The 2017 passage of the Tax Cuts and Jobs Act (TCJA) imposed a new limitation, known as “section 163(j) limitation”, on deductions for business interest expenses. Prior to the TCJA, section 163(j) of the Internal Revenue Code (IRC) applied only to certain interest paid or accrued by corporations.
However, the TCJA has significantly changed that. Seeing as the change is a permanent one for tax years that began in 2018, it is worthwhile to understand what the new business interest expense limitation is and who it affects.
What’s in this article
- What is a business interest expense?
- How did the business interest expense limitation tax code change?
- What are the latest proposed IRS regulations?
- Who is exempt from the new business interest expense limitation code?
- How do you calculate the limit?
- What are the special circumstances for partnerships and S corporations?
- What can you do to prepare?
What is a business interest expense?
A business interest expense is the cost of interest charged on business loans utilized to facilitate and maintain operations. Business interest expenses can be deductible as an ordinary business expense for designated businesses. Typically, the loan must be used to either purchase business assets or pay business expenses in order for the loan interest to qualify as deductible.
Business interest expense is more formally defined by the Internal Revenue Service (IRS) as interest on debt that’s properly allocated to a trade or business. However, it should be noted that the term “trade” or “business” does not include the following activities:
- Performing services as an employee,
- Electing real property businesses,
- Electing farm businesses, and
- Businesses that sell electrical energy, water, sewage disposal services, gas or steam through a local distribution system, or transportation of gas or steam by pipeline, if the rates are established by a specified governing body.
How did the business interest expense limitation tax code change?
Prior to the passage of the TCJA, business interest expense was generally deductible in the year which the interest was accrued or paid. However, there were certain limitations in place under IRC Section 163(j) known as “earnings stripping rules”. Under these rules, the government attempted to limit deductions by U.S. corporations for interest paid to related foreign entities not subject to U.S. income tax. Furthermore, other taxpayers were generally able to fully deduct business interest expense. However, some restrictions, such as the passive loss rules and at-risk rules, applied.
The TCJA institutes significant changes to business interest expense deductions. Effectively, it replaces the “earnings stripping rules” and applies to all types of businesses on the deductibility of net business interest expense that exceeds 30% of a taxpayer’s adjusted taxable income (ATI). Starting with tax year 2018, a taxpayer’s deduction for business interest expense for the year is considerably limited to the sum of three parts: 1) business interest income, 2) 30% of adjusted taxable income, and 3) floor plan financing interest.
The new deduction limitation has the potential to affect all types of businesses – corporate and noncorporate. Additionally, interest expense disallowed under the new limitation rules is carried forward to future tax years indefinitely and treated as business interest expenses incurred in the carry-forward year.
What are the latest proposed IRS regulations?
With the degree of change in the tax code, the IRS recently issued proposed regulations on certain definitions and how to apply the limitation. Unless otherwise specified, the proposed regulations would be effective for tax years ending after the date they are published.
The proposed regulations are organized into the following sections:
- Definitions used throughout the proposed regulations.
- General rules on how to calculate the business interest expense limitation.
- Ordering rules and rules coordinating the limitation with other tax code provisions, such as the passive activity loss rules.
- Rules for C corporations and tax-exempt corporations.
- Rules on the treatment of C corporation disallowed business interest expense carry-forwards.
- Special rules for applying the limitation to partnerships and S corporations and their owners.
- Rules for foreign corporations and their shareholders.
- Rules for foreign persons with effectively connected income.
- Rules for election by eligible real property businesses and farming businesses to be exempted.
- Rules for allocating income and expenses between nonexcepted and excepted trades and businesses. Excepted trades and businesses are electing real property businesses, electing farm businesses and regulated utilities.
- Transition rules for the limitation.
Who is exempt from the new business interest expense limitation code?
Fortunately, many businesses are exempt from the interest expense limitation. They are as follows:
The business interest expense limitation does not apply to small businesses. More specifically, the taxpayer (other than a tax shelter) is exempt from the limitation if their average annual gross receipts for the preceding three years is $25 million or less.
As such, some businesses with fluctuating annual gross receipts may qualify for the exception for some years and not for others.
