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Tax planning strategies for
year-end

11.01.18

It’s that time of year. Kids have gone back to school, the leaves are changing color, the air is getting crisp and… year-end tax planning strategies are front of mind! It’s time to revisit or start tax planning for the coming year-end, and year-end purchase of capital equipment and the associated depreciation expense are often an integral part of that planning.

The Tax Cuts and Jobs Act (TCJA) expanded two prevailing types of accelerated expensing of capital improvements: bonus depreciation and section 179 depreciation. They each have different applications and require planning to determine which is most advantageous for each business situation.

100% expensing of selected capital improvementsbonus depreciation

Originating in 2001, bonus depreciation rules allowed for immediate expensing at varying percentages in addition to the “regular” accelerated depreciation expensed over the useful life of a capital improvement. The TCJA allows for 100% expensing of certain capital improvements during 2018. Starting in 2023, the percentage drops to 80% and continues to decrease after 2023. In addition to the increased percentage, used property now qualifies for bonus depreciation. Most new and used construction equipment, office and warehouse equipment, fixtures, and vehicles qualify for 100% bonus depreciation along with certain other longer lived capital improvement assets. Now is the time to take advantage of immediate write-offs on crucial business assets. 

TCJA did not change the no dollar limitations or thresholds, so there isn’t a dollar limitation or threshold on taking bonus depreciation. Additionally, you can use bonus depreciation to create taxable losses. Bonus depreciation is automatic, and a taxpayer may elect out of the bonus depreciation rules.

However, a taxpayer can’t pick and choose bonus depreciation on an asset-by-asset basis because the election out is made by useful life. Another potential drawback is that many states do not allow bonus depreciation. This will generally result in higher state taxable income in the early years that reverses in subsequent years.

Section 179 expensing

Similar to bonus depreciation, section 179 depreciation allows for immediate expensing of certain capital improvements. The TCJA doubled the allowable section 179 deduction from $500,000 to $1,000,000. The overall capital improvement limits also increased from $2,000,000 to $2,500,000. These higher thresholds allow for even higher tax deductions for business that tend to put a lot of money in a given year on capital improvements.

In addition to these limits, section 179 cannot create a loss. Because of these constraints, section 179 is not as flexible as bonus depreciation but can be very useful if the timing purchases are planned to maximize the deduction. Many states allow section 179 expense, which may be an advantage over bonus depreciation.

Bonus Depreciation Section 179
Deduction maximum N/A $1,000,000 for 2018
Total addition phase out N/A $2,500,000 for 2018


Both section 179 and bonus depreciation are crucial tools for all businesses. They can reduce taxable income and defer tax expense by accelerating depreciation deductions. Please contact your tax advisor to determine if your business qualifies for bonus depreciation or section 179 and how to maximize each deduction for 2018.

Section 179 and bonus depreciation: where to go from here

Both section 179 and bonus depreciation are crucial tools for all businesses. They can reduce taxable income and defer tax expense by accelerating depreciation deductions. Please contact your tax advisor to determine if your business qualifies for bonus depreciation or section 179 and how to maximize each deduction for 2018.

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If you received PPP funds, read on.

The Treasury has released new information regarding Paycheck Program Protection forgiveness. 

Based on IRS guidance, if you intend to apply for forgiveness and have a reasonable expectation it will be granted, the expenses used to support forgiveness will not be permitted as a deduction in 2020. It is unclear whether this guidance would apply if a taxpayer is undecided with regard to their forgiveness application at year end. Here is what we know so far.

The CARES Act included provisions that stated PPP loan forgiveness would not be considered taxable income under the Internal Revenue Code (“IRC”). The CARES Act specifically provides the forgiveness is not taxable income under IRC Section 61.

However, the IRS has issued the following guidance on this matter, which relates to the expenses paid with the PPP loan funds.

Notice 2020-32, states IRC Section 265(a)(1) applies to disallow expenses that were included on and supported a taxpayer’s successful PPP loan forgiveness application. 

In general, this section states NO deductions are permitted for expenses that are directly attributable to tax exempt income. 

The IRS seems to have concluded, in this Notice, the PPP loan forgiveness is tax exempt income. Therefore, the salary and occupancy costs used to support forgiveness, under current IRS guidance, will not be tax deductible.

Unanswered questions

This notice, while somewhat informative, raises many unanswered questions. For example, what are the tax consequences if a PPP loan is forgiven in 2021 and the expenses supporting the forgiveness were incurred in 2020? Could the forgiveness be construed as something other than tax exempt income?

Revenue Ruling 2020-27 attempts to answer some of these questions and provides additional guidance with regard to IRS expectations. The Ruling seems to indicate there are two possible tax positions relative to expenses that qualify PPP loans for forgiveness:

  • First, the loan forgiveness could be construed as tax exempt income and, pursuant to IRC Section 265 expenses directly attributable to the exempt income are not deductible.
  • Second, loan forgiveness could be construed as the reimbursement of certain expenses, and not as tax exempt income. Under the reimbursement approach the IRS has stated if you intend to apply for forgiveness and reasonably expect to receive forgiveness the reimbursed expenses are not deductible, even if forgiveness is obtained in the following tax year. This position seems to be supported by several tax controversies which were litigated in favor of the IRS. 

Some taxpayers had anticipated using a rule known as the tax benefit rule to deduct expense in 2020 and report a recovery (income) in 2021 when the loan is forgiven. It appears the IRS is not willing to accept this filing position.

We are hoping Congress will revisit this issue and consider statutory changes which allow for the deduction of expenses. Some taxpayers are planning to extend their income tax returns, taking a wait and see approach, with the hopes Congress will amend the statutes and allow for a deduction.

