Before Congress passed the Tax Cuts and Jobs Act (TCJA), most business-related interest expense was deductible, although corporations couldn’t deduct interest paid to or guaranteed by a related party under certain circumstances. But for tax years beginning after 2017, the TCJA imposes a limit on business interest deductions, with exceptions for “small businesses” and electing real estate and farming businesses.
All businesses should evaluate the impact of the new deduction limit on their tax liability, and plan accordingly.
Do you qualify for the small business exemption?
The business interest deduction limit doesn’t apply to small businesses, defined as those whose average annual gross receipts for the preceding three years is $25 million or less. Certain related businesses must aggregate their gross receipts for purposes of the $25 million threshold. This requirement is designed to prevent larger businesses from splitting themselves into several smaller entities to avoid the limit.
How do you calculate the limit?
If the limit applies to your business, your annual deduction for business interest expense can’t exceed the sum of 1) your business interest income, if any, 2) your floor plan financing interest, if any, and 3) 30% of your adjusted taxable income. In other words, you can use an unlimited amount of business interest expense to offset business interest income, and you can fully deduct floor plan financing interest (commonly used by vehicle dealers and large appliance retailers to finance their inventories).
Any interest in excess of those amounts is limited to 30% of adjusted taxable income. Be aware that business interest income and expense don’t include investment interest income or expense. Disallowed interest expense may be carried forward indefinitely.
Adjusted taxable income means taxable income, computed without regard to:
• Nonbusiness income, gain, deduction or loss,
• Business interest income or expense,
• Net operating loss deductions,
• The 20% deduction for qualified business income of pass-through entities and sole proprietorships, and
• For tax years beginning before 2022, depreciation, amortization or depletion.
For tax years beginning after 2021, depreciation, amortization and depletion will be subtracted in computing adjusted taxable income, shrinking business interest deductions even further.
Special rules apply to pass-through entities. For partnerships, the business interest limit applies at the entity level, but any interest in excess of the limit is passed through to the partners and carried forward on their individual tax returns. The partnership also passes through “excess taxable income” — that is, the amount by which the deduction limit exceeds actual interest expense. Partners can offset this amount against unused interest deductions. For S corporations, the limit also applies at the entity level, but unused deductions are carried over at the entity level until they can be offset against corporate income.
Should you opt out?
Certain real property and farming businesses may elect not to apply the limit on business interest expense deductions. Real property businesses include development, construction, reconstruction, acquisition, conversion, rental, operation, management, lending and brokerage businesses.
If you’re eligible to opt out of the deduction limit, doing so can yield significant tax benefits. But these benefits come at a price: After you make the election, which is irrevocable, you must depreciate certain business property under the alternative depreciation system (ADS). This means longer recovery periods and lower depreciation deductions. For real property businesses, ADS applies to nonresidential real property, residential rental property and qualified improvement property. For farming businesses, it applies to any property held by the business with a recovery period of 10 years or more.
To determine whether making the election is right for your business, you need to weigh the benefits of unlimited business interest deductions against the cost of lower depreciation deductions.
Have a plan
If your business is subject to the business interest limitation, be sure to evaluate the impact of reduced interest deductions on your tax liability. If it’s significant, you might consider strategies for reducing your interest expense, such as relying more heavily on equity financing instead of debt.
Another option, if your business owns debt-financed real property, is to transfer such property to a separate entity — such as a partnership you control — in a sale-leaseback transaction and have the entity opt out of the interest limitation as a real property business. For this strategy to work, however, there must be a legitimate business purpose for the transaction (such as liability protection) other than tax avoidance.
Sidebar: IRS guidance is on the way
The IRS plans to issue regulations on the application of the business interest limit. In the meantime, the IRS has issued Notice 2018-28, which provides interim guidance on several issues, including:
Pre-Tax Cuts and Jobs Act interest. The guidance suggests that disallowed interest carried forward under prior law will be treated as business interest expense in the first tax year after 2017 and subject to the new limit.
Corporations. According to the guidance, the regs will provide that, for purposes of the business interest limit, all C corporation interest expense and income, even if investment-related, will be treated as business interest expense and income.
Pass-through entities. The guidance provides rules to avoid double counting of income and expense by pass-through entities and their owners.
Consolidated groups. The net interest expense limitation is determined on a consolidated basis, without considering obligations between group members. The regs will provide technical rules.
Earnings and profits. The guidance clarifies that disallowed interest expense will nevertheless reduce a corporation’s earnings and profits.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.