The Tax Cuts and Jobs Act (TCJA) imposes a limit on deductions for business interest for taxable years beginning in 2018. The limit, like other aspects of the law, has raised some questions for taxpayers. In response, the IRS has issued temporary guidance in Notice 2018-28 that taxpayers can rely on until it releases regulations. While the guidance provides some valuable information, it also leaves some questions unanswered.
The prior-law limit rules
Prior to the TCJA, corporations couldn’t deduct “disqualified interest” expense if the borrower’s debt equaled more than one and a half times its equity and net interest expense exceeded 50% of its adjusted taxable income (computed without regard to deductions for net interest expense, net operating losses, domestic production activities, depreciation, amortization and depletion). Disqualified interest included interest paid or accrued to:
- Related parties when the interest wasn’t subject to federal income tax,
- Unrelated parties in certain instances when a related party guaranteed the debt, or
- A real estate investment trust (REIT) by a REIT taxable subsidiary.
Previously, taxpayers could carry forward excess interest (meaning any interest that couldn’t be deducted due to the 50% of adjusted taxable income limit) indefinitely. And any excess limit (the excess of 50% of the borrower’s adjusted taxable income over its net interest expense) could be carried forward three years.
These rules were for the so-called “earnings stripping” rules. They were intended to prevent corporations from wiping out their taxable income by deducting interest payments on debt owed to certain parties.
The new-law limit
For tax years beginning after 2017, the TCJA amended Section 163(j) of the Internal Revenue Code (IRC). Under the amended rules, the deduction for business interest incurred by both corporate and non-corporate taxpayers is limited to the sum of:
- Business interest income for the taxable year,
- 30% of the taxpayer’s adjusted taxable income for the tax year, and
- The taxpayer’s floor plan financing interest paid by vehicle dealers for the tax year.
The limit applies to all taxpayers, except those with average annual gross receipts of $25 million or less, real estate or farming businesses that elect to exempt themselves (see below for how that election works), and certain regulated utilities.
The amended rules allow for the indefinite carry-forward of any business interest not deducted because of the limit. Excess limit, however, can’t be carried forward.
Treatment of pre-2018 interest carry-forwards
According to the temporary guidance, the IRS will issue regulations clarifying that taxpayers with interest carry-forwards from the last taxable year beginning before 2018 can carry them forward as business interest to their first taxable year beginning after 2017. The regulations will clarify that this business interest that is carried forward will be subject to potential disallowance under amended Section 163(j) in the same manner as any other business interest otherwise paid or accrued in a tax year beginning after 2017.
The regulations also will address the treatment of pre-2018 business interest under the TCJA-created IRC Section 59A, the base erosion and anti-abuse tax. The base erosion tax applies only to businesses with average annual gross receipts of at least $500 million.
C-corporation business interest income and expense
The IRS announced it’ll issue regulations clarifying that, for purposes of Section 163(j) only, all interest paid or accrued on a C corporation’s debt is business interest. All interest on debt held by a C corporation and includable in its gross income is business interest income.
In addition, the regulations will address the proper treatment of interest paid, accrued or includable in gross income by a non-corporate entity (for example, a partnership) in which the C corporation holds an interest. And the regulations will clarify that the disallowance and carry-forward of a deduction for a C corporation’s business interest expense won’t affect whether and when such an expense reduces the corporation’s earnings and profits.
Treatment of consolidated groups
For groups of affiliated corporations that file a consolidated tax return, forthcoming regulations will clarify that the business interest deduction limit applies at the group level. For example, a consolidated group’s taxable income for purposes of calculating its adjusted taxable income will be its consolidated taxable income. Inter-company obligations (debt between affiliated corporations) won’t count when determining the amount of the limitation.
The regulations also will address several other issues related to the application of the limit to consolidated groups. These include the allocation of the limit among group members, the treatment of disallowed interest deduction carry-forwards when a member leaves the group and the treatment of a new group member’s carry-forwards. The regulations aren’t expected to treat an affiliated group that doesn’t file a consolidated tax return as a single taxpayer for purposes of the interest expense deduction limit.
Electing to be exempt from the interest expense deduction limit
As previously mentioned, real estate and farm businesses can elect to exempt themselves from the Section 163(j) interest expense deduction limit. At first glance, making the election might seem like a no-brainer — but the election, which is irrevocable, could backfire.
Businesses that make the election must use the alternative depreciation system (ADS) for certain property (generally, real or farm property with a recovery period of 10 years or more) used in the business, regardless of when the property was placed in service. ADS depreciation is over longer periods, so an electing taxpayer’s annual depreciation deductions are reduced if the election is made. Electing businesses also can’t claim first-year bonus depreciation. Businesses should weigh the advantage of avoiding the interest expense deduction limit by making the election against the detriment of slower depreciation deductions if the election is made.
The IRS has requested comments on the rules outlined in its interim guidance. It also expects to issue regulations providing additional guidance on issues not yet covered and requested comments on which issues those regulations should address. Comments are due by May 31, 2018.