The Tax Cuts and Jobs Act (TCJA) imposes a new limitation on deductions for business interest expense. This is a permanent change for tax years beginning in 2018 and beyond. Will your business be affected? Here’s what you need to know.
3 Exceptions to the Interest Expense Limitation
Many businesses will be exempt from the interest expense limitation rules under the Tax Cuts and Jobs Act (TCJA). Does your business qualify for any of these exceptions?
1. Small business exception. Under this exception, a taxpayer (other than a tax shelter) is exempt from the limitation if the taxpayer’s average annual gross receipts are $25 million or less for the three-tax-year period ending with the preceding tax year. It’s estimated that roughly 98% of U.S. businesses will be covered by the small business exception.
Businesses with fluctuating annual gross receipts that hover near or just above the $25 million threshold may qualify for the small business exception for some years but not for others. Qualifying for this exception depends on the average annual receipts over the preceding three years.
So, if your business has three good years, it may be subject to the interest expense limitation rules for the following year. But, if it has a bad year, it may qualify for the small business exception for the following year.
2. Exception for electing real property businesses. Businesses that develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease and/or broker real property can elect out of the interest expense limitation rules. But there’s a cost: These businesses must use the Alternative Depreciation System (ADS) to depreciate their nonresidential real property, residential rental property and qualified improvement property.
3. Exception for electing farming businesses. Nurseries, sod farms, farms that raise or harvest crops or ornamental trees, certain agricultural and horticultural cooperatives, and other eligible farming businesses can elect out of the interest expense limitation rules. But, again, there’s a cost: Those businesses that opt out of the limitation must use the ADS to depreciate assets used in the farming business that have Modified Accelerated Cost Recovery System (MACRS) depreciation periods of 10 years or more.
To Elect Out … Or Not?
Qualifying real estate and farming businesses that elect out of the interest expense limitation must use the ADS to depreciate certain assets. Using the ADS results in lower annual depreciation deductions, because the ADS depreciation periods are longer than the depreciation periods under the regular MACRS rules that usually apply.
Before electing out of the business interest expense limitation, it’s important to evaluate the tax benefit of gaining bigger interest expense deductions by electing out vs. the tax detriment of lower depreciation deductions under the ADS. Finally, it’s important to understand that, if your business elects out, first-year bonus depreciation that would otherwise be allowed for the affected assets won’t be allowed under the ADS. Contact your tax advisor to discuss the pros and cons of electing out.
How Have the Rules Changed?
Under prior law, some corporations were subject to the so-called “earnings-stripping” rules. Those rules attempted to limit deductions by U.S. corporations for interest paid to related foreign entities that weren’t subject to U.S. income tax.
In general, other taxpayers could fully deduct business interest expense under prior law. But those deductions were subject to various other restrictions, such as the passive loss rules and the at-risk rules.
Under the TCJA, for tax years beginning after 2017, a taxpayer’s deduction for business interest expense for the year is limited to the sum of:
- Business interest income,
- 30% of adjusted taxable income (ATI), and
- Floor plan financing interest paid by certain vehicle dealers.
The new interest expense deduction limitation is a permanent change that can potentially affect all types of businesses. Interest expense that’s disallowed under the limitation rules is carried forward to future tax years indefinitely and treated as business interest expense incurred in the carryforward year.
Thankfully, many small and medium-size businesses will be exempt from the new limitation. (See “3 Exceptions to the Interest Expense Limitation” at right.)
What Is Business Interest Expense?
Business interest expense is defined as interest on debt that’s properly allocable to a trade or business. However, the term “trade or business” does not include the following:
- Services performed as an employee,
- Electing real property businesses,
- Electing farming businesses, and
- Businesses that sell electrical energy, water, sewage disposal services, gas or steam through a local distribution system, or transportation of gas or steam by pipeline, if the rates are established by a specified governing body.
What Is ATI?
The acronym “ATI” refers to taxable income adjusted for the following items:
- Any item of income, gain, deduction or loss that isn’t allocable to a business,
- Any business interest income or business interest expense,
- Any net operating loss (NOL) deduction,
- The new deduction for up to 20% of qualified business income from a pass-through business entity (such as a sole proprietorship, partnership, limited liability company or S corporation), and
- Any allowable deductions for depreciation, amortization and depletion for tax years beginning before 2022.
Forthcoming IRS regulations could require additional adjustments to ATI. Under a transition rule, deductions for depreciation, amortization and depletion are added back to taxable income when calculating ATI for tax years beginning before 2022.
For tax years beginning in 2022 and beyond, deductions for depreciation, amortization and depletion won’t be added back. That will often significantly increase the taxpayer’s ATI, resulting in a lower interest expense deduction limitation.
What Qualifies as “Floor Plan” Financing Interest?
Floor plan financing interest refers to interest on debt that’s used to finance motor vehicles that the taxpayer holds for sale or lease to customers and that’s secured by the motor vehicle inventory. For this purpose, motor vehicles include:
- Any self-propelled vehicles designed for transporting people or property on public streets, highways or roads,
- Boats, and
- Farm machinery and equipment.
Because it’s added back in calculating the business interest expense limitation, floor plan financing interest is effectively exempt from the limitation. However, property used in a business that has floor plan financing debt isn’t eligible for first-year bonus depreciation.
The business interest expense limitation rules are among the most complex provisions of the TCJA. Fortunately, many businesses will be exempt from the limitation. Your tax advisor can help explain the rules, calculate your business interest deduction and provide supporting documentation if you qualify for an exception to the business interest expense limitation. Your advisor also may be able to suggest some tax planning strategies to minimize the adverse effects of this provision of the new law.