TAX REFORM: WHAT REFORM MEANS FOR YOUR BOTTOM LINE. Bank Holding Company Association May 7, 2018

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2 TAX REFORM: WHAT REFORM MEANS FOR YOUR BOTTOM LINE Bank Holding Company Association May 7, 2018

3 Agenda Tax Reform History Overview of Tax Reform Business Provisions Pass Through Entity Deduction & Planning Entity Choice Considerations Individual Income Tax Reform Provisions Questions

4 TAX REFORM HISTORY

5 Tax Reform Act of 1986 vs TCJA of 2017 The last major tax reform was passed by Congress in 1986 (Reagan) No major tax reform has occurred until now, the Tax Cuts and Jobs Act of 2017 Difference in congressional votes: How many democrats voted in favor of the Tax Reform Act of 1986? 70% of Democrats in the House (176 out of 252) 94% of Democrats in the Senate (44 out of 47) What about the Tax Cuts and Jobs Act of 2017? No Democrat in either the House or Senate voted for the TCJA Why is this important?

6 Tax Reform Act of 1986 vs TCJA of 2017 Impact on the federal deficit. TRA of 1986: Revenue neutral $0 TCJA of 2017: Increase of $1.4 trillion over 10 years or $1.0 trillion if you factor in projected growth in GDP

7 Tax Reform Act of 1986 vs TCJA of 2017 Length of time to legislate TRA of 1986: Almost 2 full years House held 30 hearings and spent 26 days marking up legislation in committee Senate held 36 more hearings and the debate lasted a full month TCJA of 2017: Less than a year (April to December) No House or Senate Hearings House passed a 448-page bill on November 16 after two weeks of deliberations Senate passed a 515-page amended bill 8 days following Finance Committee Chair Orin Hatch s introduction of a conceptual mark (no legislated language) on November 9

8 OVERVIEW OF BUSINESS PROVISIONS

9 Tax Reform: Tax Cuts & Jobs Act Key Changes Impacting Business Owners Corporate tax rate reduction 20% deduction for pass-through businesses Bonus depreciation expansion and extension Limitations on business interest deductions Elimination of tax deductions for entertainment

10 Tax Reform: Tax Cuts & Jobs Act Other Changes We Are Not Covering Today Elimination of the Domestic Production Activities Deduction (DPAD) Retention of the Work Opportunity Tax Credit and Research and Development tax credit Changes to treatment of carried interest Repeal of technical termination of partnerships Alternative minimum tax repealed for corporations International tax changes

11 Business Impacts 20% Deduction Tax Change Post Reform Law Considerations 20% Pass Through Deduction Applies to U.S. operating income of an active business of a partnership, S Corporation or sole proprietorship Benefit is applicable to non-corporate taxpayers, including trusts and estates Does not apply, generally, to specified service trade or business Deduction is limited to the greater of: 50% of the taxpayer s share of W-2 wages attributable to the qualified trade or business, or 25% of W-2 wages plus 2.5 percent of original cost of depreciable, tangible property Generally results in an effective tax rate of 29.6% for individuals (i.e., 80% of highest individual rate of 37%). Analysis to see if activity rises to definition of trade or business Analysis of employee versus independent contractor Planning for capital expenditures Analysis and planning for owner compensation to ensure trade or business definition is met, while optimizing the 20 percent deduction Deduction may not be allowed at the state level in many states as majority of states begin with Adjusted Gross Income rather federal taxable income Specified service business and wage/asset limits do not apply below specified individual income limits $157,500 single filer and $315,000 joint filer

12 Business Impacts Capital Expenditures Tax Change Post Reform Law Considerations Bonus Depreciation 100 percent bonus depreciation through 2022, then phased out through 2026 Applies to new and used property acquired and retroactive to assets placed in service after 9/27/2017 Does not apply to goodwill & intangibles Adds more importance to purchase price allocation agreements, Asset deals are even more attractive States may not conform to this provision as more than half of the states currently do not conform to Bonus Depreciation Section 179 $1 million permanent expensing, subject to limitations and phaseouts Phaseout threshold increased to $2.5 million Limitation applied at the individual level so consider benefit for flow through States may not conform to this provision Depreciation limits on luxury autos and personal use property increased Effective for property placed in service after Dec. 31, 2017 Revisit leasing versus purchasing policies Like kind exchanges (LKE) No longer applicable to personal property. Limited to real property only Consider whether a LKE makes sense for real property sales