Under current law, it appears the salary, interest, rent used to support a forgiveness application will not be permitted as a tax deduction on your 2020 tax returns. This could result in a significant change in your 2020 taxable income.

Final considerations

For estimated tax payment purposes, we believe it would be reasonable to attribute the lost deductions to the quarter in which you made your final determination to file for forgiveness. This could mitigate any underpayment of estimated income tax penalties. 

If you are making safe harbor quarter estimates and/or have sufficient withholdings any incremental tax would be due with your return on April 15, 2021. Generally, the IRS safe harbor is to pay 110% of prior year tax during the current year to be penalty proof.

If you have questions about your specific situation, please contact us. We’re here to help.

COVID-19 business support

We will continue to post updates as we uncover them. Let us know if you have questions. For more information regarding the Paycheck Protection Program, the CARES Act, or other COVID-19 resources, see our COVID-19 Resource Center.

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Update: Treasury issues a revenue ruling and revenue procedure regarding PPP forgiveness

Read this if you invest in research and development. 

Businesses that invest in research and development, particularly those in the technology industry, should be aware of a major change to the tax treatment of research and experimental (R&E) expenses. Under the 2017 Tax Cuts and Jobs Act (TCJA), R&E expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes. Instead, businesses are now required to capitalize and amortize R&E expenditures over a period of five years for research conducted within the U.S. or 15 years for research conducted in a foreign jurisdiction. The new mandatory capitalization rules also apply to software development costs, regardless of whether the software is developed for sale or license to customers or for internal use.

Tax implications of mandatory capitalization rules

Under the new mandatory capitalization rules, amortization of R&E expenditures begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year one tax and cash flow impact when compared to the previous rules that allowed an immediate deduction.

For example, assume a calendar-year taxpayer incurs $50 million of US R&E expenditures in 2022. Prior to the TCJA amendment, the taxpayer would have immediately deducted all $50 million on its 2022 tax return. Under the new rules, however, the taxpayer will be entitled to deduct amortization expense of $5,000,000 in 2022, calculated by dividing $50 million by five years, and then applying the midpoint convention. The example’s $45 million decrease in year one deductions emphasizes the magnitude of the new rules for companies that invest heavily in technology and/or software development.

The new rules present additional considerations for businesses that invest in R&E, which are discussed below.

Cost/benefit of offshoring R&E activities

As noted above, R&E expenditures incurred for activities performed overseas are subject to an amortization period of 15 years, as opposed to a five-year amortization period for R&E activities carried out in the US. Given the prevalence of outsourcing R&E and software development activities to foreign jurisdictions, taxpayers that currently incur these costs outside the US are likely to experience an even more significant impact from the new rules than their counterparts that conduct R&E activities domestically. Businesses should carefully consider the tax impacts of the longer 15-year recovery period when weighing the cost savings from shifting R&E activities overseas. Further complexities may arise if the entity that is incurring the foreign R&E expenditures is a foreign corporation owned by a US taxpayer, as the new mandatory capitalization rules may also increase the US taxpayer’s Global Intangible Low-taxed Income (GILTI) inclusion.

Identifying and documenting R&E expenditures

Unless repealed or delayed by Congress (see below), the new mandatory amortization rules apply for tax years beginning after December 31, 2021. Taxpayers with R&E activities should begin assessing what actions are necessary to identify qualifying expenditures and to ensure compliance with the new rules. Some taxpayers may be able to leverage from existing financial reporting systems or tracking procedures to identify R&E; for instance, companies may already be identifying certain types of research costs for financial reporting under ASC 730 or calculating qualifying research expenditures for purposes of the research tax credit. Companies that are not currently identifying R&E costs for other purposes may have to undertake a more robust analysis, including performing interviews with operations and financial accounting personnel and developing reasonable allocation methodologies to the extent that a particular expense (e.g., rent) relates to both R&E and non-R&E activities.

Importantly, all taxpayers with R&E expenditures, regardless of industry or size, should gather and retain contemporaneous documentation necessary for the identification and calculation of costs amortized on their tax return. This documentation can play a critical role in sustaining a more favorable tax treatment upon examination by the IRS as well as demonstrating compliance with the tax law during a future M&A due diligence process.

Impact on financial reporting under ASC 740

Taxpayers also need to consider the impact of the mandatory capitalization rules on their tax provisions. In general, the addback of R&E expenditures in situations where the amounts are deducted currently for financial reporting purposes will create a new deferred tax asset. Although the book/tax disparity in the treatment of R&E expenditures is viewed as a temporary difference (the R&E amounts will eventually be deducted for tax purposes), the ancillary effects of the new rules could have other tax impacts, such as on the calculation of GILTI inclusions and Foreign-Derived Intangible Income (FDII) deductions, which ordinarily give rise to permanent differences that increase or decrease a company’s effective tax rate. The U.S. valuation allowance assessment for deferred tax assets could also be impacted due to an increase in taxable income. Further, changes to both GILTI and FDII amounts should be considered in valuation allowance assessments, as such amounts are factors in forecasts of future profitability.

The new mandatory capitalization rules for R&E expenditures and resulting increase in taxable income will likely impact the computation of quarterly estimated tax payments and extension payments owed for the 2022 tax year. Even taxpayers with net operating loss carryforwards should be aware of the tax implications of the new rules, as they may find themselves utilizing more net operating losses (NOLs) than expected in 2022 and future years, or ending up in a taxable position if the deferral of the R&E expenditures is material (or if NOLs are limited under Section 382 or the TCJA). In such instances, companies may find it prudent to examine other tax planning opportunities, such as performing an R&D tax credit study or assessing their eligibility for the FDII deduction, which may help lower their overall tax liability.

Will the new rules be delayed?

