On November 26, 2018 the IRS issued proposed regulations on the new Section 163(j) limitation related to the deduction of business interest expense. The regulations provide new guidance on a variety of issues not previously addressed while also expanding upon guidance provided in April in Notice 2018-28.
The Tax Cuts and Jobs Act (TCJA) that was enacted last December amended Code Sec. 163(j) to include a broader limitation on the business interest expense deduction. Under previous law, business interest was generally deductible. For tax years beginning after December 31, 2017, every business that has deductible business interest expense, other than certain small businesses, electing real property trades or businesses, electing farm businesses, and certain utility businesses will be affected by this broader limitation.
Effective for tax years beginning after December 31, 2017, business interest expense is limited to the sum of the taxpayer's business interest income, floor plan financing interest, and 30 percent of adjusted taxable income (ATI) for the taxable year. ATI is taxable income excluding: any item not properly allocable to a trade or business, business interest or business interest income, net operating loss deduction, the deduction under the new Section 199A, and for taxable years beginning before January 1, 2022, any deduction for depreciation, amortization, or depletion. Any disallowed interest generally may be carried forward indefinitely.
In the case of both partnerships and S Corporations, the deduction limitation applies at the entity level. However, for partnerships, disallowed interest at the entity level is then allocated to each partner as excess business interest. This is a clear distinction between the treatment of excess business interest for S Corporations vs. partnerships. As mentioned above, there is a small business exception; these rules don't apply to taxpayers with average annual gross receipts of less than $25 million for the three-tax-year period ending with the prior tax year. Since the gross receipts test is an annual determination, however, a taxpayer's status as an exempt small business can change from year to year.
The highly anticipated proposed regulations provide general rules and key definitions. The regulations provide rules specific to particular entities and industries such as special rules for C corporations, consolidated groups, partnerships, S corporations, real estate investment trusts (REITS), regulated investment companies (RICs), tax-exempt corporations, controlled foreign corporations, and foreign persons with effectively connected income.
Other key items addressed in the regulations include, but are not limited to, the relationship between the business interest deduction limitation and other provisions of the Code affecting interest, small business exception, elections for excepted trades or businesses (i.e. clarification as to the time and manner in which a real property trade or business and a farming business must make the election to opt out of the interest limitation), and, for taxpayers that are engaged in both excepted and non-excepted businesses, rules for allocating tax items between both types of trades or businesses.
It is worth noting that for purposes of the allocation rules, a taxpayer's activities are not treated as a trade or business if those activities do not involve the provision of services or products to a person other than the taxpayer.
The proposed regulations are not effective until adopted as final, but can be adopted for tax years ending after December 31, 2017, if consistently applied. There are still unresolved issues that will require more guidance (particularly relating to partnerships), however, the proposed regulations do bring clarity to a number of issues related to the new business interest deduction limitation.
All business owners should carefully assess how the proposed regulations may impact their specific circumstances as this changes the landscape for how businesses will fund their operations going forward. For more information on how your company may be affected by the new business interest expense limitations, please contact a member of our Tax team.
Erin Avnet, is a tax director in the firm’s New Jersey office. Erin provides comprehensive tax planning, consulting, and compliance services to a diverse range of clients.