Author: Alexis Long

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Financial Institutions and Banking

Monitoring and Managing Interest Rate Risk

For community banks, interest rate risk is a part of doing business, so it’s critical for banks to monitor that risk and take steps to control it. The “right” level of risk depends on several factors, including the size and complexity of a bank’s operations, as well as the sufficiency of its capital and liquidity to withstand the potential adverse impact of interest rate fluctuations.

Managing interest rate risk is particularly important in light of recent rate increases. The Office of the Comptroller of the Currency (OCC), in its Fiscal Year 2023 Bank Supervision Operating Plan, instructed examiners to determine whether banks appropriately manage interest rate risk through “effective asset and liability risk management practices,” noting that “rising rates may negatively affect asset values, deposit stability, liquidity, and earnings.”

Types of interest rate risk

In simple terms, interest rate risk means risk to a bank’s financial condition or resilience (that is, its ability to withstand periods of stress) caused by movements in interest rates. There are several types of interest rate risk, including:

Repricing risk. Banks experience this risk when their assets and liabilities reprice or mature at different times. Suppose, for example, that a bank makes a five-year, fixed-rate loan at 7% that’s funded by a six-month certificate of deposit (CD) at 3%. Every six months, when the CD renews, the bank is exposed to repricing risk. If the CD rate increases to 4% after six months, then the bank’s net interest income drops from 4% to 3%. Conversely, if the CD rate declines, the bank’s net interest income increases.

To gauge repricing risk, banks can compare their volume of assets and liabilities that mature or reprice over a given time period. The potential impact of fluctuating interest rates will depend in part on whether a bank is asset- or liability-sensitive. If it’s asset-sensitive — meaning assets reprice more quickly than liabilities — then its earnings generally increase when interest rates rise and decrease when they fall. If it’s liability-sensitive — meaning liabilities reprice more quickly than assets — then its earnings generally increase when interest rates fall and decrease when they rise. Some banks are neutral — that is, their assets and liabilities reprice at the same time.

Basis risk. This risk arises when there’s a shift in the relationship between rates in different markets or on different financial instruments. Suppose, for example, that an asset and a related liability are tied to the prime rate and the one-year U.S. Treasury rate, respectively. If the spread between those two rates widens or narrows, it will affect the bank’s net interest margins.

Yield curve risk. This risk arises from changes in the relationships among yields from similar instruments with different maturities. Suppose, for example, that a bank funds long-term loans with short-term deposits. A typical yield curve reflects rates that rise as maturities increase. However, if market conditions cause the yield curve to flatten or even slope downward, the bank’s net interest margins can shrink or even turn negative.

Options risk. Bank assets and liabilities often contain embedded options, such as the right to pay off a loan or withdraw deposits early with little or no penalty. The bank is compensated for offering customers this flexibility (typically in the form of higher interest rates on loans or lower interest rates on deposits). But granting these options creates interest rate risk. For example, if interest rates go up, deposit holders will have an incentive to move their funds into investments that enjoy higher returns. If rates go down, many borrowers will pay off their loans so they can refinance at a lower rate.

Another risk associated with rising interest rates is an increased risk of default by borrowers with variable rate loans.

Managing the risk

Banks can apply financial modeling techniques to measure and monitor their interest rate risk. If your interest rate risk is unacceptably high, consider strategies for mitigating it, such as:

  • Adjusting your bank’s mix of assets and liabilities to reduce interest rate risk,
  • Increasing capital to help the bank absorb the impact of fluctuating interest rates,
  • Reducing options risk by controlling the terms of loans and deposits, or
  • Using interest rate swaps or other techniques to hedge against interest rate risk.

Keep in mind that a key component of interest rate risk management is stress testing. (See “Stressing out about interest rate risk” below.)

Look at the big picture

This article focuses on interest rate risk, but it’s important to keep in mind that many of the risks banks face are interrelated. Thus, management of interest rate risk should be incorporated into a bank-wide risk management system.

Sidebar: Stressing out about interest rate risk

The Office of the Comptroller of the Currency (OCC) provides guidance on managing interest rate risk. The guidance urges banks to conduct periodic stress tests that include both scenario analysis and sensitivity analysis. Stress testing can help a bank manage risk by evaluating the possible impact of various adverse external events on a bank’s earnings, capital adequacy, and other financial measures.

Scenario testing examines the potential impact of various hypothetical or historical scenarios — such as rising or falling interest rates — on the bank’s financial performance. Sensitivity analysis estimates the impact of changes in certain assumptions or inputs into a financial model. It helps the bank determine which assumptions have the greatest influence on outcomes and fine-tune its assumptions accordingly.

© 2022

Categories
General

The Ways and Means Committee Chair Selection

The Ways and Means Committee is the chief tax-writing committee in the U.S. House of Representatives. It also oversees Social Security, Medicare, and other issues. Not surprisingly, it’s a popular assignment. Now that Republicans have secured a House majority, their representation on the committee is expected to increase from 17 to 25. (Democrats likely will retain 18 seats). However, at least 10 Republicans are vying for eight available spots. Also, several representatives are competing for the chairmanship. The chair will be selected by the Republican Steering Committee, but candidates for committee seats generally must undergo a three-step process that involves a House floor vote.

