The Internal Revenue Service (IRS) released long-awaited final regulations and other guidance on the limitation of business interest expense deductions under Internal Revenue Code (IRC) section 163(j).
Among several notable changes, the final regulations appear to eliminate a rule hindering manufacturers, narrow the scope of expenses subject to the limitation, provide additional clarity and flexibility for real estate businesses, and simplify the treatment of business interest for certain small business owners.
In addition to the final regulations, the IRS simultaneously issued another set of proposed regulations, which address various issues not covered in the previous guidance. The new proposed regulations provide rules for tiered partnerships, self-charged lending transactions between partners and partnerships, and debt-financed distributions, and several other areas. Lastly, the proposed regulations clarify the application of changes to section 163(j) as made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
This article provides a preliminary overview of some key areas addressed in the final regulations and other components of the business interest expense guidance package.
What is the business interest expense deduction?
The business interest expense limitation was originally enacted under the Tax Cuts and Jobs Act (TCJA) of 2017. For tax years beginning after December 31, 2017, Section 163(j) generally limits business interest expense deductions to the sum of:
- The taxpayer’s business interest income;
- 30% (or 50%, for applicable years) of the taxpayer’s adjusted taxable income (ATI); and
- The taxpayer’s floor plan financing interest expense.
Broadly, ATI is the equivalent of earnings before interest, taxes, depreciation and amortization (EBITDA) for tax years through 2021, then EBIT for tax years thereafter. Additionally, taxpayers carry forward any excess business interest expense and can potentially deduct it in the subsequent tax year.
The business interest expense deduction limitation does not apply to certain small businesses whose gross receipts are $26 million or less, electing real property trades or businesses, electing farming businesses, and certain regulated public utilities. The $26 million gross receipts threshold applies for the 2020 tax year and will be adjusted annually for inflation.
Taxpayers use Form 8990, Limitation on Business Interest Expense Under Section 163(j), to calculate and report their deduction and the amount of disallowed business interest expense to carry forward to the next tax year.
Impact of the CARES Act
The CARES Act, passed in March 2020 to stimulate the economy during the ongoing COVID-19 pandemic, increased the business interest expense deduction limitation to 50% of ATI for the 2019 and 2020 tax years for non-partnership taxpayers. However, they do have permission to elect to apply the more restrictive 30% limit.
In addition, taxpayers can elect to use their 2019 ATI in computing the 2020 limit, thereby helping taxpayers whose income declines in 2020.
What are some of the key changes included in the final regulations?
Good news for manufacturers
Taxpayers’ deductions for depreciation, amortization, and depletion are added to taxable income when computing ATI for tax years beginning prior to January 1, 2022. The final regulations now allow depreciation, amortization, and depletion that is capitalized into inventory under section 263A during those tax years to be added back when computing ATI. This rule reverses the position of the 2018 proposed regulations, which did not allow taxpayers to addback depreciation, amortization, and depletion expenses capitalized into inventory when computing ATI.
The rule reversal is welcome news for taxpayers, and especially those in the manufacturing industry, who generally are required to capitalize most of their depreciation expense. Overall, this change increases a taxpayer’s ATI, resulting in a larger interest deduction.
Narrowed definition of interest
The 2018 proposed regulations contained a broad definition of business interest expense. To the benefit of taxpayers, the final regulations have somewhat narrowed the definition of interest. For example, the final regulations generally exclude commitment fees, debt issuance costs and certain hedging income and costs from the definition of interest. Similarly, partnerships now treat guaranteed payments for the use of capital as business interest expense only under narrow circumstances.
However, we should note that the final regulations also provide an anti-avoidance rule that generally will require taxpayers to treat certain items as interest expense for section 163(j) purpose if a principal purpose of their incurrence is to avoid the section 163(j) limitation. The final regulations include examples of how and when to apply the anti-avoidance rule.
Greater clarity for real estate businesses
The final regulations include several taxpayer-friendly changes related to the real property trade or business election. As noted above, eligible real property trades or businesses can elect out of the business interest expense limitation, with the trade-off being longer depreciable lives and no bonus depreciation for residential real property, nonresidential real property and qualified improvement property.
In the 2018 proposed regulations, the IRS took the position that real property trades or businesses already exempt from section 163(j) by reason of the small business exemption (i.e., the gross receipts test) could not make the election. The final regulations clarify that eligible taxpayers can make this election, even if they also qualify for the small business exemption. In addition, the final regulations allow certain taxpayers conducting rental real estate activities to make a protective section 163(j) election to ensure their business interest expense is not subject to limitation, even if the activities do not rise to the level of a trade or business.
Safe harbors for qualified nursing/assisted living facilities
Notice 2020-59, also included in the guidance package, contains a proposed revenue procedure. It offers a safe harbor allowing taxpayers engaged in a trade or business that manages or operates qualified residential living facilities to treat it as a real property trade or business solely for purposes of section 163(j) and, thus, eligible to elect out of the limitation. The safe harbor applies to facilities that provide supplemental assistance, nursing and/or other routine medical services to customers/patients that are in residence for 90 days or more.
No further testing of interest expense of exempt partnerships and S corporations
Under the 2018 proposed regulations, partnerships and S corporations (nontax shelters) that are exempt from section 163(j) by reason of the gross receipts test were not subject to the interest limitations under section 163(j). However, these entities were still required to pass business interest expense through to the owners for testing on their respective returns. This approach was burdensome and appeared contrary to the general principle that section 163(j) apply at the entity level. However, in another taxpayer-friendly move, the final regulations reverse this position. Now partnerships and S corporations exempt from the section 163(j) limitation can deduct business interest expense.
The final regulations also eliminate the requirement that the allocated interest expense be subject to the limitation at the individual partner or shareholder level.
Aggregation rules for the gross receipts test
In addition to the final and proposed regulations and Notice 2020-59, the IRS also issued FAQs on the aggregation rules that apply for purposes of the $26 million-or-less gross receipts test (see above). Separate FAQs address the aggregation rules that apply to corporations, partnerships, trusts, estates, sole proprietorships, and affiliated service groups.
When are the final regulations effective?
The final and new 2020 proposed regulations are generally effective for tax years beginning on or after 60 days after publication in the Federal Register. For calendar year taxpayers, this typically means tax year 2021 is the first year for which they must follow the guidance of the final regulations.
However, taxpayers may choose to rely on the newly released regulations or continue to rely upon the 2018 proposed regulations (issued in December 2018) for taxable years beginning after December 31, 2017, and before the aforementioned effective date. In either case, taxpayers must apply the regulations consistently, and barring certain exceptions, in their entirety.
How can Squar Milner help?
Considering that these final and proposed regulations apply to most businesses, it is important to gain an understanding of how the limitation will apply to your set of facts and circumstances.
Our team of tax professionals and industry specialists can work with you to assess the implications of the newly released final regulations and how they affect your tax strategies. Contact your Squar Milner tax advisor to discuss how the latest changes impact your specific situation.
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.
Our Real Estate Tax, Audit & Consulting Services
The real estate team at Squar Milner is with you every step of the way. We have been through it ourselves through our own experiences as executives in the real estate industry. And now we are ready to bring that background and accounting expertise to help you through every project lifecycle.