In signing into law the legislation commonly referred to as the “Tax Cuts and Jobs Act” or the “TCJA,”1 President Trump made good on threats in recent proposals to curb the tax advantages of business leverage.2 New section 163(j), which replaces the old “earnings stripping” rules, generally limits deductions for net interest expense of a business. Former section 163(j) generally limited interest deductions for certain related-party debt and certain guarantees by affiliates of third-party debt: it applied to corporations with a debt-to-equity ratio greater than 1.5 to 1 in a taxable year. New section 163(j) applies more broadly to all debt, whether between related parties or incurred by a corporation, other entity, or individual, and regardless of the taxpayer’s debt-to-equity ratio.
General Rules
New section 163(j) applies for interest expense incurred in taxable years after December 31, 2017.3 It disallows deductions for business interest expense that exceeds an adjusted earnings-based threshold. In general, the business interest expense deduction is disallowed to the extent incurred in a taxable year in excess of (a) business interest income, (b) 30% of the taxpayer’s adjusted taxable income (defined below), and (c) floor plan financing interest.4 This limitation applies after other potential limitations on deductibility of interest expense are considered, including interest capitalization rules or other disallowance provisions.5 Disallowed interest expense may be carried forward indefinitely to succeeding taxable years.6
“Floor plan financing” interest is attributable to debt incurred to finance the acquisition of motor vehicles held for sale or lease and secured by the inventory so acquired. As a fixed part of the threshold for the limitation, floor plan financing interest is effectively deductible without limitation under section 163(j)—an exception sought by the vehicle dealer industry.7 In the same vein, the inclusion of business interest income as a threshold for the limitation allows business interest expense to be deductible up to the amount of such income (i.e., only taxpayers with net business expense are subject to limitation on the net amount). “Business interest” includes interest allocable to a trade or business and excludes “investment interest” (as defined in section 163(d), which contains a separate limitation applicable to investment interest expense of non-corporate taxpayers).8 The legislative history indicates that, for corporations, the investment interest exclusion is intended to apply only to non-corporate entities and thus that all interest income and expense will be treated as allocable to a business of the corporation and will be subject to limitation, unless one or more of its businesses can qualify for another exclusion.9
“Adjusted taxable income” is generally computed using a formula that mimics EBITDA through 2021, but then starting in 2022 a harsher definition kicks in that mimics EBIT. More specifically, adjusted taxable income means taxable income computed without regard to (1) any item of income, loss, gain, or deduction that is not allocable to a trade or business, (2) any business interest income or expense, (3) the amount of any net operating loss deduction under section 172, (4) the amount of any deduction allowed under section 199A (enacted under the TCJA to provide a new 20% deduction for business income of pass-through entities), and (5) for taxable years beginning before January 1, 2022, any depreciation, amortization, and depletion deductions.10 Treasury is given discretion to make other adjustments to this calculation.11 As will be seen below, the computation of adjusted taxable income is further complicated for taxpayers with interests in partnerships or S corporations that have incurred entity-level debt.
There are key exclusions from the new interest expense limitation rule for specified trades or businesses: the performance of services as an employee, electing real estate businesses (specifically, a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business), electing farm businesses, and certain regulated public utilities.12 Once made, the elections for real estate and farming businesses are irrevocable, and such businesses will be required to use a longer depreciation method.13 Businesses with annual average gross receipts over the prior 3 years of $25 million or less are also excluded.14 Commodities or other similar securities trading or hedging businesses are not excluded.
Partnerships and S Corporations
The business interest limitation applies at the partnership, and not the partner, level.15 Deductions for business interest are taken into account at the entity level as items of non-separately stated partnership income and loss.16 Each partner computes its adjusted taxable income without regard to its distributive share of partnership income and loss. This prevents partners from using their allocable shares of partnership adjusted taxable income to generate larger interest deductions as the taxable income is passed through.
Example 1: A and B, two individuals, are equal partners in the AB partnership. In 2018, AB generates $100 of non-interest taxable income (not taking the business interest deduction into account) and incurs $30 of business interest expense. AB’s interest limitation is $30 ($100 X 30%). Thus, the full $30 is deductible. A’s share of AB’s taxable income is $35 (A’s 50% allocable share of $70 taxable income ($100 pre-interest taxable income minus $30 deductible interest expense)). Aside from its allocable share of AB’s income and loss, A earns no taxable income but separately incurs $30 of business interest expense. The interest expense limitation rules prevent A from using the $35 in net income allocable from AB to generate additional interest expense deductions.