The version of the Build Back Better Act that was passed by the US House of Representatives in November 2021 would have delayed the effective date of the TCJA’s mandatory capitalization rules for R&E expenditures until tax years beginning after December 31, 2025. While this specific provision of the House bill enjoyed broad bipartisan support, the BBBA bill did not make it out of the Senate, and recent comments by some members of the Senate have indicated that the BBB bill is unlikely to become law in its latest form. Accordingly, the original effective date contained in the TCJA (i.e., taxable years beginning after December 31, 2021) for the mandatory capitalization of R&E expenditures remains in place.
 
The changes to the tax treatment of R&E expenditures can be complex. While taxpayers and tax practitioners alike remain hopeful that Congress will agree on a bill that allows for uninterrupted immediate deductibility of these expenditures, at least for now, companies must start considering the implications of the new rules as currently enacted. 

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Mandatory capitalization of R&E expenses—will the new rules impact your business?

The automotive industry is experiencing a convergence of disruptions unlike any seen since 1910. Autonomous, connectivity, electrification, mobility, and subscription business models are reshaping the automotive industry and creating a frenzy of activity.

There are dozens of self-driving car companies, an untold number of connectivity applications, and over 500 mobility related technology and technology-enabled solutions offered by existing companies and start-ups. Additionally, there are subscription models with varying degrees of success, with some original equipment manufacturers (OEMs) terminating programs recently and others recommitting to them, and regarding electric vehicles (EV), there are 17 public EV OEMs and four private EV OEMs. As Harley-Davidson’s recent announcement to take its EV division, LiveWire, indicates there is ample fuel to fund new entrants into this space and capital to accelerate innovation. Where this lands is anyone’s guess but the factors at play do suggest significant uncertainty.

To highlight the disruption occurring within the automotive landscape, two great examples of disrupters entering the market are Tesla and Carvana. These two companies currently have market capitalization that far exceed the traditional dealerships and OEMs. Carvana has a market cap of $31B, exceeding the combined market capitalization of Carmax, AutoNation, and Asbury. Tesla has a market cap of $1T, exceeding the combined market capitalization of Toyota, Volkswagen, GM, and Ford.

An integral part of the industry, dealerships are also seeing significant changes, especially as it pertains to EV, which is the focus of our discussion in the rest of this article.

The market for electric vehicles

The market for EVs resulted from changes in three main areas including regulation, consumer behavior, and technology.

Regulation

Governments and cities have introduced regulations and incentives to accelerate the shift to sustainable mobility. Regulators worldwide are defining more stringent emissions targets. The European Union seeks to align climate, energy, land use, transport, and taxation policies to reduce net greenhouse gas emissions by at least 55% by 2030. The Biden administration introduced a 50% EV target for 2030.

Consumer behavior

Consumer mindsets have also shifted toward sustainable mobility, with more than 45% of consumers considering buying an EV. A recent survey by Cars.com revealed two-thirds of Americans are interested in buying an EV, despite barriers such as higher sticker prices than internal combustion engine (ICE) models and limited access to charging stations. In China, consumer interest is even stronger than in Europe and the US.

Technology

Both the convergence of technological innovations (e.g., autonomous) and battery development have created the path to an emissions free industry.

Are electric vehicles here to stay?

For many years, lack of product availability, unfavorable pricing, limited charging infrastructure and battery range, and consumer demand have held back the widespread adoption of EV. However, the tipping point in passenger EV adoption occurred in the second half of 2020, when EV sales and penetration accelerated in major markets despite the economic crisis caused by the COVID-19 pandemic. Europe spearheaded this development, where EV adoption reached 8% due to policy mandates such as stricter emissions targets for OEMs and generous subsidies for consumers.

On a global level, a recent McKinsey study projects EV adoption will reach 45% by 2030-2035 under current expected regulatory targets, with the major markets reaching these levels on varying timelines. New regulatory targets in the European Union and the United States now aim for an EV share of at least 50% by 2030, and several countries have announced accelerated timelines for ICE sales bans in 2030 or 2035. By 2035, the largest automotive markets will go nearly entirely electric.

  • Europe may reach 60% – 75% EV sales by 2030, driven by regulatory targets on the low end and on reported consumer preference on the high end.
  • In the US, in Q2 2021, EV sales reached 3.6% of total car sales. The aggressive electrification target for 2030 and US OEMs support of electrification have led to many declaring ICE bans by 2035.

China will also continue to see strong growth in electrification and remain the largest EV market by vehicle volume based on strong consumer demand, despite low EV subsidies and no official end date for ICE sales. Adoption modeling yields a Chinese EV share as much as 70% for new car sales in 2030.

Some OEMs have stated their intentions to stop investing in new ICE platforms and models and many more have already defined a specific date to end ICE vehicle production. There will be 100 EVs offered by over 25 OEMs in the US market by 2024. Many large traditional OEMs are targeting 50%-70% EV in all markets by 2030:


 
Headwinds to transition

While there is strong momentum toward EV transition and bets made by governments and OEMs will only accelerate it, there are significant headwinds which may slow the pace of the transition. Public institutions, businesses, and consumers will need to resolve several issues and overcome some challenges.

Chips

AlixPartners estimates the chip shortage has cost the industry $210B and 7.7 million units in 2021, doubling their forecast in May. And yet, according to Intel CEO, Pat Gelsinger, by 2030 chips will make up 20% of the components of premium cars — five times more than their proportion in 2019. Despite the major announcements of investments in new fab plants in the US and elsewhere, the long development time to bring these operations online begs the question whether this additional capacity will come in time to support the demand for EVs.

