to continue to qualify for the cash method of accounting. The gross receipts test is biased against businesses such as community banks that have low margins on high gross revenues. Increasing the average gross receipts threshold to $20 million will assist community banks' ability to expand their service offerings and generate greater gross receipts.
Chapter Nine: Long-Term Capital Gains Tax Relief Reduced tax rates for long-term capital gains encourage capital formation for new and growth firms and ensures the preservation of community-based enterprises. A lower capital gains rate provides investors with a higher after-tax return on investment, thereby encouraging an increase in the national savings rate. The two relief items sought would benefit both community banks and their customers.
Chapter Ten: Allow Community Banks to Opt Out of Tax Mark-to-Market Accounting Dealers in securities are subject to the mark-to-market (MTM) method of accounting. The only way community banks can be exempt from the rule is to qualify annually for the negligible sales exemption in the Treasury regulations. If a community bank exceeds the securities sales limitation for one year, it subjects itself to MTM that year and all subsequent years. Allowing community banks to opt out of the MTM rules would eliminate unnecessary administrative burden.
Chapter Eleven: Technology Investments for Year 2000 and Beyond Community banks have incurred and are incurring significant costs to ready their computer systems for the Year 2000 (Y2K). A significant obstacle for community banks is that they cannot take a tax credit for the Y2K expenditures except for extraordinary circumstances. Furthermore, the costs incurred by community banks to purchase new computers and other hardware are subject to the normal depreciation rules. Community banks are unable to increase their depreciation deductions to accurately match the expected service life of the equipment and the undepreciated tax basis is not allowed as a deduction until the bank disposes of the asset. Implementation of these proposed tax treatments for Y2K expenditures and computer equipment resources will help community banks better serve the needs of their communities and meet the demands of their customers for new technology based services.
Chapter Twelve: Employee Benefit Plan Relief for Community Banks Employees are one of community banks' most valued assets. To attract a strong and stable workforce, community banks must be armed with fair, flexible and consistent options for employee benefit programs. Excess funds held in community bank employee pension plans can be put to valuable use as additional investments in the local community. Changing the law to allow controlled access to excess funds will level the playing field between banks and tax-exempt competitors since the 50 percent excise tax on reversions currently does not apply to tax exempt plan sponsors. Removing the "use it or lose it" rule for flexible-spending accounts provides employees of community banks with a tax-advantaged method of providing for unforeseen medical and dependent care needs. Providing employees increased options for the timing and use of their income set aside in flexible spending accounts will improve community banks' ability to attract and retain high quality employees. Modifying the rules that govern employee benefits will ultimately benefit small communities and help small banks attract the best employees. Amending the rules to allow net unrealized appreciation on employer securities that are distributed from qualified plans to retain its character when rolled over to a Conduit IRA will allow taxpayers in similar situations to be treated more equitably under the tax law. Taxpayers who are forced to take distributions upon plan terminations prior to reaching age 59 1/2 and without a separation from employment, do not satisfy the rules for lump sum distribution. The following four recommendations to provide employee benefit plan relief for community banks will enhance their ability to compete in today's marketplace.
Chapter Thirteen: Capitalization of Certain Costs Capitalization of certain costs is a contentious issue between community banks and the Internal Revenue Service. IRS has argued that loan origination costs should be capitalized and amortized over the life of the asset. Permitting community banks to deduct loan origination costs will avoid the need to perform complex and costly computations to amortize the costs. In the case of foreclosed property, the rules related to cost capitalization can hit community bankers during challenging economic periods. Clarifying issues related to capitalization of costs can help community banks manage better and improve their long-term viability. This chapter suggests three relief measures.
Chapter Fourteen: Accounting for Interest on Loans Accounting for interest on loans differently for regulatory and tax purposes increases accounting complexity for community banks. Federal bank regulators require community banks to stop accruing interest on loans once payments are not received for a specified number of days. The Internal Revenue Service requires significantly more documentation to justify the non-accrual of interest income. The inconsistent treatment by two federal agencies results in additional administrative costs for community banks. The following measures would decrease this administrative burden.
