The Tax Cuts and Jobs Act (TCJA) brought about lower tax rates for most business taxpayers, but it also includes some aspects that many business owners don’t view as favorable. One of these is the limitation on the amount of interest expense a business can deduct.
This new rule (section 163(j) of the tax code) limits the ability of many businesses (not just corporations) to deduct interest expense paid or accrued.
Prior to the TCJA, business interest expense was generally deductible in the year in which the interest was paid or accrued, except that corporations were subject to certain limitations, also known as “the earnings stripping rules.”
The TCJA created a new limitation, replacing earning stripping rules and applying it to all businesses, not just corporations.
What is the New Limitation on Deductible Business Interest Expense?
Starting in 2018, the deduction for business interest expense is limited to the sum of:
- 30% of its adjusted taxable income (ATI)
- The amount of interest income includable in the business’ gross income for the year
- Any floor-plan financing interest of the business
ATI is generally the business’ taxable income computed without regard to:
- Any income, deduction, gain or loss not allocable to a trade or business
- Any business interest income or expense
- Any net operating loss deduction
- Any deduction for certain pass-through income under the new section 199A and
- Any deduction for depreciation, amortization or depletion (for tax years beginning before January 1, 2022)
For tax years beginning after January 1, 2022, the ATI definition will change because depreciation, amortization and depletion deductions will no longer be excluded from ATI.
The new business interest expense limitation does not apply to taxpayers with average gross receipts that do not exceed $25 million for the three preceding taxable years. However, businesses may need to include the gross receipts of certain related parties when determining whether this $25 million threshold applies. If the related group’s gross receipts exceed $25 million, the 30% limitation applies for each separate entity.
There is no grandfathering for existing debt. The new limitation applies to all business debt. However, businesses can generally carry forward any unused business interest expense indefinitely.
To illustrate, say ABC Corp. has $1,000,000 of ATI, $50,000 of business interest income and $450,000 of business interest expense for its 2018 tax year. The maximum amount of interest ABC Corp. can deduct for 2018 would be $350,000, or 30% of its ATI plus its business interest income.
The $100,000 of business interest expense that is disallowed as a deduction in 2018 can be:
- carried forward
- treated as interest expense paid or accrued in 2019
- subject to the same limitations.
The new rules are complex and can have a significant impact on the taxable income of your business. If you have any questions about the IRC Section 163(j) or need help analyzing the effect of tax reform on your business, we encourage you to contact Brown Schultz Sheridan & Fritz today.
ABOUT THE AUTHOR
Sean is a Tax Senior Staff Accountant with Brown Schultz Sheridan & Fritz.
He has over two years of experience in public accounting. Sean specializes in tax compliance and tax planning services for partnerships, corporations and individuals.