Battery prices

The high cost of vehicles based on batteries continues to hold back consumers. As lithium prices soar, reflecting escalating demand and limited sources of production, it’s unclear when battery costs will decline to establish EV vehicle price parity with ICE vehicles. That said, EV motor maintenance is limited to 100,000. While motors and engines last upwards of 20 years, the typical EV battery lasts 200,000 miles — not quite 20 years. Tesla, however, is rumored to be developing an EV battery that will last 1,000,000 miles, which would extend the life of an EV vehicle well beyond the 11.9 years of today’s average vehicle. So, over time, the total cost of ownership of an EV vehicle is likely to decline enough to overcome any consumer resistance due to price.

 Charging infrastructure

The lack of charging infrastructure and limited EV range due to battery life has greatly inhibited EV adoption. The Bipartisan Infrastructure Framework includes $15 billion to speed up adoption of EVs and accelerate the US EV market. The plan sets aside $7.5 billion to construct a nationwide EV charging network. However, according to a report issued in July 2021 by The International Council on Clean Transportation, the total charging units in homes, workplaces, and public stations to support the EV goals set by government and OEMs will require tremendous investments in charging stations, notably in home charging stations, and the electrical grid infrastructure to support demand. It is uncertain whether the required rate of growth in charging stations and grid capacity can be met to support EV goals.

New business models

Another issue on dealers’ minds is direct-to-consumer (D2C) sales, the business model that’s fueled Tesla’s marketing of more than 2,000,000 EVs sold to date. Tesla does operate about 160 company-owned showrooms, yet sales are transacted online. At last count, 33 states allowed D2C auto sales, with others’ legislatures debating bills that would bypass the so-called franchise system that has legally connected dealers and manufacturers for more than a century. National Automobile Dealers Association (NADA), state dealer groups and traditional automakers have advocated maintaining the franchise system, claiming that it levels the playing field.

Impact on after-market spending and margins

One genuine concern for dealerships is the fact that EVs don’t require oil changes, transmission repairs and other services owners of ICE vehicles routinely bear —services that account for 50% of dealerships’ gross profits. ICE vehicles have 2,000 moving parts while EVs have 20. Fewer moving parts require less maintenance and repair and lowers vehicle service contract (VSC) attachment rates. While owners will spend more on EV related parts (e.g., tires), BEV owners will likely spend 40% less on after-market parts and service compared to ICE owners by 2030. A 2019 report from AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell.

While this does not bode well for dealership profitability, the US now has a record 280 million cars, trucks, and SUVs registered with state motor vehicle departments. The average age of vehicles in the US has climbed to an all-time high of 11.9 years. One in four cars and trucks on the road are at least 16 years old. So, despite EV sales trending towards 50%-75% of total sales in the largest markets by 2030, the impact on dealership profitability will not be abrupt. With a significant install base of ICE vehicles with a remaining life that will extend well past 2030 and a continuing high volume of ICE vehicle sales over the next three years, dealerships do have some time to plan. 

Implications and key takeaways for dealers

One thing is clear: Dealerships are operating within an increasingly disrupted environment which has affected the bottom line and created some uncertainty for the future. Over the past several years (with the exception of the COVID-19 pandemic) dealerships have experienced margin compression on vehicle sales. With threats to their services business, margin compression could continue. Higher front-end margins, notably in finance and insurance (F&I), will come under further pressure as EV and battery prices decline.

The good news? Most EV OEMs require factory authorized dealership service departments for repair and maintenance. Further, even though 70% of aftermarket service of ICE vehicles are handled by independent shops, franchise dealers don’t want to cede EVs to them, especially as consumers familiarize themselves with battery charging and other peculiarities. “The EV owner might trust the dealers more to perform service than the aftermarket shops earlier in their ownership period,” according to Chris Sutton, Vice President of automotive retail for market research firm J.D. Power. So, the threat of DIY and independent service centers may be limited in the near term.

For reasons outlined in “The Dealership of Tomorrow 2.0” report, prepared in February 2020 by Glen Turner for NADA, the dealership model of store ownership should remain very dominant in the US through at least 2030, even with the disruption caused by EVs. The trend of the decline in store owners, however, will continue with rooftops per owner increasing from two stores per owner before the Great Recession to three stores per owner by the late 2020s. That’s a 50% increase in stores per owner.

Although the margin compression and scale of the investments to counter the disruptive forces dealerships face are significant and would typically suggest greater consolidation, Glen asserts that economies of scale are probably elusive beyond chains of 50-100 stores. So, there may very well be some leaders who emerge as winners in this transition.

The path forward

Many dealerships are embracing the EV transition. While there are fundamentals to guide dealerships over the coming years, there are many uncertainties and unanswered questions. To address these uncertainties and develop a plan to confidently face the future, dealerships should develop a business strategy, shift their operating model, and build a roadmap for change.

Regarding strategy, the key question centers on the degree of scale necessary to compete and grow profitably. Which portfolio of brands to invest in? How many stores to develop and in which markets? Whether to acquire other dealerships?

In redefining the operating model, dealerships must focus on how to create the best customer experience efficiently and effectively. How to enable this through the optimal digital and omnichannel strategy in collaboration with the OEMs? Should subscription services be offered for bundles of brand and vehicle portfolios and/or maintenance programs? Whether, when, and to what degree to invest in charging infrastructure to reduce electricity costs and/or to create new revenue streams by selling electricity back to the grid or by providing a service to customers? What role does solar play in this approach? How to fully utilize the federal, state, and local incentives? How to design the site plan to accommodate battery quarantines? What risks and costs are associated with onsite EV infrastructure? What insurance coverages are necessary and plans for litigation support may be appropriate? How to comply with OEM service department requirements and ensure the number of required and certified technicians are retained?

