- The revised Section 163(j) imposed a limitation on the deduction for business interest expense, but that limitation cap was temporarily lowered by the CARES Act.
- This temporary pandemic relief ends for 2021 and the limitation becomes even more restrictive in 2022 for capital-intensive businesses, which could negatively impact your tax situation.
- There is a small business exception subject to a certain threshold of gross receipts.
- Agribusiness, real estate, and other businesses are encouraged to review their tax situations carefully before considering any elections or changes..
The Tax Cuts and Jobs Act of 2017 revised Section 163(j) by imposing a limitation on the deduction for business interest expense for years beginning after December 31, 2017. Section 163(j) limits business interest payments for taxpayers with gross receipts of $25 million ($26 million for 2019, 2020, and 2021, and $27 million for 2022). The amount of deductible business interest expense cannot exceed the sum of:
- The taxpayer’s business interest income,
- 30% of the taxpayer’s adjusted taxable income (ATI), and
- The taxpayer’s floor plan financing interest.
Any business interest expense not allowed as a deduction due to the Section 163(j) limitation is generally carried forward and treated as business interest paid or accrued in the next taxable year.
In response to the COVID-19 crisis, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) eased the burden of this limitation temporarily. Taxpayers could elect to use 50% of ATI limitation for 2019 and 2020 (rather than the normal 30%) and to use their 2019 ATI to compute their 2020 business interest limitation. The CARES Act relief allowed many businesses to deduct their interest in full.
The business interest limitation returned with a vengeance in 2022: the limitation is back to 30% of ATI — and depreciation, amortization, and depletion are no longer added back in computing ATI after the 2021 tax year. These changes may limit your deduction for business interest even if you haven’t previously been subject to this limitation.
Selected planning ideas
Qualify for the small business exception
Certain businesses are eligible for a “small business exception” to Section 163(j). To qualify, the business’ gross receipts must be less than the gross receipts threshold amounts and the business cannot be a “tax shelter.”
For this purpose, a “tax shelter” is defined as a pass-through entity (such as a partnership or S corporation) if more than 35% of the losses during the taxable year are allocated to limited partners or limited entrepreneurs. A “limited entrepreneur” is an owner who does not actively participate in the management of the entity. Active participation is determined based on facts and circumstances.
Partnerships facing these “tax shelter” rules may need to undertake some tax planning measures, such as adopting a carefully drafted special allocation provision so that no more than 35% of total losses are allocated to limited partners. Be sure to consider the effects this special allocation may have on the economic deal of the partners.
Another planning alternative is for the limited partners or entrepreneurs to actively participate in the business to avoid limited partner or entrepreneur status.
Taxpayers with losses should consult with their tax advisors and review their situations carefully to help avoid the tax shelter trap that could subject them to the Section 163(j) limitation.
Consider electing out
Certain farming and real estate businesses may consider making a one-time irrevocable election to opt out of the Section 163(j) limitation.
However, these taxpayers would then be required to use the Alternative Deprecation System (ADS) for certain categories of assets, which has longer depreciation periods and lower annual depreciation deductions than under the regular depreciation rules. Additionally, affected assets are not eligible for a bonus depreciation deduction.
On the flip side, businesses making this election will be exempt from the business interest limitation rules — which can be substantial if the business projects a steady decrease in its net income, or possibly even losses, due to its depreciation expense deductions.
If you previously evaluated the election but decided not to opt out, re-evaluate the election in light of recent changes to the rules, such as the inability to add back depreciation in computing ATI and the ability to use a 30-year depreciation life for residential rental property under ADS (rather than 40 years, as was the case until recently).
Major industries impacted
Most production agriculture falls under the small business exception, but an increasing number of farms have sufficient gross receipts or could be classified as a tax shelter. For those that do not fall under the exception, farms that have high investment income and/or are highly leveraged may be subject to the limitation.
As indicated above, farms may elect out of the Section 163(j). However, because farming is cyclical, look at electing out through a long-term prism. The loss of the Modified Accelerated Cost Recovery System and bonus depreciation on certain categories of assets in order to deduct business interest expense might be beneficial in the short run, but may become problematic over time. Larger farming operations may be phased out of the Section 179 deduction and rely on bonus depreciation to reduce taxable income. Electing out of Section 163(j) could take away one of the biggest tools farmers use to normalize farm income.
Real property businesses that elect out of the Section 163(j) limitation must depreciate their current and future residential rental property, nonresidential real property, and qualified improvement property using ADS, which means a slightly longer depreciation period for residential and nonresidential properties. Other classes of assets — such as land improvements, 5-year, and 7-year property — continue to be depreciated under the regular depreciation rules and can be eligible for bonus depreciation.
- Nonresidential real property — Depreciable period changes from 39-year life to 40-year life
- Qualified improvement property — No longer eligible for bonus depreciation under ADS and depreciable life extended from 15 years to 20 years
- Residential real property — Depreciable life changes from 27.5 years to 30 years
Before making this election, real property businesses should consider the cost and benefit analysis of the decrease in depreciation expense due to the extended depreciable life of their assets and the benefit of the additional business interest expense above the limitation. Contact your tax advisor to find out if your business qualifies for this election.
Other industries and businesses
Although the real estate and farming industries are most heavily impacted by the limitation of business interest, other highly leveraged businesses may be impacted by this limitation without the option of electing out. This includes manufacturing and distribution and consolidated corporations as well as international business holdings.
Section 163(j) limitations also apply to controlled foreign corporations (CFC). A CFC is a foreign corporation in which more than 50% of its stock (by vote or value) is owned by U.S. shareholders. Similar to domestic Subchapter C corporations, a CFC’s interest expense is considered business interest and, thus, is not subject to Section 163(j) exemptions applicable to investment interest.
The Section 163(j) interest expense disallowance rules, when applied to CFCs, are extremely complex and can affect a U.S. shareholder’s Subpart F and global intangible low-taxed income inclusions. A U.S. shareholder owning stock in multiple CFCs generally must apply the Section 163(j) disallowance rules on a CFC-by-CFC basis; however, the shareholder may elect to treat certain CFCs as a single group. Consult an international tax advisor for assistance with these computations.
How we can help
Use caution when deciding to make tax elections and consider all facets of your business activity. Proactive, personalized planning is the key to helping you navigate your tax liabilities and identify new opportunities for savings. Our tax professionals can help you evaluate your options and make informed decisions.