Tax Season Trap Door: Business Interest Expense Limitation for Pass-through Entities & their Owners
This article assumes that its readers are familiar with the basics of 163(j). If that assumption is false, please first read our earlier article, written just after the Tax Cuts and Jobs Act was passed. Our previous article is a summary of the Business Interest Expense Limitation as written in the Code, while this article explains the new guidance, primarily derived from the proposed regulations.
None of these new sources is truly authoritative. Proposed regulations and notices do not carry the force of law that temporary or final regulations and revenue procedures do, but they are informative, and give us a sneak peek at what the authoritative versions of these documents will look like. The “before and after” versions are both written by the same party (the IRS), and it is likely that most of the language in these documents, with some significant and insignificant adjustments, will make it into the final versions.
And now, our panelists – John Hadwen and Josh Lapierre
John: Happy Tax Season! A tax accountant’s favorite time of year but this year there are many new laws taking effect for many taxpayers. One of the more complex aspects of the new law is the business interest expense limitation, a topic on which the IRS published proposed regulations right between Thanksgiving and Christmas. Now that we’ve had plenty of time to let the turkey digest and decipher the proposed regulations, what are your initial thoughts for pass-through entities and their owners?
Josh: Happy Tax Season as well! Certainly 439 pages is a lot to take in around the holidays. The new business interest limitation is quite expansive and everyone should be considering the applicability and impact. Most discussions and articles up to this point have been using a general formula for the limitation and now the rules are going to be required to be applied. We are going to need to go through the mechanics and application for filing and reporting and for some businesses it is going to require extra time and consideration from taxpayers and their advisors. If you own a business and incurred interest expense and have not discussed its applicability to you, you should - NOW. For pass-through entities this new law is a game changer. For this first year advisors are going to be working with clients to fully understand and report the additional information, if required, and this will require more time and information than in previous years. The pass-through entities add additional layers with items that may or may not be required to be reported to the owners of the business.
John: So how can a taxpayer get out of this new limitation?
Josh: Great question, and one that everyone should first visit. Being exempt from these rules could save a business time and taxes. First, there is an exemption from the limitation on interest deductibility for taxpayers (other than tax shelters) whose average annual gross receipts did not exceed $25 million for the three preceding taxable years; however, taxpayers may need to include the gross receipts of related parties for purposes of determining whether this threshold has been met.
John: Tax shelters? I thought the IRS did away with those years ago.
Josh: A tax shelter is broader than you think. A tax shelter as defined by Section 448 includes a “syndicate,” a term which is defined by Section 1256 as any partnership or other entity (other than a C corporation) if more than 35% of the losses of the entity during the tax year are allocable to limited partners or limited entrepreneurs. Lastly, Section 461 defines a “limited entrepreneur” as any owner of a business that is not a limited partner, but that is not actively engaged in the operations or management of the business. This language is sure to subject many small businesses to this limitation. For real estate businesses that are leveraged and generate a loss, if it is allocated to a limited member, you will be required to apply these new rules unless you elect out as a real property trade or business (discussed below).
John: Can you explain the farming and real property trade or business?
Josh: Farming and real estate businesses can make a one-time irrevocable election to not be subject to the limitation. However, an electing taxpayer is required to use the Alternative Depreciation System (“ADS”) for certain depreciable property, which entails using straight-line depreciation over a longer depreciable recovery period than what is normally allowable for regular tax purposes.
John: So if I’m a farming or real estate business and don’t want to be subject to these rules I have to make an irrevocable election and use a depreciation method that doesn’t allow me to use bonus depreciation? Sounds pretty unfair.
Josh: For farming and real property businesses that are subject to the limitation depending on the interest and depreciation (current and future) it is going to be a consideration that needs to be modeled out. As I noted above the election is irrevocable. Although electing out of the business interest expense deduction limitation eliminates a real property trade or business’ eligibility to claim bonus depreciation for nonresidential real property, residential rental property, and qualified improvement property, those three types of property do not qualify for bonus depreciation in any event. An electing real property trade or business may deduct bonus depreciation for all qualified tangible property (for example, office equipment, office furniture, and machinery) and land improvements.
John: That’s not as bad as it sounds. I hope they don’t make me have to file a change in accounting method (Form 3115) with this election and force clients to recapture any bonus depreciation.
Josh: Fortunately the IRS came out with Rev Proc 2019-08, clarifying that taxpayers don’t need to retroactively change their depreciation and file a change in accounting method. This gives advisors a direction on what the adjustment to depreciation may look like when considering for a client.
John: So what happens if you can’t meet the exceptions above?