Chapter Fifteen: Repeal Recognition of Gain on Certain Distributions of Stock of a Controlled Corporation Consolidation is occurring among community banks as they seek to take advantage of synergies in their marketplace. Current rules governing the recognition of gain on certain distributions of a controlled corporation restrict community banks' opportunities to improve efficiencies and fine-tune their operations. Allowing smaller institutions to utilize the traditional and longstanding rules for tax-free restructuring helps stabilize the capital and profitability of community banks. Reinstatement of the prior law will allow smaller financial institutions to make business decisions that are not dictated by tax law. This chapter recommends exempting smaller institutions with assets less than $5 billion from the IRC §355 ownership requirements contained in the 1997 Tax Act. Chapter Sixteen: Amortize Purchased Mortgage Servicing Rights Separately Many community banks purchase mortgage servicing rights as investments However, the Internal Revenue Service's application of a proposed rule seriously reduces the effectiveness and attractiveness of purchased mortgage servicing rights (PMSRs). Clarifying that community banks that acquire PMSRs may separately amortize each individual servicing right results in a more accurate reflection of income. Further, allowing community banks to determine for themselves whether the costs outweigh the administrative convenience of the mass asset approach allows community banks to best manage their portfolios. Chapter Seventeen: Clarify Treatment of Trust-Preferred Securities Community banks have found trust-preferred securities to be considerably beneficial and a very efficient way of raising Tier 1 capital. By issuing trust-preferred securities, community banks avoid diluting control of the bank and, at the same time, expand participation in bank "ownership." However, uncertainty regarding the tax treatment of these securities by the Internal Revenue Service complicates community banks' effective use of trust-preferred securities. The regulatory confusion hinders the community bank's ability to function efficiently and threatens the continued viability of small banks. Clarifying the deductibility of interest payments made in a trust-preferred security arrangement will remove a great deal of uncertainty for community banks that use these instruments to raise Tier I capital. It will also allow community banks to raise the capital needed to service their communities without sacrificing control of their local community bank. Chapter Eighteen: Repeal Alternative Minimum Tax for Community Banks As originally enacted by the 1997 Tax Act, the $5 million and the $7.5 million gross receipts tests were intended to provide much needed relief for small corporations. However, gross receipts for a community bank are not comparable to gross receipts in other industries. A community bank's gross receipts consist primarily of interest income. Community banks as small as $50 million in assets can produce gross receipts in excess of $5 million. Excluding such small entities from the relief provisions provided to small corporations conflicts with Congress's original intent for the alternative minimum tax (AMT) exemption. The gross receipts tests are biased against businesses such as community banks that have low margins on high gross revenues. This chapter recommends exempting community banks from AMT until their average gross receipts exceed $20 million. Permitting small community banks to be exempt from AMT until their average gross receipts exceed $20 million enhances their viability and improves the fairness of the tax law. Chapter Nineteen: Reduce EFT Liability for Customer Misuse The Electronic Funds Transfer Act (EFTA) was enacted in 1978 to provide protection to consumers who choose to use electronic funds transfers (EFT). The law establishes consumer liability for unauthorized transfers, making consumers responsible for unauthorized withdrawals if the user can be adequately identified. However, the law provides that in no case will the consumer be liable for more than $500. Further, banks bear the burden to disprove that any transfer the consumer identifies as unauthorized is indeed authorized. As a result, community banks often assume losses caused by consumer neglect. This chapter recommends a more reasonable allocation of responsibility, thereby encouraging community banks to expand convenient EFT services and be able to more favorably evaluate new and emerging technologies and products for their customers.
Chapter Twenty: Government Payment Reclamations Community banks play an important role in reducing the costs associated with federal payments. However, community banks should not have to bear the costs of payments made in error or after a recipient dies or becomes incapacitated. Community banks should not be the collection agents for the federal government. Two recommendations would provide community banks important relief:
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