Section 6

Tax Update

Presented By:

Ken Johnson & Bettina Brown

Vavrinek, Trine, Day & Co., LLP

Ta x U p d a t e

T A X U P D A T E | N O V 1 3 , 2 0 1 7

P r e s e n t e d b y : K e n J o h n s o n & B e t t i n a B r o w n

• Overview of the Proposed House Tax Bill

• Impact of a Corporate Tax Rate Decrease on Banks

• Year End Tax Planning

• Stock Options and Restricted Stock

• IRS Sec 475 Dealer Status Due to Loan Sales

• Bad Debt Conformity Election

• The following information is from the proposed House

Tax Bill which broadens the tax base and lowers rates.

Individual Highlights

• Proposed Tax Rates:

Tax Rate Single Filers Married Filing Joint

12% $0 - $45,000 $0 - $90,000

25% $45,001 - $200,000 $90,001 - $260,000

35% $200,001 – $500,000 $260,001 - $1,000,000

39.6% $500,001 and up $1,000,001 and up

Individual Highlights Continued

• Eliminates Personal Exemptions

• Standard Deduction nearly doubles to $12,000 Single

and $24,000 MFJ

• Repeals Alternative Minimum Tax

• Eliminates the itemized state tax or sales tax deduction

and limits the property tax deduction to $10,000.

• Increased the Child Tax Credit and adds two new Family

Credits.

Individual Highlights Continued

• Curbs the Mortgage Interest Deduction on new homes to

mortgages loans up to $500,000, limited to Principal

Residence.

• The exclusion for the gain on the sale of a principal

residence is limited to once every five years with a

requirement that the taxpayer use the home as the

residence for five out of the eight prior years.

• Repeals many other deductions such as medical

expenses, tax preparation fees, student loan interest,

alimony and moving expenses.

Corporate Highlights

• New Tax Rate of 20%

• Repeals Alternative Minimum Tax but limits NOL usage

to 90% for NOLs 2018 and forward.

• Net Operating Losses for 2018 and forward generally

cannot be carried back and usage is limited to 90% of

TI.

• Establishes a 25% Tax Rate for Pass-Through Entities

with certain “guard-rails”.

Corporate Highlights Continued

• Allows Immediate Expensing of Fixed Assets with a Life

of 20 Years or Less. Applies to Qualified Property Placed

in Service After 9/27/17.

• Entertainment Expenses Not Deductible

Other Tax Highlights

• Estate Tax Exemption Doubled to $ 10,000,000 per

person with a 6 year phase out.

• No Changes to 401(k) Plans

• Non-Qualified Deferred Compensation would be taxed as

soon as there is no longer substantial risk of forfeiture.

Stock options are included.

• The Re-Measurement of a Net DTA is Recorded through

Income Tax Expense in the Quarter that the Rate

Reduction is Enacted.

• Below is a table of the Blended Federal and State

Rates based on changes to the Federal Rate.

• Decrease in Value is a Debit to Tax Expense

State Fed Rate 35% Fed Rate 34% Fed Rate 20%

California 42.05% 41.15% 28.67%

Arizona 38.18% 37.23% 23.92%

• Example of Reduction of DTA and AFS Tax Entry:

Description Inventory Valued 41% Valued 29% Decrease

Net DTAs $2,000,000 $820,000 $580,000 $240,000

AFS Tax DTA $1,000,000 $410,000 $290,000 $120,000

Total Net DTAs $3,000,000 $1,230,000 $870,000 $360,000

Account Entry Debit Credit

Tax Expense $360,000

Net DTA $240,000

AFS Tax DTA $120,000

• Example of Reduction of DTA and AFS Tax Entry:

Account Original 41% Re-Valued 29%

AFS Invest Loss ($1,000,000) ($1,000,000)

AFS Tax DTA $410,000 $290,000

AFS Capital OCI $590,000 $590,000

Net Total of AFS Accts $0 $120,000

• Security AFS Tax Adjustment Change is Posted through

the Tax Expense. This Leaves a “Dangling” Debit/Credit

on the Balance Sheet. Located in the capital section.

