By John Werlhof – Principal CliftonLarsonAllen Email T. 916.218.7128
- Congress offset part of the cost of the recent tax cuts with limits to the amount of interest certain businesses can deduct.
- The section 163(j) limitation applies to all business entity types and is generally applied at the entity level.
- Final IRS rules allow you to increase your adjusted taxable income for cost of goods sold depreciation, which substantially increases the amount of the limit for many manufacturers.
- If your business uses a calendar year end, you will need to apply the final IRS rules beginning in 2021.
Tax reform included many provisions that reduce taxes on your business income, such as a corporate tax rate cut and a new 20% deduction for pass-through business income. Congress offset part of the cost of the tax cuts by limiting the amount of interest certain businesses can deduct (also known as the section 163[j] limitation). The IRS recently issued final regulations and other guidance to provide relief and clarity on the interest limit. Understand key aspects of the new guidance, as well as opportunities for you to increase your interest deductions.
Comparision of business interest limitation guidance
|Original Proposed Regulations||New Guidance|
|Computation of adjusted taxable income (ATI)||Cost of goods sold depreciation not an adjustment in computing ATI||Cost of goods sold depreciation added back in computing ATI|
|Definition of interest||Expansive — interest includes guaranteed payments for use of capital, debt issuance costs, commitment fees, and other costs not typically considered interest||More restrictive, although subject to an anti-abuse rule|
|Self-charged interest||Not addressed||Relief for loans from a partner to a partnership; no relief yet for S corporations or for loans among entities with common ownership|
|Electing out of limitation||Real estate and farming businesses subject to the limit can elect out||Real estate and farming businesses can elect out, even if not subject to limit; certain activities that may not be a business (e.g., senior care facilities and rentals with minimal day-to-day activity) can elect out|
|Treatment of small business partnerships and S corporations||Business interest expense subject to limit at owner’s level unless owner is a small business as well||Business interest expense not subject to limit at entity or owner level|
Compute the section 163(j) limitation
Your deduction for net business interest is generally limited to 30% of adjusted taxable income (50% for certain organizations in 2019 and all organizations in 2020, reverting to 30% in 2021). Adjusted taxable income is generally taxable income without taking into account:
- Nonbusiness income, like gains from the sale of assets held for investment
- Business interest expense or income
- Net operating loss deductions
- The 20% pass-through business income deduction
- Depreciation, amortization, or depletion (for the 2018-2021 tax years)
This example illustrates how the limit applies:
Auburn Company is a C corporation and has the following items of income and expense during the 2020 tax year:
Auburn’s deduction for net interest expense is limited to $75. This means $25 of interest expense is not currently deductible ($150 interest expense – $50 interest income = $100 net interest expense – $75 limit = $25 disallowance).
The limitation applies to all business entity types and is generally applied at the entity level. Any interest that is not deductible is carried forward and can be used in later years if the organization generates enough income. Floor plan financing interest is not subject to the limit.
Effect of new guidance on computing the limitation
The original IRS guidance adopted an expansive definition of interest, which caused certain non-interest expense items to be subject to the limit. This included debt issuance costs and partnership guaranteed payments made to partners for the use of capital.
The final rules scale back the definition of interest, which is subject to an anti-abuse rule that curtails the use of tax-motivated planning to avoid the limitation. If your deduction for business interest has been limited, the change that reduces the amount of your expenses subject to the limit increases the amount of interest you can deduct.
The IRS initially considered cost of goods sold depreciation (e.g., depreciation of manufacturing equipment) to be part of inventory costs rather than depreciation expense — and didn’t allow it to be added back in as you computed adjusted taxable income. Final IRS rules allow you to increase your adjusted taxable income for cost of goods sold depreciation, which substantially increases the amount of the limit for many manufacturers.
The interest paid on loans you make to your business (or that you have one of your businesses make to another one of your businesses) is commonly referred to as self-charged interest. For example, if you lend $100,000 to your wholly-owned S corporation and charge 5% interest, the $5,000 interest the S corporation pays you is self-charged interest. The loan to your S corporation generally doesn’t affect your taxable income because you are allocated a $5,000 interest deduction from the S corporation to offset your $5,000 of interest income.
However, if the S corporation isn’t able to deduct the interest expense due to the business interest limitation, your taxable income would actually increase by $5,000 as a result of the self-charged interest. The IRS has not yet issued guidance that provides relief for self-lending transactions involving S corporations or loans between commonly-owned businesses. It did, however, provide some relief for partners who lend money to their partnership.
Exceptions to the limitation
The limitation does not apply to small businesses, electing real property businesses, and electing farming businesses. Each of these exceptions is discussed, in turn, below.
Small business exception
Businesses with average annual gross receipts over a trailing three-year period of $26 million or less are not subject to the limitation. The gross receipts of related businesses must be combined for purposes of the $26 million test, so taxpayers cannot break the business up into several separate legal entities to avoid the limitation. Even if average gross receipts are less than $26 million, the business is subject to the limit if it generates a loss and allocates more than 35% of the loss to limited partners.
Under the original IRS proposal, if interest of a partnership or S corporation escaped the limitation at the entity level because of the small business exception, the entity’s interest was subject to the limit at the owner level — unless the owner also qualified for the small business exception. The final IRS rules provide that interest of a small business partnership or S corporation is not limited at either the entity or owner level, regardless of whether the owner qualifies for the small business exception.
Electing real property business
You may elect not to have the business interest limitation apply if you are engaged in a real property business, which includes a real estate development, construction, rental, management, or brokerage business, among others. Under the final IRS rules, you can choose to make the election on a protective basis if it is unclear whether or not your rental activity is a business. The election is irrevocable and carries a cost: if you make the election you are required to use the alternative depreciation system for nonresidential real property, residential rental property, and qualified improvement property. The following table summarizes the differences:
|Applying interest limitation||Electing out of interest limitation|
|Asset category||Depreciable life (years)||Eligible for bonus?||Depreciable life (years)||Eligible for bonus?|
|Nonresidential real property||39||No||40||No|
|Residential rental property||27.5||No||30 or 40||No|
|Qualified improvement property||15||Yes||20||No|
|Most other tangible property||5 to 15||Yes||5 to 15||Yes|
Electing farming business
You can elect out of the interest limitation if you’re engaged in a farming business. A farming business includes the traditional cultivation of land or the raising or harvesting of any agricultural or horticultural commodity. It also includes, but is not limited to, a business that operates a nursery or sod farm, raising or harvesting fruit, nut, or ornamental trees, or any trade or business of a specified agricultural or horticultural cooperative.
An electing farming business is not able to claim bonus depreciation and must use longer depreciation lives for any asset with a useful life of more than 10 years, which includes land improvements, barns, and other farm buildings.