When the Treasury Department released proposed regulations in early August of this year for Sec. 199A, created by the Tax Cuts and Jobs Act (TCJA), some of the tax press seemed surprised that banks organized as S-corporations (S-banks) qualified for the 20 percent deduction that Sec. 199A grants certain pass-through businesses. For instance, Tax Analysts' headline was "Giving Banks Pass-through Deduction Spurs Criticism." The Los Angeles Times headline read, “Treasury says some banks are not financial-services firms, giving them new tax break.” And the American Banker’s lead was “Treasury clarifies beneficial tax treatment for S Corp Banks.”

These headlines make it look like the banking industry was granted a special favor by Treasury, but the truth is much more mundane. The regulations allow S-banks to take the 20 percent deduction because the statutory text of the TCJA says they qualify.

Sec. 199A of the law is written in such a way that specified service trade or businesses (SSTBs) explicitly cited in the law, such as accounting, health, legal, and financial services, do not qualify for the deduction. If a business is not a SSTB, then it can take the deduction and its income is classified as Qualified Business Income (QBI).

Sec. 199A enumerates SSTBs in Sections 199A(d)(2)(A) and (B) with a cross reference to Sec. 1202(e)(3)(A). Banking is not listed in any of those sections—it is listed in Sec. 1202 (e)(3)(B). And so, it is not an enumerated SSTB; and, therefore, qualifies for the deduction. This statutory reading appeared to leave little doubt that S-banks qualify.

The American Bankers Association (ABA), where I work, and other banking groups asked Treasury for clarification on S-banks qualifying for the deduction because some observers reasoned that because banks engage in certain SSTBs, some or all of their income may not qualify. Treasury cleared up most, but not all, of the confusion with the proposed regulations.

It is clear that the income S-banks earn from making loans and taking deposits is QBI. What remains at question is whether Treasury will allow income banks earn from other core banking activities they are expressly allowed to conduct by their regulators, but that happen to be SSTBs, to qualify for the deduction as well. Or worse, if those SSTBs will potentially disqualify all a bank’s income from the deduction.

In addition to making loans and taking deposits, banks are allowed to perform a variety of other services that are part of the core business of banking, including trust and fiduciary services, insurance brokerage, originating and selling mortgages, assisting customers in retirement planning, safe deposit and safe-keeping of customer assets, and other related financial service activities. These activities may be performed in a bank holding company, a bank, or in one or more subsidiaries.

The specific financial services that are excluded under Sec. 199A, according to the Treasury regulations, are providing financial services to clients with respect to finances, developing retirement plans, wealth transition plans, as well as brokerage services, investment and investment management, trading, and dealing in securities, partnership interests, and commodities. Because these businesses are also core banking activities, many S-banks engage in them. Banking is unique in the context of Sec. 199A because most other industries don’t have a similar mix of QBI and SSTBs that put the income of their core business at risk of losing the deduction.

The purpose of the Treasury regulations was to prevent pass-through businesses that mostly earn their income from the skill or reputation of their principal workers from taking the deduction. Those earning income mostly from their labor while self-employed would not have the benefit of lower tax rates on their labor income than those that work for an employer.

Banks do not earn their income from the skill or reputation of a few employees though. They are regulated entities with significant capital, employees, technology, premises, and processes that represent an integrated business. The regulation of banks is significant and includes reviews of compensation practices. Manager-shareholders of S-banks have an important role in leading the success of an individual bank, but those individuals are only part of the business activities of the organization.

The activities that Congress allows banks to conduct constitute an umbrella business of banking. When banks perform trust or advisory services, they are providing a service their customers would have a difficult time finding elsewhere. Many S-banks are in rural areas, meaning they are the only provider of financial services for their customers.

Granting the deduction to the entire income of a bank does not create a loophole because banks are full-fledged businesses and highly regulated. Acquiring a bank charter is an arduous exercise and any business seeking to become a bank would have to actually become a bank by soliciting deposits, making loans, and doing all the other things banks do while making itself subject to strict regulations. There is little chance a business that isn’t a bank would do all those things just to qualify for the deduction.