13 Business Impacts Interest Expense Limitation Tax Change Post Reform Law Considerations Business interest expense limitations Limits the net interest expense deduction to 30 percent of adjusted taxable income (ATI) For 2018 through 2021, ATI will approximate earnings before interest, taxes, depreciation and amortization (EBITDA) After 2021, ATI will approximate earnings before interest and taxes (EBIT) Disallowed interest generally may be carried forward indefinitely Small business exemption (preceding three year average gross receipts <$25 million) Debt obligations and financing needs should be evaluated for limitations and potential restructuring opportunities Project and calculate deduction limitation effects

14 Business Impacts Entertainment, Transportation Tax Change Post Reform Law Considerations Disallowance of qualified transportation fringe Expenses associated with providing qualified transportation fringe to employees (except for safety reasons) and expenses incurred for employer provided transportation (for commuting between residence and place of employment) are disallowed Companies should review company policies with respect to transportation benefits Disallowance of entertainment expenses No deduction is allowed for any activity considered to be entertainment, amusement of recreation, or payment of membership dues to any club Further restrictions apply to expenses associated with employer provided eating facilities under the de minimis fringe exception, effective after Dec. 31, 2017 Companies should review company policies with respect to entertainment expense and club membership policies Detail should be given to general ledger accounts used to properly isolate expenses still qualifying for the 50 percent deduction (food and beverages associated with the trade or business)

15 Business Impacts Accounting Method, FMLA Credit Tax Change Post Reform Law Considerations Overall method of accounting Use of cash method for C corporations and partnerships with C corporation partners is expanded Applies to businesses with gross receipts up to $25 million (increased from $5 million) Companies should determine if an accounting method change is favorable Family Medical Leave Act Credit Eligible to employers for wages paid to qualifying employees on family and medical leave The credit is available as long as the amount paid to employees on leave is at least 50% of their normal wages Leave payments must be made in 2018 and Credit is not available beginning in Credit ranges from 12.5% - 25% on wages paid on leave. Leave cannot exceed 12 weeks per year. Eligible employers are those with a written policy in place allowing (1) qualifying full-time employees at last two weeks of paid family and medical leave a year, and (2) less than full-time employees a pro-rated amount of leave. Qualifying employees are those who have been employed by the employer for one year or more. Vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.

16 HIGHLIGHT OF THE NEW LAW CORPORATE RATE CUTS

17 Details of the reduced corporate tax rate Reduction from 35 percent to 21 percent Effective in 2018 Repeals alternative minimum tax (AMT) Changed from tiered rate structure to flat rate Dividends received deductions (DRD) for corporation-to-corporation dividends adjusted accordingly Reduces 80 percent DRD to 65 percent and 70 percent DRD to 50 percent to preserve current effective rates 17

18 Reducing 35 percent to 21 percent an example for an individual shareholder Prior income tax rules $100 of corporate income Less $35 tax at 35 percent rate $65 of cash on balance sheet Less $13 tax at 20 percent rate $52 of after tax cash 48 percent combined income tax rate 3.8 percent tax on $65 or $2.47 All-in percent tax rate New income tax rules $100 of corporate income Less $21 tax at 21 percent rate $79 of cash on balance sheet Less $15.8 tax at 20 percent rate $63.2 of after tax cash 36.8 percent combined income tax rate 3.8 percent tax on $79 or $3 All-in 39.8 percent tax rate 18

19 PASS-THROUGH ENTITY DEDUCTION

20 20 percent pass-through deduction in a nutshell Qualified business income from flow-through entities (partnerships, S corporations and sole proprietorships) eligible for a 20 percent deduction Applies to operating income of active businesses If at 37 percent tax rate then the 20 percent deduction results in an approx percent federal tax Compare to corporate tax rate of 21 percent Does not apply, generally, to professions or financial businesses Business must either: Pay W-2 wages equal to 40 percent of income to get the full 20 percent deduction Limit deduction to 2.5 percent of original cost of depreciable, tangible property plus 25 percent of wages Business type and wage/asset limits do not apply below specified income limits 20

21 Specified service businesses No benefits (above the income threshold) for owners of specified service businesses, defined as: Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees [OR OWNERS] What does this mean? Awaiting guidance from IRS and Treasury.. 21

