When the Tax Cuts and Jobs Act was placed into law on December 22, 2017, it introduced new limitations on the deductibility of business interest expenses under section 163(j). Business interest expense refers to interest paid or accrued in the operation of a trade or business. Examples could be loans to finance the purchase of long-term assets like buildings, machinery, and vehicles. Read on to further understand the limitations and strategies available to help reduce the effects of this new law.
The Tax Cuts and Jobs act, which is now in effect as of January 1, 2018, brought about many changes, resulting in new areas of law to consider. One of these new areas relates to the deductibility of interest expense from debt used in the ordinary course of business. The new law places a limitation on the deductibility of this expense.
Business Interest Expense
Business interest expense is defined as the amount of interest paid on debt generated and used by a business. The limitation relates to all forms of businesses, including sole proprietorships. Business interest expense is all forms of debt except for those that are related to property held for investment. This would include items such as mortgages financing real estate held for investment (appreciation growth), but not for rent.
For C corporations and tax-exempt corporations, all interest income or expense, even those allocated to investment activities, will be treated as being related to the trade or business for the application of the 163(j) limitation. However, for tax-exempt companies this would only apply to the income that is considered in the calculation of unrelated business income tax (UBIT). If a C corporation or tax-exempt corporation is considered to be a partner in a domestic partnership, the partner, themselves, would determine the treatment of the business vs. investment interest, in order to properly flow the information to non-C corporation partners on the form K-1.
In general, the new tax law limits the deductibility of business interest expenses to 30 percent of a business’ adjusted taxable income for the year, which is ultimately based off of a formula provided by the IRS. In most cases this is the earnings before interest expense, tax, depreciation, and amortization, also known as EBITDA. Additionally, any interest income would be removed from the calculation for the adjusted taxable income. Any interest expense that is not deductible due to the 30 percent limitation may be carried forward indefinitely, allowing it to be deducted in future years. However, any carryover is added into the calculation in the following years’ 163(j) limitation.
One thing to note is that the limitation under 163(j) related to interest expense does not apply to any companies that have less than $25 million in average gross receipts over the past three years. Additionally, in order to determine whether the company is under the $25 million limit, revenues of companies with similar owners may need to be included. If a company is owned at least 80% by the same 5 owners of another company then they would be considered brother-sister companies, and the revenues would be aggregated for the provision of the $25 million gross receipts test. For companies owned by a common parent company, if the parent company owns more than 80% of the total stock or interest in each subsidiary, these companies would need to be aggregated as well.
If you are subject to this limit by exceeding the $25 million gross receipts test, are you out of luck? Not entirely. There are eligible elections that can be made to allow your companies to be excluded from the 163(j) provision. However, these elections do come with various consequences that should be carefully analyzed in order to ensure that a benefit is being received by making such election. One such consequence is the change of the depreciation method utilized for tax purposes, and should be discussed in detail with your company’s tax advisor.
The new limitation on the deductibility of business interest is one that could have a large impact on the taxable income generated by various businesses. As usual, the tax laws and strategies surrounding these changes are complex and deserve careful consideration. If you have questions about these changes or would like to assess whether your business may have issues regarding this limitation, please feel free to contact our office at (858) 558-9200.