Authored by Paul Dillon, Michelle Hobbs and Patrick Balthazor
The legislation informally known as the Tax Cuts and Jobs Act (TCJA) places a limit on the amount of interest expense that businesses can deduct on their tax returns. Seen as a revenue-raiser to help pay for the corporate tax rate reduction, businesses, starting in 2018, can only deduct interest based on a formula. The following continues our series updating you on the changes brought about by the TCJA.
Section 163(j) of the Internal Revenue Code disallows the deduction for net business interest expense of any taxpayer in excess of the sum of the following for the taxable year: a) business interest income, b) 30 percent of “adjusted taxable income,” and c) floor plan financing interest. The section 163(j) limitation should be applied after other interest disallowance, deferral, capitalization or other limitation provisions. Therefore, original issue discount (OID) deferral rules, any capitalization requirements, related-party rules among others must first be applied prior to calculating the 30 percent limit.
Adjusted business income is the taxable income of the taxpayer computed without regard to:
- For years beginning before Jan. 1, 2022:
- Items of income or loss not allocable to the trade or business
- Any business interest or business interest income
- Any net operating loss under section 172
- Any deduction for certain pass-through income under section 199A
- Any deduction for depreciation, amortization or depletion
- For years beginning on or after Jan. 1, 2022:
- The same as above other than the adjustment for depreciation, amortization and/or depletion.
Items to note
- This limitation applies only to business interest expense. Nonbusiness interest, such as investment interest, would continue to be subject to the limitation on investment interest expense.
- The calculation includes only taxable interest income in determining net business interest expense. Therefore, investments in tax-free municipal bonds would not increase a taxpayer’s interest expense capacity.
- It appears any interest expense deduction carryover could be subject to limitations in ownership shift situations, similar to net operating losses.
- In addition, financial services entities seem to have no special rules. As an example, the determination of net business interest expense is unclear for an insurer generating significant interest income related to investments as an integral part of its active insurance business.
- In a tiered-entity structure, the upper tier does not use its share of pass-through activity from the lower tier in computing its limitation. Therefore, if the only activity the upper tier has is the lower tier plus some interest expense, the upper tier has an interest expense deduction of zero.
- Section 1231 gains on sale of an asset used in a trade or business appear to be included in the determination of trade or business income. While not specifically addressed, since section 1231 losses are afforded ordinary loss treatment rather than capital losses, it appears they would be included in the computation of adjusted business income, thereby reducing it.
- The new limitation does not apply to certain small businesses, i.e., any taxpayer (other than a tax shelter) that meets the gross receipts test of section 448(c). In other words, businesses with average annual gross receipts of $25 million or less are exempt from this 30 percent limit. See the aggregation rules discussion later in this alert. In addition, this exception does not apply to tax shelters.
The definition of a “tax shelter” for this purpose is more broad than you would expect. Most people think of tax shelters as an abusive tax tool. However, for the purposes of this code provision, it will include many operating businesses that would not ordinarily be thought of as a tax shelter. The test really has to do with if operating losses from an entity are allocated to partners or S corporation shareholders that are not active in the business.
Namely, any partnership or S corporation that allocates more than 35 percent of its losses for the year to limited partners or limited entrepreneurs is considered a tax shelter.
For purposes of this section, an interest in an entity shall not be treated as held by a limited partner or a limited entrepreneur if they meet one of the following requirements:
- An individual who directly owns an interest and actively participates in the management of the entity
- An individual who directly owns an interest and has a spouse, child, grandchild or parent who actively participates in the management of the entity
- An individual who directly owns an interest and actively participated in the management of the entity for a minimum of five years
- An individual’s estate that directly owns an interest if the individual actively participated in the management of the entity for a minimum of five years
- The limitation does not apply to “floor plan financing interest.” For this purpose, floor plan financing interest means indebtedness used to finance motor vehicles held for sale or lease, and secured by such inventory.
- The law allows real property and farming trades or businesses to make an irrevocable election out of the business interest deduction limitation. These businesses must then use the alternative depreciation system (ADS) to depreciate property with a recovery period of 10 years or more. Expect guidance from the IRS as to the timing and format of such elections.
Real property trades or businesses include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage services. Grouping of activities is not expected to control the determination of a taxpayer’s real property trades or businesses. Farming trades or businesses include cultivation of land, harvesting of any agricultural or horticultural commodity, operating a nursery or sod farm as well as the raising or harvesting of trees bearing fruits, nuts, other crops or ornamental trees.
- The interest deduction limit does not apply to certain regulated public utilities or to certain electric cooperatives.
Application to partnerships and S corporations
Partnerships and S corporations are also subject to the business interest limitation rules (with some modifications). If a partnership or S corporation has enough taxable income to deduct its business interest, both partnerships and S corporations can pass their “excess taxable income” to their partners or shareholders. However, if interest expense is limited at the partnership or S corporation level, there is a difference in the treatment of the disallowed interest between partnerships and S corporations.