• How Does Dangling Debit/Credit get Reversed

• Aggregate Portfolio Approach

• Item-by-Item Approach

• Defer Revenue

• Postpone Loan Sales Until 2018 – unless a dealer

• Defer Gain Transactions Until 2018

• Accelerate Deductions

• Bonus Accrual Should be Fixed and Determinable

• Pay bonuses prior to year end

• Prior to year end, establish a bonus pool with

Board approval to pay entire pool to various

employees

• Accelerate Deductions Continued

• Prior to year end, Bank or Board to adopt a

provision to reallocate bonus pool amounts if

an employees leaves to ensure entire bonus

pool is paid out.

• Pay bonus pool out by March 15

• Claim Maximum Sec 179 Fixed Asset Deduction

• Deduct Prepaids Using the 12 Month Rule

• Deductible Prepaids must meet the

qualifications and be paid based on an invoice

received and paid prior to year end.

• Reverse Existing DTAs

• Dispose of OREO properties with prior book write

downs that were not deducted for tax.

Incentive Stock Options

• There are several requirements that must be met to

ensure the tax preferred status of incentive stock

options.

• Granted to individuals in connection with employment

• Options are non-transferable

• Option price is not less than fair market value

• Options period not greater than 10 years

• Annual vesting based on FMV at grant date cannot exceed $100,000. Any shares exceeding the limit have NQ tax treatment

Incentive Stock Options Continued

• Options meeting the ISO requirements are ISO unless

specified as NQ.

• There is no tax event when the shares are granted

• When the shares are exercised, if the holding

requirement is not met, a disqualifying disposition

occurs and additional income will need to be reported

for the employee.

• Form 3921 prepared annually to report the exercise of

every ISO in the prior year.

Incentive Stock Options Continued

• The income reported for the employees is a tax

deduction for the Bank.

• The tax effect of the deduction goes through current tax

expense (No more APIC Windfall Pool).

• The easiest way to record is to add the ISO exercise

income deduction as a minus on the monthly tax

accrual worksheet.

Non-Qualified Stock Options

• NQ Stock Options may be granted to employees or non -

employees.

• There is no tax event when the shares are granted.

• When the shares are exercised, the difference between

the exercise price and the FMV at exercise is reported as

ordinary income.

• The income reported for an employee is reported on Form W-2 and is subject to all withholding requirements.

• The income reported for a non-employee is reported on Form 1099-Misc, Box 7.

Non-Qualified Stock Options Continued

• The income reported for the individuals is a tax

deduction for the Bank.

• The tax deduction needs to be split between the

permanent amount and the temporary deduction.

• The prior stock option expense is the temporary

deduction.

• The difference between the tax deduction and the

temporary deduction is the permanent deduction.

Depending on the current value, this amount could

be a addback or a deduction to taxable income.

Non-Qualified Stock Options Continued

• The tax effect of the permanent amount goes through

current tax expense (No more APIC Windfall Pool).

• The easiest way to record is to add the permanent

NQ amount as a plus or minus on the monthly tax

accrual worksheet.

Restricted Stock Grants

• At grant date, an individual receives restricted shares of

stock.

• Shares are issued and outstanding and can received

dividends.

Restricted Stock Grants Continued

• If the individual makes an 83(b) election within 30 days

of grant, income will be reported to the individual based

on the fair market value at grant date.

• Employees income will be reported on form W -2,

subject to all withholding requirements.

• Non-employees income will be reported on form

1099-Misc, Box 7.

• The income reported to the individuals is a tax

deduction for the Bank in the year reported.

Restricted Stock Grants Continued

• If no 83(b) election is made, income will be reported to

the individual based on the fair market value at date of

vesting, when all the restrictions are lifted.

• The reporting for employees and non -employees is

the same as the prior slide.

• The income reported for the individuals is a tax

deduction to the Bank in the year reported.

• The tax deduction needs to be split between the

permanent amount and the temporary deduction.

Restricted Stock Grants Continued

• The temporary deduction is the amount of

restricted stock grant book expense.

• The difference between the tax deduction and the

temporary deduction is the permanent deduction.

Depending on the current value, this amount could

be a addback or a deduction to taxable income

• The tax effect of the permanent amount goes

through current tax expense.