Once dealerships have answered these questions, the opportunities will need to be prioritized and organized into a roadmap to guide the transition through 2030 and beyond. For any investments required, a clear and tangible business case should be developed to properly filter out those initiatives which should and shouldn’t be pursued.

Written by Bob Gray. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com

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Electric vehicles: Convergence of the industry

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its fourth quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,839 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In fourth quarter 2021, this section included the financial information of 4,391 FDIC-insured community banks. BerryDunn’s key takeaways from the community bank section of the report are as follows:

  • The banking industry as a whole saw a $132 billion increase in net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly attributable to the $163.3 billion decrease in provision expense, supported by continued economic growth and supplementary credit quality improvement. NIM declined to 2.54%, a 28 basis-point decrease from 2020 as the growth rate in average earning assets outpaced the growth rate in net interest income.
  • For community banks, full-year net income increased $7.4 billion to $32.7 billion. Despite the increase in annual net income, community banks saw a $719.9 million decrease in net income from third quarter 2021. Higher noninterest expenses continue to place pressure on community banks as inflation rates spike going into 2022. Annual NIM fell 12 basis points from 2020 to 3.27%. The average yield on earning assets fell 42 basis points to 3.58%, while the average funding cost fell 30 basis points to 0.31%. The percentage of unprofitable community banks declined to 3.2%, the lowest level on record. 

    *See Exhibit B at the end of this article for more information on the fourth-quarter year-over-year change in income.
     
  • Net gains on loan sales revenue declined $1.5 billion (50.6%) from fourth quarter 2020. However, growth in net interest income of $1.3 billion (6.7%) from fourth quarter 2020 overcame the $707 million decline in noninterest income. Net operating revenue increased $588.4 million (2.3%) from fourth quarter 2020.
  • Noninterest expense increased 3.4% from fourth quarter 2020. This increase was mainly attributable to higher data processing and marketing expenses. That being said, average assets per employee increased 10% from fourth quarter 2020. Noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020 to 2.51%, despite 69.4% of community banks reporting higher noninterest expense.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) declined by $1.1 billion to $11.1 billion from third quarter 2021. The noncurrent rate dropped 7 basis points to 0.58% from third quarter 2021, the lowest noncurrent rate on record for community banks.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 53.7 percentage points from a year ago to 223.8%. This ratio is well above the 147.9% reported before the pandemic in fourth quarter 2019 and continues to be a record high. The coverage ratio for community banks is 49.9 percentage points above the coverage ratio for noncommunity banks. As a result, provision expense declined $914.9 million from fourth quarter 2020, but remained at $320.8 million for fourth quarter 2021, representing a $39.2 million increase from third quarter 2021.
  • The net charge-off rate declined 6 basis points from fourth quarter 2020 to 0.09%.
  • Trends in loans and leases started looking up, as community banks saw an increase of $24.3 billion within fourth quarter 2021. This growth was mainly seen in the nonfarm nonresidential commercial real estate (CRE), which held a balance of $16.3 billion. Total loans and leases increased by $34.2 billion (2%) for the year 2021. Growth of $50.6 billion in CRE loans attributed to the increase. A decline in commercial and industrial loan balances of $62.3 billion (20.1%) from fourth quarter 2020 offset a portion of this increase. This decline was mainly due to Paycheck Protection Program (PPP) loan repayment and forgiveness.

    *See Exhibit C at the end of this article for more information on the change in loan balances.
     
  • More than 75% of community banks reported an increase in deposit balances for the fourth quarter. In total, deposit growth was 2.8% during fourth quarter 2021.
  • The average community bank leverage ratio (CBLR) for the 1,699 banks that elected to use the CBLR framework was 11.2%, nearly unchanged from third quarter 2021. The average leverage capital ratio was 10.16%.
  • The number of community banks declined by 59 to 4,391 from third quarter 2021, a decrease of 168 from December 2020. This change includes six banks transitioning from community to noncommunity banks, four banks transitioning from noncommunity to community banks, 54 community bank mergers or consolidations, and three community banks having ceased operations.

Fourth quarter 2021 was another strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 7.1% ($511.6 million). This quarter concluded another strong year financially for community banks. However, NIMs continue to show record lows, as shown in Exhibit A, which shows the trends in quarterly NIM.

The consensus remains that community banks will likely need to find creative ways to increase their NIM, grow their earning asset bases, or continue to increase noninterest income to maintain current net income levels. In regards to the latter, many pressures to noninterest income streams exist. Financial technology (fintech) companies are changing the way we bank by automating processes that have traditionally been manual (for instance, loan approval). Decentralized financing (DeFi) also poses a threat to the banking industry. Building off of fintech’s automation, DeFi looks to cut out the middle-man (banks) altogether by building financial services on a blockchain. Ongoing investment in technology should continue to be a focus, as banks look to compete with non-traditional players in the financial services industry. 

The larger, noncommunity banks are also putting pressure on community banks and their ability to generate noninterest income, as recently seen by Citi, Bank of America, and many other large banks following behind Capital One Bank in eliminating all overdraft fees. According to the Consumer Financial Protection Bureau, the financial services industry brought in $15.5 billion in overdraft fees in 2019. Seen as a move to enhance Capital One Bank’s financial inclusion of customers, community banks will also need to find innovative ways to enhance relationships with current and potential customers. As fintech companies and DeFi become more mainstream and accepted in the marketplace, the value propositions of community banks will likely need to change. Furthermore, as PPP loan forgiveness comes to an end, PPP loan fees will no longer supplement revenues. Although seen as a one-time extraordinary event, this fee income was significant for many community banks’ 2021 and 2020 revenues.

