Limiting business interest expense

For tax years beginning after 2017, the deduction for business interest expense cannot exceed the sum of the taxpayer’s:

• Business interest income for the tax year;
• 30% of adjusted taxable income (ATI) for the year, or zero if the taxpayer’s ATI is less than zero; and
• Floor plan financing interest expense (Sec. 163(j); Prop. Regs. Sec. 1.163(j)-2(b)).

The prior Sec. 163(j) rules, which covered so-called earnings stripping and denied a corporation’s interest deduction for disqualified interest to the extent it had excess interest expense in a year that its debt-to-equity ratio was greater than 1.5 to 1, have been repealed.

Note: Proposed regulations providing guidance for the Sec. 163(j) limitation were issued in November 2018 (REG-106089-18). These proposed regulations would be effective when finalized. However, taxpayers and their related parties may apply these rules to tax years beginning after 2017, if they are applied consistently.

The Sec. 163(j) limitation applies to any interest properly allocable to a trade or business. For corporations that are partners in a partnership (or members of a limited liability company (LLC) taxed as a partnership), the limitation applies first at the partnership level and again at the partner and shareholder level. It applies to both active and passive activities, but a rental real estate business can elect out.

The Sec. 163(j) limitation applies only to business interest expense that would otherwise be deductible in the current tax year (Prop. Regs. Sec. 1.163(j)-3(b)(1)).

Definition of business interest expense

For a C corporation, all interest income and interest expense are treated as properly allocable to a trade or business (Prop. Regs. Sec. 1.163(j)-4(b)(1)). An exception to this statement is provided for allocations made to excepted trades or businesses, as described in Prop. Regs. Sec. 1.163(j)-10.

For purposes of the Sec. 163(j) limit, business interest expense is defined as the following (Sec. 163(j)(5); Prop. Regs. Sec. 1.163(j)-1(b)(2)(i)):

Interest expense that is properly allocable to a nonexcepted trade or business: A nonexcepted trade or business is any trade or business that is not an excepted trade or business. Excepted trades or businesses are (1) the trade or business of being an employee; (2) any electing real property trade or business; (3) any electing farming business; or (4) any excepted utility trade or business (Sec. 163(j)(7); Prop. Regs. Sec. 1.163(j)-1(b)(38)).

Floor plan financing interest: The term “floor plan financing interest” applies to indebtedness used to finance the acquisition of motor vehicles held for sale or lease and secured by the inventory so acquired (Prop. Regs. Secs. 1.163(j)-1(b)(16) and (17)). A motor vehicle for these purposes includes any self-propelled vehicle designed for transporting people or property on public streets, highways, or roads, as well as boats or farm machinery and equipment (Sec. 163(j)(9)).

Disallowed business interest expense carryforwards: Any business interest expense that is disallowed in the current year or any disallowed disqualified interest that is allocable to a nonexcepted trade or business under Prop. Regs. Sec. 1.163(j)-10 is carried forward to the succeeding tax year as a business interest expense that is subject to the limitation in the succeeding tax year (Prop. Regs. Sec. 1.163(j)-2(c)(1)).

Treatment of disallowed business interest expense carryforwards

Disallowed business interest expense is the amount of business interest expense for a tax year in excess of the amount allowed as a deduction for that tax year under the Sec. 163(j) limit (Prop. Regs. Sec. 1.163(j)-1(b)(8)). Disallowed disqualified interest is interest expense, including carryforwards, for which a deduction was disallowed under former Sec. 163(j) (which was repealed) in the taxpayer’s last tax year beginning before 2018 (Prop. Regs. Sec. 1.163(j)-1(b)(10)).

Current-year business interest expense is deducted before any disallowed business interest expense carryforwards are deducted in that year. Disallowed business interest expense carryforwards are then deducted in the order of the tax year in which they occurred (Prop. Regs. Sec. 1.163(j)-5(b)(2)).

Prop. Regs. Sec. 1.163(j)-5(b)(3) addresses the treatment of disallowed business interest expense carryforwards for consolidated groups. Prop. Regs. Sec. 1.163(j)-5(d) addresses limitations on disallowed business interest expense carryforwards from separate return limitation years (SRLYs), which are years in which the corporation did not join in filing a consolidated return with the other group members.

