Planning for the New Business Interest Expense Deduction Limitation
As part of the Tax Cuts and Jobs Act (“TCJA”) signed into law on December 22, 2017, some important changes have been made with respect to the deductibility of business interest expense for tax years beginning after December 31, 2017. Under prior law, business interest expense was generally deductible in the year in which the interest was paid or accrued, except that corporations were subject to certain limitations under IRC Section 163(j) (“the earnings stripping rules”). The tax reform created a new limitation, which replaces the “earnings stripping rules” and applies to all businesses, regardless of form, on the deductibility of net business interest expense that exceeds 30% of a taxpayer’s “adjusted taxable income.”
TCJA provides 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. TCJA also allows farming and real estate businesses to 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. An exception from the limitation has also been provided for interest expense on floor plan financing (e.g., financing for the acquisition of motor vehicles, boats or farm machinery held by the taxpayer for sale or lease).
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. For C corporations, this disallowed interest expense carryforward is considered a tax attribute that would be limited under a Section 382 ownership change.
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).
Example: For 2018, assume that X (a C corporation) has $1,000,000 of EBITDA on an income tax basis, $50,000 of business interest income, and $400,000 of business interest expense. None of its business interest expense is floor plan financing interest. X’s tax depreciation and amortization expense equal $200,000. X’s net business interest expense is $350,000; its adjusted taxable income is $1,000,000. The maximum interest expense that X can deduct in 2018 is 30% of its adjusted taxable income, or $300,000. The $50,000 excess business interest expense will be disallowed as a deduction in 2018 and treated as interest expense paid or accrued in 2019.
In 2019, assume that X has $1,400,000 of EBITDA on an income tax basis, but all other facts remain the same as 2018. X’s 2019 net business interest expense is $400,000 (including the $50,000 interest expense that was disallowed in 2018 and carried over as an amount paid or accrued in 2019). The maximum interest expense that X can deduct in 2019 is 30% of its adjusted taxable income, or $420,000. X would be able to fully deduct the $400,000 of net business interest expense in 2019.
Now, assume the same facts for 2018 were to apply in 2022. Adjusted taxable income would be $800,000 (after deducting $200,000 of depreciation and amortization expense); the maximum interest expense that X could deduct in 2022 is 30% of $800,000, or $240,000. $110,000 of X’s net business interest expense would be disallowed as a deduction in 2022, and carried forward to 2023.
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” from those pass-through entities. 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.
For partnerships, any disallowed business interest expense deduction (“excess business interest”) is passed through to the partners and does not carry over as interest paid or accrued by the partnership in the subsequent taxable year. Instead, such excess business interest must be treated as business interest paid or accrued by the partner in the next succeeding taxable year in which the partner is allocated excess taxable income from such partnership, but only to the extent of such excess taxable income. In other words, the partner cannot use adjusted taxable income from other sources to deduct excess business interest expense from a partnership; the excess business interest expense from that partnership can only be deducted to the extent that there is sufficient excess taxable income from that specific partnership to absorb the deduction. Furthermore, any excess business interest passed through to partners reduce the partners’ basis in their partnership interests.
For S corporations, 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.
Although these new rules can be complex and have a significant impact on the taxable income of businesses, your Cherry Bekaert professionals can help you evaluate the effect of these limitations, as well as analyze the effects on your overall income tax rate under TCJA with our proprietary software solutions. Please contact your Cherry Bekaert professional for guidance, or send an email to firstname.lastname@example.org.