To the extent a partnership has excess capacity for interest deductions (i.e., it could have deducted more interest expense if it had incurred such expense), a partner can use its proportionate share of the excess capacity to permit greater deductions for other interest expense it incurred at the partner level. The rules accomplish this by permitting partners to add to their separate computation of adjusted taxable income for the business interest expense deduction calculation their allocable share of the partnership’s “excess taxable income.” A partnership’s “excess taxable income” is the amount that bears the same ratio to the partnership’s adjusted taxable income as the excess of 30% of the partnership’s adjusted taxable income over the amount by which the partnership’s business interest expense (reduced by any floor plan financing interest expense) exceeds its business interest income bears to 30% of the partnership’s adjusted taxable income.17 In other words, the excess taxable income amount should generally correspond to the partnership’s adjusted taxable income, multiplied by the quotient of the excess capacity divided by the total available limitation.
Example 2: Same facts as Example 1, except the AB partnership generates $200 of non-interest taxable income. AB’s interest limitation is now $60 ($200 X 30%). Thus, the full $30 of interest expense incurred by AB is deductible, and an additional $30 could have been deducted before reaching the limitation. AB’s total “excess taxable income” is $100 (($30 excess / $60 limitation) X $200 total taxable income). A’s share of AB’s taxable income is $85 (A’s 50% allocable share of $200 taxable income minus $30 deductible interest expense). A is also allocated $50 of “excess taxable income” from AB that, when added to its separate amount of adjusted taxable income of $0, results in total adjusted taxable income for A of $50 for this purpose. A can deduct an additional $15 ($50 X 30%) of its partner-level interest expense, but the remaining $15 will be disallowed.
Section 163(j)(4)(D) states that rules similar to the rules discussed above, pertaining to entity-level interest expense deductions and the ability of pass-through owners to use a portion of the entity’s excess capacity, will apply with respect to S corporations and their shareholders.
Special carryforward rules apply if a partnership has excess interest expense that is disallowed under the new rules. The excess interest expense is allocated to partners based on their distributive shares of non-separately stated taxable income and loss of the partnership, and will be treated as paid or accrued by the partners starting in the next taxable year in which the partners are allocated excess taxable income from the partnership.18 Thus, carryforwards of disallowed interest expense can only be used by partners against (and to the extent of) subsequent excess taxable income of the partnership.
Example 3: Same facts as Example 2, except the AB partnership incurs $80 of interest expense in 2018, and aside from the AB partnership income, A earns $100 in non-interest taxable income in 2018. AB’s interest expense limitation is still $60 ($200 X 30%). Thus, $20 of AB’s interest expense is not deductible. Even though A has sufficient taxable income before its allocable share of income from AB, its $10 share of the $20 excess interest expense can only be deducted in taxable years after 2018 to the extent A is allocated “excess taxable income” from AB.
A downward basis adjustment (not below zero) to a partner’s partnership interest is made at the time the excess interest expense is allocated to the partner, even though the carryover can only give rise to partner deductions in later years.19 The result is a timing mismatch between the deduction and the basis reduction, which limits the partner’s ability to receive tax-free actual or deemed cash distributions and other partnership loss deductions. However, if a partnership interest is disposed of in a taxable or non-recognition transaction before a deduction is taken, the partner’s basis in the interest is increased immediately before the disposition by the partner’s share of the excess interest expense allocated to, but not yet deducted by, the partner.20 The rules also prohibit a transferor and a transferee from taking a deduction for the excess interest expense that creates this basis increase.21 In effect, a partner that has had excess interest expense reflected in its outside basis before taking a corresponding interest expense deduction will true-up its basis for the suspended deduction upon the transfer of its partnership interest. In the case of a taxable transfer, the basis adjustment effectively accelerates the loss but converts it from ordinary to capital (except to the extent the basis increase was allocated to “hot assets” under section 751).22 It is unclear if this basis rule applies to complete or partial dispositions, or to both.
