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The new business interest expense limitation under Section 163(j)

What it means, who it affects

Laura Pearson, CPA | June/July 2019 Footnote

Editor's note: Updated May 31, 2019

The 2017 Tax Cuts and Jobs Act (TCJA) provided a reduction in the corporate tax rate from 35 to 21 percent; however, the TCJA also included revenue-raising provisions such as the revised Section 163(j), which limits the deductibility of business interest expense for all types of taxpayers. 

Historically, Section 163(j) limited the deductibility of interest expense paid by corporations to certain related parties that did not pay U.S. income tax if the corporation’s debt to equity exceeded 1.5:1. The TCJA repealed this rule and replaced it with a new version of Section 163(j), which is more expansive with regard to the taxpayers it affects; it limits taxpayers’ deduction for business interest expense regardless of who receives the interest. 

The impact of Section 163(j) may be surprisingly significant for taxpayers, particularly those in highly leveraged businesses, potentially driving change in taxpayers’ approaches to raising capital for operations and future growth. For example, U.S. private-equity funds that generally use third-party debt to facilitate acquisitions of portfolio companies may consider the after-tax cost of borrowing as a result of the new Section 163(j).

Looking at the effects

Section 163(j) applies to all taxpayers, including individuals, partnerships and corporations, for taxable years beginning after Dec. 31, 2017, and limits the deductibility of interest by the taxpayer to the sum of its 1) business interest income, 2) 30% of adjusted taxable income (ATI) and 3) certain floor plan financing interest. 

For individual and pass-through taxpayers (i.e., S Corporations and partnerships), it’s imperative to distinguish between interest income and interest expense that is investment in nature versus trade or business. All interest income and interest expense of a C Corporation is treated as business interest income and expense for purposes of the limitation. The proposed regulations published in the Federal Register by the Department of Treasury and the IRS on Dec. 28, 2018, provide an expansive definition of interest, which includes amounts paid, received or accrued as compensation for the use or forbearance of money, including guaranteed payments for the use of capital under Section 707(c), original issue discounts and debt issuance costs. 

ATI is the taxable income of the taxpayer excluding business interest and business interest income, net operating loss deductions and deductions for qualified business income under Section 199A. For tax years beginning after Dec. 31, 2017, and before Jan. 1, 2022, ATI also excludes deductions for depreciation, amortization and depletion. This may create a planning consideration for taxpayers who are able to accelerate tax depreciation deductions into tax years beginning before Jan. 1, 2022, thereby increasing ATI and potentially their deductible business interest expense in years 2022 and beyond with no impact to ATI in 2018–2021.

If a taxpayer has disallowed business interest expense, the excess business interest expense is carried forward and treated as business interest expense paid in the next succeeding taxable year, subject to the Section 163(j) limitation for such year. For example, Corporation AB has an ATI of $50,000, $2,000 business interest income and business interest expense of $20,000. AB’s deductible interest expense is limited to $17,000 (($50,000 x 30%) + $2,000). The excess business interest expense of $3,000 ($20,000 - $17,000) will be carried forward to the following year.

Possible exemptions

Select taxpayers may be exempt from the application of Section 163(j) if they are small-business taxpayers with average gross receipts for the prior three years of $25 million or less as defined in Section 448(c). While the small-business taxpayer exception may provide relief for several small businesses, it’s important to note the aggregation rules when quantifying their gross receipts. If an entity is part of a tiered structure or has common ownership with other entities, the entity may be required to include the gross receipts of the upper-tier entities or related entities when applying the $25 million threshold, potentially resulting in an inability to claim the small-business exception. 

Interest may be excluded from the limitation if it is incurred in connection with the trade or business of providing services as an employee, an electing real property trade or business, an electing farming business, or certain regulated utility businesses. 

A real property trade or business is defined as one involved in a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage business. A qualifying real estate business that makes a real property trade or business election is not subject to Section 163(j) and will be able to deduct all its business interest expense in the current year without regard to its ATI. A disadvantage of making the irrevocable election is that the taxpayer is then required to depreciate certain property using the alternative depreciation system (ADS).

The application of Section 163(j) can be much more complex for S Corporations, partnerships and individuals. In the context of a pass-through entity (i.e., an S Corporation or partnership), the limitation is first applied at the entity level. Any excess business interest expense calculated by an S Corporation is an attribute of the corporation that is carried forward to succeeding taxable years. However, in the case of a partnership, the excess business interest expense is allocated to the partners and carried forward at the partner level. The partner may be eligible to deduct the excess business interest expense in a future year to the extent the partner is allocated excess taxable income or excess business interest income from the same partnership. This is likely to create additional complexities for taxpayers with interests in more than one partnership, as they will be required to track their excess business interest expenses separately for each investment. 

Additionally, given the opportunity for special allocations of taxable income to the partners of a partnership, partnerships may need to complete the extensive 11-step process as provided in the proposed regulations to determine the proper allocation of excess taxable income, excess business interest expense and certain other items to its partners.

Other considerations

Taxpayers and their professional service providers may consider preparing projections of taxable income, ATI, business interest income and business interest expense through 2022 to quantify their deductible interest and identify key drivers of the limitation. Such analysis may motivate taxpayers to consider capital structure planning, legal entity restructuring and accounting method planning to reduce the impact of the 163(j) limitation. Taxpayers with a complex state footprint may also consider how state tax conformity or nonconformity to the Internal Revenue Code in addition to state filing groups or methods may affect their Section 163(j) limitation, especially when a taxpayer’s state filing method or group is different from their federal consolidated filing group. The state of Minnesota conforms to the Internal Revenue Code as of Dec. 16, 2016, meaning that taxpayers will not be subject to the new Section 163(j) limitation for Minnesota purposes and will need to report any excess business interest expense as an adjustment to federal taxable income when determining Minnesota taxable income for tax year 2018.

While the newly enacted Section 163(j) limitation may seem straightforward at first glance, the limitation may unexpectedly affect many taxpayers at both the federal and state level and should be a key consideration for taxpayers and their professional service providers going forward.

Laura Pearson, CPA is a senior manager at Deloitte Tax LLP and is an MNCPA member. She has more than 10 years of experience working with public and private clients in the real estate, asset management and manufacturing industries. You may reach her at laurapearson@deloitte.com or 612-397-4123.
This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.

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Dive into the 11-step process

Partnerships may need to complete this extensive 11-step process as provided in the proposed IRS regulations to determine the proper allocation of excess taxable income, excess business interest expense and certain other items to its partners.