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Business Interest Expense Limitation under the Tax Cuts and Jobs Act of 2017

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Interest deduction rules were significantly amended under The Tax Cuts and Jobs Act (TCJA) signed into law last December 2017. In early December 2018, the IRS issued highly anticipated proposed regulations related to this new code section.

Previously, business interest was generally allowed as a tax deduction in the year in which the interest was paid or accrued. For tax years ending after December 31, 2017, TCJA now limits the deduction for interest expense if such expense (net of business interest income) is in excess of 30% of a taxpayer’s adjusted taxable income as defined below.

Business interest is any interest paid or accrued on indebtedness properly allocable to a trade or business. Business interest income is the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. It is important to highlight that business interest expense/income does NOT include investment interest expense/income and is not considered in the limitation.

This new limitation introduced a new term, “adjusted taxable income,” or ATI. In order to calculate the interest limitation, taxpayers will need to calculate ATI, which is the taxable income of the taxpayer computed without regard to:

  1. Any item of income, gain, deduction, or loss which is not properly allocable to a trade or business;
  2. Any business interest or business interest income;
  3. The amount of any net operating loss deduction;
  4. The amount of any deduction for qualified business income allowed under Section 199A; and
  5. In the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion.

Any interest in excess of the sum of net business interest, 30% of ATI and floor plan financing interest is generally carried forward indefinitely and will be treated as business interest paid or accrued in the succeeding taxable year, except in the case of pass-through entities such as partnerships and S corporations (discussed later). There is currently no provision to carry the interest back to preceding years.

The business interest expense limitation does not apply to taxpayers who qualify for the following exceptions:

  • If the taxpayer’s average annual gross receipts for the prior three years (ending with the taxable year which precedes such taxable year) do not exceed $25,000,000 (adjusted annually for inflation starting in 2019).
  • If the business is a regulated public utility company.

A potential pitfall exists to the gross receipts exception. This exception does not apply to certain entities classified as “tax shelters”. This includes any partnership where more than 35% of the losses are allocated to limited partners. Partnerships such as hedge funds and private equity funds need to plan accordingly.

Certain businesses may elect out of the business interest limitation. A real property trade or business may make a one-time, irrevocable, election out of the business interest limitation but this election comes with some trade-offs. Once the election is made, the taxpayer must depreciate any nonresidential real property, residential rental property and qualified improvement property under the MACRS alternative depreciation system (ADS) and is not allowed to take bonus depreciation. Taxpayers engaged in a farming business may also make the same election with its own set of different rules and limitations. Taxpayers must analyze the trade-off between taking more interest expense and the longer recovery period through ADS.

Special rules for how partnerships and S corporations treat disallowed business interest expense also apply. For partnerships and S corporations, business interest not deductible (due to these limitations) is allocated to each partner/shareholder in the same manner as non-separately stated items of the partnership or S corporation. The business interest expense limitation will need to be calculated at both the partnership and partner level. Partnership and S Corporation basis calculations and limitations may also apply.

It should be noted, that there is no phase in period, no grandfathering of existing debt and this rule applies regardless of whether the interest is paid to a related party.

The rules surrounding the business interest expense limitation are complex and offer a variety of planning opportunities. The new rules are only partially explained in the proposed regulations. More guidance from the IRS is expected. Please contact your local Marcum LLP tax professional to discuss how these changes will affect your business.

 
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