The Tax Cuts and Jobs Act of 2017 revised and broadened the already in existence Internal Revenue Code “IRC” §163(j) business interest deduction limitation rules for companies with tax years beginning after December 31, 2017. The IRS released initial guidance on these new rules on April 2, 2018, with Notice 2018-28. And then on November 26, 2018, the IRS issued expansive proposed regulations (439 pages to be exact) which may be relied upon until the final regulations are published. Depending on the size and nature of your business, these regulations could have a significant impact on you and your business’s ability to deduct all interest expense incurred for 2018 and future tax years.
Who Is Impacted by the New Regulations?
All U.S. taxpayers who are not specifically exempt or excepted as stated in IRC §163(j) are subject to the business interest expense limitation.
Exempt businesses: Small businesses with average annual gross receipts of $25 million or less for the 3 years preceding the current tax year are exempt from the business interest expense limitation. There are still reporting and recordkeeping requirements at the entity level, but none of their interest expense will be subject to the limitation.
Excepted businesses: Certain trades or businesses have been excepted from the business interest expense limitation, some of which must make the irrevocable election to be excepted. Those trades or businesses are:
- The trade or business of performing services as an employee;
- Electing real property trades or businesses;
- Electing farming trades or businesses; and
- The trade or business involving certain regulated public utilities (beyond the scope of this memo).
What Is the Limitation?
Assuming that the business is not excluded via one of the reasons in the prior paragraph, IRC §163(j)(1) states that the amount allowed as a deduction for any taxable year for business interest shall not exceed the sum of the businesses interest income of the taxpayer; plus 30 percent of the adjusted taxable income “ATI” of the taxpayer; plus the floor plan financing interest expense of the taxpayer. The ATI calculation is complicated, but for the most part, it is calculated by taking an individual or company’s taxable income and adding back to it deductions for:
- Business interest expense (or subtract business interest income);
- Net operating losses;
- Deductions under section 199A (new qualified business income deduction);
- For tax years beginning before 1/1/2022, depreciation, amortization, and depletion;
- Capital loss carryback and carryover; and
- Income, gain, deduction, or loss which is allocable to an excepted trade or business.
For most trades or businesses, the simplest way to look at this is that the business interest expense deductible is limited to around 30% of EBITDA for tax years starting after 12/31/2017 and before 1/1/2022. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and is a common metric used to evaluate a company’s operating performance. For tax years beginning on or after 1/1/2022, the business interest expense deductible is limited to around 30% of EBIT. EBIT is simply EBITDA but without an adjustment for depreciation and amortization. Any excess business interest expense, defined as interest that cannot be deducted in the current year due to this limitation, can be carried forward indefinitely.
Interest and Business Interest Defined
The proposed regulations have defined interest as “any amount paid or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement.” This means that interest includes conventional debt instruments as well as transactions that are indebtedness in substance although not in form. The definition includes interest in the forms of original issue discount, accrued market discount, acquisition discounts, and deferred payment contracts. The definition also includes certain other amounts that are closely related to interest such as interest rate swaps and debt issuance costs. Business interest is defined as “interest that is properly allocable to a non-excepted trade or business or that is floor plan financing interest expense.” Investment interest is considered business interest for C-Corporations but not for pass-through entities and individuals.
C-Corporation versus Pass-Through Treatment
C-Corporations calculate the business interest deduction limitation at the entity level. Any excess business interest expense that cannot be deducted in the current year is carried forward and retested in each future year to determine its deductibility. In any year of disallowance, the corporation’s earnings & profits “E&P” calculation, which is defined as the calculation to determine the corporation’s ability to pay dividends to its shareholders, will generally be reduced by the excess business interest expense. For a consolidated group of corporations, the business interest deduction limitation is calculated on a group-wide basis.
Partnerships and S-Corporations first apply the business interest deduction limitation test at the entity level. Any deduction for business interest expense not disallowed under IRC §163(j) is taken into account in determining the non-separately stated taxable income or loss of the entity. This means that, to the extent that an entity’s business interest expense is less than or equal to its limitation, the business interest expense would lose its character as business interest expense at the partner or shareholder’s level and would no longer be subject to any IRC §163(j) limitations. If there is excess business interest expense at the Partnership or S-Corporation level, it is passed through to the partner or shareholder where the IRC §163(j) limitation is ultimately determined.
Other Things to Consider
Real property and farming businesses with over $25 million of average annual gross receipts that elect to be excepted from the business interest deduction limitation rules must use the alternative depreciation system (ADS) on specific fixed asset additions that would otherwise be available for the general depreciation systems (GDS). ADS depreciation typically carries a longer tax life and is not eligible for bonus depreciation.
Also, if floor plan interest expense paid by the taxpayer is included in the business interest deduction limitation calculation, the taxpayer is prohibited from claiming the new 100% bonus depreciation on property acquired for use in the trade or business.
The changes to the business interest deduction limitation outlined in IRC §163(j) and the Proposed Regulations are complicated and include a lot more detail than what is covered in this summary. These changes could result in considerable unfavorable tax treatment for taxpayers with significant business interest expense. If you are a taxpayer with greater than $25 million in gross receipts and have significant business interest expense, you should consult your tax advisor to understand the impact this will have on you and your business.