The Tax Cuts and Jobs Act of 2017 contained major amendments to Code Section 163(j) and now pass-through entities, individuals, and even tax-exempt organizations are all facing significantly new rules that limit the deductibility of business interest expense. All taxpayers are going to have to consider how this may affect their bottom line going forward. These limitations apply to businesses with $25,000,000 of gross receipts or more, but the gross receipts test is very complicated and should be reviewed by all.
In order to understand what has changed, let’s refresh on how the rules generally worked prior to January 1, 2018. The original intent was to limit excessive related party interest expense deductions that teetered on that arm’s-length balance beam for C Corporations. Specifically, certain disqualified interest expenses (“DQI”) paid or accrued by a C Corporation were subject to two threshold tests. Disqualified interest included non-taxable related party interest, unrelated party interest subject to certain related party guarantees, or interest expense paid to a REIT from a taxable REIT subsidiary. A deduction was disallowed if two threshold tests were met: 1) the debt-to-equity ratio of the corporation exceeded 1.5:1 and net interest expense exceeded 50% of the entity’s Adjusted Taxable Income (“ATI”), calculated as defined in the section. Any disallowed DQI amounts were treated as paid or accrued in the following year, and could be carried forward indefinitely. Additionally, excess interest expense limitation (the excess, if any, of 50% of the ATI over the net interest expense) could be carried forward three years.
The new 163(j) now limits a taxpayer’s deduction for business interest expense to the sum of:
- business interest income,
- 30% of the newly calculated ATI of the taxpayer, and
- floor plan financing interest (which only applies to dealers of certain self-propelled vehicles and machinery).
The definition of interest under this section is broadened but detailed, and includes amounts closely related to interest such as debt issuance costs and loan commitment fees. Currently, a taxpayer is allowed to add-back depreciation, amortization, and depletion in calculating ATI. These favorable adjustments will not be allowed as an addback beginning in 2022, lowering the potential 30% ATI, and thus increasing the 163(j) limitation.
What was previously tracked as disallowed disqualified interest and carried forward indefinitely under the old 163(j) rules will continue to be considered disallowed business interest expense to the extent these amounts would otherwise be business interest expense for the taxpayer. What was previously tracked as excess interest expense limitation does not carry forward and is lost after 12/31/2017. A new excess interest expense limitation is calculated starting in 2018 and is carried forward indefinitely, but no corresponding excess limitation carryforward will be available after 2017.
However, there is a small business exception for most taxpayers with average gross receipts under $25,000,000 based on the preceding three taxable years. There are certain excepted trades or businesses (certain services companies, regulated utilities companies, and real property or farming trades or businesses) that irrevocably elect out. Tax-exempt entities must only take into account gross receipts from unrelated trades or businesses to determine if the gross receipts test is met. Aggregation rules under IRC Sections 52 and 414 apply in in calculating the gross receipts test. These rules typically include aggregating gross receipts for commonly owned businesses when determining if the $25,000,000 threshold has been met.
For partnerships, the limitation is applied at the entity level, and then allocated to each partner in the same manner as any non-separately stated taxable income or loss items. It is the partner’s calculation to determine what excess amounts will be included, or disallowed and carried forward. Specific steps to track these items are included in the recently issued regulations, but there is still much guidance needed on various partner-partnership issues.
S Corporations are treated slightly different and in a more straightforward manner. Once again, the limitation is applied at the entity level, however, any excess amounts are not allocated to the members, but are instead carried forward at the S Corporation level. An S corporation allocates any excess taxable income and excess business interest expense to its shareholders on a pro-rata basis.
Individuals, with business income from sole proprietorships and single member LLCs, must include all gross receipt items that would be gross receipts for a corporation or partnership. These receipts include business receipts and investment receipts, and only inherently personal items, such as Social Security benefits, personal injury awards and wages received as an employee are not included in the gross receipts calculation.
C Corporations will need to consider how 163(j) affects their E&P calculations with ordering rules. RICs and REITs are largely treated as C Corporations, and it is expected that their ATI will not reflect deductions for dividends paid and other similar special corporate deductions. Consolidated groups will calculate a single consolidated limitation, whereas members of an affiliated group that does not file a consolidated return will not aggregate for purposes of calculating the limitation.
US controlled foreign corporations and partnerships are treated much like their domestic counterparts for purposes of 163(j). Foreign corporations and partnerships that are engaged in a US trade or business may also be subject to interest limitations, to the extent they have effectively connected income.
Farming and real property trades or businesses that irrevocably elect out of the 163(j) limitation rules must use ADS depreciation lives for real property. Taxpayers can carve out any excepted business activity and associated interest from their non-excepted businesses, and de minimus rules may apply. When the election is made, the activity is allowed to deduct interest in full and the 163(j) limitations do not apply.
While leveraging your business is rarely a decision made in a tax-consequence bubble, with deduction limitations like these, all taxpayers will have to at least give it extra consideration going forward.
Kayla Waters is a manager based out of our Albany, NY office.