Investigating two overlooked strategies could put you on your way to cutting taxes by half. Got your attention?   Bank profitability islike a puzzle. To understand the whole picture requires understandinghow each piece of the puzzle fits with the other pieces.
 
The pieces most bankersfocus on are net interest margin, noninterest income, noninterestexpense, the level of earning assets, and leverage. Unfortunately,bankers overlook an important piece of the puzzle: taxes. It’s the lostpuzzle piece that has fallen into those dark recesses of the sofa.
 
Money left on the table
The average community bank pays 32.66% of pre-tax income in taxes. Yetother community banks pay as little as 18% of pretax income in taxes.Clearly America’s community banking industry overall is not taxefficient.
 
Take a look at the numbers.A bank that generates $10,000,000 in pretax income would have a taxbill of $3,266,000 at the 32.66% rate, or $1,800,000 at the 18% rate.That difference could help pay for a new branch or the launch of amajor new product. This is why taxes are a key driver of bankprofitability.
 
But why would a bank paytaxes at a 32.66% rate when it might lower the rate to 18%? The reasonis simple: Most tax accountants for banks do very little tax-planning,yet they will admit the bank could lower its tax rate.
 
Thus, the responsibilityfalls to a bank’s executives to know how to lower the tax rate and tothen create a plan to do that. Every strategic plan should address thetax piece of the profitability puzzle.
 
Banks calculate their taxesin two ways: The regular tax and the alternative minimum tax. The bankis required to pay the higher of the two amounts. Tax efficiency isusually reached when the bank does not pay more than the tax computedat approximately 20%, the alternative minimum tax rate, so that is asuitable target. If a board focuses on tax planning as part of thebank’s strategic direction, over time, tax efficiency can be attained.
 
Two ways to reduce taxes
Two major methods to permanently reduce tax liability are:
1. Purchasing bank-owned life insurance (BOLI)
2. Creating a portfolio of bank-qualified tax-exempt securities.
 
Method one: BOLI
BOLI is a strategic part of succession planning. Compared to mostindustries, community banking does not typically use key-man insuranceto protect the bank from an untimely loss of senior management. BOLI,in most cases, can be a cost-efficient method to provide strategickey-man insurance. It provides income that is tax deferred and willhelp a bank move to tax efficiency.
 
Method two:
Don’t be fooled! The market for bank-qualified tax-exempt securities isliquid and can supply all of the securities a bank would need to createa tax-efficient strategy. How does a bank find these securities? Overthe years, the dealers in these securities have moved to small andregional brokerage firms.
 
Build taxes into strategic plan
Every community bank should have a tax plan as part of its strategicplan, with the goal of tax efficiency. Of course, tax strategies arenot without risk. No matter how tax efficient and profitable a strategymight look, the first question for directors or management is: “Whatrisk does this entail?” Typically, a bank may only look at a strategybased on how much money will land on the bottom line. The reality isthat banks make money based on the assumption of risk.
 
For instance, a bank maycompare BOLI products that have different returns. The key risk of BOLIis the credit quality of the insurance company. On a long-term basis,the bank needs that insurance company to make payments on the deathbenefits. If the insurance company has problems making the payments,the bank’s strategy may not be viable. The best way to minimize thiscredit risk is to buy policies only from the top-rated companies in theindustry.
 
On the other hand,bank-qualified tax-exempt securities typically carry an AAA rating and,further, they are insured. Thus, credit risk is not a real factor.However, due to their longer-term maturities, tax exempts tend to havemore market-price volatility. This can impact a bank’s economic valueof equity (EVE) in a rising-rate environment. This may have a negativeimpact on the bank’s capital position. Pre-purchase modeling of anindividual security will reveal its inherent volatility and whetherthis security will fit into the bank’s overall balance sheet.
 
Make no excuses
In years past, management and directors were concerned with retainingas much net income as possible. This included doing tax losses atyearend to maximize tax efficiency. In the current banking environment,however, banks often are more concerned with current earnings. It couldbe argued that banks are giving away future value by not being taxefficient.
 
Beyond the focus on currentearnings, another excuse is that loans yield more than bank-qualifiedtax-exempt securities, on a taxable-equivalent basis. Thus, many bankshave been increasing the size of their loan portfolio and decreasingthe size of their investment portfolio.
 
While loans are higheryielding in the current environment, bankers should analyze the loanyield under different scenarios. And, of course, credit risk isincreased. And more capital is needed to support a loan, compared to abank-qualified tax-exempt general obligation. Under the new FDICassessment schedule, banks may be paying higher FDIC premiums becauseof credit risk. It can be argued that banks are not getting the levelof yield in the current market to compensate them for the risk they aretaking by making a loan. More importantly, loans are very susceptibleto refinancing risk if interest rates decrease.
 
Bank-qualified tax-exemptsecurities, on the other hand, have longer-term call featuresavailable. This call protection is very valuable as interest ratesdecline. While loan yields are declining overall, a portfolio ofcall-protected tax-exempt securities will maintain its yield.
 
Get your tax counsel on board
It is imperative that any tax strategy should receive the review andadvice of the bank’s tax counsel (typically the bank’s outside auditfirm). Tax counsel should also review the implementation of anystrategy on the tactical level. Any tax strategy requires a high levelof compliance.
 
What I’ve outlined here isjust a taste of what a community bank can accomplish if tax planning ispart of the bank’s overall strategic plan. There are numerousconservative short-term and long-term strategies and tactics whichcommunity banks can utilize. The important point is that a communitybank must work with its tax counsel to make sure the tax plan isimplemented properly. BJ 
 
The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0507/index.php?startid=22

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