One provision of the 2017 Tax Cuts and Jobs Act (TCJA) that has generated considerable concern among business owners is the new limitation on deductions for business interest expenses.
Prior to the provision, interest paid on business loans or credit lines could be deducted as an ordinary business expense. One section of the Internal Revenue Code—Section 163(j)—limited the deductions for certain types of interest expense that some C corporations paid, but most businesses were able to fully deduct business interest expense in the year it was accrued or paid.
The TCJA significantly changed that. The act expanded Section 163(j) to apply to all types of business interest expense, and it broadened the section’s scope to encompass all businesses, including pass-through entities such as partnerships, S corporations, and sole proprietorships.
Exemptions From the New Limits
Fortunately, many businesses—particularly small businesses—are still exempt from the Section 163(j) limitation. For tax year 2019, businesses (other than tax shelters) are exempt if their average annual gross receipts for the preceding three years were $26 million or less. This threshold amount is adjusted for inflation annually, so businesses with fluctuating revenues around that level could find they qualify for the exemption in some years but not in others. For purposes of this test the gross receipts of commonly owned entities must be aggregated.
Certain real property and farming businesses are permitted to opt out of the new business interest expense limitation, but only if they agree to use the Alternative Depreciation System (ADS) to depreciate certain long-term assets. The ADS usually results in lower depreciation deductions than the standard rules, so opting out of the business interest limitations might not be advisable. Moreover, this election is irrevocable.
Some regulated utilities and pipeline businesses whose rates are established by specified governing bodies are also exempt from the new limits.
New Limits and Special Rules
For businesses that do not qualify for these exemptions, business interest expense deductions are now limited to the sum of three parts:
- Business interest income
- Thirty percent of adjusted taxable income (ATI)
- Interest expense for floor plan financing used by big-ticket retailers such as auto, boat, and appliance dealers
Note that the definition of ATI will be changing. For now, ATI is equal to earnings before interest, taxes, depreciation, and amortization (EBITDA), but for tax years beginning after Dec. 31, 2021, ATI will include deductions for depreciation and amortization, making it equivalent to EBIT.
Any interest expense that is disallowed under the new rules can be carried forward indefinitely, so it eventually could be treated as business interest expense in a future tax year. It is a relatively straightforward process for regular C corporations, but it gets more complicated with pass-through entities.
In a partnership, any interest expense in excess of the limit is passed through to the partners and carried forward on their individual returns. In S corporations, on the other hand, unused deductions are not passed through to shareholders; they are carried forward at the entity level until they can be used.
IRS Form 8990, “Limitation on Business Interest Expense Under Section 163(j),” provides some basic guidance, but businesses with revenues approaching or above the $26 million threshold should consult their accountant to develop strategies to deal with the new limits.
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