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Why M&A Tax Planning Is Even More Important in Today’s Regional Banking Environment

November 16th, 2023

This article was written by Jack Johnson, Manager, Tax.

The rapid rise in interest rates, the increased vacancies in CRE, and the flight of yield seeking depositors have created a challenging environment for regional banks. In this environment, banks may seek to engage in M&A transactions to improve efficiency and competitiveness. This article will address some key issues for banks to consider in today’s environment.

Regulatory Capital

The typical regional bank merger creates a short period federal income tax return. If the merger is timed too early in the calendar year, one-time costs, such as cashing out Target executive stock options, systems conversion, the sale of underwater debt securities, and safe-harbor investment banking fees may create a tax net operating loss (NOL). NOLs may no longer be carried back but have an indefinite carryforward subject to annual limitations.

However, for regulatory capital purposes, the deferred tax asset (DTA) created by tax NOLs goes into the “bad DTA bucket” and, after netting any allocated deferred tax liabilities (DTLs), gets fully disallowed for purposes of regulatory capital. The same goes for any DTAs arising from capital loss or other carryforwards.

To mitigate this, the Acquiring Bank should obtain the right to review a draft of Target’s final short period federal income tax return, in order to take any actions that might avoid or reduce a tax NOL in that short period. This could include electing out of bonus depreciation or electing to capitalize certain expenses. Target Banks who wish to be more attractive to Acquiring Banks can also take actions during the final short period to reduce or eliminate a tax NOL.

Executive Compensation

Enacted tax law changes will, in future tax years, restrict or eliminate the deductibility of executive compensation, even in situations where the Target executive continues with Acquiring and is not otherwise a covered employee under the rules. This “once covered, always covered” rule can also reduce or eliminate the future value of existing DTAs at the Target.

Target executives may also have golden parachute arrangements, which may result in large change of control payments becoming not deductible. Prudent tax planning in advance of an M&A transaction can reduce or, in some cases, eliminate the nondeductible nature of these payments, while in many cases leaving the Target executive in no worse a position, or even possibly in a better position, on their personal income tax returns.

Bad Debt Planning

Due diligence may identify issues with Target loans that indicate the need for significant write downs in purchase accounting. If those loans in fact become partially worthless, they may need to be charged off for income tax purposes. The timing of when those tax bad debt charge offs occur can create a tax NOL at either Target Bank or Acquiring Bank, with adverse regulatory capital consequences.

Whether Target Bank or Acquiring Bank have made the conformity election for deducting tax bad debts, or whether either Bank signed the IRS Industry Directive in 2014 may significantly impact planning for the timing of Target’s tax deduction for bad debt charge offs.

Tax Due Diligence

Today’s environment also raises new challenges for tax due diligence. Where does Target operate? Will a merger of Target Bank into Acquiring Bank trigger state tax nexus in any new states for Acquiring Bank? Do any of those new states require combined or unitary income tax returns? Does Acquiring Bank already have customers in states where Target Bank operates, but Acquiring Bank has not yet filed state tax returns in those states? Has Target implemented aggressive state tax planning strategies?

These and other questions must be addressed as part of tax due diligence to avoid unanticipated problems down the road.

The above are only a few examples of the impact of today’s regional banking environment on the need for thorough M&A merger tax planning. We would be glad to discuss these and other bank tax M&A issues with you at your convenience.

If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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