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The Interest Expense Limitation Rules, IRC Section 163(j), Flipped Upside Down

One of the significant budget revenue drivers under the Tax Cut and Jobs Act (TCJA) passed in December of 2017 was the interest expense limitation rules under Section 163(j) that impacted a variety of taxpayers including individuals, corporations, and partnerships. Under the TCJA, a taxpayer’s business interest expense deduction was limited to the amount of business interest income, 30% of adjusted taxable income, and floor plan financing. In the 2018 and 2019 taxable years, adjusted taxable income is generally calculated by starting with federal taxable income and making a variety of adjustments, including adding back net business interest expense, depreciation and amortization, and net operating loss deductions.

Under the CARES Act, the TCJA interest expense limitation was modified in hopes of stimulating the economy and helping businesses endure this unprecedented time. Under the CARES Act, the government retroactively increased the amount of business interest expense that could be deductible for taxable years beginning in 2019 and 2020 by increasing the limitation from 30% of the taxpayer's adjusted taxable income to a 50% adjusted taxable income limitation.

In the simplest example, assume an S Corporation generated $500,000 of business interest expense in the 2019 taxable year. In addition, the S Corporation had adjusted taxable income in 2019 of $1,300,000, and no business interest income or floor plan financing. Under the TCJA, the S corporation would have been allowed to deduct $390,000 of business interest expense (1,300,000 x 30%) in the 2019 taxable year, and carryforward $110,000 of excess business interest expense indefinitely. Under the CARES adjustment, the same S corporation can amend their 2019 tax return, and now be allowed to deduct the entire $500,000 of interest expense created in 2019 as the limitation was increased to $650,000 ((1,300,000 x 50%). This would generally result in a $110,000 decrease in S Corporation taxable income, and cash tax refunds can be received as soon as the S Corporation and shareholders amend their tax returns filings.

Special Rules for Partnerships:

The ability for the adjusted taxable income percentage to increase to 50% does not apply to partnerships with a taxable year beginning in 2019. As the 2019 calendar year, original partnership deadline passed on March 15, 2020, before the peak of the COVID stay in place orders in the US, it is not surprising the IRS has provided special rules for partners and partnerships for taxable years beginning in 2019.

Instead of the partnership having to amend their 2019 tax returns to recalculate the interest expense limitation using the increased 50% adjusted taxable income limitation provided by the CARES Act, the Act requires partners to treat 50% of their 2019 excess business interest expense allocated to them from partnership’s as fully deductible on their 2020 tax return. The ability for a partner to immediately deduct 50% of their allocated portion of partnership excess business interest expense related to the 2019 taxable year is regardless of whether that particular partnership generated excess taxable income in the 2020 taxable year. The remaining 50% of partners' allocated excess business interest expense related to the 2019 taxable year will be utilized based on prior TCJA guidance. In general, under the TCJA, excess business interest expense allocated to a partner cannot be deducted by the partners until that particular partnership has generated excess taxable income.

Using a similar example as above, assume XYZ Partnership generated excess business interest expense in the 2019 taxable year of $110,000. XYZ partnership is equally owned by Adam and Bob. Adam would have been allocated $55,000 of excess business interest expense. Instead of the partnership amending their 2019 tax return for the increased adjusted taxable income limitation of 50%, the partners are required to deduct 50% of any 2019 allocated excess business interest expense on their 2020 tax return. Adam would be allowed to deduct $27,500 (50% x 55,000) of interest expense on his 2020 tax return regardless of whether the XYZ partnership itself generated excess taxable income in the 2020 taxable year. In addition, Adam would treat the remaining $27,500 of 2019 disallowed interest expense from XYZ partnership as a deduction when and if XYZ partnership generated excess taxable income in 2020 or the future. The limitation to the partnership exception is that the partners receiving an additional deduction will not be able to recognize the benefit until their 2020 tax return is filed, and the potential cash benefit will not be received until 2021.

Please note that the ability for the adjusted taxable income percentage to increase to 50% does apply to partnerships with a taxable year beginning in 2020.

Election Out:

A taxpayer can elect not to apply the 50 percent adjusted taxable income limitation to any taxable year beginning in 2019 or 2020, and instead, apply the 30 percent adjusted taxable income limitation. In the case of a partnership, the election must be made by the partnership and may be made only for taxable years beginning in 2020, as partners are required to utilize 50% of excess business interest expense allocated to them in 2019 on their 2020 tax return. However, a partner may elect out from taking 50% of the excess business interest expense in 2020 as well. The election, once made, cannot be revoked without the consent of the Secretary of the Treasury or his delegate.

Election to utilize 2019 Adjusted Taxable Income in 2020:

Anticipating that for many taxpayers the 2020 taxable year may not be as profitable as 2019, and not wanting to hinder the use of financing if needed, the CARES Act also provides the opportunity for taxpayers to elect to use their 2019 adjusted taxable income when calculating their 2020 interest expense limitation. No formal statement is required to make or revoke this election but will be noted based on the adjusted taxable income that is utilized for the interest expense limitation calculation on the taxpayers 2020 tax return.

Impact on Trades or Businesses with a Real Property Trade or Business Elections:

Under the TCJA, there was the capability to not have to apply the interest expense limitation rules if a taxpayer made, what was deemed at the time, an irrevocable real property trade or business election. A real property trade or business is a trade or business involved in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. This election could have been made by businesses in the 2018 or the 2019 taxable year to avoid the interest expense limitation calculation altogether.

If such an election is made, non-residential real property, residential rental property, and qualified improvement property is required to utilize the alternative depreciation system, which is generally slower, and qualified improvement property would not be bonus depreciation eligible. Prior to the CARES Act, the ability to bonus qualified improvement property was not available due to an error in the bill.

The Department of Treasury provided relief for taxpayers that made real property trade or business elections in 2018, 2019, or 2020 taxable year. Taxpayers may withdraw the election, so that they may be able to have their business interest expense limitation applied with an increased 50% adjusted taxable income limitation, and potentially benefit from bonus depreciation on their qualified improvement property.

If a taxpayer made a real property trade or business election with its timely filed original Federal income tax return, including extensions, for a 2018, 2019, or 2020 taxable year and now wants to withdraw the election they may do so by filing an amended Federal income tax return, amended Form 1065, or AAR, as applicable. The amended Federal income tax return must include the adjustment to taxable income for the late section 163(j)(7) election and any collateral adjustments to taxable income or to tax liability. The amended tax returns generally have to be filed by October 15, 2021, with deadlines being sooner for BBA Audit regime partnerships who want to file an amended partnership tax return as opposed to filing an AAR.

There are also similar procedures provided regarding a business's ability to make the real property trade or business election in 2018, 2019, or 2020 even if not made on their originally filed return.

Much of the guidance that was being provided through the Department of Treasury in the last two years, surrounding the TCJA interest expense limitation rules have become more complicated based on the CARES Act and Revenue Procedure 2020-22. However, even with the increased complexity, it does seem that the interest expense limitation rules have been relaxed which hopefully will allow businesses to feel more comfortable when exploring financing transactions to get through this tumultuous time. The timing of when this benefit can be received depends on the business entity type, and how quickly your professional service teams can work through the CARES tax provision adjustments that will impact any amended tax returns. Please do not hesitate to contact your Bonadio Group professional services team members for further assistance.

Contact your Bonadio team for more information.

The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We therefore make no warranties, expressed or implied, on the services provided hereunder.