The Tax Cuts and Jobs Act (TCJA) changed how businesses and tax practitioners must think of taxes. For businesses, one of the most impactful changes was to the interest expense deduction under Internal Revenue Code Sec. 163(j). This subsection potentially affects businesses that pay or accrue interest on debt of any type.
As with the majority of the TCJA, changes from Sec. 163(j) are effective for tax years beginning after Dec. 31, 2017, and will affect most businesses. While there are exceptions introduced by Sec. 163(j), tax preparers should familiarize themselves with the full scope of the changes to the business interest expense deduction.
Consider the TCJA limits the deduction from interest paid in Sec. 163(j)(1): “The amount allowed as deduction … for any taxable year for business interest shall not exceed the sum of the business interest income of such a taxpayer for such taxable year, 30 percent of adjusted taxable income of such taxpayer … plus the floor plan financing interest of such taxpayer…. The amount determined … shall not be less than zero.”
“Business interest,” “business interest income” and “adjusted taxable income” are later defined in paragraphs (5), (6), and (8) of subsection (j).
Paragraph (5) of IRC Sec. 163(j) states: “… the term “business interest” means any interest paid or accrued on indebtedness properly allocable to a trade or business. Such term shall not include investment interest ….”
Paragraph (6) defines “business interest income” as: “… the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Such term shall not include investment income …”
Paragraph (8) states: “… the term “adjusted taxable income” means taxable income of the taxpayer – computed without regard to:
- any item of income, gain, deduction, or loss which is not properly allocable to a trade or business
- any business interest or business interest income
- the amount of any net operating loss deduction under Sec. 172
- the amount of any deduction allowed under Sec. 199A, and
- in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion, and computed with such other adjustments as provided by the Secretary.”
The result is that interest paid by a trade or business is not automatically allowed as an expense for determining the business’ taxable income. Additional care by tax preparers will be required to notify clients of this change, and to ensure that any interest paid or accrued is directly allocated to the business. Otherwise, a disallowance of interest paid may surprise the taxpayer.
The good news is that any disallowed interest expense is not lost. Per Sec. 163(j)(2): “The amount of any business interest not allowed as a deduction for any taxable year by reason of paragraph (1) shall be treated as business interest paid or accrued in the succeeding taxable year.”
Thus, any disallowed portion is carried forward and may be utilized in the following tax years when the taxpayer has business interest income to apply against the disallowed interest. Note that paragraph (2) makes no mention of an expiration for the disallowed interest carryforward.
There are some exceptions for what qualifies as a “trade or business” by Sec. 163(j)(7)(A): “… the term “trade or business” shall not include:
- the trade or business of performing services as an employee
- any electing real property trade or business
- any electing farming business, or
- the trade or business or the furnishing or sale of … [certain utilities].”
An exception is also made for certain small businesses under Sec. 163(j)(3). Be aware that this exception must meet the gross receipts test as defined by Sec. 448(a)(3). Aside from these small business, the most prominent exceptions most tax practitioners will likely encounter are farms and real estate businesses. To be recognized as an exception, the business must elect out of Sec. 163(j) and file the election on their tax return.
With this overview of the limitations placed upon business interest expense introduced by the TCJA, tax practitioners and taxpayers are urged to look deeper into specific portions of subsection (j) as it specifically applies to pass-through entities, and the basis allocations that follow from any disallowed business interest expense, impact on manufacturers, foreign-owned corporations, and the election requirements for farms and real property businesses.
By keeping these issues in mind, tax preparers will be better prepared for the challenges introduced by the TCJA and Sec. 163(j).
Editor’s note: Read Jeremy Claybrook’s companion article covering new limits on business losses.