Deduction Limitations on Business Interest Expense: Final Regulations Are Released
Treasury and the IRS recently released final regulations under Section 163(j) of the Tax Code, which relates to limitations on the deduction of business interest expense. This section was revised as part of the 2017 Tax Cuts and Jobs Act (TCJA) and was further modified as part of the CARES Act provisions.
As part of the TCJA changes, Section 163(j) limits the amount allowed as a deduction for business interest to the sum of:
- the taxpayer’s business interest income for the year;
- 30 percent of the taxpayer’s adjusted taxable income (ATI); and, if applicable,
- the taxpayer’s floor plan financing interest expense.
A CARES Act provision increased the ATI percentage from 30 percent to 50 percent for 2019 and 2020 (with exceptions for partnerships).
The deduction limitation does NOT apply to the following:
- Small businesses with average annual gross receipts of $25 million or less
- Electing real property trades or businesses
- Electing farming businesses
- Certain regulated public utilities
Key Highlights of the Final Regulations
One highlight of the final regulations involves the expanded definition of the word “interest.” Interest now excludes expenditures for commitment fees, debt issuance costs, partnership guaranteed payments, and hedging gains or losses.
The regulations also enhanced the existing Anti-Avoidance rule, which generally requires that any expense or loss is treated as interest for 163(j) purposes if 1) the expense or loss is economically equivalent to interest and 2) the main goal of the structuring of the transaction is to reduce the taxpayer’s interest expense.
A couple of things need to be kept in mind when calculating ATI (taxable income +/- certain specified adjustments, including adding back depreciation and amortization).
- Any depreciation, amortization, or depletion capitalized to inventory and included in Cost of Goods Sold (COGS) may be added back to taxable income in the year capitalized.
- ATI must be reduced by the full amount of basis adjustment on disposed assets with respect to amortization, depreciation, or depletion taken on those assets, whether or not the taxpayer recognized a gain on the disposition (to avoid an adjustment duplication).
The rules state that a certain order must be followed for these components:
- The 163(j) limitation should be computed after other provisions of the Code that capitalize, defer, disallow, or otherwise limit the deductibility of the expense are applied
- The interaction between 163(j) and the discharge of indebtedness income was not addressed and is subject to further consideration and guidance in the future
Here are a few other items of note in the new regulations for business interest expense:
- The final regulations clarified that 163(j) is not a method of accounting
- Business interest expense that is disallowed under 163(j) is carried forward indefinitely, and these carryforwards are deducted in the order in which they arose (and the current year expense should be deducted prior to any carryforwards from a prior year)
- All interest expense and interest income of a C corporation should be treated as business interest expense and business interest income for purposes of 163(j), except to the extent that such amounts are allocable to an excepted trade or business (this includes a corporate partner’s allocable share of the partnership’s investment income and expenses which are reclassified as trade or business activity of the corporate partner)
- The “Single-entity” approach for consolidated groups for purposes of 163(j) means that intercompany transactions are disregarded when calculating ATI, and the limitation is calculated at the consolidated group level and allocated to each member pro rata based on its contribution to consolidated business interest expense
- For partnerships, deductible business interest expense is allocated to partners in the same manner as non-separately stated taxable income or loss of the partnership. The final regulations bypassed an 11-step computation that was being proposed to determine allocable business interest expense for each partner, and rather just allows for allocation in the same proportion as each partner’s share of the partnership’s allocable ATI
If you’d like to know more about how these final regulations impact your tax return, please feel free to reach out any time.