Untangling tax reform: business interest limitation

Authored by Paul Dillon, Michelle Hobbs and Patrick Balthazor

Another revenue-raiser to help pay for the Tax Cuts and Jobs Act (TCJA) reduction in the corporate tax rate is the new section 163(j) limitation on the business interest expense deduction. This article summarizes the computation formula and provides insight to many of the open questions for which we anticipate guidance from Treasury.

Computation formula

The deduction for net business interest expense of any taxpayer is limited to the 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 is applied after other interest disallowance, deferral, capitalization or other limitation provisions. The original issue discount deferral rules, any capitalization requirements and related-party rules, among others, are applied prior to calculating the 30 percent limit.

Adjusted business income is the taxable income of the taxpayer computed without regard to:

  1. 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
  2. For years beginning on or after Jan. 1, 2022:
    • The same as above other than the adjustment for depreciation, amortization and/or depletion.

Limitations rules for pass-through entities. 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. In the case of an S corporation, any interest limitation is suspended at the entity level and taken into consideration in later years (subject to limitation).

However, in the case of partnerships, any currently nondeductible interest is allocated to the partners as a separately stated item. The suspended interest is then deductible in any year the partner receives an allocation of excess taxable income. However, the partner’s basis in the partnership is reduced in the year they receive the allocation of suspended interest. This could create basis limitation implications resulting in other taxable impacts. Conversely, since the suspended interest remains at the entity level for S corporations, shareholder stock basis is not reduced by the currently disallowed interest deduction. This means additional tracking is necessary to determine correct partner basis as excess interest is actually deducted.

“Excess taxable income” is a proportion of the partnership’s adjusted taxable income equal to:

  • 30 percent of the adjusted taxable income of the partnership, minus
  • the difference of the partnership business interest over the partnership business interest income, divided by
  • 30 percent of the adjusted taxable income of the partnership.

Items to note

  1. 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. However, investment interest continues to be an itemized deduction. Due to the $10,000 cap on state and local income and property taxes, the value of itemized deductions will be diminished for many taxpayers.
  2. 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.
  3. It appears any interest expense deduction carryover could be subject to limitations in ownership shift situations, similar to net operating losses.
  4. 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.
  5. 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. 
  6. 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.

Exceptions

Keep in mind the following taxpayers are not subject to these limitations:

  • trades or businesses with less than $25 million in gross receipts
  • employees
  • furnishing or selling certain types of energy
  • electing farming businesses
  • electing real property trades or businesses
  1. 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
       
    Currently, no specific guidance exists on how “active participation” is defined. As a result, the question remains as to the degree of involvement required by each member or shareholder to avoid syndicate classification. If an entity is organized by a group of professionals all of whom participate in the management of the company (e.g., a law firm), it should not be difficult to avoid being classified as a syndicate. However, if the entity is organized as an investment vehicle and the owners choose to have the organization run by a manager, it is unlikely the entity will be able to escape the 30 percent deduction limitation via the small business exception unless the managers own more than 65 percent of the company.
     
  2. 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.
  3. 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.
  4. The interest deduction limit does not apply to certain regulated public utilities or to certain electric cooperatives.

Real estate related items to consider

  1. 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.
  2. 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.
  3. 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.

Unresolved issues

Understanding there are multiple questions as to how these new business interest deduction limitations will apply, the IRS issued a notice outlining several subjects where guidance is anticipated. These areas include application to C corporations and consolidated groups, treatment of disallowed interest prior to 2018, impact on earnings and profits, application to affiliated groups and application to tiered entity structures. In addition, pass-through entities will need to provide pertinent information to partners although the format of such disclosure is not yet known.

Application to C corporations and consolidated groups

Traditionally, C corporations cannot have nonbusiness or passive interest. On the other hand, in the context of the interest expense deduction limitations, what happens when a C corporation owns an interest in a partnership that passes through to the corporate owner passive activity interest expense? In addition, would interest income from an underlying partnership automatically be considered business income, which would increase the amount of business interest expense the C corporation could deduct.

With respect to consolidated groups, it is presumed the interest expense deduction limitation will be applied at the federal consolidated level. Under Notice 2018-28 issued earlier this year, Treasury indicated it intends to issue regulations providing that an affiliated group filing a consolidated return will be treated as a single taxpayer for purposes of the limitation, but such treatment will not be permitted for an affiliated group (such as brother-sister corporations) not filing a consolidated return. However, what if the consolidated group contains some members who are subject to the limitation and others with activities exempted from the limitation (energy businesses or electing real property businesses). Guidance is eagerly being awaited on this issue by such consolidated groups.

A further issue arises as to what will happen to disallowed interest expense carryover amounts if a consolidated return member leaves the group. Will new members entering the consolidated group have to apply the separate return limitation year (SRLY) rules to any previous interest expense carryovers?

Treatment of disallowed interest prior to 2018

Prior to the TCJA being enacted, there were circumstances under which C corporations were limited in the amount of interest expense they could deduct (i.e., earnings stripping). To the extent those C corporations have disqualified interest deductions carrying forward post-2017, the presumption is this carryover will be added to current-year interest expense and subject to the new limitations.

Impact on earnings and profits

It appears Treasury and the IRS believe any disallowance and carryforward of a C corporation’s business interest expense will not affect whether or when the actual expense reduces its earnings and profits.

Application to affiliated groups

In circumstances where a group of entities not filing a consolidated return is considered to be affiliated for tax purposes, will the interest expense limitation be applied at the group level? If so, it appears the IRS is planning to use rules under pre-TCJA law to determine the allocation between group members. Basically, this will mean common ownership between family members, more than 50 percent owners, control groups, subsidiaries and controlled partnerships among others. Groups with greater than 10 percent tax-exempt ownership could automatically be deemed to be related.

Application to tiered-entity structures

Many situations where the ability to double count business income and adjusted taxable income exists; most especially, in tiered structures where lower-tier entity activity passes up into multiple upper levels. The TCJA indicates that partners cannot include their distributive share of partnership activity when determining such partner’s interest expense limitation. Treasury and the IRS are expected to clarify what this means and the mechanics of doing so.

Conclusion

Clearly, the interest expense deduction is much more complex than the deceivingly simple formula. While the computation may be a straightforward exercise in math, the analysis needed in getting to the formula and the determination of allocating the allowable expense will be one of the more complicated areas of the TCJA. In addition, limitations on the interest expense deduction may affect taxable income. As a result, evaluate whether current-year estimated tax payments should be increased. We will continue to provide insight as guidance is issued.

Please visit our tax reform resource center for additional information.

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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.