Business Interest Deduction Limitation

Overview

The Tax Cuts and Jobs Act (the Act) created a new Business Interest Deduction limitation, effective for tax years starting after December 31, 2017. This new provision limits the deduction for business interest for all businesses, though an exception to the limitation applies for businesses who meet the gross receipts test, discussed below.

What is the Business Interest Deduction?

Businesses are allowed to deduct any interest paid or accrued on debt that is properly allocable to a trade or business, and is not considered investment income. Historically, this interest deduction has not been subject to many limitations.

Scope: Then and Now

Internal Revenue Code (IRC) Section 163(j) is the code section that provides for a limitation on the deduction for business interest. Prior to the Act, this provision had a limited application and only applied to U.S. corporations or U.S. branches of foreign corporations to prevent businesses from stripping earnings and avoiding U.S. taxation. The Act changed this code section to apply to all taxpayers and all debt, even if the debt arises from a related-party transaction.

The Limitation

The deduction is limited to the sum of business interest income, 30 percent of adjusted taxable income (ATI), and floor plan financing interest. ATI is generally taxable income, computed without regard to:

  • activity that is not allocable to the trade or business;
  • business interest expense or business interest income;
  • depreciation, amortization, or depletion (for tax years beginning before January 1, 2022);
  • net operating losses under Section 172; or
  • the new 20% qualified business income deduction under Section 199A.

Floor plan financing interest is generally defined as interest paid or accrued on debt used to finance the acquisition of motor vehicles held for sale or lease, and which is secured by the inventory acquired.

If the limitation applies, the disallowed business interest will carry forward to the succeeding taxable year.

Gross Receipts Test Exemption - Small Businesses

There is an exemption from the limitation for small businesses with average annual gross receipts for the three taxable years ending prior to the taxable year at hand that is less than $25,000,000. However, taxpayers in controlled groups and partnerships may be required to aggregate gross receipts, so this should be considered when calculating whether or not the limitation should apply.

Carve Outs

Farming, real estate businesses, dealerships and certain public utility businesses successfully lobbied to avoid the application of this limitation. For dealerships, floor plan financing is fully deductible without limitation. However, these dealerships are excluded from 100% bonus depreciation on any of their assets.

Farming and real estate businesses may elect out of the new 30% limitation, but they will be required to use the Alternative Depreciation System ("ADS") to depreciate their depreciable assets. Businesses using ADS are not eligible for 100% bonus depreciation. If the election is made, it is irrevocable, and ADS treatment will apply to all depreciable assets that are already owned or will be purchased in the future.

Real Property Business - Election Comparison

   Application of Interest Limitation Election Out of Interest Limitation
Asset Category Depreciable Life (years) Eligible for Bonus Depreciable Life Eligible for Bonus
Nonresidential Real Property 39 NO 40 NO
Residential Rental Property 27.5 NO 30 NO
Qualified Improvement
Property - under current law
39 50%
168(k)(2)(A)(iv)
40 NO
Qualified Improvement
Property - if corrected
15 YES 20 NO

So, How does it Work?

Let’s use a hypothetical company, ABC Corporation, and assume it exceeds the small business exemption. ABC Corporation is in the business of residential rental property and, for illustration purposes, will not elect out of the business interest limitation. For the taxable year, ABC Corporation has the following income statement:

Application of Interest Limitation
Gross receipts 100,000,000
Interest income 1,000,000
Cost of goods sold 0
Interest expense -50,000,000
Amortization -500,000
Depreciation -25,000,000
Taxable income before interest limitation 25,500,000
 
Adjusted Taxable Income
Taxable income before interest limitation 25,500,000
Add back: net interest expense 49,000,000
Add back: Amortization 500,000
Add back: Depreciation 25,000,000
Adjusted taxable income 100,000,000
 
Business Interest Deduction Limitation
Adjusted taxable income 100,000,000
Multiply by 30% x 30%
Business interest deduction limitation 30,000,000
 
Taxable Income AFTER Interest Limitation
Gross receipts 100,000,000
Interest income 1,000,000
Cost of goods sold 0
Interest expense -30,000,000
Amortization -500,000
Depreciation -25,000,000
Taxable income before interest limitation 45,500,000

ABC Corporation can only deduct $30,000,000 of its $49,000,000 of net interest expense. The remaining $19,000,000 of disallowed interest expense will carry forward until used in a future year. The $19,000,000 disallowance is calculated as follows:

Disallowed Deduction Carried Forward
Net Interest Expense -49,000,000
Business Interest Deduction Limitation 30,000,000
Disallowed Deduction -19,000,000

$50,000,000 interest expense - $1,000,000 interest income = $49,000,000 net interest expense

$49,000,000 net interest expense - $30,000,000 interest expense limitation = $19,000,000 disallowance

ABC Corporation will have taxable income of $45,500,000 if they do not elect out, but will have taxable income of $25,500,000 if they do elect out. Therefore, the election out is most beneficial in the current year where there is high business interest expense. However, electing out will likely decrease the depreciation deduction for the current year and future years, thus slightly increasing taxable income. The decision of whether or not an election out should be made should therefore take into account the impact on current and future depreciation.

Effect of Depreciation, Amortization, and Depletion on ATI and the Deduction

The larger the ATI, the larger the deduction. Starting in 2022, ATI will be reduced by depreciation, amortization, and depletion. Therefore, the deduction will likely decrease for many businesses at that point. Looking at our example above, if depreciation and amortization were included in the calculation of ATI, ABC corporation would have $52,150,000 of taxable income. The following shows this calculation:

ABC Corporation YR 2022 Interest Limitation & Taxable Income
ATI $74,500,000.00
2022 Limitation $22,350,000.00
Taxable Income $52,150,000.00

ATI would be $74,500,000 because depreciation and amortization amount are not added back. ATI of $74,500,000 is then multiplied by 30%, which results in a limitation for business interest in the amount of $22,350,000. Taxable income ($74,500,000) is then reduced by the limitation amount ($22,350,000) to equal $52,150,000 of taxable income.

Conclusion

The new business interest expense limitation can be complicated, depending on the type of business and the business’s average gross receipts. For businesses that qualify to elect out of the limitation, it is important to compare the effects of the deduction limitation and the depreciation adjustments on overall taxable income for the current and future years. For businesses that will be subject to the limitation, planning should focus on the method of providing future financing since the limitation may restrict cash flow.

Please consult your tax advisor or a member of the HBK Tax Advisory Group to determine whether or not this limitation applies to your business.

About the Author(s)

Paul Lewis, JD joined HBK in 2017, in the Tax Advisory Group and works in the firm’s Blue Bell, Pennsylvania office. Paul earned a Bachelor of Science in International Business from Franciscan University of Steubenville, Ohio and a Juris Doctor from Temple University in Philadelphia, Pennsylvania, where he also completed a Business Law Certification. He currently is pursuing and expects to complete an LL.M. in Taxation.

Paul has experience in tax law working at a Low Income Taxpayer Clinic with Community Legal Services - a Philadelphia non-profit, and V.I.T.A. the volunteer income tax assistance program of the Taxpayer Advocate Service – an independent organization within the IRS. In addition, Paul has experience in insurance litigation at White and Williams LLP and Wealth and Fiduciary Planning services at Wilmington Trust Company.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.