Categories
Tax

2022 Year-End Tax Planning for Individuals

With rising interest rates, inflation, and continuing market volatility, tax planning is as essential as ever for taxpayers looking to manage cash flow while paying the least amount of taxes possible over time. As we approach year-end, now is the time for individuals, business owners, and family offices to review their 2022 and 2023 tax situations and identify opportunities for reducing, deferring, or accelerating their tax obligations.

The information contained within this article is based on federal laws and policies in effect as of the publication date. This article discusses tax planning for federal taxes. Applicable state and foreign taxes should also be considered. Taxpayers should consult with a trusted advisor when making tax and financial decisions regarding any of the items below.

 

Click here to view the year-end tax planning checklist for individuals.

Categories
Tax

2022 Year-End Tax Planning for Businesses

U.S. businesses are facing pressure to drive revenue, manage costs and increase shareholder value, all while surrounded by economic and political uncertainties. Disruptions to supply chains brought about by the pandemic have continued into 2022. Inflation and rising interest rates have made the cost of debt, goods and services more expensive and cooled consumer spending. The stock market has declined sharply, and the prospect of a recession is on the rise. What’s more, the outcomes of the upcoming November U.S. congressional elections — which as of the publication of this article are as yet unknown — will shape future tax policies. How do businesses thrive in uncertain times? By turning toward opportunity, which includes proactive tax planning. Tax planning is essential for U.S. businesses looking for ways to optimize cash flow while minimizing their total tax liability over the long term.

 

This article provides a checklist of areas where, with proper planning, businesses may be able to reduce or defer taxes over time.  Unless otherwise noted, the information contained in this article is based on enacted tax laws and policies as of the publication date and is subject to change based on future legislative or tax policy changes.

 

Click here to view the year-end tax planning checklist for businesses.

Categories
Tax

Plan Now to Make Tax-Smart Year-End Gifts to Loved Ones

Are you feeling generous at year-end? Taxpayers can transfer substantial amounts free of gift taxes to their children or other recipients each year through the proper use of the annual exclusion. The exclusion amount is adjusted for inflation annually, and for 2022, the amount is $16,000. The exclusion covers gifts that an individual makes to each recipient each year. So a taxpayer with three children can transfer a total of $48,000 to the children this year free of federal gift taxes. If the only gifts are made this way during a year, there’s no need to file a federal gift tax return. If annual gifts exceed $16,000, the exclusion covers the first $16,000 and only the excess is taxable.

 Note: This discussion isn’t relevant to gifts made to a spouse because they’re gift tax-free under separate marital deduction rules.

Gift splitting by married taxpayers

If you’re married, gifts made during a year can be treated as split between the spouses, even if the cash or asset is actually given to an individual by only one of you. Therefore, by gift splitting, up to $32,000 a year can be transferred to each recipient by a married couple because two exclusions are available. So for example, a married couple with three married children can transfer a total of $192,000 each year to their children and the children’s spouses ($32,000 times six). If gift splitting is involved, both spouses must consent to it. This is indicated on the gift tax return (or returns) of the spouses’ file. (If more than $16,000 is being transferred by a spouse, a gift tax return must be filed, even if the $32,000 exclusion covers total gifts.) 

The “present interest” requirement

For a gift to qualify for the annual exclusion, it must be a “present interest” gift, meaning the recipient’s enjoyment of the gift can’t be postponed to the future. For example, let’s say you put cash into a trust and provide that your adult child is to receive income from it while your child is alive and your grandchild is to receive the principal at your child’s death. Your grandchild’s interest is a “future interest.” Special valuation tables determine the value of the separate interests you set up for each recipient. The gift of the income interest qualifies for the annual exclusion because the enjoyment of it isn’t deferred, so the first $16,000 of its total value won’t be taxed. However, the “remainder” interest is a taxable gift in its entirety. If the gift recipient is a minor and the terms of the trust provide that the income may be spent by or for the minor before he or she reaches age 21 and that any amount left is to go to the minor at age 21, then the annual exclusion is available. The present interest rule won’t apply.

“Unified” credit for taxable gifts

Even gifts that aren’t covered by the exclusion, and are therefore taxable, may not result in a tax liability. That’s because a tax credit wipes out the federal gift tax liability on the first taxable gifts that you make in your lifetime, up to $12.06 million for 2022. However, to the extent you use this credit against a gift tax liability, it reduces or eliminates the credit available for use against the federal estate tax at your death. 

Contact your ATA representative if you are interested in making year-end gifts to your loved ones or if you have any questions about tax planning.

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Helpful Articles

401(k) and Profit Sharing Limits for 2022 & 2023

In the downloadable file below, you can find 401(k) and profit sharing limits for 2022 & 2023.

 

Important information for those with a 401(k) account or those considering opening an account:

Required Minimum Distribution (RMD) rules apply to all employer-sponsored retirement plans. RMD rules require those with Traditional and Roth 401(k)s to withdraw a certain amount from their account each year once they turn 72. If the RMD is not withdrawn by the applicable deadline, the individual will be taxed 50% on the amount not withdrawn; individuals can withdraw more than the minimum amount. These withdrawals are considered taxable income. To find your RMD, use this worksheet from the IRS.

