The Tax Cuts and Jobs Act (TCJA) imposes a new limitation on deductions for business interest expense. The IRS recently issued guidance in the form of proposed regulations. The business interest expense limitation is a permanent change for tax years that began in 2018. Thankfully, many businesses are unaffected. Here's what you need to know.
Before the TCJA, some corporations were subject to the so-called “earnings stripping” rules. Those rules attempted to limit deductions by U.S. corporations for interest paid to related foreign entities that weren't subject to U.S. income tax. Other taxpayers could generally fully deduct business interest expense (subject to restrictions, such as the passive loss rules and the at-risk rules).
The TCJA shifts the business interest deduction playing field. For tax years beginning in 2018, a taxpayer's deduction for business interest expense for the year is limited to the sum of: 1) business interest income, plus 2) 30% of adjusted taxable income (as defined later), plus 3) floor plan financing interest paid by certain vehicle dealers. This new interest expense deduction limitation can potentially affect all types of businesses — corporate and noncorporate.
Business interest expense is defined as interest on debt that's properly allocable to a trade or business. However, the term trade or business doesn't include the following excepted activities:
- Performing services as an employee,
- Electing real property businesses,
- Electing farming businesses, and
- Businesses that sell electrical energy, water, sewage disposal services, gas or steam through a local distribution system, or transportation of gas or steam by pipeline, if the rates are established by a specified governing body.
Interest expense that's disallowed under the limitation rules is carried forward to future tax years indefinitely and treated as business interest expense incurred in the carry-forward year.
The IRS has issued proposed regulations on how to apply the business interest expense limitation. The proposed regulations are organized into these sections:
1. Definitions used throughout the proposed regulations.
2. General rules on how to calculate the business interest expense limitation.
3. Ordering rules and rules coordinating the limitation with other tax code provisions, such as the passive activity loss rules.
4. Rules for C corporations and tax-exempt corporations.
5. Rules on the treatment of C corporation disallowed business interest expense carry-forwards.
6. Special rules for applying the limitation to partnerships and S corporations and their owners.
7. Rules for foreign corporations and their shareholders.
8. Rules for foreign persons with effectively connected income.
9. Rules for elections by eligible real property businesses and farming businesses to be exempted from the business interest expense limitation.
10. Rules for allocating income and expenses between non-excepted and excepted trades and businesses. Excepted trades and businesses are electing real property businesses, electing farming businesses and regulated utilities.
11. Transition rules for the limitation.
Unless otherwise stated,the proposed regs would be effective for tax years ending after the date they're published in the form of final regulations. However, taxpayers can choose to follow the proposed rules for tax years beginning in 2018 — if they apply the proposed rules consistently.
Small Business Exception
The good news is that many businesses are exempt from the interest expense limitation rules under what we'll call the small business exception. With this exception, a taxpayer (other than a tax shelter) is exempt from the limitation if the taxpayer's average annual gross receipts are $25 million or less for the three-tax-year period ending with the preceding tax year.
Businesses that have fluctuating annual gross receipts may qualify for the small business exception for some years but not for others — depending on the average annual receipts amount for the preceding three-tax-year period. For example, if your business has three good years, it may be subject to the interest expense limitation rules for the following year. But if it's been a bad year, it may qualify for the small business exception for the following year. If average annual receipts are typically over the $25 million threshold, but not by much, judicious planning may allow you to qualify for the small business exception for at least some years. Your tax advisor can help with that.
Interaction with Other Limitations
The rules in the proposed regs generally apply only to interest expense that could otherwise be deducted without regard to the business interest expense limitation. So interest expense that has been disallowed, deferred or capitalized in the current tax year, or that hasn't been accrued yet, shouldn't be taken into account when considering the limitation. However, the limitation should be applied before applying the passive activity loss rules, the at-risk rules and the new excess business loss disallowance rule.
Calculating the Deduction Limitation
Assuming your business doesn't qualify for an exception, the business interest expense deduction for the tax year can't exceed the sum of: 1) business interest income, plus 2) 30% of adjusted taxable income, plus 3) any floor plan financing interest expense.