22 For joint filers with incomes below $315,000 (and comparable single filers) a special rule No wage or asset requirements, and no service business limitations Phased-out quickly as income rises from $315,000 to $415,000 Close to 100 percent marginal tax rate? Many lawyers, accountants, physicians and dentists probably earn under $315,000 of household income For two married accountants, lawyers, physicians or dentists each earning $150,000, the total deduction is $60,000 for a tax cut in the range of $15,000 Potential to apply to bank directors with taxable income below threshold 22

23 Problems and issues Employee versus independent contractor? Conversions under $315,000? Are all service businesses without large physical plants disqualified because their principal asset is the skill and reputation of their employees or owners? Can an owner without wages or assets pay himself a wage and get a reduction in the overall tax liability? Will reasonable compensation rules apply to S corporations? 23

24 BEST OF BOTH WORLDS STILL VALUABLE DEPRECIATION, EXPENSING, BONUS DEPRECIATION

25 Ultimate changes to depreciation complex and hard to analyze at this point, but generally speaking Basic, pre-bonus depreciation rules, viewed as non-economic by some, remain in baseline 100 percent bonus depreciation through 2022, then phased out through Applies to new and used property acquired $1 million permanent expensing under section 179, subject to limitations and phase-outs Changes to real property depreciation complex and may depend on choice of whether to apply business interest limitations 25

26 PAYING THE PIPER BUSINESS INTEREST DEDUCTIONS CUTBACK

27 Important changes to interest limitations Caps net interest deduction at 30 percent of adjusted taxable income an amount based on earnings before interest, taxes, depreciation and amortization (EBITDA) for four years After 2021, then limits the deduction to 30 percent of earnings before interest and taxes (EBIT) Taxpayers with average gross receipts of $25 million or less are excluded from the interest limitation Allows limited deductions to carry forward forever Various exceptions for real estate, utilities, farming and certain small businesses Special rules for partners and partnerships 27

28 OTHER IMPORTANT BUSINESS DEDUCTION LIMITATIONS, LIBERALIZATIONS OR DEFERRALS

29 Good news Generally, expanded use of cash method of accounting for small C corporations and partnerships with C corporation partners Family Medical Leave Act Credit 29

30 Not good news No more NOL carrybacks and a mixed bag of limitations and modifications to the carryforward rules Limits like-kind exchanges to certain real property Disallowance of qualified transportation fringe Increased limitations on deductibility of certain expenses of entertainment, etc. 30

31 ENTITY CHOICE CONSIDERATIONS

32 Some history... NUMBER OF RETURNS FILED ,500,000 C Corporations S Corporations Partnerships 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000, ,

33 C vs Pass-through - Basics General C Corporation subject to double taxation Pass-through shareholder basis increase Example 1 Annual taxable income of $750,000 Company distributes significant portion of after tax earnings to shareholders - $350,000 S Corporation distribution computed to leave same amount of cash in entity as C corporation did

34 C vs Pass-through - Example C Corporation Active Pass-through With QBI Deduction Active Pass-through No QBI Deduction Taxable Income 750, , ,000 Corporate Tax Rate 21.0% 0.0% 0.0% Corporate Tax on Income 158, After-Tax Cash in Corporation 592, , ,000 Shareholder Dividend 350, , ,000 Cash Remaining in Corporation 242, , ,000 Shareholder Dividend 350, , ,000 Earnings Taxed at Shareholder Level 750, ,000 Tax Rate on Dividend / Income Passed Through 23.8% 29.6% 37.0% Tax Dividend / Income Passed Through 83, , ,000 Net Cash to Shareholder 267, , ,000 Total Tax Paid 241, , ,000 Effective Tax Rate 32.13% 29.60% 37.07% Shareholder Basis Increase N/A 242, ,000 For simplification, the above calculation excludes effect of state taxes

35 Factors Favoring Pass-through Business qualifies for 20% deduction Potential for taxable sale or exit Is the ownership all on the same page regarding exit strategy Likely an asset sale Time frame limits on re-election of S corporation Significant discretionary distributions annually Minimal needs for investment of excess cash within the business Little or no debt Not likely to make significant business acquisitions Minimal or no shareholder redemptions

36 Factors Favoring Pass-through (cont.) Has implemented or planning to implement GRAT or similar wealth transfer strategies ESOP ownership (S corp only) Business not very profitable or operating at a loss

37 Reconsidering your taxable entity type You need to be talking to your tax advisor Requires a comprehensive review of current and future state of your business, and potentially a crystal ball Need to consider the chances of significant future law changes Can I undo what I just did?

