The Tax Cuts and Jobs Act (TCJA) imposes a limit on deductions for business interest for taxable years beginning in 2018. The limit, like other aspects of the law, has raised some questions for taxpayers. In response, the IRS has issued temporary guidance in Notice 2018-28 that taxpayers can rely on until the IRS releases regulations. While the guidance provides some valuable information, it also leaves some questions unanswered.
The New-Law Limit
For tax years beginning after 2017, the TCJA amended Section 163(j) of the Internal Revenue Code (IRC). Under the amended rules, the deduction for business interest incurred by both corporate and noncorporate taxpayers is limited to the sum of:
- Business interest income for the taxable year,
- The taxpayer’s floor plan financing interest paid by vehicle dealers for the tax year, and
- 30% of the taxpayer’s adjusted taxable income for the tax year.
It’s important to note the current definition of adjusted taxable income, which equals taxable income without regard to interest income and expenses, net operating losses, depreciation and amortization. It’s also important to note that in 2022 this definition changes, at which time depreciation and amortization will no longer be added back.
The interest expense deduction limit applies to all taxpayers, EXCEPT:
- Those with average annual gross receipts of $25 million or less,
- Real estate or farming businesses that elect to exempt themselves (see below for how that election works), and
- Certain regulated utilities.
The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limit. Excess limit, however, cannot be carried forward.
C Corporation Business Interest Income and Expense
The IRS announced it will issue regulations clarifying that, for purposes of Section 163(j) only, all interest paid or accrued on a C Corporation’s debt is business interest. All interest on debt held by a C Corporation and includable in its gross income is business interest income.
In addition, the regulations will address the proper treatment of interest paid, accrued or includable in gross income by a noncorporate entity (for example, a partnership) in which the C Corporation holds an interest. And the regulations will clarify that the disallowance and carryforward of a deduction for a C corporation’s business interest expense won’t affect whether and when such an expense reduces the corporation’s earnings and profits.
Treatment of Consolidated Groups
For groups of affiliated corporations that file a consolidated tax return, forthcoming regulations will clarify that the business interest deduction limit applies at the group level. For example, a consolidated group’s taxable income for purposes of calculating its adjusted taxable income will be its consolidated taxable income. Intercompany obligations (debt between affiliated corporations) won’t count when determining the amount of the limitation.
The regulations also will address several other issues related to the application of the limit to consolidated groups. These include the allocation of the limit among group members, the treatment of disallowed interest deduction carryforwards when a member leaves the group and the treatment of a new group member’s carryforwards. The regulations aren’t expected to treat an affiliated group that doesn’t file a consolidated tax return as a single taxpayer for purposes of the interest expense deduction limit.
Electing to Be Exempt from Interest Expense Deduction Limit
As previously mentioned, real estate and farm businesses can elect to exempt themselves from the Section 163(j) interest expense deduction limit. At first glance, making the election might seem like a no-brainer — but the election, which is irrevocable, could have significant ramifications in other areas.
Businesses that make the election must use the alternative depreciation system (ADS) for certain property (generally, real or farm property with a recovery period of 10 years or more) used in the business, regardless of when the property was placed in service. ADS depreciation is over longer periods, so an electing taxpayer’s annual depreciation deductions are reduced if the election is made. Electing businesses also can’t claim first-year bonus depreciation. Businesses should weigh the advantage of avoiding the interest expense deduction limit by making the election against the detriment of slower depreciation deductions if the election is made.
The IRS has requested comments on the rules outlined in its interim guidance. It also expects to issue regulations providing additional guidance on issues not yet covered and requested comments on which issues those regulations should address. Comments are due by May 31, 2018; instructions for submitting comments can be found at the end of Notice 2018-28.
Read our previous post on “The Interplay of Bonus Depreciation and Interest Expense Limitation.”
Please contact a member of your service team, or contact Mike Kolk at firstname.lastname@example.org for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.