Given the integrated nature of the business of banking, the significant capital deployed, the risks taken by banks, and the minimal risk of creating a loophole for the deduction, Treasury should  allow all income earned by S-banks to qualify for the deduction. To address any potential ambiguity in the interpretation of Sec. 199A, the final regulations could create a “banking trade or business” that is QBI. Such a banking trade or business would include only the limited set of activities in which regulated banks are permitted to engage.

If Treasury takes the view that banking is not a single business line and therefore S-banks’ income does not fully qualify for the deduction, S-banks may have to split up their activities into different business lines; those that are QBI and those that are not. While this would likely go against the intent of Congress, it would also impose a significant and unnecessary administrative burden on banks, complicate tax administration, and ultimately raise costs for borrowers, including small businesses. This would undermine the objective of the tax law changes. 

Should Treasury go this route, it will need to clarify that banks are allowed to separate their business activities. For instance, if an S-bank has an SSTB that surpasses the de minimis thresholds (10 percent for businesses with gross revenue of $25 million or less and 5 percent for businesses over that threshold), will it need to segregate that income from the QBI so it pays the full rate on the SSTB income and maintains the 20 percent deduction for the qualifying income? Or does the bank lose the 20 percent deduction altogether? The Treasury regulations are not clear on this important point.

The two potential SSTBs that are most likely to cause difficulties for S-banks are: investment management because of the trust services many offer and their sale of loans (mostly mortgages) they originate to Government Sponsored Entities (GSEs) and loan aggregators. Preliminary research using 2017 Call Report data conducted at ABA indicates that there may be more than 50 S-banks that have income from financial management, fiduciary, and trust services that would put them over the threshold.

Banks frequently sell loans they originate to GSEs like FannieMae and FreddieMac or loan aggregators to maintain the safety and soundness of their business. Selling loans allows them to increase liquidity and diversification, reduce credit and interest rate risk, and manage capital, among other benefits. Some have questioned that the selling of loans to GSEs may constitute “dealing in securities.”

However, since the sale of loans to a GSE is a core banking activity, and the GSEs are not customers, Treasury should make clear that selling loans originated by a bank as part of normal business operations is not an SSTB. Using the same data referenced above indicates there may be almost 100 S-banks that would have income from the sale of loans that would cross the de minimis thresholds.

It would be a punitive result if banks in such a situation were denied the deduction on all their income if they have SSTBs over the thresholds, and that is unlikely what Treasury has in mind. But until Treasury makes it explicit that businesses can segregate SSTB income and leave their QBI untainted for purposes of the deduction, there will be some that believe having an SSTB over the threshold taints an entire bank’s income.

If Treasury ends up forcing S-banks to break apart their businesses for purposes of the deduction (assuming they can still claim the deduction for their QBI if their SSTB is greater than the threshold), it will inject unfairness into the banking industry. For instance, two banks with almost identical operations and income could have significantly different tax rates. One with a trust business that grew to outstrip the de minimis threshold could have a higher tax rate than a similar bank that chose to concentrate its business in another way. The later would gain a market advantage by way of its lower tax rate.

Fluctuations in interest rates and the broader economy could also create unfairness and cause complications and uncertainty for S-banks. One year all a bank’s income might be QBI but the next they might end up with an SSTB because interest rates fell and therefore the fee income they earn from their trust business, for instance, rose as a share of their total income. This could become a yearly headache for such banks.  

S-banks are already paying a higher tax rate (29.6 percent assuming all their income qualifies for the deduction) than their competitors organized as C-corporations (21 percent). If Treasury takes the position that S-banks need to carve out their SSTBs, that differential will rise even more, tipping the market further against S-banks.

Treasury has a hard job in crafting the regulations for Sec. 199A. Congress created the complicated deduction and Treasury has done an admirable job making it into a workable policy. As Treasury finalizes the regulations post the October 1 end of the comment period, it should continue that good work by recognizing banking as an umbrella of business activities that generates qualified business income. That would be the right answer, the fairest outcome, and what Congress intended.

Curtis Dubay is a senior economist at the American Bankers Association. Prior to that he was a research fellow in tax and economic policy at The Heritage Foundation. He has also worked at PwC and the Tax Foundation. Dubay received his master's degree in economics from the University of Connecticut and his bachelor's degree in economics and leadership studies from the University of Richmond. He resides in Washington, DC with his wife and three sons. He can be reached at cdubay@aba.com.