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Helpful Articles

M&A on the Way? Consider a QOE Report

Whether you’re considering selling your business or acquiring another one, due diligence is a must. In many mergers and acquisitions (M&A), prospective buyers obtain a quality of earnings (QOE) report to evaluate the accuracy and sustainability of the seller’s reported earnings. Sometimes sellers get their own QOE reports to spot potential problems that might derail a transaction and identify ways to preserve or even increase the company’s value. 

Here’s what you should know about this critical document. Different from an audit QOE reports are not the same as audits. An audit yields an opinion on whether the financial statements of a business fairly present its financial position in accordance with Generally Accepted Accounting Principles (GAAP). It’s based on historical results as of the company’s fiscal year-end. In contrast, a QOE report determines whether a business’s earnings are accurate and sustainable and whether its forecasts of future performance are achievable. It typically evaluates performance over the most recent interim 12-month period. 

EBITDA effects 

Generally, the starting point for a QOE report is the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a business’s ability to generate cash flow than net income does. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies, and other strategic decisions that may vary depending on who’s managing the company. The next step is to “normalize” EBITDA by: Eliminating certain nonrecurring revenues and expenses, Adjusting owners’ compensation to market rates, and Adding back other discretionary expenses. Additional adjustments are sometimes needed to reflect industry-based accounting conventions. Examples include valuing inventory using the first-in, first-out (FIFO) method rather than the last-in, first-out (LIFO) method, or recognizing revenue based on the percentage-of-completion method rather than the completed-contract method. 

Continued viability 

A QOE report identifies factors that bear on the business’s continued viability as a going concern, such as operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality, and supply chain stability. It’s also critical to scrutinize trends to determine whether they reflect improvements in earnings quality or potential red flags. For example, an upward trend in EBITDA could be caused by a positive indicator of future growth, such as increasing sales, or a sign of fiscally responsible management, such as effective cost-cutting. Alternatively, higher earnings could be the result of deferred spending on plant and equipment, a sign that the company isn’t reinvesting in its future capacity. In some cases, changes in accounting methods can give the appearance of higher earnings when no real financial improvements were made. 

A powerful tool

If an M&A transaction is on your agenda, a QOE report can be a powerful tool no matter which side of the table you’re on. When done right, it goes beyond financials to provide insights into the factors that really drive value.

Contact one of our experts to discuss more about M&A.

Categories
Tax

Sen. John Thune and Sen. Ben Cardin Recently Introduced the Athlete Opportunity and Taxpayer Integrity Act

More than a year ago, the U.S. Supreme Court ruled that student-athletes can be compensated for the use of their names, images, or likenesses (NIL). Now, a new bipartisan bill would eliminate a tax incentive for contributions to tax-exempt affiliates of colleges and universities. Since the ruling, groups of college boosters (third-party entities that promote a program’s interests) have formed what are known as NIL collectives. Sen. John Thune (R-SD) and Sen. Ben Cardin (D-MD) recently introduced the Athlete Opportunity and Taxpayer Integrity Act, which would bar individuals and organizations from claiming tax deductions for donations used by collectives for NIL payouts to student-athletes.

Contact one of our experts with all your tax-related questions.

Categories
Tax

Deducting Eligible Medical Expenses

Taxpayers that itemize may be able to deduct eligible medical expenses they incurred for themselves, their spouses, and dependents, subject to limits. Taxpayers bear the burden to prove the expenses, to show they were paid during the tax year and weren’t reimbursed by insurance. 

 

One corporate executive and her husband deducted medical expenses of $41,648 on behalf of her father. They claimed the medical bills were paid by intrafamily loans but provided no proof that the loans had been repaid or that insurance hadn’t reimbursed them. Their records, they stated, were lost due to a hurricane and other setbacks. The U.S. Tax Court partially disallowed the deduction. (TC Memo 2022-99)

 

Contact one of our experts to discuss what expenses are eligible for deduction.

Categories
Tax

Hurricane Ian Victims in Florida Qualify for Tax Relief

-UPDATE-

Hurricane Ian is likely to rank as one of the most destructive storms in U.S. history. The federal government has announced tax relief for all of Florida’s residents and businesses. If you’ve been affected by Hurricane Ian, visit the IRS’s dedicated webpage for details, updates, and resources: https://bit.ly/3rqYnyI

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The IRS has provided return filing and payment extensions to taxpayers who are located in FEMA-designated areas of Florida affected by Hurricane Ian. The relief postpones various deadlines that occurred starting Sept. 23, 2022, until Feb. 15, 2023. This means individuals who have a valid extension to file their 2021 tax returns due to run out on Oct. 17, 2022, now have until Feb. 15, 2023, to file. The IRS noted, however, that because tax payments related to these 2021 returns were due on April 18, 2022, those payments aren’t eligible for this relief. For more information: https://bit.ly/3BWZyL0