Oct 19, 2021Making Sense of Business Interest Deductibility
In the Tax Cuts and Jobs Act (TCJA) of 2017, Congress decided to limit the deduction that a business may claim for its interest expense to 30% of “adjusted taxable income”. This limit allowed Congress to raise tax revenue over the course of the next several years in order to allow them to make cuts elsewhere. For many tax professionals, this limit is uncharted territory. Before the TCJA, business interest was always fully deductible. Now, the deductibility of business interest is subject to the complex rules of §163(j).
Why Limit the Deductibility of Business Interest?
In addition to raising additional tax revenue by limiting the deductibility of business interest, Congress had other reasons for limiting the deductibility of business interest.
Perhaps the most prevalent is that they wanted to level the playing field for investment between debt and equity. Normally, corporate finance professionals believe that financing a business with debt is more advantageous than equity because debt creates a so-called “tax shield” from earnings. Because interest has traditionally been deductible, business interest expense created through debt financing has allowed companies the ability to pay less in taxes. Obviously, this is true only to the extent that a company won’t default on its debt. This isn’t often a large issue though, and many companies firmly believe that financing through debt is the best option. By limiting the deductibility of business interest, Congress has begun to incentivize the issuance of additional equity.
Another reason that Congress chose to limit the deductibility of business interest is because the business interest expense is subject to a lot of gamesmanship. For example, when you allow business to fully deduct interest expense, many companies will engage in “earnings stripping”. This is where a U.S. corporation borrows money from a foreign affiliate in a low-tax jurisdiction. When the U.S. corporation deducts the interest it pays on the borrowing, it strips the earnings out of the high-tax U.S., and moves those earnings to a lower-tax jurisdiction.
Who Is Subject to the Limitation?
The rules that Congress enacted to limit the deductibility of business interest are extremely complex. Before we dive into how the limitation is calculated, it is important to know who is subject to the limit and who is not subject to the limit. The way this rule is written is that all trades or businesses are subject to this limit unless they are excluded. The following list contains taxpayers who are not subject to this limitation:
- Any business with average gross receipts over the prior three years of less than $26 Million under §448 (note that this test is applied to ALL types of taxpayers; not just C-Corporations and partnerships with a C-Corporate Partner).
- An employee
- A business that furnishes or sells certain types of energy
- An electing farm business, OR
- An electing real property trade or business
Computing the Interest Limitation
A business can only deduct its interest expense up to the sum of: 1) Any business interest income for the year, plus 2) 30% of “adjusted taxable income” for the year, plus 3) Any interest from floor-plan financing.
Perhaps the biggest question is how is adjusted taxable income calculated? §163(j)(8) defines adjusted taxable income as taxable income BEFORE:
- Any item of income, gain, loss, or deduction that is not allocable to the business
- Any interest income or expense
- Any Net Operating Loss
- Any §199A (QBI) deduction
- Any depreciation, amortization, or depletion (through December 31, 2021)
Now that we’ve seen exactly what the law says, an example illustrating how to calculate the 30% of adjusted taxable income will likely be helpful:
Example: A Co. has taxable income of $250,000. Included in that amount is $10,000 of interest income, $150,000 of interest expense, $180,000 of depreciation, and $10,000 of amortization. A Co. computes its "adjusted taxable income" as follows:
$250,000 - $10,000 + $150,000 + $180,000 + $10,000 = $580,000. The adjusted taxable income is then multiplied by 30%, yielding a limitation of $174,000. Don’t forget, the total limitation is $174,000 PLUS interest income of $10,000, or $184,000. Because the interest expense of $150,000 is less than the limitation of $184,000, the interest is deductible in full.
After the computation of the limitation, a business may have excess business interest that is not deductible. In general, these amounts are carried forward indefinitely at either the entity or partner level. Although a detailed discussion of how this carryforward occurs is beyond the scope of this article, it is important to realize that these rules are complex and will certainly require the help of a professional.
You may be thinking that this is a complicated rule – and you’d be correct. Tax professionals have struggled to figure out exactly what each provision means and how it is applied. Over the course of the past few years (since the creation of this limit), the IRS has published additional guidance to help tax professionals navigate the limitation. If your business is required to calculate this limitation, it is absolutely vital that you seek out a trained and experienced tax professional to help ensure that the calculation is done correctly.