The New IRC Section 163(j) Business Interest Expense Limitation and Pass-Through Entities
By Gail J. D'Addio, Director, Tax & Business Services
The Tax Cuts and Jobs Act (TCJA) created a new limitation on the deduction of business interest expense for tax years beginning after December 31, 2017. The new law applies to interest on all business debt without a transition rule for debt in place prior to the enactment of the law.
Under new section 163(j) of the Internal Revenue Code (IRC), the deduction for business interest expense is generally limited to the sum of: a) business interest income; b) floor plan financing interest expense (i.e., financing to acquire motor vehicles, boats, or farm machinery held for sale or lease); and c) 30% of Adjusted Taxable Income (ATI). For tax years beginning before January 1, 2022, ATI is essentially equal to EBIDTA, i.e., net business income before federal income taxes, the business interest deduction, amortization, depreciation, and depletion.
Any interest expense disallowed as a current year deduction can be carried forward indefinitely to future years and will be considered as business interest paid, subject to that year’s limitation.
For example, assume that for 2018, T has $50,000 of business interest income; $250,000 of business interest expense (none of which is floor plan financing interest expense); and $500,000 of EBIDTA determined on a tax basis. Under the new rule, the $250,000 of business interest expense is deductible only to the extent of the $50,000 of business interest income plus $150,000 (30% X $500,000), for a total of $200,000. The excess $50,000 of business interest expense is nondeductible in 2018 and is carried over to 2019 to be treated as business interest paid in that year.
The IRC section 163(j) limitation applies broadly, but certain taxpayers are excluded. These include:
- Certain small businesses – i.e., those with average gross receipts over the three prior tax year no greater than $25 million. In determining the amount of gross receipts of a taxpayer, the gross receipts of all related parties under IRC sections 52, 414(m) and 414(o) must be aggregated. Additionally, if the business is a partner or S shareholder, it must consider its share of the partnership’s or the S corporation’s gross receipts. To be excluded under this rule, a taxpayer cannot be considered to be a “tax shelter,” which is defined more broadly than might be expected. If a taxpayer allocates more than 35% of its losses to owners who are inactive in the business, it is considered to be a tax shelter for this purpose.
- Taxpayers in the trade or business of providing services as an employee or a regulated public utility.
- Real property or farm trades or businesses that elect out of the limitation pursuant to IRC section 163(j)(7). The cost of this election is that the taxpayer is required to use the Alternate Depreciation System (ADS) instead of the normal Modified Accelerated Cost Recovery System (MACRS) to depreciate certain assets. This causes a deferral of depreciation benefits. Furthermore, assets required to use ADS are not eligible for bonus depreciation. If the law is corrected in the future and permits Qualified Improvement Property (QIP) to be eligible for bonus depreciation, this can be a significant downside to the election.
New Form 8990, Limitation on Business Interest Expense under Section 163(j), is used to compute whether a limitation applies for the tax year.
Special Rules for Pass-Through Entities
Section 163(j) and the regulations proposed by Treasury provide special rules for partners in tax partnerships and shareholders of S corporations. it would be reasonable to expect that the rules for these pass-through entities would be similar, the S corporation rules are much simpler than those applicable to partnerships.
The goal of both sets of rules is to cause the interest limitation to apply at the entity level and not at the level of the equity owner. The starting point is that the partnership or the S corporation must calculate the limitation on the amount of deductible business interest expense at its level. The income of the entity which is allocated to the partner or S shareholder is net of the deductible interest.
Additionally, both S corporations and partnerships can allocate Excess Taxable Income (ETI) to their owners. ETI is the portion of the entity’s ATI which exceeds the amount needed to permit the deduction of all of the entity’s business interest expense. A partner or S corporation shareholder allocated ETI can use this amount in determining its own ATI for expensing business interest.
For S corporations, any nondeductible interest expense remains suspended at the level of the entity. This amount is carried over and is considered as business interest paid by the S corporation in the following year and is subject to that year’s section 163(j) limitation.
A different set of rules apply to partnerships:
- Any nondeductible business interest expense (Excess Business Interest or EBI) does not remain with the partnership and does not affect the entity’s computation of deductible business interest in future years. Instead, the EBI is allocated to each partner as an information item on Schedule K-1.
- The partner cannot utilize ATI from other businesses or from other pass-through entities to deduct EBI in the current year. Instead, the partner must maintain a record of the EBI deduction from the partnership as a carryover item. It can be deducted only against EBI income or ETI allocated from that specific partnership in the later years.
Since the S corporation business interest limitation and carryover are determined at the corporate level, the nondeductible interest expense does not reduce the shareholder’s stock basis. However, the EBI allocated to a partner produces an immediate reduction in that partner’s outside basis of its partnership interest. This can impact the utilization of allocated losses or affect the tax consequences of partnership distributions. Under a special rule, the partner can add back to the basis of its partnership interest any unused interest deduction upon a sale or disposition of its partnership interest.
To avoid double dipping, a pass-through entity owner cannot use its distributive shares of income, gain, loss, or deduction allocated on a Schedule K-1 in determining its personal ATI to qualify the deduction of other personal-level business interest expense. This income has already been used by the entity to compute its deductible business interest expense, and Congress recognized that it should not be used again.
As you can see, this new provision of the TCJA does not produce much simplification. It has many component parts that must be considered to determine the appropriate deduction of business interest for partners and S corporation shareholders.