Real Property Businesses
Eligible real property businesses have the option to elect out of the new business interest expense limitation. However, choosing to do so comes at a cost.
Real property is property that includes land and buildings, as well as anything affixed to the land. Examples are warehouses, factories, offices and other buildings owned by a business. Furthermore, real property may include anything beneath the surface of the land (i.e. minerals, natural gas, oil, etc.), rights to the use of the property, and leasehold improvements.
Real property businesses include those developing, redeveloping, constructing, reconstructing, acquiring, converting, renting, operating, managing, leasing and brokering real property.
The TCJA limitation allows real property businesses to elect out of the rules if they utilize the Alternative Depreciation System (ADS) to depreciate their nonresidential real property, residential rental property and qualified improvement property. Employing ADS results in lower annual depreciation deductions due to depreciation periods longer than the ones under the standard Modified Accelerated Cost Recovery System (MACRS) rules. If a business decides to elect out of the limitation, first-year bonus depreciation that would otherwise be permitted for real property assets is no longer allowed under the ADS.
Similar to real property businesses, eligible farming businesses have the ability to opt out of the business interest expense limitation rules.
Eligible farming businesses include:
- Sod farms
- Raising or harvesting tree crops, other crops or ornamental trees
- Certain agricultural and horticultural cooperatives
They are able to elect out of the limitation if they utilize ADS to depreciate assets used in farming businesses that have MACRS depreciation periods of 10 or more years.
*Please note the decision to opt out, for both farming and real property businesses, is irrevocable.
How do you calculate the limit?
According to one particular estimate, the limitation does not affect 98% of all U.S. businesses. However, if you are among the affected 2% it is important to understand how to calculate your deduction limitation.
If the limit applies to your business, your annual deduction for business interest expense cannot exceed the sum of:
- Business interest income
- 30% of your adjusted taxable income
- Floor plan financing (commonly used by vehicle dealers and large appliance retailers)
Please note that business interest income and expense do not include investment interest income or expense. Also, disallowed interest expense may be carried forward indefinitely.
Adjusted taxable income is taxable income without the following included:
- Items of income, gain, deduction or loss that are not allocable to a business,
- Any business interest income or expense,
- Any net operating loss (NOL) deduction,
- The deduction for up to 20% of qualified business income from a pass-through business entity,
- Any allowable depreciation, amortization or depletion deductions for tax years beginning before 2022, and
- Other adjustments listed in the proposed regulations.
For tax years before and including 2021, depreciation, amortization and depletion are added back when calculating adjusted taxable income. However, starting in tax years beginning in 2022, depreciation, amortization and depletion will not be added back.
What are the special circumstances for partnerships and S corporations?
The business interest expense limitation inherently becomes more complex when considering partnerships, limited liability companies (LLCs) treated as partnerships for tax purposes, and S corporations.
Special rules apply to pass-through entities. Essentially, the limitation is determined at both the entity level and the owner level. In regards to partnerships, any interest in excess of the limit is passed through to the partners and carried forward on their individual tax returns. The partnership also passes through “excess taxable income” (amount by which the deduction limit exceeds actual interest expense). Partners can offset this excess amount against unused interest deductions.
For S corporations, unused deductions are carried over at the entity level until they can be offset against corporate income.
What can you do to prepare?
The new business interest expense limitation rules are complicated. Even if you are exempt from the new code, it is extremely important to document that you do not qualify for the limitation. This is a precautionary step in case the IRS comes knocking on your door.
On the other hand, if you are among the businesses affected by the rule change, having a trusted tax advisor to develop strategies to minimize the effects is critical.
You can also read up on some IRS-distributed materials regarding the limitation. The IRS officially released Form 8990 “Limitation on Business Interest Expense Under Section 163(j)”. They also provided a list of basic questions and answers about the limitation.
Either way, we are ready and capable of guiding you through the process. You do not have to navigate the sweeping tax reform rules put in place by the TCJA all alone. Rather, allow your experienced tax advisors at Squar Milner to help. Please contact your Squar Milner tax professional to discuss how these changes affect you and your business.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.