The Sub S Bank Report – October 2011 (Volume 14, Issue 3)

It seems that everyone has an opinion on tax reform these days.  Republican or Democrat, liberal or conservative, policymakers from all backgrounds are proposing legislation aimed at reforming the Tax Code.  The American Jobs Act of 2011, released by President Obama in early September, is clearly the most recognized tax initiative of late which could significantly impact small businesses, including Subchapter S banks, across the country.  What is less known to most, however, is the flood of similar tax reform proposals that have been introduced in Washington throughout 2011.  While no single proposal appears to have gained any meaningful traction within either Chamber, as the Bush-era tax cuts move closer to their scheduled expiration in 2012, the Subchapter S Bank Association has been keeping a close eye on the various proposals seeking to address the upcoming deadline. 

The tax cuts instituted under the Bush Administration reduced individual marginal rates and lowered the tax on long-term capital gains and dividend payments to 15%.  Save for any new legislation, rates are set to return to their 2003 levels when the tax cuts sunset at the end of this year.

Introduced in the Senate by Senator Harry Reid (D-NV) as S. 1660, the American Jobs Act is a $447 billion package intended to provide tax relief to individuals and businesses and stimulate job creation.  Criticized by Republicans and Democrats alike, S. 1660 was shot down in the Senate on October 11th.  Senate Democrats are now planning to break the bill up into a number of pieces in hopes that some of the measures will be passed.

Among the noteworthy provisions of S. 1660, Section 401 proposed to amend Chapter 1 of the Tax Code by adding a new Section 69 entitled “Limitation on Certain Deductions and Exclusions.”  Proposed Section 69 would have reduced the value of itemized deductions and certain other tax expenditures for high-income taxpayers by limiting the tax value of otherwise allowable deductions and exclusions to a maximum of 28%.  Abigail Urtz of FTN Financial notes that this provision “would substantially shift demand for tax-exempt municipals by reducing the tax advantage,” causing an increase in rates to compensate for the lack of demand.

Like most tax initiatives, the American Jobs Act would only have affected individual taxpayers currently falling within the marginal rate brackets of 33% and 35% (formerly 36% and 39.6%).  What the legislation failed to address is the substantial impact these changes would have on pass-through businesses.  Even more troubling, however, Senate Democrats rewrote the President’s original bill to impose an additional 5.6% surtax on individuals reporting modified adjusted gross income over $1 million, including income from capital gains and dividends.  This too would dramatically impact Sub S shareholders and would likely threaten the continued viability of Subchapter S for financial institutions.

As of this writing, we have not seen which provisions of S. 1660 will be fragmented off and reintroduced in the Senate. 

The Bipartisan Tax Fairness and Simplification Act of 2011 was introduced by Senators Wyden (D-OR) and Coats (R-IN) earlier this April, but has not yet found its way out of the Senate Finance Committee.  The Wyden-Coats proposal would simplify the Tax Code by reducing the marginal rate brackets from six to three, consisting of only 15%, 25% and 35% levels, and would completely eliminate the Alternative Minimum Tax.  The bill would also implement a new 35% exclusion and progressive rate structure for dividend and long-term capital gains income, as well as cut the holding period for long-term capital gain recognition to six months for the first $500,000 of a taxpayer’s capital gains income.

A number of other proposals have been introduced in the House.  Congressman Dreier (R-CA) introduced the Fair and Simple Tax Act of 2011, which would lower individual and corporate rates to 25%, repeal the estate and gift taxes, institute a 10% capital gains tax, and make the Bush-era tax cuts permanent.  The proposal would also allow an inflation adjustment to the basis of capital assets for the purpose of determining gain and loss. 

H.R. 934, sponsored by Congressman Sessions (R-TX), would amend the Tax Code to establish a flat income tax rate of 18% for corporations, including personal service corporations.  As written, Congressman Sessions’ proposal would only seek to amend the corporate tax, leaving individual rates unaffected.  Both the Fair and Simple Tax Act of 2011 and H.R. 934 appear to have stalled in the House Ways and Means Committee.

Two proposals would incorporate a type of personal election for certain taxpayers.  The Freedom Flat Tax Act, supported by Congressman Burgess (R-TX), would amend the Tax Code to authorize an individual or “person engaged in business activity” to make an irrevocable election to be subject to a flat tax of 19% for the first two years after the election is made, and 17% thereafter.  The proposal would redefine taxable income to include all wages, retirement distributions and unemployment compensation in excess of the standard deduction.  The standard deduction would also be amended to encompass the sum of two distinct figures, termed the “basic standard deduction” and the “additional standard deduction.”  The basic standard deduction would be $30,320 for joint filers and $15,160 for single taxpayers, while the additional standard deduction would permit further deductions of $6,530 for each dependent meeting the requirements of a “qualifying child” under the Tax Code. 