Example 4: Same facts as Example 3, except in 2019 the AB partnership incurs no taxable income and incurs no interest expense, and A sells its entire partnership interest to individual C (an unrelated party) on January 1, 2019 for $190. Also assume that A had “outside” basis in AB of $50 at the beginning of 2018. Its outside basis would increase by $100, its allocable share of AB taxable income (before taking any business interest deduction into account), and decrease by $20, its share of the total AB interest expense (this reflects the $10 that A could actually deduct on its tax return for 2018, and its $10 share of the suspended excess interest expense), resulting in an outside basis of $130 at the end of 2018. Immediately before the sale of its interest to C on January 1, 2019, A’s basis is then increased by $10 (the excess business interest allocated to, but not yet deducted by, A on its tax return). A’s gain on the sale is $50 ($190 less $140 basis), and neither A nor C is permitted a deduction with respect to the $10 of excess business interest expense allocated to A in 2018.
These special carryforward and corresponding basis rules will not apply to S corporations and their shareholders.23
As a result of the special limitation and carryover rules applicable to pass-throughs, in a given taxable year a pass-through investor’s overall interest expense limitation under new section 163(j) may be less than 30% of its aggregate adjusted taxable income. For taxpayers that face this unfortunate result given their current leverage, consideration ought to be given to restructuring existing debt or investment structures to effectively increase their aggregate interest expense limitations.
Corporations
Carryovers of disallowed interest expense are treated as attributes that can be carried over in certain non-recognition transfers.24 However, carryovers of disallowed interest are treated as items of pre-change loss that are subject to limitation under section 382 upon certain ownership changes.25
The text and regulations under old section 163(j) applied the earnings stripping rules at the consolidated group level,26 but new section 163(j) is silent on the matter.27 If the new limitation were not applied at the consolidated group level, a consolidated group that happens to have debt in members with little or no separate adjusted taxable income would face an onerous interest expense limitation, even if there was sufficient groupwide adjusted taxable income available to increase the limitation. On the other hand, taxpayers would easily be able to restructure debt (new and existing) within a consolidated group to circumvent the limitation. For instance, a consolidated group could cause debt to be incurred by a group member with sufficient adjusted taxable income to avoid hitting the limitation, even if the group’s consolidated income would produce a different result. Possibly in light of these potential outcomes, a Treasury official during a recent public event indicated that forthcoming guidance would confirm that new section 163(j) applies at the consolidated group level (and not on an elective basis).28
Concluding Thoughts
New section 163(j) does not appear to grant specific regulatory authority for additional guidance, whereas old section 163(j) granted such authority in numerous places.29 Nonetheless, administrative guidance will be needed to address several open issues, such as rules applicable to foreign taxpayers with income effectively connected to a U.S. trade or business and to consolidated groups with intercompany loans and, in particular, with highly leveraged members that join or leave the group.
Together with other provisions of the TCJA, including the lower corporate tax rate, the deduction for business income of pass-through entities, and the provision allowing immediate expensing for acquisitions of tangible property, the new interest expense limitation may make foreign debt more attractive if the tax deductions would be higher outside the U.S. (e.g., in certain European jurisdictions).
The new limitation will likely reinvigorate investments in preferred equity structures in lieu of partnership debt, particularly as interest rates rise and in later years when the definition of “adjusted taxable income” will not include the add-back for depreciation and amortization. If properly structured, a preferred equity interest in a partnership does not give rise to interest expense, and section 163(j) should not apply. Economically, however, by allocating income away from the common interest holders, the use of a preferred interest in lieu of debt has an effect similar to deductible interest expense. Furthermore, if the partnership generates “qualified business income” eligible for the new deduction for pass-through income under section 199A (and if the preferred interest holder is a non-corporate taxpayer that could benefit from the deduction), payments on the preferred interests should qualify for the pass-through deduction, even if treated as guaranteed payments for capital, because section 199A excludes only guaranteed payments for services from the deduction.30 Whether and how the Service may attempt to restrain those approaches remains to be seen, especially as preferred equity arrangements take more aggressive steps to mimic the economics of debt. Perhaps in lieu of the recent attention to section 385,31 efforts might be refocused on recharacterizing equity as debt for tax purposes in certain circumstances that circumvent new section 163(j).
