In signing into law the legislation commonly referred to as the “Tax Cuts and Jobs Act” or the “TCJA,” President Trump made good on threats in recent proposals to curb the tax advantages of business leverage. 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. 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. This limitation applies after other potential limitations on deductibility of interest expense are considered, including interest capitalization rules or other disallowance provisions. Disallowed interest expense may be carried forward indefinitely to succeeding taxable years.
“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. 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). 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.
“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. Treasury is given discretion to make other adjustments to this calculation. 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. Once made, the elections for real estate and farming businesses are irrevocable, and such businesses will be required to use a longer depreciation method. Businesses with annual average gross receipts over the prior 3 years of $25 million or less are also excluded. 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. Deductions for business interest are taken into account at the entity level as items of non-separately stated partnership income and loss. 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. 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. 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.