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Long-awaited guidance issued on the business interest expense deduction limitation

Authored by Michelle Hobbs and Mike Schiavo

The Internal Revenue Service (IRS) released the long-awaited final regulations under IRC section 163(j) that contain some good news for manufacturers and other taxpayers.

Upon preliminary review of the 575-page final regulations, it appears the IRS generally was responsive to taxpayer comments. For example, one of the rules in the proposed regulations that disproportionately impacted manufacturers was revised. The regulations narrow the scope of expenses considered business interest expense 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.

All that said, the rules are still extremely complex and require careful study and analysis. And, as if almost 600 pages of final regulations wasn’t enough, the IRS 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 transaction between partners and partnerships, and debt-financed distributions, and several other areas. Lastly, the proposed regulations clarify the application of the changes to section 163(j) as made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

The final and new proposed regulations are generally effective for tax years beginning after the date that is 60 days from the date they are published in the federal register. However, taxpayers may choose to rely on the newly released regulations or continue to rely upon the initial set of proposed regulations (issued in December 2018) for taxable years beginning after Dec. 31, 2017, and before the aforementioned effective date. In either case, the regulations must be applied consistently, and barring certain exceptions, in their entirety.

This alert is a preliminary overview of some key areas in the final regulations. We will be providing additional information in the coming weeks and months as we analyze the new guidance in detail. We encourage you to contact your Baker Tilly advisor to discuss how these issues may affect your tax position.

Background

A key revenue raiser included in the Tax Cuts and Jobs Act (TCJA or Act) was the limitation of the business interest expense deduction for many taxpayers. Essentially, a limitation of 30% of adjusted taxable income (ATI) was placed on the amount of business interest expense that could be deducted in a given tax year. 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. Any excess business interest expense would be carried forward and potentially deducted in the subsequent tax year (handled somewhat differently for certain types of taxpayers). The CARES Act, passed in March 2020 to stimulate the economy during the ongoing COVID-19 pandemic, increased this limitation to 50% of ATI for the 2019 and 2020 tax years for nonpartnership taxpayers.

Notable changes in the final regulations

Good news for manufacturers

Under the proposed regulations, depreciation, amortization or depletion capitalized into inventory under the uniform capitalization (UNICAP) rules was not added back in the computation of a taxpayer’s ATI. This rule was particularly detrimental to taxpayers in the manufacturing industry, who generally are required to capitalize most of their depreciation expense. Baker Tilly, along with other tax practitioners, urged the IRS to reverse this position — and fortunately, the IRS listened. For tax years beginning before Jan. 1, 2022, taxpayers will now be allowed to add back depreciation, etc., to ATI that was capitalized into inventory, regardless of the period the amounts are actually recovered through cost of goods sold. This change increases a taxpayer’s ATI, thereby allowing for a larger interest deduction.

Definition of interest narrowed, fewer items subject to limitation

The initial proposed regulations contained an unexpectedly broad definition of business interest expense. Commenters noted that many items that are typically not viewed as interest were nevertheless caught up in this wide net, and subject to limitation. To the benefit of taxpayers, the final regulations have somewhat narrowed the definition of interest. For example, commitment fees, debt issuance costs and certain hedging costs were removed from the definition of interest. In the partnership context, guaranteed payments for the use of capital are now only treated as business interest expense under narrow circumstances.

More clarity and flexibility for real estate businesses

The final regulations include several taxpayer-friendly changes related to the real property trade or business election. As a refresher, 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.

The IRS took the position in the initial proposed regulations that real property trades or businesses that were 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 don’t rise to the level of a trade or business.

Safe harbor provided for qualified nursing/assisted living facilities

Along with the regulations package, the IRS also issued a proposed revenue procedure (Notice 2020-59) that provides a safe harbor for qualified residential living facilities to be treated as a real property trade or business 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.

Interest expense of exempt partnerships and S corporations not subject to further testing

Under the initial 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. In another taxpayer-friendly result, the final regulations reverse this position, allowing business interest expense to be deducted by partnerships and S corporations exempt from the section 163(j) limitation. The final regulations also eliminate the requirement that the allocated interest expense be subject to the limitation at the individual partner or shareholder level.

Conclusion

These final and proposed regulations apply to most businesses; therefore, it is important to gain an understanding of how the limitation will apply to your set of facts and circumstances. This alert covers only a small portion of these rules. We encourage you to contact your Baker Tilly advisor to discuss their application to your specific situation.

For more information on this topic or to learn how Baker Tilly specialists can help, contact our team.

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.

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