Some taxpayers may have carryforwards beyond 2017 for disallowed interest expense under the old section 163(j) earnings stripping rules. The new rules entirely supplant the old rules, including the carryover provisions. The statutory text and legislative history under the TCJA are silent on the treatment of carryovers under the old rules, and the new rules appear to be sufficiently different so as prevent automatic coordination between the two. Unless guidance is issued, it would appear that old section 163(j) carryovers are unusable after 2017. ■
1 Publ. L. No. 115-97, 1st Sess., 115th Cong. (Dec. 22, 2017).
2 See, .e.g., A Better Way: Our Vision for a Confident America, 25-26 (June 24, 2016) (the 2016 House Blueprint); Donald J. Trump, Tax Reform That Will Make America Great Again (the Trump Campaign Tax Plan).
3 TCJA § 13301(c).
4 I.R.C. § 163(j)(1).
5 Committee of Conference, Tax Cuts and Jobs Act - Conference Report to Accompany H.R. 1, H. Rept. 115-466, at 387 (Dec. 15, 2017) (the Conference Report).
6 I.R.C. § 163(j)(2).
7 I.R.C. § 163(j)(9).
8 I.R.C. § 163(j)(6). Investment interest generally includes interest attributable to property held for investment and is subject to separate limitation rules. See I.R.C. §§ 163(d)(1), (3).
9 Conference Report, at 386 n.688.
10 I.R.C. § 163(j)(8). Although not explicit, “depreciation” excluded from “adjusted taxable income” (through 2022, unless further extended) for this purpose should include deductions under the increased bonus depreciation provisions included in section 168(k), as revised by the TCJA (often referred to alternatively as new “immediate expensing” provisions). See I.R.C. § 163(j)(8); Conference Report, at 387 n. 689. The Conference Report, in a passage summarizing the House version of the bill, states broadly that “[a]ny deduction allowable for depreciation, amortization, or depletion includes any deduction allowable for any amount treated as depreciation, amortization, or depletion under present law.” Conference Report, at 387 n. 689 (emphasis added). The qualification that it applies to depreciation “under present law” might suggest that adjusted taxable income should not be reduced by the additional bonus depreciation enacted under the new law, but the text of section 163(j)(8)(v) states generally that it applies, for the applicable years, to “any deduction allowable for depreciation, amortization, or depletion.” This has been identified as a point needing immediate guidance. See AICPA Letter to David J. Kautter & William M. Paul, Request for Immediate Guidance Regarding Pub. L. No. 115-97, at 3 (Jan. 29, 2018).
11 I.R.C. § 163(j)(8)(B).
12 I.R.C. § 163(j)(7).
13 See I.R.C. § 168(g)(1)(F) (electing real property trades or businesses); § 168(g)(1)(G) (electing farming businesses).
14 I.R.C. §§ 163(j)(3); 448(c). For taxpayers that are not corporations or partnerships (such as sole proprietorships), the gross receipts test under section 448(c) is applied as if such taxpayer were a corporation or partnership.
15 I.R.C. § 163(j)(4)(A)(i).
16 Id.
17 I.R.C. § 163(j)(4)(C).
18 I.R.C. § 163(j)(4)(B)(i).
19 See I.R.C. § 163(j)(4)(B)(iii)(I).
20 I.R.C. § 163(j)(4)(B)(iii)(II).
21 Id.
22 See id.
23 See I.R.C. § 163(j)(4)(D).
24 See I.R.C. § 381(c)(20).
25 See I.R.C. §§ 382(d)(3), (k)(1).
26 I.R.C. § 163(j)(6)(C) (prior to amendment by the TCJA); Prop. Treas. Reg. § 1.163(j)-5.
27 Although the text of section 163(j) is silent, the Conference Report, in a passage summarizing the House version of the bill, states that “[i]n the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.” Conference Report, at 386.
28 See Emily L. Foster, Business Interest Deduction Limit Parameters Explained, 2018 Tax Notes Today 18-2 (Jan. 26, 2018).
29 See I.R.C. § 163(j)(9) (prior to amendment by the TCJA) (granting regulatory authority for anti-abuse provisions, affiliated group rules, rules for coordination with section 884, and rules for partnerships).
30 See I.R.C. § 199A(c)(4)(B).
31 Recent final and temporary regulations issued under section 385 that purported to expand its reach have since been delayed under Notice 2017-36, 2017-33 I.R.B. 208 (July 28, 2017), and shortly before enactment of the TCJA, the Treasury issued a statement announcing its intent to revoke and/or substantially revise them. U.S. Department of the Treasury, Second Report to the President on Identifying and Reducing Tax Regulatory Burdens Under Executive Order 13789, at 6-8 (Oct. 2, 2017).