Josh: The new limitation generally applies at the tax return filer level to all business debt incurred by the taxpayer, and there is no grandfathering for existing debt. The amount of any business interest expense not allowed as a deduction for any taxable year is treated as a business expense paid or accrued in the following taxable year, and may be carried forward indefinitely.
The 30% limitation effectively applies only to net business interest expense (i.e., the excess of business interest expense over business interest income). The limitation is based on the taxpayer’s “adjusted taxable income.” For tax years beginning after December 31, 2017, and before January 1, 2022, “adjusted taxable income” is computed without regard to deductions allowable for depreciation, amortization, depletion, or business interest expense (similar to EBITDA). For tax years beginning after December 31, 2021, adjusted taxable income will include deductions for depreciation and amortization, but not business interest expense (similar to EBIT). A lot can happen with the tax law between now and 2022, but I expect that this slight change in the definition of adjusted taxable income will subject a much greater number of businesses to business interest expense limitations.
John: That doesn’t sound too complex. Probably the same rules apply to S Corporation and Partnership since the IRS consider these both pass-through entities, right?
Josh: Logically that would make sense but there are two different sets of rules and the IRS has requested comments related to this.
John: You can’t be serious.
Josh: They are only proposed regulations but that’s what they indicate.
John: Don’t tell me. There’s a 20 step allocation process in these proposed regulations for partnerships.
Josh: Close. It’s only an 11 step process but let’s not dive into that and focus on the basics.
Assuming the limitation applies, remember that the first pass at the limitation calculation is done at the partnership (entity) level. Unless by some fluke the entity’s interest is exactly 30% of its adjusted taxable income (ATI), each entity-level computation will result in one of two possible conditions: (1) Excess taxable income will exist if interest is not limited at the entity level, or (2) excess business interest will exist if interest is limited. One or the other of these two excesses will be spit out of the partnership for its partners to contend with at the partner level, and that is where things become a little complex.
Excess taxable income is relevant at the partner level only in the year it is passed through to the partner. It is not carried forward from one year to the next. By contrast, a partnership’s disallowed business interest expense deduction (“excess business interest”) is passed through to the partners and from that point on is tracked at the partner (rather than partnership) level. Disallowed interest carried forward is treated as business interest paid or accrued by the partner in the next succeeding year in which the same partnership has excess taxable income. Then, and only then, can the disallowed interest expense be eligible to join that partner’s overall computation of allowable interest expense. At that point, it is possible that business income from other entities will be used to ultimately deduct all or some of the first year’s disallowed expense. But an earlier year’s disallowed loss will never get to that point unless the partnership that produced it later passes through excess taxable income to that partner.
Basically, a person might indirectly be the victim of Sec. 163(j) interest limitation if he or she is a partner in an entity that suffered a limitation at the entity level. In a later year, that same partnership might contribute to sort of a neutralization of those prior year limitations, but only by passing through excess taxable income to that partner, allowing him or her to accomplish that neutralization at the personal level. A limitation can occur at either the entity or personal level, but the neutralization (through use of excess taxable income) can only occur at the personal level.
John: What you’re describing seems like it could be explained using the concept of silos and playgrounds.
Josh: I’m intrigued… how so?
John: Excess business interest passed through to a partner is placed in its own silo with that partnership’s name on the door. That expense can leave that silo in a later year, in whole or in part, but only if excess taxable income is generated by that same partnership. If so, the silo is unlocked, and that amount of prior year excess business interest is let out to play on the playground. The playground is where all of the other “freed up” prior year excess expenses (from other partnerships or sole proprietor endeavors) join together with excess taxable incomes to take part in the partner’s overall163(j) calculation.
Josh: These rules make me feel like I’ve been on the merry-go-round ride in your playground, but yes, that analogy works. The two examples below should drive this home.
Year 1 – Assuming the partner is subject to the 163(j) limitations. Partner receives disallowed interest of $10,000 from PRS1. Partner receives excess taxable income from PRS 2 of $100,000. The partner has no other activity. The $10,000 excess business interest is disallowed and carried forward to the next year.
Year 2 – PRS1 passes out excess taxable income of $10,000. PRS2 passes out $2,000 of excess taxable income. Partner has no other activity. The excess taxable income of PRS1 of $10,000 has unlocked the $10,000 of prior year excess business interest and is considered paid or accrued in year 2. Both the excess taxable income of $10,000 and $2,000 are included in the partner’s ATI. The excess business interest of $10,000, since it was unlocked, goes into the partner’s 163(j) calculation. The partner’s ATI is $12,000 (the excess taxable income of PRS1 and PRS2) and thus 30% is $4,000. The interest is $10,000 with $6,000 disallowed and $4,000 deductible. In this case the excess taxable income of PRS2 helped deduct excess business interest of PRS1 ONLY because PRS1 had enough excess taxable to unlock the previously disallowed interest.