Partners of a partnership and shareholders of an S corporation have unique rules to calculate their interest deduction limitation. The limitation is applied at the partnership or S corporation level, and each partner’s or shareholder’s adjusted taxable income is increased by their distributive share of the partnership’s or S corporation’s “excess taxable income.”
Excess taxable income is a proportion of the partnership’s or S corporation’s adjusted taxable income equal to:
- 30 percent of the adjusted taxable income of the partnership or S corporation, minus
- the difference of the partnership/S corporation’s business interest over the partnership/S corporation’s business interest income, divided by
- 30 percent of the adjusted taxable income of the partnership/S corporation.
The excess taxable income allows a partner or shareholder to use its distributive share of the excess (or unused) taxable income limitation of the partnership or S corporation in computing the partner’s or shareholder’s business income limitation. Any excess taxable income is passed through to the partners or shareholders and is added to the partner’s or shareholder’s adjusted taxable income to determine any limitations on business interest at the partner or shareholder level. For example, assume that a partnership has $200 of adjusted business income and $40 of interest expense. The partnership only needs $133.33 of adjusted business income to support a full deduction of the $40 of interest expense ($133.33 multiplied by 30% = $40). As a result, the partnership has $66.67 ($200 minus $133.33) of excess taxable income that it allocates to its partners, and the partners can use this amount to increase their own taxable income limitation.
The special carryforward rules, described below, apply to partners in the case of business interest not allowed as a deduction to the partnership for any tax year due to the business interest limitation. The special carryforward rules do not apply in the case of an S corporation. Only the general carryforward rule applies to an S corporation.
A special carryforward rule allows partners to carry forward unused business interest expense deductions of the partnership. If the partnership is unable to deduct business interest by virtue of exceeding the business interest income limitation, the partners will be allocated such excess business interest in the same manner as nonseparately stated taxable income or loss of the partnership. If any excess business interest is allocated to a partner, it will be treated as paid or accrued by the partner in the next year in which the partner is allocated excess taxable income. Until that time, the partner will not be able to deduct the interest expense allocation even though it has reduced their basis in the partnership. If a partner is allocated any excess business interest, its basis in the partnership interest will be decreased (but not below zero) by the amount of such excess business interest. This will result in a timing mismatch of when the deduction is taken and when the reduction in basis will be deemed to occur.
If a partner has been allocated excess business interest and disposes of its partnership interest in between the time when the basis in its partnership interest is decreased to reflect such allocation and the time it is deemed to have been paid or accrued by the partner, the partner’s basis in its partnership interest will be increased immediately before the disposition by the amount that the basis reduction exceeds the amount of excess interest expense that has already been treated as paid or accrued by the partner.
For S corporations, if the interest expense is limited, no allocation is made to the shareholders. Rather, under the general carryforward rule, it remains suspended at the corporate level.
In a related group of entities, it appears the aggregation rules apply in determining whether the $25 million gross receipts threshold is met or exceeded. If the group’s gross receipts, when aggregated, exceeds $25 million, the 30 percent limitation is then applied at each separate entity. In a consolidated group, the 30 percent limitation is applied at the parent level or whichever entity files the consolidated return.
For groups of pass-through entities, any excess taxable income amounts would be allocated to the partner/shareholder and would only be used against excess business interest from the respective entity before it can offset any other business interest. In other words, excess interest deductions from one entity cannot offset excess taxable income from another.
Real-estate-related items to consider
- The election out of the business interest limitation applies only with respect to debt incurred by the entity acquiring/operating real estate. It is uncertain whether debt incurred by an upper-tier entity (such as a real estate fund), then subsequently contributed as capital to a lower-tier operating entity could be availed of this exception, since the upper-tier partner is not acquiring or operating real estate.
- The election out of the business interest limitation by a partnership will result in the partnership having to depreciate the project over the ADS recovery period. For residential buildings placed in service after Dec. 31, 2017, the TCJA reduces the ADS recovery period to 30 years. For existing projects, however, it is not clear whether the applicable recovery period is the 30-year period provided in the TCJA or the 40-year recovery period in effect under prior law.
- The election is irrevocable. Therefore, you won’t be able to opt back in to the interest limitation in later years when the interest deduction may not be limited under the 30 percent rule.
The revised section 163(j) is effective for tax years beginning after Dec. 31, 2017. We expect the Treasury to release guidance on calculations of the limitation, definitions as well as explanations on how this section will interact with other interest expense limitations. We will continue to update you on this provision as well as the multitude of other changes brought on by the TCJA. In the meantime, we encourage you to contact your Baker Tilly tax advisor to help you maximize your business interest deduction.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.