The importance of the efficiency ratio (see Exhibit D below) is also magnified as community banks attempt to manage their noninterest expenses in light of low NIMs and inflationary pressures. Although noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020, such expenses increased 3.4% from fourth quarter 2020. And, inflationary pressures will likely be exacerbated as a result of Russia’s invasion of Ukraine. Inflationary pressure was already seen in fourth quarter 2021, as net income decreased $719.9 million from third quarter 2021, despite only a $39.2 million increase in provision expense from third quarter 2021. Banks with manual processes can improve efficiency and support a remote workforce with increased automation.

Furthermore, many of the uncertainties that we have been discussing quarter-over-quarter, and that have thus become “themes” for the banking industry in 2021, still exist. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. Also, payment deferrals have made some credit quality indicators, such as past due status, less reliable. Payment deferrals for many borrowers are coming to a halt and many community banks had nominal amounts of borrowers that remained on deferral as of December 31, 2021. So, the true financial picture of these borrowers may start to come into focus. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy.

The outlook for office space remains uncertain. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. As noted in a recent FDIC article, “the full effects of changing dynamics in the sector are still developing. Office property demand may take time to stabilize as tenants navigate remote work decisions and adjust how much space they need.” The FDIC article further mentions reduced office space could also have implications for the multifamily and retail markets that cater to those office employees. Similarly, the hotel industry remains in flux and the post-pandemic success of the industry is likely dependent on the recovery of business travel and gas prices for hotels dependent on summer tourism. If virtual conferences and meetings become the new norm, the hotel industry could see itself having to pivot. Even a transition to a hybrid model, which is more likely to occur, could have significant implications for the industry. Banks should closely monitor these borrowers, as identifying early signs of credit deterioration could be essential to preserving the relationship.

The financial services industry is full of excitement right now. While the industry faces many challenges, these challenges also bring opportunity for banks to experiment and differentiate themselves. Bank customers arguably need the assistance of their bank more than ever as they navigate continued financial uncertainty. This need allows community banks to do what they do best: develop long-lasting relationships with customers and become a trusted advisor. If there is anything this pandemic has shown to the financial industry, it is that community banks are truly one of the leaders of their communities. As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC Issues its Fourth Quarter 2021 Quarterly Banking Profile

When we meet with hospital boards to review the results of their audit, we are most often asked to share what we are seeing in the industry—and how their hospital compares with others in our client base. As we (hopefully) emerge from the COVID-19 pandemic, I wanted to see where we are as an industry after two challenging years. In reviewing our own benchmarking data, and reading this very comprehensive CFO Outlook Survey by BDO, it reinforced that these are challenging times indeed. 

The pressures of top line sustainability, cost containment, and recruitment and retention of talent are very real. And while healthcare providers are seasoned to the continual challenges and opportunities, the difference going forward, post-pandemic, will be what this looks like for rural providers without the influx of stimulus funds and beyond the initial surge of postponed surgeries. Based on the BDO survey, 69% of healthcare organizations surveyed expect an increase in profitability. Is your organization prepared to take the steps to make it happen? What is your financial resilience outlook?

You can read the survey here. If you would like to discuss further, please contact our Hospital Consulting team. We’re here to help.
 

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Healthcare survey: A comprehensive look at the industry

Read this if you are an NFP interested in being a fiscal sponsor. 

Charitable projects or startup charities awaiting their IRS determination may look for an established 501(c)(3) organization to lend their tax-exempt status and certain administrative benefits onto the project or startup so that it can receive grants and tax-deductible contributions that it would otherwise not be able to receive. That’s where you come in. Now that you have agreed to be a fiscal sponsor, what does that actually mean?

Fiscal sponsorship definition

Fiscal sponsorship is an arrangement between a 501(c)(3) public charity, the “Sponsor” and a “Project” (an organization or a group of individuals not recognized as a 501(c)(3)).

How does fiscal sponsorship work?

Fiscal sponsorship allows the Sponsor to accept funds restricted to the Project on the Project’s behalf. The Sponsor accepts the responsibility to make sure the funds are spent to achieve the Project’s goals. The Sponsor has full control and discretion of the donated funds. All revenue collected and expenses paid out are reported on the Statement of Operations of the Sponsor. The activity of the Project must be consistent and in furtherance of the Sponsor’s tax-exempt purpose. A Sponsor cannot have this type of arrangement with any Project—it must be consistent with the Sponsor’s exempt mission. 

Arrangement types

There are two common types of Fiscal Sponsorship arrangements, the Direct Model and the Grant Model

In the Direct Model the Project becomes an integrated part of the Sponsor. The Project does not have a legal identity separate from the Sponsor. Donations and grants for the Project are directly received by the Sponsor, and the use of the funds is reported on the Sponsor’s tax filings. An employer-employee relationship is formed between the Sponsor and the Project so that staff and volunteers of the Project become employees and volunteers of the Sponsor. Due to this relationship, the Sponsor is both fiscally and legally liable for all actions of the Project and thus must exercise significant control over the Project’s actions and funding to protect its tax-exempt status. 

In the Grant Model the Sponsor and the Project have a grantor-grantee relationship. The Project submits a grant request to the Sponsor detailing the project and its activities. The Sponsor approves the request and then receives funds on behalf of the Project and disperses them accordingly. The Sponsor may receive a one-time grant on behalf of the Project, or the relationship may be continual. In this model, the Sponsor is not legally liable for all actions of the Project, but is still fiscally liable for the Project’s actions. The Sponsor must still exercise enough control over the Project’s funds to ensure they are used in accordance with the grant agreement. Also, unlike the direct model, the Project is still required to comply with any tax reporting requirements required by the legal status of the Project. 

What are some advantages of Fiscal Sponsorship?

