The Tax Cuts and Jobs Act of 2017 significantly modified Code Section 163(j), which may alter the way companies choose to leverage their businesses. For taxable years beginning after December 31, 2017, Code Section 163(j) limits the business interest expense deduction to the sum of business interest income, 30% of adjusted taxable income (ATI) and floor plan financing interest. Any business interest expense that is non-deductible during a tax year due to the Code Section 163(j) interest expense limitation is carried forward indefinitely and is treated as business interest paid or accrued in the next succeeding tax year.
This enhanced interest expense limitation generally applies to all businesses and entity types. Exceptions to this rule apply to companies that are considered a small business taxpayer (less than $25 million in average gross receipts for the prior three tax years and not a tax shelter), electing real property trades or businesses, an electing farming business and certain utility businesses.
For purposes of calculating ATI, the modified Code Section 163(j) defines ATI as taxable income without regard to the following:
• Any item of income, gain, deduction or loss which is not properly allocable to a trade or business
• Any business income or business interest expense
• Any amount of net operating loss deduction as defined under section 172
• Any amount of qualified business income deduction under section 199A
• Any deduction for depreciation, amortization or depletion (only for tax years beginning before 2022)
The mechanics of the interest expense limitation in Code Section 163(j) varies among different entity types.
Partnerships: The Code Section 163(j) limitation is first determined at the partnership level and any amount of business interest expense that is non-deductible is allocated to the partners in the same manner as the partners’ distributive share of non-separately stated taxable income or loss of the partnership. Any amount of disallowed business interest expense allocated to a partner is only deductible by that partner to the extent that the same partnership allocates excess taxable income to the partner. Excess taxable income is the amount of adjusted taxable income that is in excess of the amount of adjusted taxable income needed to support the entity’s business interest expense.
S Corporations: An S Corporation’s treatment of the Code Section 163(j) limitation is similar to partnerships in that the limitation is applied at the entity level. However, any disallowed business interest expense is carried forward indefinitely at the S Corporation level versus passing through to its shareholders. The S Corporation is able to allocate excess taxable income and excess business interest income (interest income in excess of interest expense) to its shareholders. If applicable, the shareholders can use these attributes from the S Corporation in calculating their own Code Section 163(j) limitation.
C Corporations: Although the concepts of Code Section 163(j) as it applies to C Corporations seem simple, there are notable items that taxpayers need to be aware of. Unlike non-corporate taxpayers, all interest paid or accrued on indebtedness is considered business interest expense even if considered or classified as investment interest expense or income. Current year business interest expense must be deducted before prior year carryovers of disallowed business interest expense are deducted. In addition, it will be important for C Corporation taxpayers to properly track their business interest expense carryovers to ensure corporate earnings and profits (E&P) do not get further reduced in a subsequent year if the carryforward is deducted.
Individuals: In certain circumstances, an individual taxpayer will need to calculate his or her ATI to be able to determine if any business interest expense allocated from a partnership, sole proprietorship, single-member LLC or any other business interest expense is subject to limitation. Thorough recordkeeping is going to be especially important at the individual level to track the attributes allocated from a Partnership or S Corporation in order to properly apply the business Code Section 163(j) interest expense limitations and determine allowable deductions.
The rules and regulations of Code Section 163(j) as modified by the TCJA are complex and nuanced. As such, taxpayers need to have some fundamental understanding of these provisions in order to appropriately evaluate how they capitalize their businesses. We can help. Please contact your GBQ advisor to discuss how these changes may impact your business.
Article written by:
Ashley Neel, CPA