38 OVERVIEW OF THE INDIVIDUAL AND WEALTH TRANSFER PROVISIONS

39 Summary of provisions Area Brackets and rates Summary Seven tax brackets 10, 12, 22, 24, 32, 35, and 37 percent. The top individual rate of 37 percent will apply at incomes of $500,000/$600,000 Brackets and rates for estates and trusts Alternative minimum tax Condenses the number of tax brackets from seven to four, including 10, 24, 35 and 37 percent brackets Retained with higher exemptions ($70,300/ $109,400); phase-out of exemption increased to $500,000/$1,000,000 39

40 Summary of provisions (cont.) Area Summary Personal exemptions Repeals Standard deduction Doubles to $12,000/$24,000; retains additional deduction for blind and elderly Mortgage interest Limits to interest on $750,000 of indebtedness on newly purchased principal and second residences incurred after Dec. 15, 2017; not allowed for home equity loans or lines of credit unless they are used to buy, build, or substantially improve the home that secures the loan 40

41 Summary of provisions(cont.) Area State and local tax deductions Summary Deduction of up to $10,000 for state and local property, income or sales taxes allowed Charitable contributions Preserves deduction and increases the AGI limitation for cash contributions to public charities and certain private foundations from 50 percent to 60 percent 529 plans Up to $10,000 of 529 plans can be used per student for public, private and religious elementary and secondary schools 41

42 Summary of provisions (cont.) Summary of provisions (cont.) Area Other deductions Summary Deductions for casualty and theft losses limited to those incurred in a disaster area Alimony paid for divorce after Dec. 31, 2018, not deductible/includible after 2018 Miscellaneous deductions Eliminates miscellaneous deductions over 2 percent of AGI 42

43 Summary of provisions (cont.) Area Summary Medical expenses Medical expenses exceeding 7.5 percent of AGI deductible for 2017 and 2018; eliminates AMT preference for medical expense deductions for 2017 and Overall limitation on itemized deductions (Pease limitation) IRAs Suspends 3 percent of AGI limit on deductions Conversion of traditional IRA to a Roth IRA cannot be recharacterized; can still convert traditional IRA into a Roth IRA. 43

44 Summary of provisions (cont.) Area Estate, gift and GST tax Summary Exemptions are doubled to approximately $11 million, effective January The estate, gift and GST tax rates remain the same as prior law. Estate and GST tax not repealed Provisions sunset after

45 Key provisions of prior law left undisturbed Income tax The 3.8 percent tax on investment income under section 1411 and the.9 percent Medicare tax on compensation Tax rates on capital gains and qualified dividends Exclusion of gain on sale of a residence Ability to identify the securities that an investor is deemed to sell, i.e., the Senate s proposal for a first-in, first out method not included Pre-tax contribution limits (including catch-ups) for 401(k) plans Ability for beneficiaries to stretch IRA withdrawals out over their lifetimes Student loan interest deductions, adoption assistance programs, dependent care accounts, tuition waivers, employer paid tuition, teacher supplies deduction and Archer medical savings accounts 45

46 Observations on impact on estate planning Doubling of the exemptions (and indexing thereafter) effectively repeals the estate tax for many individuals But sunsetting makes the planning more problematic The doubling of the estate tax exemption is reason enough to review your current estate plan, e.g., the funding of a so-called credit shelter trust Key inquiries will be: Whether the current or projected estate will be taxable in the first place, and Whether there is a need (or, just as important, a desire) to reduce the taxable estate Perhaps just use the increased exemption to fix problems with existing planning Plans for estate tax liquidity also should be revisited For increased exemptions, sunsetting, etc. 46

47 Tax reform resource center Visit our tax reform resource center for more information on how legislation can affect your business and tax planning at 47

48 2018 RSM US LLP. All Rights Reserved.

49 Jerry Kissell RSM US LLP 801 Nicollet Avenue, Suite 1100 Minneapolis, MN (612) This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute audit, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. RSM US LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. Internal Revenue Service rules require us to inform you that this communication may be deemed a solicitation to provide tax services. This communication is being sent to individuals who have subscribed to receive it or who we believe would have an interest in the topics discussed. RSM US LLP is a limited liability partnership and the U.S. member firm of RSM International, a global network of independent audit, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. RSM and the RSM logo are registered trademarks of RSM International Association. The power of being understood is a registered trademark of RSM US LLP.