Financial Institutions Should Not Overlook Sec.163(j)
The dreaded section 163(j) interest expense limitation and its complexities have haunted CPAs and businesses since the day tax reform was written. One industry that remained less concerned than others with these new limitations was financial institutions, which typically have more interest income than interest expense, which in many cases prevents the limitations from applying. However, as research has been conducted and regulations released, the impact of this regulation has found its way to financial institutions, although to what degree is highly situation and fact dependent.
Some background on the limitation may be useful. BNN previously described the topic in this article published shortly after the limitation was created. In summary, as part of the Tax Cuts and Jobs Act, Congress amended Internal Revenue Code Section 163(j), to add a new limitation on deduction of interest expense incurred in a trade or business. The new limitation applies to all businesses with net business interest expense, regardless of form of business (partnership, corporation, sole proprietor, etc.). It is effective for tax years beginning after December 31, 2017, with additional limitations introduced for years beginning after December 31, 2021. In general, the limitation disallows any net interest expense that is in excess of 30% of a taxpayer’s adjusted taxable income (“ATI”). Disallowed interest expenses due to these rules can be indefinitely carried forward. We highly recommend another article that dives deeper into the specifics of the limitation.
With that background, let’s look at a few different ways this limitation can impact banks:
Low income housing or other K-1 investments:
Perhaps the most frequently seen limitation comes from K-1s that pass income through to banks. Many of these investments are highly leveraged and produce net interest expense. The limitation looks not only to the entity that incurred the interest, but also to that entity’s owner, as well. If the deduction is disallowed at the partnership level, then the partner can’t deduct the interest expense either until there is excess taxable income from that partnership that frees up previously disallowed interest to flow into the partner’s calculation on Form 8990.
Many of these low income housing investments may never produce excess taxable income, however. Instead, interest expense will be disallowed year after year until the partner sells or otherwise exits the partnership. In that case, the partner’s basis in the partnership is reduced each year by the disallowed interest expense and when the partner exits the partnership the basis is immediately increased by the disallowed interest expense. The problem with this is that it could create a larger capital loss upon exit. In other words, while the deduction is not lost, it may turn an ordinary loss into a capital loss, and capital losses can be deducted only if the bank has an offsetting capital gain. If not, the bank would have to carry the capital loss either back for up to 3 years, or forward for up to 5 years. If it remains unused at that point, it expires. Some banks have a difficult time generating capital gains because of Section 582 so it could be possible the capital loss is never deducted and the lost amount is written off through tax expense.
If the bank is in a position where capital gains are difficult to generate, then this loss limitation should be factored into the pricing and valuation of a K-1 investment before entering.
There is one potential “out” for these partnership investments if they operate as farming or real estate businesses. They could make an irrevocable election not to be subject to the limitation, but in exchange, they must use ADS depreciation instead of MACRS, thereby increasing depreciable lives of assets and reducing tax-deductible depreciation expense each year. An analysis would need to be done to weigh the benefit of deductible interest expense vs. the reduced depreciation expense deduction and see what provides the most benefit. This election is made on the partnership return, so the ability of the bank to influence making the election might depend on its ownership percentage and overall structure and relationships between the shareholders and managing members.
Banks could see a state tax impact from the interest limitation if it operates as a consolidated group and one entity has net interest expense. In that situation, it is possible that federally there would be no limitation because 163(j) is a consolidated calculation. However, in states that require separate entity filing (or separate entity calculations) an entity with net interest expense could be subject to a disallowance. Many states have not fully addressed 163(j), and guidance continues to trickle in. Banks should look at potential 163(j) limitations not only at the federal level, but on a state-by-state basis, knowing that limitations could impact tax returns and ASC 740 accounting (tax provisions).
Sec.163(j) may also impact banks indirectly by changing the actions of its customers. Because the limitations apply only for taxpayers with gross receipts exceeding $25,000,000, this would involve mostly large customers, but those who may be affected might look for alternatives to commercial lending that would not limit their ability to deduct interest. They also may forgo debt entirely if the interest expense is non-deductible.
While it initially seemed that banks might be in the clear when it comes to 163(j) interest limitations, it appears that broad assessment is not entirely accurate (as seems to be the way of the tax code!). Generally a bank itself may not experience a federal limitation, but it can be impacted by a K-1 investment, which may now require consideration of this limitation as part of its rate of return. 163(j) can also affect a bank’s state taxes, and has the potential to diminish the bank’s customer base.
For more information or a discussion on how this may impact your bank, please contact Adam Aucoin or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.