Adjusted taxable income means taxable income calculated by making adjustments to factor out the following:
1. Items of income, gain, deduction or loss that aren't allocable to a business,
2. Any business interest income or business interest expense,
3. Any net operating loss deduction,
4. The deduction for up to 20% of qualified business income from a pass-through business entity,
5. Any allowable depreciation, amortization or depletion deductions for tax years beginning before 2022, and
6. Other adjustments listed in the proposed regulations.
Deductions for depreciation, amortization, and depletion are added back when calculating adjusted taxable income for tax years beginning before 2022. For tax years beginning in 2022 and beyond, these deductions won't be added back, which may greatly increase the taxpayer's adjusted taxable income amount and result in a lower interest expense limitation amount.
For 2019, BB Co. has $20,000 of business interest income, $250,000 of business interest expense and $1 million of adjusted taxable income. Assume the small business exception doesn't apply. The company can deduct all $250,000 of its business interest expense because that amount is less than the deductible limit of $320,000 [$20,000 of business interest income + $300,000 (30% of the $1 million of adjusted taxable income)].
For 2020, BB Co. has $20,000 of business interest income, $120,000 of business interest expense and only $100,000 of adjusted taxable income. The company can only deduct $50,000 of its business interest expense in 2020 [$20,000 of business interest income + $30,000 (30% of the $100,000 of adjusted taxable income)]. The $70,000 of disallowed interest expense ($120,000 – $50,000) is carried forward to future years.
This example illustrates that the business interest expense limitation is more likely to affect a business when it's having a subpar year. The only good news is that the disallowed interest is carried forward to future years, so it can potentially be deducted when things get better.
Important: For tax years beginning before 2022, taking advantage of generous depreciation tax breaks (such as 100% first-year bonus depreciation and Section 179 deductions) will not reduce adjusted taxable income. For later years, taking advantage of such breaks will reduce adjusted taxable income, which will make the interest expense limitation more likely to come into play.
Special Partnership and S Corporation Rules
The interest expense deduction limitation rules get more complicated for businesses operating as partnerships, limited liability companies (LLCs) treated as partnerships for tax purposes and S corporations.
Basically, the limitation is calculated at both the entity level and at the owner level. Special rules prevent double counting of income when calculating an owner's adjusted taxable income for purposes of applying the limitation at the owner level.
The proposed regs set forth the special rules for applying the business interest expense limitation to partnerships and S corporations and their owners. The provisions are complex and present significant compliance challenges for affected taxpayers.
Minimize the Effects
As you can see, the business interest expense limitation rules are complicated. Fortunately, many businesses are exempt from the limitation. According to one estimate, about 98% of U.S. businesses are covered by the small business exception.
If your business is among the 98%, it's important to properly document that fact in case the IRS comes calling. Your tax advisor can help.
On the other hand, if your business is affected by the limitation, your tax advisor may be able to suggest planning moves to minimize the ill effects.
Electing Out of the Limitation
Eligible real property and farming businesses can elect out of the new business interest expense limitation. However, electing to be exempt has a tax cost.
Real Property Businesses
Real property businesses can elect out of the rules if they use the Alternative Depreciation System (ADS) to depreciate their nonresidential real property, residential rental property and qualified improvement property. Using the ADS results in lower annual depreciation deductions because its depreciation periods are longer than the depreciation periods under the regular MACRS (Modified Accelerated Cost Recovery System) rules that usually apply. Real property businesses include developing, redeveloping, constructing, reconstructing, acquiring, converting, renting, operating, managing, leasing and brokering real property.
Affected real estate businesses should evaluate the tax benefit of gaining bigger interest expense deductions by electing out of the interest expense limitation rules vs. the tax detriment of lower depreciation deductions under the ADS. If the election out is made, first-year bonus depreciation that would otherwise be allowed for real property assets won't be allowed under the ADS.
Eligible farming businesses can also elect out of the interest expense limitation rules. Farming businesses include nurseries; sod farms; raising or harvesting of tree crops, other crops, or ornamental trees; and certain agricultural and horticultural cooperatives. These businesses can elect out of the rules if they use the ADS to depreciate assets used in the farming business that have MACRS depreciation periods of 10 years or more.