We often highlight articles from our customers that would be interesting and relevant to the Firmex community. We hope you enjoy this in-depth article by Jonathan Wegner of Baird Holm LLP, on strategies for the banking sector in light possible upcoming Congressional tax and capital gains changes.
As 2012 gears up for another fall election cycle, the U.S. Congress is poised for another showdown on taxes, spending, debt ceilings and politically difficult decisions.
For bankers, however, this is not a replay of the tax showdown in 2010 or debt-ceiling debacle of 2011. Although Congress may once again kick the can down the road for a few quarters or even another year, real change appears to be coming, and bankers are beginning to take steps to prepare for what might be around the corner.
This time, the decisions facing the Congress and the country as a whole are being framed in even starker terms than when Congress last faced — and failed to resolve — these issues in August 2011. At that time, Congressional leaders agreed to $109 billion in automatic annual spending cuts from the defense and domestic budgets if a super committee failed to reach agreement on how to cut spending by $1.2 billion over the next decade.
The committee failed, and the automatic spending cuts now are scheduled to coincide with the sunset of the payroll tax cut and the Bush-era tax cuts, which could collectively result in an additional tax increase of about $500 billion effective Jan. 1. As if the suspense wrought by this so-called fiscal cliff was not enough, the situation is exacerbated by the prospect of the United States hitting its debt ceiling in mid-February 2013.
Despite Rising Tax Rates, M&A Activity Remains Slow
For community bank owners, the prospect of what appears to be an inevitable hike to capital gains rates has led some to look for an exit in 2012. However, even for institutions for which a sale makes strategic sense, owners appear not to regard higher tax rates as enough of a catalyst to overcome other obstacles, such as the lower multiples institutions command in today’s market, valuation challenges for problem assets and the post-sale challenge of where to productively invest transaction proceeds.
Some owners may recall how Congress delayed the capital gains rate increase for two more years in 2010 and may be hoping for another extension. Even if Congress does extend the Bush-era tax cuts for a period, however, the Affordable Care Act imposes a new 3.8 percent tax on investment profits, dividends and other non-wage income for persons with adjusted gross income in excess of $250,000.
For those still hoping to lock in gains at today’s rates, such hopes are quickly fleeting. Even if a seller identifies a buyer capable of meeting the tight timeframes between now and year-end for negotiating a transaction, completing applications and receiving regulatory approvals, it is all but impossible to effect a data conversion in the months of December and January, meaning that a buyer may need to agree to operate an acquired institution on a legacy platform for a few months to complete a deal prior to year-end. Even in the best of times, such buyers are difficult to find, and even for the few deals already in the pipeline, time is running out.
Harvesting Gains for Investment Clients
Many institutions with longstanding brokerage arrangements or trust departments have diversified into wealth management services in recent years. For banks that service a significant number of high-net-worth investors, many such clients appear to be sitting on the sidelines waiting to see who will control Congress and the White House after Nov. 6 and what the lame duck session Congress may enact before year-end. Depending on the outcome, many advisers are anticipating a rush to harvest capital gains in the last two months of 2012. As such, it behooves financial institutions to be in active communication with their investment clients prior to the election to help these clients maximize the tax effectiveness of their portfolios.
Returning Capital to Investors
The common complaint that FDIC stands for Forever Demanding Increased Capital could not be more true in recent years. Many banks today have capital ratios well in excess of regulatory requirements and would even significantly exceed requirements under the proposed risk-weighting requirements for Basel III.
For such excessively well-capitalized institutions that are taxed as C corporations and not interested in pursuing an acquisition in the near future, a return of capital to investors through a dividend may make sense before year-end. On Jan. 1, dividend rates are set to rise from the current 15 percent to 39.6 percent for high earners (plus the new 3.8 percent ACA tax, resulting in a maximum dividend tax rate of 43.4 percent for some taxpayers).
Strategic Planning Initiatives
Because dividends may become far less attractive for some institutions, those with sizable war chests may become more likely to commence stock repurchase programs and seek to put capital to work through acquisitions, loan participation arrangements and other investment vehicles. For organizations eligible for taxation as S corporations, tax-effective yields will make municipal bonds even more attractive than they have been in recent years.
For all institutions, strategic planning in light of whatever the new year brings will be crucial. Boards have spent the last four years struggling to guide their institutions through changing regulatory and capital requirements and the prospect of major fiscal changes now adds another layer of uncertainty to the mix. While nobody can be sure as to what Washington, D.C., may eventually agree on, recent history has at least one comforting lesson: The U.S. dollar remains the world’s reserve currency, and any upheaval in markets generally results in a flight to quality, which for most investors remains U.S. Treasuries (despite the dysfunction in Washington, D.C.). While experts and pundits disagree on what fiscal policy will look like in the future, they generally believe that markets will allow the United States the time it needs to get its fiscal house in order — provided it acts soon.
For banks, which are one of the biggest buyers of U.S. Treasuries, that is a small island of consolation in a sea of uncertainty. In the meantime, follow fiscal developments closely and watch for new risks and opportunities that may emerge after the storm passes.
Please contact Jonathan Wegner at 402-344-0500 or email jwegner(at)bairdholm.com if you would like to discuss this article.