(The Tax Cuts and Jobs Act’s Amendment of Section 163(j))
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 this limitation can be indefinitely carried forward.
Three important exceptions may allow certain entities to avoid the limitation:
- The new limit does not apply to entities whose average gross receipts over the prior three years do not exceed $25,000,000. Certain related parties must aggregate their receipts for this measurement.
- Also, real property trade or business may elect out of this limitation. A real property trade or business is any real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operations, management, leasing or brokerage trade or business.
- Finally, a farming business may elect out of the limitation of the deduction of interest. A farming business is any trade or business of farming (including operating a nursery or sod farm), or the raising or harvesting of trees bearing fruit, nuts, or other crops; and ornamental trees (excluding evergreen trees that are more than 6 years old).
- Observation: The $25,000,000 exception exempts a taxpayer automatically. Real property or farming businesses are exempt only by election, and in exchange must use the alternative depreciation system (ADS) for certain property.
Prior to the Act, the Sec. 163(j) rules primarily limited interest deductions in cases where a thinly-capitalized corporation paid interest to a related party (usually a foreign entity), where that related party was not subject to tax on the interest income. Thus, its application was rather narrow. Those rules survive, but are now joined by this additional provision that will have much broader application.
A number of new terms are introduced with this portion of the new law, and familiarity with them is necessary to understand the application of these rules.
Business Interest Expense is any interest paid or accrued on indebtedness properly allocable to a trade or business. It does not include investment interest expense.
Business Interest Income is the amount of interest income includable in the gross income of the taxpayer. It does not include investment income.
Floor Plan Financing Interest is interest paid or accrued on floor plan financing indebtedness, which is indebtedness used to finance the acquisition of motor vehicles held for sale or lease, and secured by the inventory acquired. A motor vehicle includes a self-propelled vehicle designed for transporting persons or property on a public street or highway, a boat, and farm machinery or equipment.
Adjusted Taxable Income is the taxpayer’s regular taxable income computed without regard to:
- Any item of income, gain, deduction, or loss that is not properly allocable to a trade or business,
- Any business interest expense or business interest income,
- Any net operating loss (NOL) deduction,
- The 20% deduction for qualified business income of a pass-through entity under Section 199A, and
- Allowable deductions for depreciation, amortization, or depletion, for tax years beginning before January 1, 2022.
- Observation: The disappearance of depreciation, amortization, and depletion beginning in 2022 is a subtle feature in this provision that will have a not-so-subtle impact on some taxpayers. Heavily-leveraged businesses that are not limited in the first few years of the Act’s existence might find the limitation will apply once these significant addbacks can no longer be made.
Excess Taxable Income is a term not easily explained, but very necessary in understanding this limitation. In typical Congressional doublespeak, the rule reads as follows:
The term ‘excess taxable income’ means, with respect to any partnership, the amount which bears the same ratio to the partnership’s adjusted taxable income as—
- “(i) the excess (if any) of—
- “(I) the amount determined for the partnership under paragraph (1)(B), over
“(II) the amount (if any) by which the business interest of the partnership, reduced by the floor plan financing interest, exceeds the business interest income of the partnership, bears to
“(ii) the amount determined for the partnership under paragraph (1)(B).
- Observation: The language above is an excellent example of what tax accountants are dealing with when trying to unravel the new law.
Reworded in plain English, excess taxable income (“ETI”) is equal to the outcome of the following steps:
- This result as a numerator: (30% of ATI) – (net interest expense, reduced by any floor plan interest expense),
- Is divided by this result as the denominator: (30% of ATI),
- With the fraction resulting from the two steps above being multiplied by ATI to produce the ETI.
For taxpayers who do not qualify for one of the three exceptions listed above, the deduction for business interest expense shall not exceed the sum of:
- Business interest income, plus
- 30% of ATI, plus
- Floorplan financing interest
Any disallowed business interest is carried forward indefinitely, with certain restrictions applying to partnerships and S Corporations. In the case of a partnership or S Corporation, the interest deduction limitation is computed at the entity level, but any disallowed interest of the entity, known as excess business interest, is allocated to each partner or shareholder.
A partner or shareholder subject to the limitations of the deduction for business interest (i.e. a corporation partner in a partnership or tiered entity structure) cannot include in their ATI (for the limitation purposes) the partnership or S Corporation’s distributive share of any item of income, gain or loss. This is designed to prevent double counting of the same amounts used in the ATI of the entity in which the owner is a partner or shareholder. However, if a partnership or S Corporation has “excess taxable income” for purposes of this limitation, that excess is passed through to the partners or shareholders, and increases their ATI. The math is a bit complex, but before reading the examples below, please refer back to the definitions of “excess taxable income” provided earlier – especially the second description, which breaks down the components.
Example 1: 123, LLC is a partnership owned 50/50 by AB and XZ. AB is a corporation. 123, LLC generates $150 of adjusted taxable income. 123, LLC has $45 of business interest expense. 123, LLC can deduct up to $45 of business interest ($150 * 30%). There is no disallowed business interest and no excess taxable income. Assuming no other expenses, AB’s share of net taxable income from 123, LLC is $52.5 ((150 – 45) *50%). If AB is subject to the limitation of business interest analysis at its own level, its adjusted taxable income would be calculated without regard to the income passed through from 123, LLC.
Example 2: Assuming the same facts as example 1, except 123, LLC business interest expense was $25. The limit of business interest is $45 ($150 * 30%) and thus the excess business interest is $20 ($45 - $25). The excess taxable income, as described above, is $66.67. AB’s share of the excess taxable income is $33.33. For purposes of determining AB’s limitation of interest deduction they can increase their adjusted taxable income by $33.33, the excess business income passed through from 123, LLC. As a result, AB may be able to deduct additional business interest of up to $10 ($33.3 * 30%) due to the excess taxable income from 123 that AB may otherwise have been disallowed.
Example 3 (Tiered Entity - Disallowed Interest at Lower Tier): Similar facts to example 1, except 123, LLC business interest expense is $95. 123, LLC can deduct $45 ($150 * 30%) of interest expense and the disallowed interest expense is $50 ($95 – $45). The disallowed business interest expense is passed through to the partners. AB’s share of the disallowed interest, $25, must be carried forward and treated as interest expense paid or accrued in the succeeding tax year. AB can only deduct the disallowed interest expense carried forward when it is allocated excess taxable income from 123, LLC.
The new business deduction limitation rules are complex, especially as they relate to tiered ownership. The complexities reach a whole new level for flow-through entities, due to the carryforwards and tracking that take place at an owner’s level. Entities that are subject to this limit will need to provide supplemental information on Schedules K-1 to enable owners to properly apply these rules. Finally, note that this article covers only the federal impact of this rule. It remains unclear how various states will follow, dodge, or partially implement these rules.
If you have any questions regarding the Tax Cuts and Jobs Act, please contact Josh Lapierre 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, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.