Year 1 – Same as above.
Year 2 – PRS1 passes out excess taxable income of $1,000. PRS2 passes out $200,000 of excess taxable income. Partner has no other activity. The excess taxable income of PRS1 of $1,000 has unlocked $1,000 of prior year disallowed to be considered paid or accrued in year 2. Both the excess taxable income of $1,000 and $200,000 are included in the partner’s ATI. The excess business interest of $1,000, since it was unlocked, goes into the partner’s 163j calculation. Assuming no other activity, the partner’s ATI is $201,000 (the excess taxable income of PRS1 and PRS2) and thus 30% is $60,300. The interest of $1,000 included in the calculation is all deductible. The $9,000 of previously disallowed interest expense is still excess business interest disallowed and carried forward.
Josh: Note also that any excess business interest passed through to partners reduces the partners’ basis in their partnership interests.
John: Hopefully it’s simpler for S Corporations.
Josh: Based on the proposed regulations and law it is a little bit simpler for S corporations but they expect and are requesting comments on this. We will see what the final regulations say later this year. For now, any disallowed business interest expense deduction carries over to the subsequent taxable year of the S corporation and is treated as additional interest expense paid or accrued by the S corporation in that year. The disallowed deductions do not reduce the shareholder’s basis in their stock.
John: So if a pass-through entity applies the limitation at the entity level we’re done with this limitation?
Josh: That would be nice but not quite. A double-counting rule prevents a partner or shareholder from including their distributive share of any of the pass-through entity’s items of income, gain, deduction or loss in the determination of their adjusted taxable income unless it is considered “excess taxable income.” To the extent that a partner or shareholder has “excess taxable income” from pass-through entities (i.e., one or more other pass-through entities fully deducted its own business interest expense because it was less than 30% of the adjusted taxable income of that pass-through entity), the partner’s or shareholder’s share of “excess taxable income” may be factored in by the partner or shareholder in computing their own adjusted taxable income for that year.
In the event a partner has excess business interest expense from a prior taxable year and is allocated excess taxable income or excess business interest income from the same partnership in a succeeding taxable year, the partner must treat, for purposes of section 163(j), the excess business interest expense as business interest expense paid or accrued by the partner in an amount equal to the partner’s share of the partnership’s excess taxable income or excess business interest income in such succeeding taxable year.
John: Well, if we can use the small taxpayer exemption or qualify as an excepted business then we don’t have to do any computation at the individual level.
Josh: Again, that would be nice but it’s not quite that simple. If a partner or S corporation shareholder is allocated any section 163(j) item that is allocable to an excepted trade or business, such items are excluded from the partner’s or S Corporation shareholder’s section 163(j) deduction calculation. This is the electing farming, real estate property, and regulated utility trade or business.
However, if a partnership or S corporation is not subject to section 163(j) by reason of the small business exemption a partner or S corporation shareholder is allocated business interest expense from an exempt entity, that allocated business interest expense will be subject to the partner’s or S corporation shareholder’s section 163(j) limitations. Additionally, a partner or S corporation shareholder includes items of income, gain, loss, or deduction of such exempt entity when calculating its ATI. Finally, business interest income of such exempt entity is included in the partner’s or S corporation shareholder’s section 163(j) limitation regardless of the exempt entity’s business interest expense amount.
John: That’s a lot to think about. Maybe they’ll give us a hall pass on these regulations for 2018.
Josh: I like the idea but I would not bet on it! The regulations are lengthy and complex and all businesses need to consider the impact to their 2018 income tax returns and beyond. There are a number of areas in these regulations we didn’t discuss today that some taxpayers need to consider, including C Corporations, consolidated groups, and the application to controlled foreign corporations. Treasury has requested comments on a number of issues in these regulations and there is a public hearing on February 27, 2019. I do not anticipate the final regulations to be issued prior to the April 15 deadline.
While these regulations can be relied on currently, they are merely proposed regulations and the Treasury Department, as is customary, is soliciting written or electronic comments and public hearing requests, and asking that such responses be received by 60 days after the date of publication in the federal register. These proposed regulations will continue to evolve based on that feedback and will ultimately produce final regulations that could look very different in some areas (and unchanged in others). For now there is a road map of sorts provided by these proposed regulations and many taxpayers should begin to consider the impact of them and consider any tax planning and action items they should take.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.