The Section 163(j) Business Interest Expense Limitation: 2021 Final Regulations Impact on Self-Charged Interest for Partnerships

The Tax Cuts and Jobs Act (“TCJA”) made significant changes to Section 163(j) of the Internal Revenue Code of 1986 by limiting the deductibility of business interest expense. Under the new Section 163(j) rules, for tax years beginning after December 31, 2017, the business interest expense deduction is limited to the sum of 30% of adjusted taxable income (“ATI”), its business interest income (“BII”), and its floor plan financing interest. As a result of the coronavirus outbreak, the 30% limitation was increased to a 50% limitation by Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) for the 2018 through 2020 tax years.

Adjusted taxable income (“ATI”) means taxable income of the taxpayer computed without regard to:

• Any item of income, gain, deduction, or loss, which is not properly allocable to a trade or business;
• Any business interest income or business interest expense;
• The amount of any net operating loss deduction under section 172;
• The amount of any qualified business income deduction allowed under section 199A;
• For tax years beginning before 2022, any deduction for depreciation, amortization, or depletion attributable to a trade or business; and
• Adjustments described in published guidance.

Business Interest Income (“BII”) means interest paid or accrued that is properly allocable to a trade or business. Business interest expense does not include investment interest.

Limitation of Business Interest Expense

The IRS and U.S. Department of the Treasury issued proposed regulations for the implementation of the new Section 163(j) rules on November 26, 2018 (the “Proposed Regulations”), and on July 28, 2020, released final regulations (the “Final Regulations”) in addition to new Proposed Regulations providing further guidance on the original Proposed Regulations. Additionally, Proposed Regulations were published in the Federal Register on September 14, 2020, and were finalized with issuance of the Final Regulations by the Treasury and IRS on January 5, 2021.

In general, the purpose of IRC Section 163(j) is to limit a taxpayer’s deduction for business interest expense (“BIE”) in any tax year to the sum of:

1. The taxpayer’s business interest income for the tax year;
2. 30% of the taxpayer’s ATI for the tax year (but not less than zero). Under the CARES Act, for 2019 and 2020 the 30% is changed to 50%, except in the case of a partnership. A partnership must use 30% for 2019, but uses 50% for 2020. Any business may elect to apply the 30% limitation rather than the 50% limitation for a given year. (Reg. Section 1.163(j)-2(b)(2)). In 2020, a taxpayer may elect to use its 2019 ATI (Reg. Section 1.163(j)-2(b)(3) and if 2020 is a short period it can prorate its 2019 ATI; and
3. The taxpayer’s floor plan financing interest for the tax year.

The business interest deduction limitation is applied at the partnership level, and each partner’s ATI is increased by the partner’s share of excess taxable income (“ETI”) and excess business interest income (“EBII”). The amount of partnership BIE exceeding the Section 163(j) limitation is carried forward at the partner level as excess business interest expense (“EBIE”). The final regulations give clarity on the treatment of interest expense on self-charged lending transactions.

This article provides an analysis of how the new final regulations impact the self-charged interest rules.

Self-Charged Interest Rules

Reg. 1.469-7 outlines the scenarios that cause interest expense to be classified as self-charged and, therefore, limited in their deductibility. The most common three scenarios are as follows:

• The taxpayer makes a loan to a pass-through entity in which it owns a direct or indirect interest at any time during the entity’s tax year (for purposes of this regulation, a “pass-through entity” refers to a partnership or an S corporation).
• The pass-through entity makes a loan to a person or persons that own direct or indirect interests in the pass-through entity.
• A loan is made between two pass-through entities where each of the entities’ owners have the same proportionate ownership interests in each entity.

In general, the interest charged on a loan between a pass-through entity and its owner (self-charged lending transaction) can lead to limitations on the deductibility of interest expense. Deductions for the interest expense may be disallowed while the lender is taxed on the interest income. An owner of a pass-through entity in a self-charged interest situation can end up reporting interest income generated by the loan while the interest expense is nondeductible.

The example below illustrates the potential problem of self-charged interest:

A partner that is not engaged in a lending business makes a loan to a partnership. The partnership uses the money to make expenditures in connection with a passive activity in which the partner owns an interest. As a result, the lending partner has portfolio interest income (as the lender) and a distributive share of the partnership’s passive interest deductions. A similar result can occur if a partnership, not engaged in a lending business, loans money to a partner who uses the money to make passive activity expenditures. The borrowing partner receives a distributive share of the partnership’s portfolio interest income and has passive interest deductions resulting, from his use of the debt proceeds. In either case, the Code does not allow the partner to deduct the passive interest deductions from the portfolio interest income because the partner in substance has loaned the money to herself.