  • Projects are able to “test the waters” before deciding to be a separate independent entity.
  • Donors are able to make tax deductible charitable contributions now to a cause that is not yet recognized as a tax-exempt entity.
  • By working with an established 501(c)(3) entity the Project will have access to a larger network of donors and experience in fundraising.
  • The Project is not required to incorporate or file for their own tax-exempt status right away, saving start-up fees.
  • Fiscal Sponsors provide additional services to the Project such as administrative support, accounting, office space, grant writing and technical support which the Project may not be able to afford.

What are some disadvantages of fiscal sponsorship?

  • Depending on the model used, legal and fiscal control of the Project is held by the Sponsor creating a loss of control for the Project.
  • A Fiscal Sponsor may charge an administrative fee for use of their facilities, services, and staff.
  • Credit for the Project may fall onto the Sponsor as donations are received and controlled by the Sponsor.

Fiscal Sponsorship vs. Fiscal Agency

Fiscal Agency is an arrangement with an established charity to act as the legal Agent for a Project, but the Agent doesn’t retain discretion and control of the donated funds. The Agent is acting on behalf of the Project who ultimately has the right to control the Agent’s activities. Funds contributed to a Project with a fiscal Agent are not tax deductible to the donor. Typically the collections and disbursements made by the Sponsor are not reported on the Sponsor’s Statement of Operations, but instead are recorded through their balance sheet.

IRS criteria for a Fiscal Sponsorship

  • Grants/donations are given to a 501(c)(3) tax-exempt organization (the Sponsor) that acts as a guardian of the funds for a project that does not have 501(c)(3) status.
  • The Sponsor must use funds received for specific charitable projects that further the Sponsor’s own tax-exempt purpose.
  • The Sponsor must retain discretion and control as to the use of the funds.
  • The Sponsor must maintain records that substantiate the use of funds for appropriate 501(c)(3) purposes.
  • Typically, the Project will be short-term or the sponsored group is seeking tax-exempt status.

If criteria are not met, the IRS can deem donations as not tax-deductible.

Other items of note

  • There must be a written agreement in place.
  • The 501(c)(3) Sponsor should periodically review activities of the Project to ensure they remain consistent with their own tax-exempt mission (including internal audits of financial reports and any bank accounts of the Project).
  • The Sponsor must ensure the Project does not engage in prohibited activities (i.e. political campaign activities or conducting excessive amounts of unrelated business income activities).
  • The Sponsor must be able to clearly communicate to donors that funds earmarked for the Project are subject to their discretion and control, and cannot guarantee funds will be automatically advanced to the Project.
  • The Sponsor can also provide general and administrative support services to the Project and charge a fee (generally 5-15%) of donations made to the Project.

As you can see it is not as easy as just agreeing to be a Fiscal Sponsor. There are reporting requirements and decisions to be made to ensure that the arrangement qualifies as intended with the IRS so that neither the Project nor the Sponsor receive any unintended consequences.

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So you want to be a fiscal sponsor. Now what?

Read this if you are a business interested in the Build Back Better Act. 

2021 was a busy legislative year. A new administration took office. The American Rescue Plan was enacted in March. The Infrastructure Investment and Jobs Act (IIJA) was signed into law in November. The last major piece of legislation the Biden administration sought to enact in 2021 was the Build Back Better Act (BBBA). But in the face of opposition by some moderate democratic senators regarding certain policy provisions and its price tag, the BBBA did not make it through the Senate by December 31. With the calendar having turned the page to 2022, what is the future of the BBBA?

With a recent Supreme Court retirement announcement, global affairs issues and voting rights legislation, both Congress and the administration have much on their plate as we enter February 2022. With such a crowded agenda, the BBBA seems to have faded of late. Nonetheless, the bill has what appear to be three possible paths ahead.

First, the bill could get new life and be taken up in its current form, or close to it, in the Senate. Given the opposition to some of the bill policy provisions, recent comments from a senator about the bill’s being “dead,” and its price tag—even after the bill was reduced by nearly half over the past several months—it seems unlikely that it would pass the Senate in a form close to what it was in December.

Second, the bill could simply die on the vine. Having entered 2022, and with midterm elections on the calendar in November, it may be too difficult to revive any part of the bill this year.

Finally, the bill could be split up into separate pieces of legislation. While some provisions in the current bill do not have adequate support to ensure passage in the Senate, some provisions likely do. For example, climate issues, energy provisions, and tax matters could be taken up in separate bills or included in other legislative packages, such as the fiscal year 2022 spending bill. If legislative priorities are addressed this way, we may see these provisions revived or even enacted into law throughout the year.

One thing is certain: No matter how powerful a crystal ball one can find it cannot predict what is going to happen in an unpredictable legislative year. As events develop, we will follow them and provide our insights along the way.

Written by Todd Simmens. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com

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The Build Back Better Act in a legislative lull 

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its third quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,914 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In third quarter 2021, this section included the financial information of 4,450 FDIC-insured community banks. Community banks are identified based on criteria defined in the FDIC’s 2020 Community Banking Study. Here are BerryDunn’s key takeaways from the community bank section of the report:

  • There was a $1.4 billion increase in quarterly net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly due to higher net interest income and lower provision expenses. Net interest income had increased $2.2 billion due to lower interest expense and higher commercial and industrial (C&I) loan interest income, mainly due to fees earned through the payoff and forgiveness of Paycheck Protection Program (PPP) loans. Provision expense decreased $1.4 billion from third quarter 2020. However, it remained positive at $270.4 million, which was an increase of $219.2 million from second quarter 2021. For noncommunity banks, provision expense was negative $5.2 billion for third quarter 2021

    *See Exhibit B at the end of this article for more information on the third-quarter year-over-year change in income.
     
