An easily overlooked application of the rules which allow businesses to deduct the interest expense is the possibility that certain related businesses may need to aggregate their gross receipts when determining the deductibility of their interest expense.
The Internal Revenue Code (IRC) Section 163(j) (163j), which limits the ability of certain businesses to deduct their interest expense, was significantly modified by The Tax Cuts and Jobs Act of 2017 (TCJA). In general, 163j now limits the ability of a business to deduct current year interest expense to 30% of its adjusted taxable income (ATI) unless it is considered a small business or an excepted business (ATI after 2021 is generally the net operating income of the business, less depreciation, amortization, and depletion).
A small business for 163j is a business in which the average gross receipts for the three prior years was below $25 million, indexed for inflation ($27 million for 2022 and $29 million for 2023). An excepted business is a business that is allowed to make an election not subject to 163j but must depreciate its real estate assets including qualified improvement property under the alternative depreciation system (ADS) and is not allowed to take bonus depreciation. Additionally, if a pass-through entity hands out more than 35% of its losses to passive investors, it is subject to 163j even though it does not cross the gross receipts threshold.
Although the $25 million threshold may seem generous for many small to midsize entities, taxpayers should carefully examine the aggregation rules under IRC Section 448(c)(2), as they could result in the gross receipts of multiple entities being combined for applying the aggregation rules.
Simply put, entities must aggregate their gross receipts to the extent they are treated as a single employer under IRC Section 52(a) (52a) or Section 52(b) (52b). 52a relates to corporate entities while 52b relates to non-corporate entities, such as sole proprietorships, a partnership, trust, or estate. The focus of this article will be on non-corporate entities but conceptually the rules are very similar.
Under the principles of 52b, gross receipts of entities that are deemed to be under common control must be aggregated for purposes of applying the $25 million gross receipts test. A controlled group could be a parent-subsidiary controlled group, a brother-sister controlled group, or a combined group.
For a parent-subsidiary group under 52b there must be a common parent organization and such organization must own more than 50% of the subsidiary. For a trust or estate subsidiary this would be an actuarial interest of more than 50% of the trust or estate. For a partnership subsidiary this would more than 50% of the profit interest or capital interest of the partnership.
Under 52b, a brother-sister group exists among organizations conducting trades or business if two or more such organizations satisfy a controlling interest requirement and an effective control requirement.
A controlling interest requirement exists if five or fewer people who are individuals, estates, or trusts own a controlling interest in each organization. An effective control requirement exists if the same five or fewer people are in effective control, considering the ownership of each person only to the extent that particular person’s ownership is identical with respect to each organization. A controlling interest for an individual, trust, or estate is an ownership of at least 80% of the actuarial interest. Controlling interest for a partnership is ownership of at least 80% of the profit interest or capital interest of that partnership. Effective control for a trust or estate is an ownership of at least 50% of the actuarial interest. Effective control for a partnership is ownership of at least 50% of the profit interest or capital interest of that partnership.
A combined group under common control for 52b is a group of three or more organizations, where each organization is a member of either a parent-subsidiary or brother-sister group under common control, and at least one organization is the common parent organization of a parent-subsidiary group and also a member of a brother-sister group.
These determinations can be challenging for taxpayers if there is limited insight into the other activities of its owners. This may result in significant uncertainties as to whether taxpayers are subject to the interest expense limitation under 163j. This is why it is important for taxpayers and their tax professionals to understand these relationships and their impacts on the aggregation rules so that the proper planning can be implemented to avoid any unpleasant and unforeseen consequences later on.
Businesses that have any concerns or questions regarding the deductibility of business interest expense or any other matter should contact Reuben Rutman at firstname.lastname@example.org or your Citrin Cooperman advisor.
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