The exception under this regulation provides for recharacterization of a portion of the taxpayer’s distributive share of self-charged interest income as passive activity gross income and recharacterization of certain deductions for self-charged interest expense that are properly allocable to the self-charged interest income as passive activity deductions. This exception allows for the “netting” of income and deductions that otherwise would be placed into separate categories of income and deductions and not offset one another. It should be noted that the pass-through entity irrevocably elect out of the recharacterization.

The purpose of the 2020 Proposed Regulations was to avoid subjecting business interest expense associated with a partner loan, to the extent such business interest expense would be allocated to the lending partner, to the limitations of Section 163(j). The 2020 Proposed Section 163(j) Regulations provided that in the case of a lending transaction between a partner (“lending partner”) and partnership (“borrowing partnership”) in which the lending partner owns a direct interest in any BIE of the borrowing partnership attributable to the self-charged lending transaction, that self-charged interest is considered BIE for purposes of determining the partnership’s IRC Section 163(j) limitation. Under the Final Section 163(j) Regulations, if a partner lends money to a partnership and is allocated EBIE from the partnership (interest that is not currently deductible), the lending partner may treat the interest income attributable to it as receiving an allocation of EBII from the borrowing partnership in the same taxable year, which frees up the EBIE, equal to the interest income generated by the partner from the lending transaction. In the case of a lending partner, other than a C corporation, that has interest income on the self-charged lending transaction greater than the lending partner’s allocation of EBIE from the borrowing partnership, and the interest income would be considered portfolio investment income in the hands of the lending partner for purposes of Section 163(d) in that year, the excess amount of interest income will continue to be treated as investment income for that year for purposes of Section 163(d).

An Example:

• A and B are partners in partnership ABC. In Year 2, A lends $10,000 to ABC and receives $1,000 of interest income for the taxable year (self-charged lending transaction). A is not in the trade or business of lending money. ABC has $1,000 of business interest expense, and A and B are each allocated $500 of such business interest expense as their distributive share of ABC’s business interest expense for the taxable year.
• In Year 2, ABC has $3,000 of ATI. ABC’s section 163(j) limit is 30 percent of its ATI plus its business interest income, or $900 ($3,000 x 30 percent). Thus, ABC has $900 of deductible business interest expense, $100 of excess business interest expense, $0 of excess taxable income, and $0 of excess business interest income. $50 of EBIE is allocated to A.
• A treats $50 of its $1,000 of interest income as excess business interest income allocated from ABC in Year 2. Because A is deemed to have been allocated $50 of excess business interest income from ABC, and excess business interest expense from a partnership is treated as paid or accrued by a partner to the extent excess business interest income is allocated from such partnership to a partner, A treats its $50 allocation of excess business interest expense from ABC in Year 2 as business interest expense paid or accrued in Year 2. A, in computing its limit under section 163(j), has $50 of business interest income ($50 deemed allocation of excess business interest income from ABC in Year 2) and $50 of business interest expense ($50 allocation of excess business interest expense treated as paid or accrued in Year 2). Thus, A’s $50 of business interest expense is deductible business interest expense.

2021 Final and Additional Proposed Regulations

The January 5, 2021 Final Regulations adopted the rules contained in the 2020 Proposed Regulations. Certain partners who have made a loan to partnerships are allowed to deduct their share of partnership interest expense with respect to the loan even if the interest expense deduction was disallowed to the partnership under Section 163(j). It does not apply to loans made by a partnership to a partner or loans made by a partner in an upper-tier partnership to a lower-tier partnership in which the upper tier partnership owns an interest. Therefore, it is important that pass-through entities and their related owners consider whether the limited nature of the final 163(j) regulations for self-charged Interest relief will affect their current and future financing.

The final regulations released on January 5, 2021, apply to taxable years beginning on or after the date that is 60 days after the regulations are published in the Federal Register. However, a taxpayer and its related parties are permitted to retroactively apply the 2021 Final Regulations to taxable years beginning after December 31, 2017, and before the 2021 Final Regulations are otherwise applicable, and they are consistently applied. Taxpayers should consult their tax advisors if their businesses are not opting out of Section 163(j) to discuss the complexities of tax compliance under the new regulations.

Summary

The Section 163(j) rules relating to self-charged interest are highly complex and some provisions have not yet been finalized but remain in proposed form. For specific questions, contact your Marcum professional to discuss planning opportunities under the new rules for your pass-through business.