Recently, the US Treasury and the Internal Revenue Service issued proposed regulations that provided taxpayers with some much-needed clarity surrounding the business interest deduction under the revised Internal Revenue Code Section 163(j). The new limitation placed on business interest expense is one of the most significant and expansive aspects of the Tax Cuts and Jobs Act (TCJA) passed in December 2017, as its cumbersome provisions effects all types of tax entity structures—both domestic and foreign, across varied industries. The recently issued proposed regulations offer taxpayers and their advisors detailed guidance on whether, and to what extent, their business interest expense will be deductible in determining their federal taxable income.
Generally, the interest expense limitation under Section 163(j) will apply to all taxpayers in a trade or business (as defined by Section 162), except for those taxpayers that meet the “small business” gross receipts test or are engaged in “excepted trades or businesses.”
A taxpayer will be considered a “small business” for the taxable year and thus exempt from the onerous provisions of IRC Section 163(j) if, for the three-year period preceding the tax year in question, its average annual gross receipts do not exceed $25,000,000. Aggregation rules apply when considering whether a taxpayer falls under the $25,000,000 threshold. The gross receipts of all related entities must be aggregated, including those that are commonly controlled or part of an affiliated service group. Special rules apply for those taxpayers with short taxable years or predecessor entities.
The small business exception does not apply to tax shelters. A partnership or S Corporation is deemed a tax shelter if more than 35% of the entity’s losses are allocated to passive partners, and thus the entity is subject to the provisions of IRC Section 163(j).
The excepted trades or businesses are providing services as an employee, electing real property trades or businesses (hereinafter referred to as “RPTB”), electing farming businesses and certain utility businesses. A RPTB is a term that includes many lines of real estate businesses, including real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. In the case of an electing RPTB, the election is irrevocable. As a result of making the election, the business interest expense would not be limited under IRC Section 163(j), however, certain depreciation adjustments are required, such as a longer depreciable life for certain assets.
If a taxpayer does not fall under one of the four exceptions previously mentioned, the deductible interest expense for the year will be limited to the sum of the following three components:
Calculating adjusted taxable income (hereinafter referred to as “ATI”) is a lengthy and complex process. ATI starts with a taxpayer’s taxable income for the year and must include the following adjustments, if applicable:
Additions to taxable income:
Subtractions from taxable income:
The proposed regulations greatly expand the scope of what the IRS considers “interest” for purposes of the interest expense limitation. Businesses will find that deductions historically not categorized as interest will now be included in the limitation—such as debt issuance costs, guaranteed payments for the use of capital and commitment fees.
For purposes of Sec. 163(j), all interest expense and interest income of a C Corporation is treated as business interest expense and business interest income. If a C Corporation taxpayer is invested in an underlying partnership and receives its share of investment interest income and investment expense from that partnership, the characterization will be ignored and all interest income and expense will be treated as “properly allocable to a trade or business of a C Corporation.” Note that the re-characterization will not affect the character of these items at the partnership level.
Taxpayers that file in a consolidated group will calculate one single Section 163(j) limitation for federal tax purposes. There are also detailed ordering rules for C Corporations that govern the deductibility of current year interest expense and the carry-forward of disallowed interest expense to future tax years.
The effects of the business interest limitation is further complicated due to the flow-through nature of the partnerships and S Corporations, which combine attributes at both the entity and owner levels.
The overall interest limitation is applied at the partnership level, and the deductible interest is included as an ordinary deduction of the partnership. However, the business interest expense not allowed as a deduction through to the partners and creates a partner-level attribute called “excess business interest expense” (hereinafter referred to as “EBI”), which is carried forward. EBI can only be deducted by the partner in future taxable years if they receive excess taxable income (“ETI”) from the same partnership. ETI is the amount of Adjusted Taxable Income of the partnership that was in excess of what it needed to deduct its business interest expense. The proposed regulations have introduced a lengthy eleven-step process for partnerships to determine how to allocate ETI once calculated and the other excess tax attributes as it relates to the Section 163(j) business interest deduction. Also, the proposed regulations do not offer any guidance on tiered partnership structures as it relates to the partnership and partner level computations.
S Corporations also apply the Sec. 163(j) limitation at the entity level. Any EBI of the S Corporation is not allocated to its shareholders, but instead carried forward at the S Corporation level and is applied against the ATI of the S Corporation. However, like a partnership, an S Corporation allocates any ETI to its shareholders on a pro-rata basis.
Businesses should anticipate additional complexity in determining their state tax liability, as not all states conform to all of the TCJA changes.
As businesses and individuals tackle the increased burdens of their 2018 tax compliance, many questions remain in navigating the intricacies and practicalities of Section 163(j), including the implementation and preparation of Form 8990, Limitation on Business Interest Expense Under 163(j). Please contact your Citrin Cooperman adviser or a member of our Citrin Cooperman Federal Tax Policy Team to find out how we can help you and answer all of your questions regarding the 163(j) business interest limitation.