The Sec. 163(j) limit applies before the application of the Sec. 465 at-risk, Sec. 469 passive activity, and Sec. 461(l) excess loss provisions (Prop. Regs. Sec. 1.163(j)-3(b)(4)). Generally, other Code provisions that permanently disallow or defer interest expense are applied before the Sec. 163(j) limit (Prop. Regs. Secs. 1.163(j)-3(b)(2) and (3)).

Prop. Regs. Sec. 1.163(j)-5(c) deals with disallowed business interest expense carryforwards in transactions to which Sec. 381(a) applies. Prop. Regs. Sec. 1.163(j)-5(e) provides rules for ­applying Sec. 382.

If a disallowed amount is carried forward to a tax year in which the small business exemption applies to the taxpayer, the limit on business interest expense does not apply to the carryforward amount in that tax year (Prop. Regs. Sec. 1.163(j)-2(c)(2)).

Small business exemption

Businesses (other than tax shelters) with average annual gross receipts that do not exceed the limit established in Sec. 448(c) of an inflation-adjusted $25 million ($26 million for tax years beginning in 2019) are exempt from the limitations under Sec. 163(j) (Sec. 163(j)(3); Prop. Regs. Sec. 1.163(j)-2(d)). Arrangements made to avoid the application of the Sec. 163(j) limitation by forming multiple entities to meet the gross receipts exemption may be disregarded or recharacterized by the IRS (Prop. Regs. Sec. 1.163(j)-2(h)).

Consolidated groups

Prop. Regs. Sec. 1.163(j)-4(d) includes special rules for calculating Sec. 163(j) limitations for consolidated groups.

Calculating ATI

ATI is the taxable income of the taxpayer computed with the following adjustments to prevent double-counting (Sec. 163(j)(8); Prop. Regs. Sec. 1.163(j)-1(b)(1)):

Additions

1. Any business interest expense;
2. Any net operating loss deduction under Sec. 172;
3. Any qualified business income deduction under Sec. 199A;
4. For tax years beginning before 2022, any deduction for depreciation, amortization, or depletion;
5. Any deduction for a capital loss carryback or carryover; and
6. Any deduction or loss that is not properly allocable to a nonexcepted trade or business.

Subtractions

1. Any business interest income;
2. Any floor plan financing interest expense for the tax year;
3. With respect to the sale or other disposition of the property, the lesser of:
   1. Gain recognized on the sale or other disposition of the property; or
   2. Any depreciation, amortization, or depletion deductions for the tax years beginning after 2017 and before 2022 with respect to such property;
4. With respect to the sale or disposition of stock of a member of a consolidated group that includes the selling member, the investment adjustments as defined in Prop. Regs. Sec. 1.1502-32 with respect to such stock that are attributable to the deductions for depreciation, amortization, or depletion for the tax years beginning after 2017 and before 2022 with respect to such property;
5. With respect to the sale or disposition of a partnership interest, the taxpayer’s distributive share of deductions for depreciation, amortization, or depletion for the tax years beginning after 2017 and before 2022 with respect to such property held by the partnership at the time of the sale or disposition to the extent the deductions were allowable under Sec. 704(d); and
6. Any income or gain that is not properly allocable to a nonexcepted trade or business.

Other adjustments

ATI is also adjusted for depreciation, amortization, or depletion expenses capitalized in inventory under Sec. 263A and other adjustments provided in Prop. Regs. Secs. 1.163(j)-2 through -11.

Additional rules

Additional rules for computing ATI for C corporations include:

1. All items of income, gain, loss, or deduction are treated as allocable to a trade or business for purposes of Sec. 163(j) (Prop. Regs. Sec. 1.163(j)-4(b)(2)).
2. Any investment interest that a partnership pays or accrues that is allocated to a C corporation partner is treated by the C corporation as interest expense allocable to a trade or business by the C corporation partner. Similarly, except as provided in Prop. Regs. Sec. 1.163(j)-7(d)(1)(ii), any investment income or investment expenses that a partnership receives, pays, or accrues, and that is allocated to a C corporation partner is treated by the C corporation as allocable to a trade or business of that partner (Prop. Regs. Sec. 1.163(j)-4(b)(3)(i)).
3. Investment interest expense of a partnership that is treated as business interest expense by a C corporation partner is not treated as excess business interest expense. Investment interest income of a partnership that is treated as business interest income by a C corporation partner is not treated as excess taxable income (Prop. Regs. Sec. 1.163(j)-4(b)(3)(iii)).   

This case study has been adapted from PPC’s Tax Planning Guide: Closely Held Corporations, 32d edition (March 2019), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).