What Lenders Need To Know About Tax Reform – Part I

Banking With The Tax Cut and Jobs Act - Tax Reform

No matter your politics and no matter how you feel about the recently passed Tax Cut and Jobs Act of 2017 (TCJA), one thing is certain – the change has created confusion and anxiety across the households and businesses of America. As a result, the most significant tax overhaul since 1986 has created a near-perfect opportunity for banks to take a thought leadership position to speak with their clients as well as the media to promote the bank and its financial expertise. According to the Joint Committee on Taxation, businesses will get 44% of the $1.5T in tax cuts. Here at CenterState for instance, we are rolling out a series of speaking engagements to educate our customers and boost customer engagement. We went through the complete legislation and have come up with our most important topics to speak with current and potential commercial borrowers. In this multi-part article, we break down the salient points of TCJA; discuss the pertinent conversations to have between lenders and borrowers; look at how tax reform will impact pricing/credit; and, provide some tools to help banks become better relationship-driven bankers.  


The Objective


The key objective here is twofold - Bankers need to do this analysis anyway to help understand how tax reform will impact bank credit. In doing so, we are recommending that bankers work closely with their commercial customers and their professionals to help their customers take better advantage of tax law changes all the while increasing their thought leadership position in the eyes of the client. To be clear, we are not advocating bankers dispense tax advice, but be knowledgeable enough on the new tax law changes to help with business advice particularly as it pertains to the best use of banking products. If done correctly, bankers can become even more of a trusted advisor and bring greater relationship value to their customer.


Lender Discussion Points On The Tax Cut and Jobs Act 


Top Marginal Corporate Tax Rate History


Discussion Point: Earnings – The easy conversation to start is the one over earnings. The corporate tax rate decreases from 35% to 21%, the repeal of the alternative minimum tax, the removal of the special 25% rate for personal service corporations and the reduction of dividends received deductions means more cash at the business. The much talked about “pass-through change” means that sole proprietorships, partnerships, and S corporations will get a 20% tax deduction with the exception of service companies (covered later) such as law, accounting, consulting, medical and staffing firms that make over a certain level of annual income. Roughly, for every $100k of corporate income produced, corporate cash will increase approximately $14k compared to last year.  For pass-through owners, what would have been an all-in tax rate of a little over 50% is now an all-in tax rate of a little under 40% taking into account taxes at the corporate and personal level.


Banker Leadership: More earnings mean more deposit balances no matter if these balances go out in the form of dividends, investments or gifts. The first discussion to have is what level of extra cash does management expect and what they plan to do with the larger balances. Since the spirit of tax reform was to have businesses reinvest earnings to create jobs and growth, this is the next conversation to have.  Less tax means higher returns on investments which moves many marginal projects above their hurdle rates. Higher returns also mean more investment options which means more opportunities for banks to provide debt capital. Banks can supply debt to allow responsible leverage to further allow the acquisition or building of revenue-producing assets or the investment in cost-saving equipment or technology. While we will discuss the changes in a firm’s cost of capital that will occur as a result of TCJA and how lenders can position themselves to discuss the salient points of the TCJA, one key preliminary takeaway is that for a majority of bank clients, the TCJA should increase the demand for loans, reduce credit risk for banks, and increase the profitability of clients at the bank level. The secondary reverberations of this impact will likely mean tighter loan spreads, more demand for fixed-rate loans and higher returns for banks.


Below is an example of the direct impact of a pricing change for the average community bank loan. Here, this is a $500k loan with a 20-year amortization due in five years. Assuming variable pricing at 2.35% spread the risk-adjusted return is 11.3% (below left). With just the reduction of Federal taxes for the bank, that return would move to 13.9%. The other way to look at this is, banks could have priced this loan at a 2.02% spread, or a reduction of 33 basis points and still achieved the same 11.3% return.


Of course, for most scenarios, the new tax structure has a positive impact on both the bank and the borrower. For the borrower, the biggest impact is the increase in cash flow as tax expense is lowered in each period making for better free cash flow and better debt service coverage. In addition, this greater cash flow also increases cash balances thereby improving the borrower’s liquidity. In our example below, the annual probability of default drops by ten basis points per annum from 2.0% to 1.9%. In addition, the lower tax rates also increase the value of the real estate held as collateral increasing the bank’s collateral coverage. As a result, the loss given default decreases as well. The next change for the bank means a reduction of expected loss from 0.61% to 0.56%. Thus, taking into account both the bank’s tax bracket change, the borrower’s cash flow change and improving credit quality, the risk-adjusted return on equity moves from 11.3% to 14.2% (below right) assuming no change in pricing. If pricing, were to change, banks could charge a spread of 1.96%, or almost 40 basis points lower, and still achieve the same 11.3% return. We also note that we are assuming no secondary change in the borrower’s business that could result as a result as a result of an improving economy, lower taxes or change in either volume or prices of goods sold. 


Loan Pricing with the Tax Cut Jobs Act


Discussion Point: The Pass-through Deduction: The details of the 20% pass-through deduction also merits lender’s attention to help them render advice. Not only does the provision generally not apply to passive, professional and financial businesses, but there is one other further test. To qualify for the full 20% pass-through deduction, a business must either pay W-2 wages to equal at least 40% of income OR, limit the deduction to 2.5% of the original cost of depreciable, tangible property PLUS 25% of wages.


Pass-through deduction algorithm



Banker Leadership: To fully qualify for the 20% pass-through deduction, higher earning investors are incented to invest in businesses that are active (instead of passive) and have material tangible assets. For example, an investment in a parking lot where the operation is contracted out would likely result in not qualifying for the full deduction as there is not enough wages paid or enough depreciable property. However, if the investor had one of his or her employees manage and operate the property, there would likely be enough wage expense to qualify. Similarly, investments where there is a high percentage of real property, such as hospitality, would likely to qualify. There is also some ambiguity if a project, such as a parking lot, were leased to a law firm, medical facility or other exempted businesses. In these cases, even if the investment met the wage and/or asset test, it may not qualify for the 20% pass-through deduction. While the application of the pass-through deduction still is being tested and worked out, bankers should at least be aware enough to help review a customer’s investments in order to help determine what projects need further review.   


Up Next


Banks should check with their tax professionals and consider bringing those professionals together to help train lenders as well as to co-sponsor client events. Equally important, all bankers need to work with their tax professionals to monitor changes and interpretations to the new tax law. The 185-page law is just weeks old, wasn’t made public until last month and is still very much open to interpretation. As such, we expect lender and borrower’s strategies to be dynamic.


Coming up in our next segment, we will cover how lenders might want to work with borrowers regarding the changes in interest deductibility, what industries are likely to benefit from tax reform, how real estate financing is impacted, the changes in a borrower’s cost of capital and how a borrower’s international operations are affected.


We will also provide some additional tools lenders can use to work with their borrowers as the end goal is to not only understand what the Tax Cut and Jobs Act does to credit and pricing but how banks can use these tax changes to become more of a relationship-driven institution. With that goal in mind, we leave you with a quick video on how we plan to leverage some of these changes from a marketing perspective.