By: Valerie F. Gainer and Cassee L. Vivian
Business Interest Expense Deduction
The 2017 Tax Cuts and Jobs Act revised § 163(j) of the Internal Revenue Code (“Code”) to limit the deduction available for business interest expenses in a taxable year to an amount no greater than the sum of:
- The taxpayer’s business interest income;
- Thirty percent (30%) of the taxpayer’s adjusted taxable income (“ATI”); and
- The taxpayer’s floor plan financing interest.
The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) allows the thirty percent (30%) ATI factor in the above formula to be increased to fifty percent (50%) for tax years beginning in 2019 or 2020.
2018 Proposed Regulations versus 2020 Final Regulations
On July 28, 2020, the IRS finalized the proposed regulations regarding § 163(j) that were published at the end of 2018. These final regulations address several key issues regarding the breadth of the § 163(j) limitation including:
- The application of the limitation to partnerships and S Corporations and their partners and shareholders.
- Rectifying definitional issues relating to the term “taxable income.”
- Fixing inconsistencies regarding how depreciation, amortization, and depletion are included in calculating adjusted taxable income.
- Providing guidance for real property trade or business elections.
The following is a further explanation of certain changes from the 2018 Proposed Regulations (“Proposed Regulations”) and the 2020 Final Regulations (“Final Regulations”).
Partnerships and S Corporations
Under Code § 163, the allocation of excess taxable income, excess business interest income, and excess business interest expense among partners is determined “in the same manner as the non-separately stated taxable income or loss of the partnership.” Proposed Regulation § 1.163(j)-6(f)(2) sets out an eleven-step calculation for partnerships to use to allocate excess taxable income, excess business interest income, and excess business interest expense to partners. Under the Final Regulations, the eleven-step calculation is subject to an exception for certain partnerships that allocate non-separately stated taxable income pro rata.
Under Proposed Regulation § 1.163(j)-6(m)(1), the business interest expense allocated to a partner or S Corporation shareholder from a partnership or S Corporation treated as an exempt entity under § 1.163(j)-2(d) is subject to the partner’s or shareholder’s limitations under Code § 163(j). The Final Regulations reverse course, taking the position that business interest expenses of exempt entities allocated to partners or S Corporation shareholders will not be subject to such partners’ or shareholders’ Code § 163(j) limitations.
Taxable Income and Tentative Taxable Income
The Proposed Regulations defined ATI as a taxpayer’s “taxable income,” adjusted pursuant to specific parameters. This was problematic since the term “taxable income” had different meanings depending upon its context in the Code § 163 regulations. To solve this issue, the Final Regulations use the term “tentative taxable income” to describe the initial value which will be adjusted to determine ATI.
Depreciation, Amortization, and Depletion in relation to ATI
Code § 163(j)(8)(A) lists items that should be excluded when calculating taxable income for purposes of ATI, including any allowable deduction for depreciation, amortization, or depletion for tax years beginning before January 1, 2022. Consequently, Proposed Regulation § 1.163(j)-1(b)(1)(i) called for the amounts deducted for depreciation, amortization and depletion in taxable years starting before the beginning of calendar year 2022 to be added back into taxable income. Incongruously, expenses for depreciation, amortization, and depletion that capitalized into inventory pursuant to § 263A were not an add-back when calculating taxable income for purposes of ATI under the Proposed Regulations. The Final Regulations address this discrepancy, providing that such depreciation, amortization, and depletion amounts will be an add-back to tentative taxable income for purposes of the ATI computation.
Additionally, under the Proposed Regulations, the value equal to the lesser of (1) the gain from the sale or disposal of property, or (2) the depreciation, amortization, or depletion deductions related to the property for tax years starting after the end of calendar year 2017 but before the beginning of calendar year 2022, is one of the subtractions made from taxable income to ascertain ATI. The Final Regulations have virtually discontinued the foregoing “lesser of” subtraction, instead allowing only the subtraction of depreciation deductions for tax years starting after the end of calendar year 2017 but before the beginning of calendar year 2022 related to the disposed of property.
Importantly, new proposed regulations regarding Code § 163(j) were issued at the same time as the 2020 Final Regulations. These new proposed regulations would allow taxpayers to use the “lesser of” standard set forth above if they so choose, provided they use the “lessor of” standard consistently.
C Corporations
Under the Proposed Regulations, regulated investment companies (“RICs”) and real estate investment trusts (“REITs”), for purposes of calculating ATI, did not have to subtract their deductions for paying dividends from their taxable income. The Final Regulations determined that dividends paid to investors by RICs and REITs are similar to a cooperative’s deductions under §§ 1382(b)(1), 1382(b)(2), and 1382(c). To provide consistency among taxpayers, the Final Regulations state that deductions under the foregoing Code sections will not reduce a cooperative’s tentative taxable income for ATI calculation purposes.
Proposed Regulation § 1.163(j)-4(c)(1) provides that the disallowance and carry-forward of a deduction for a C corporation’s business interest expense under § 1.163(j)-2 will not affect whether or when the business interest expense reduces the taxpayer’s earnings and profits. Some commenters on the Proposed Regulation suggested that if a partnership incurs the business interest expense, as opposed to a C corporation partner, the partner should reduce its earnings and profits twice, once when the expense is allocated to the partner from the partnership and again when the C corporation partner claims a deduction for that expense. The Final Regulations address these comments and clarify that a C corporation partner cannot reduce earnings and profits twice in this scenario.
Elections for Real Property Trades or Businesses and Farming Businesses
Businesses interested in being electing real property trades or businesses or electing farming businesses should review Final Regulation § 1.163(j)-9 for guidance. A protective election is available for certain taxpayers concerned with whether their rental real estate activities are trades or businesses under § 162.
IRS Notice 2020-59 Safe Harbor for Qualified Residential Living Facilities
IRS Notice 2020-59 sets forth a proposed Revenue Procedure which would enable qualified residential living facilities (“QRLFs”) to avoid Code § 163(j)’s limit on the business interest expense deduction.
As outlined above, Code § 163’s limitation calculation involves a taxpayer’s business interest expense. Only trades or businesses can have a “business interest.” Electing real property trades or businesses are not treated as trades or businesses for purposes of Code § 163’s business interest expense deduction limitation. The proposed revenue procedure allows QRLFs to be treated as electing real property trades or businesses. If an election is made, the taxpayer must use the alternative depreciation system in Code § 168(g).