• The easiest way to record is to add the permanent amount as a plus or minus on the monthly tax accrual worksheet.

Restricted Stock Units

• At grant date, an individual is granted the right to

receive shares of stock at a future date. Shares are

not issued until a future date.

• When requirements have been met and shares are

no longer subject to substantial risk of forfeiture,

tax treatment will vary depending on whether the

shares are issued at that date or deferred until a

later date.

Restricted Stock Units Continued

• If shares vest and are issued at the same time, the

current fair market value of the shares is reported

as ordinary income, subject to all required payroll

taxes.

Restricted Stock Units Continued

• If issuance of shares is deferred, the current fair market

value of the shares is subject to FICA taxation and the

appropriate FICA tax must be collected from the

employee.

• Shares not issued within 2 ½ months of vesting will

trigger 409(a) rules and must meet all 409(a) rules.

• When shares are issued at a later date, the current

fair market value of the shares is reportable as

ordinary income subject to federal and state

withholding.

• If a Bank Sells more than 60 loans, including

participations, the Bank has Dealer Status for IRS

purposes.

• Once a Dealer for tax purposes, always a Dealer

• Dealers are subject to IRS Sec 475 Mark to Market Rules

• At the end of the year, gains on Loan HFS is taxable

• Securities subject to the Mark to Market Rules include

loans, stocks, bonds or any other evidence of

indebtedness, even if not held for sale.

• To ensure the above Securities are not subject to the IRS

Mark to Market Rules, a tax identification should be

made.

• The tax identification can be added to a Bank Policy

specifying either the general ledger accounts for

Investments or Loans not HFS or incorporating a

Blanket Identification for Investments or Loans.

The following paragraph may be added to the Bank’s ALCO, Loan and/or Investment Policy.

The Revenue Reconciliation Tax Act of 1993 included mark -to- market tax accounting provisions (IRC Sec 475) for “dealers” in securities. Dealers are required to (1) account for inventories of securities at fair market value (lower of cost or market is no longer allowed); and (2) mark-to-market all other securities at the close of their taxable year. Securities classified as either Not Held for Sale or Held for Investment are not subject to the tax mark-to-market rules.

For tax identification purposes, the Bank has established two categories of investments and loans:

(1) Held for Sale (2) Not Held for Sale, or Held for Investment

All securities held by the Bank should be classified under one of these categories. Securities purchased must be classified by the end of the business day they are acquired.

Pursuant to the provision of section 475 of the Internal Revenue Code of 1986, as amended, the Bank Name hereby makes the following identifications:

All securities held in accounts XXXX through XXXX and loans contained in accounts XXXX through XXXX are hereby identified as exempt from the mark to market rules because the securities and loans contained in these general ledger accounts are “held for investment/not held for sale” as defined in section 475(b)(1)(A) or (B).

OR

All investment securities, loans and other forms of indebtedness are “held for investment/not held for sale” except for loans contained in general ledger account XXXX. Loans in this general ledger accounts are identified as “held for sale”.

• IRC Sec 166 allows a tax deduction for both wholly and

partially worthless debt.

• The deductibility of a partial charge off is based on facts

and circumstances.

• The IRS may disallow the portion of a partial charge

off related to estimated selling costs.

• The IRS permits a Bank to make a Bad Debt Conformity

Election.

• The Election bypasses the “proof ” required by an

IRS examiner for partial loan charge offs.

• To make the Bad Debt Conformity Election, the Bank

needs to request and obtain an Express Determination

Letter from the federal regulators.

• Once the EDL has been obtained from the federal

regulators, a Form 3115 can be filed with the corporate

tax return to make the Election.

• Once the Election has been made, the Bank needs to

request and obtain an EDL at every future federal

regulatory exam.

• EDLs usually need to be requested at the beginning

of a federal regulatory exam.

• There is an automatic change available to fix a Bad Debt

Conformity Election that is not valid due to a failure to

obtain an EDL at every federal regulatory audit.

• To fix the Bad Debt Conformity Election, an EDL will need

to be requested and a new Form 3115 filed with the

corporate tax return. A EDL will need to be obtained for

the current federal regulatory exam and at all future

federal regulatory exams.