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