Not to be left on the sidelines, Louisiana Representative Steve Scalise also joined in the tax reform parade, sponsoring a bill entitled the Buffett Rule Act of 2011, which, as written, would instruct the IRS to provide a prominent checkbox line on 1040 forms to allow those inclined to pay extra income tax to do so.

Finally, led by Speaker Boehner (R-OH), House Republicans are gearing up a proposal to counter the American Jobs Act.  The Republican initiative would cap the top tax rates at no more than 25% for job-creating businesses and individuals, and attempt to reform the Tax Code to allow global American companies to bring back overseas profits without being subject to double taxation.  The effect the Republican initiative could have on S corporations and other pass-through entities is uncertain, as proposed legislation on the issue is still forthcoming.  However, House Republicans have made their intentions clear that lowering tax burdens on businesses is a fundamental tenet of their agenda.  Up-to-date information on the issue can be found at the initiative’s website, The House Republican Plan for America’s Job Creators, available at http://www.gop.gov/indepth/jobs.

With 2012 also being an election year, the focus on tax reform continues to heighten in the eyes of Presidential and Congressional candidates alike.  We will continue to closely monitor the proposals brewing in Washington.

Mr. Toppin is a partner with the law firm of Kennedy, Toppin & Sutherland, LLP, specializing in counseling community banks on corporate, banking, regulatory, lending and securities matters. He is also the Executive Director of the Subchapter S Bank Association. He can be reached by email at btoppin@ktsllp.com or by phone at (210) 228-4414.

The Department of Treasury’s Office of Tax Analysis (OTA) released a technical paper this August proposing to narrow the flow-through tax treatment afforded to small businesses.  In the paper, the OTA suggests that because the tax code does not expressly define the term “small business,” certain organizations—chiefly, those that generate sizeable revenues—should not be afforded the benefits of flow-through taxation (i.e., organizing as partnerships, LLCs or S corporations).

The OTA’s new definition of small business would only include organizations that reported annual total income of less than $10 million and annual deductions of less than $10 million. Currently, there is no limit on the amount of income or deductions for small businesses. The OTA noted that because many provisions within the tax code utilize gross receipts in identifying entities eligible for preferential treatment, and due to the fact that business filers do not report the number of employees on their tax returns, the OTA would use a total income threshold to separate small businesses from their larger counterparts. Organizations exceeding the total income or deduction thresholds would be required to pay corporate level taxes, and distributions would also be taxed at dividend rates.

The OTA notes in the paper that, based on the 2007 tax year, only a small fraction of S corporations—roughly 2.5%—would be affected by the proposed changes. The impact on Subchapter S banks, however, would likely be much higher. Indeed, potentially half of the 2,400-plus Sub S banks or bank holding companies would likely exceed either or both of the $10 million thresholds, causing them to become subject to double-taxation.

Subchapter S financial institutions would be disproportionately affected compared to S corporations in general simply because of the nature of how banks generate profits. A net interest margin (the difference of interest income minus interest expense divided by average earning assets) of over four percent is considered high-performing, so for banks, volume is a key to profitability. It is not uncommon for a bank with as little as $165 million in total assets to generate more than $10 million in interest income in a given year. And most would agree that a $165 million bank should qualify as a small business.

It is worth noting that this technical paper is written in the abstract; it merely contemplates the tax impact of imposing a cap on total income and deductions. It does not discuss how such a change in the tax code should, or even could, be implemented. In all likelihood, a significant overhaul would be necessary.

In the wake of The Report on Tax Reform Options: Simplification, Compliance and Corporate Taxation, released by the President’s Economic Recovery Board in August 2010, the OTA’s newly-issued methodology is yet another step closer to the imposition of double taxation on small businesses. One proposal under the Tax Reform Options report would broaden the corporate tax base by applying the corporate tax to pass-through entities based on an entity’s size or the number of shareholders. Furthermore, one such instance specifically referenced in the report as a potential situation where “imposing the corporate tax might be appropriate” was with respect to very large S corporation banks or credit unions. It appears that the OTA’s recent shift methodologies in defining small business could be the first of many policy issues that may draw the increased attention of lawmakers as the extensions to the Bush-era tax cuts move closer to expiring. The Subchapter S Bank Association is closely monitoring this situation and will keep its members updated as more information becomes available.