  • Quarterly NIM increased 3 basis points from third quarter 2020 to 3.31%. The average yield on earning assets fell 20 basis points to 3.60% while the average funding cost fell 23 basis points to 0.29%. This was the first annual expansion of NIM since first quarter 2019. The annual decline in both yield and cost of funds were the smallest reported since first quarter 2020.
  • Net gains on loan sales revenue declined $1.2 billion (41.5%) from third quarter 2020. However, other noninterest income increased $343.3 million or 15.2% while revenue from service charges on deposit accounts increased $100.3 million or 14.5%. In total, noninterest income decreased $616.3 million from third quarter 2020.
  • Noninterest expense increased 5.7% from third quarter 2020. This increase was mainly attributable to salary and benefit expenses, which saw an increase of $402.2 million (4.3%). That being said, average assets per employee increased 10.4% from third quarter 2020. Noninterest expense as a percentage of average assets declined 12 basis points from third quarter 2020 to 2.45%, despite 74.1% of community banks reporting higher noninterest expense.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) declined by $847 million, or 7.1%, from second quarter 2021. The noncurrent rate dropped 4 basis points to 0.65% from second quarter 2021.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 44.1 percentage points year-over-year to 203.5%. This ratio is well above the financial crisis average of 147.9% and is a record high. The coverage ratio for community banks is 26.2 percentage points above the coverage ratio for noncommunity banks.
  • Net charge-offs declined 4 basis points from third quarter 2020 to 0.06%.
  • Loans and leases declined from second quarter 2021 by 0.2%. This decrease was mainly seen in the C&I loan category, which was driven by a $45.6 billion decrease in PPP loan balances due to their payoff and forgiveness. Total loans and leases declined by $19.2 billion (1.1%) from third quarter 2020. The largest decline was shown in C&I loans ($87.3 billion or 24.9%). Growth in other loan categories, such as nonfarm nonresidential commercial real estate, construction & development, and multifamily loans of $69.9 million offset a portion of this decline. 

    *See Exhibit C at the end of this article for more information on the change in loan balances.
     
  • Nearly seven out of ten community banks reported an increase in deposit balances during the third quarter. Growth in deposits above the insurance limit increased by $57.8 billion, or 5.5%, while growth in deposits below the insurance limit showed an increase of $1.7 billion, or 0.1%, from second quarter 2021. In total, deposit growth was 2.6% during third quarter 2021.
  • The average community bank leverage ratio (CBLR) for the 1,737 banks that elected to use the CBLR framework was 11.3%. The average leverage capital ratio was 10.25%.
  • The number of community banks declined by 40 to 4,450 from second quarter 2021. This change includes one new community bank, 10 banks transitioning from community to noncommunity bank, five banks transitioning from noncommunity to community bank, 35 community bank mergers or consolidations, and one community bank having ceased operations.

Third quarter 2021 was another strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 19.6% ($1.4 billion). However, NIMs remain low despite seeing growth in the most recent quarter (for the first time since first quarter 2019), as shown in Exhibit A. The consensus remains that community banks will likely need to find creative ways to increase their NIM, grow their earning asset bases, or continue to increase noninterest income to maintain current net income levels. In regards to the latter, many pressures to noninterest income streams exist. Financial technology (fintech) companies are changing the way we bank by automating processes that have traditionally been manual (for instance, loan approval). Decentralized financing (DeFi) also poses a threat to the banking industry. Building off of fintech’s automation, DeFi looks to cut out the middle-man (banks) altogether by building financial services on a blockchain. Ongoing investment in technology should continue to be a focus, as banks look to compete with nontraditional players in the financial services industry. The larger, noncommunity banks are also putting pressure on community banks and their ability to generate noninterest income, as recently seen by Capital One Bank eliminating all overdraft fees.

According to the Consumer Financial Protection Bureau, the financial services industry brought in $15.5 billion in overdraft fees in 2019. Seen as a move to enhance Capital One Bank’s relationships with its customers, community banks will also need to find innovative ways to enhance relationships with current and potential customers. As fintech companies and DeFi become more mainstream and accepted in the marketplace, the value propositions of community banks will likely need to change.

The importance of the efficiency ratio (noninterest expense as a percentage of total revenue) is also magnified as community banks attempt to manage their noninterest expenses in light of low NIMs. Banks appear to be strongly focusing on noninterest expense management, as seen by the 12 basis point decline from third quarter 2020 in noninterest expense as a percentage of average assets, although inflated balance sheets may have something to do with the decrease in the percentage.

Furthermore, much uncertainty still exists. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. And, payment deferrals have made some credit quality indicators, such as past due status, less reliable. Payment deferrals for many borrowers are coming to a halt. So, the true financial picture of these borrowers may start to come into focus. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy.

For seasonal borrowers, current indications, such as the most recent results from the Federal Reserve’s Beige Book, show that economic activity was modest in August and September 2021. Supply chain pressures, labor shortages, and concerns over COVID-19 variants (delta and now omicron) have slowed economic growth and continue to provide uncertainty as to (1) the trajectory of the economy, (2) whether inflation is transitory, and (3) the need for the Federal Reserve to increase the federal funds target rate. If an increase in the federal funds target rate is used to combat inflation, community banks could see their NIMs in another transitory stage.

Also, as offices start to open, employers will start to reassess their office needs. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. Banks should closely monitor these borrowers, as identifying early signs of credit deterioration could be essential to preserving the relationship.

The financial services industry is full of excitement right now. While the industry faces many challenges, these challenges also bring opportunity for banks to experiment and differentiate themselves. The forces at play right now indicate the industry will likely look much different ten years from now. However, as the pandemic has exhibited, you may be full steam ahead in one direction and then an unforeseen force may totally up-end your plans. As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC issues its Third Quarter 2021 Quarterly Banking Profile