The 2017 Tax Cuts and Jobs Act (TCJA) significantly changed limits on business interest deductions in the Internal Revenue Code Section 163(j). Prior to the TCJA, Code section 163(j) only applied to certain interest paid or accrued by corporations. These changes began with the tax year 2018, and should garner the attention of all business owners, particularly those who carry significant debt. You may want to make changes to your business in 2019 to align with the impact this change has on your business income and allowable adjusted taxable income (ATI).
Overview of 163(j) Changes
Section 163(j), the “earning stripping” section, has changed allowable deduction limits, including disallowed business interest expense carried over from 2018. Deductible interest expense now cannot exceed 30% of the business’ yearly ATI. While there are exceptions, which we’ll cover briefly, how – and how long – you can carry disallowed business interest forward is also impacted by the new limit.
Exceptions to the Business Interest Expense Deduction Limit
Generally, this limitation applies to taxpayers with business interest expense, except for certain small businesses that meet “the $25 million or less gross receipts test” as spelled out in section 448(c) when it is not a tax shelter (as defined in section 448(a)(3)). The limitation also may not apply to certain types of public utilities and electric cooperatives, certain small businesses with income below $25M, as well as certain farms and real property businesses. The $25 million amount will be adjusted for inflation for the 2019 taxable year and subsequent years.
Code Section 448(a)(3) defines a tax shelter as any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale; any syndicate (within the meaning of section 1256(e)(3)(B)), and any tax shelter as defined in section 6662(d)(2)(C)(ii). If your business meets the definition of a tax shelter, section 163(j) applies. Also, a tax shelter cannot use cash method of accounting.
There is also an exception regarding interest on floor plan financing, for businesses like dealerships for cars, boats, or other types of equipment or machinery for sale or lease.
It’s important to understand that interest has been more broadly defined in this act, and can include, for example, gains from certain kinds of transactions. The definition of interest was expanded to attempt to address transactions that may have previously been entered into to avoid Section 163(j).
IRS has a detailed description of what types of businesses may be excepted from the limit on its website, and includes how to be considered an excepted business. There may be consequences in making an election to be an excepted business, including requiring certain assets that must be depreciated under the alternative depreciation system (ADS) going forward.
While disallowed business interests in excess of the allowed 30% can be carried forward, carry-forward may be limited in the next taxable year if the section 163(j) limitation continues to apply to you. That has the potential for major implications, so carrying forward has to be carefully considered.
That’s not all. Changes in this act affect how your ATI is calculated for 2018, and you can also expect more changes to come. Per the IRS, “For taxable years beginning after 2021, deductions for depreciation, amortization, or depletion are not taken into account in calculating ATI.” These changes can have a significant impact on your business income.
While changes to business interest limits may seem challenging, with careful guidance and an understanding of the changes made through TCJA, you can find the best path forward.
Goldin Peiser & Peiser counsels many types of businesses, including partnerships and S corporations, on best practices on determining ATI and your going-forward deductions. Contact Eric Olsen, CPA to learn more about this topic or about our tax and advisory services at 972-818-5300.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.