With the economic outlook turned decisively negative, investors have focused again on the prospects for municipal credit.  August’s gloomy economic reports came just as state treasurers were breathing a sigh of relief after six straight quarters of growth in tax receipts and a much improved budget picture.  The strong performance of tax revenues resulted in a surplus for at least twelve states in fiscal year 2011, and some states with exceptional rebounds saw their ratings and outlooks revised upward. 

The key change in municipal credit from recent downward revisions to growth is not an expectation for plummeting revenues—receipts will continue to increase with any growth in GDP—it is the risk that budget gaps may open again if revenue growth fails to meet projections.  It is time to become reacquainted with important credit considerations when the economic outlook turns sour.

Tax Revenues Still Projected to Grow

Municipal tax revenues are highly correlated with economic activity.  As most municipalities rely on some combination of sales, income, and property tax revenues, changes in economic growth and housing markets have important consequences for municipal budgets.  However, revenue performance varies between sales and income taxes—which generally perform with a six-month lag to the economy—and property taxes—which perform with multi-year lags to regional housing markets due to timing of reassessments.

States, the bellwethers of municipal credit performance, depend primarily on sales and income tax revenues for operations.  When economic cycles turn, state budgets are the first to buckle and can be important predictors of broader municipal market stress as problems flow down to lower levels of government.  The graph below highlights historical growth in state tax revenues and nominal GDP.   A simple regression of tax revenues and GDP returns, an r-squared of 0.68, suggests the majority of growth in tax revenues can be explained by changes in GDP.  The regression also suggests that states benefit on the recovery side from a high revenue beta of 1.89, which suggests that state tax revenues grow (or fall) 189% more than GDP.

Applying FTN’s forecast for lower GDP growth, we see that a 1.89 revenue beta would still produce healthy gains in state tax receipts.  The risk to municipal credit emerges, however, in the state budgeting process. Expenditures are crafted around revenue projections, so revenue shortfalls could open budget gaps that would have to be closed with mid-year spending cuts, increased taxes, or reserve withdrawals.  Of course, it is easier to adjust budgets when spending is allowed to grow than it was when states were forced to carve out of already reduced budgets.  It is also important to consider the fine line between economic growth and contraction.  Any return to recessionary territory could be detrimental to states riding on a revenue beta over 1.

Weakness Not Distributed Equally

In many ways, the “Great Recession” in America was a regional recession.  While the effects were far reaching and left few unscathed, the worst problems were concentrated in specific pockets of the country, particularly those with overheated housing markets.

Many areas of the country with the most severe contractions are still experiencing stress in local housing markets.  Housing prices and activity have stagnated, and backlogs of foreclosures threaten hopes of any near-term recovery.  Just as the plunge into recession took on regional intensity, the crawl back out has also followed a regional trend.

The importance of housing to the national recovery was underscored last week by the Federal Reserve’s decision to reinvest maturing Treasury’s in agency-backed mortgage securities.  The Federal Open Market Committee whined all summer about its reluctance to initiate further easing, so last week’s twist shows just how critical housing has become to our national agenda.

A recovery in housing may be even more important to local municipalities.  Unlike states, many local governments rely heavily on property tax receipts to fund operations.  In regions where house prices have tumbled by double digits, revenues have been hard hit and may take years to recover previous peaks.  Since property tax receipts tend to lag market changes by three or more years, municipalities will take even longer to benefit from a recovery in housing. 

Course of Action

To hedge against a further economic slowdown or slump, investors should look to regions of the map with the strongest economies through the recession.  These areas have maintained the strongest employment bases, consumption, and housing markets, which are all key drivers of municipal income, sales, and property tax revenues.  These areas have also seen the strongest GDP growth during the recovery (2009-2010) and should deteriorate less if we fall back into recession.  Investors in red or orange states can still realize the added tax advantage of purchasing in-state by looking to stronger pockets.  For example, California buyers should concentrate in coastal areas versus central valley regions bordering Nevada and Arizona.  Similarly, Ohio buyers may look to regions bordering Kentucky or Pennsylvania economies.

Investors should also minimize exposure to credits with material dependence on state funding, particularly those in weak states.  States will be among the first credits to experience stress from a slowdown and will pass the buck to local governments through lower funding.  States may also come under stress from reduced federal funding through deficit reduction legislation.  School districts are typically the most state-dependent credits but can be layered with state enhancement wrappers to hedge against state funding pressures.  Other sectors that hold up well during economic downturns are essential service revenue bonds such as water or sewer credits, and revenue backed structures with low sensitivity to economic cycles.

Ms. Urtz manages municipal credit strategies for FTN Financial Capital Markets. She follows general credit trends and sector-specific developments to help customers identify and manage credit risk. Ms. Urtz uses her extensive database and municipal credit information to identify relative value opportunities through research publications and tailored investment strategies.