One of the most complicated provisions of the Tax Cuts and Jobs Act (TCJA) is the new limitation on deductions for business interest expense. At face value, this limitation seems straightforward, but the devil is in the details.
Do You Qualify for an Exception to the Interest Expense Limitation?
The following businesses are exempt from the interest expense limitation rules under the Tax Cuts and Jobs Act (TCJA):
Mechanics of the Small Business Exception
How does the small business exception work? Suppose you run your business as a calendar-year C corporation. Your company had gross receipts of $20 million in 2015, $25 million in 2016 and $29 million in 2017. So, your average annual gross receipts were $24.67 million for the preceding three-tax-year period. That's below the $25 million threshold. So, for the 2018 tax year, your company qualifies for the small business exception and it's exempt from the interest expense limitation rules for 2018.
On the other hand, if you started your business in 2016, the average annual gross receipts test for the 2018 tax year would be based on average annual gross receipts for only 2016 and 2017. Businesses with fluctuating annual gross receipts near the $25 million threshold may qualify for the small business exception for some years but not for others.
Contact your tax advisor to discuss planning opportunities related to these exceptions.
Here's an explanation and example of how to calculate your deduction for business interest expense under the new law — and why it's critical to get input from a tax professional as the new limitation goes into effect for tax years beginning in 2018.
Annual Limit on Business Interest Expense
Assuming your business doesn't qualify for an exception to the business interest expense limitation (see "Do You Qualify for an Exception to the Interest Expense Limitation?" at right), your deduction for the tax year can't exceed the sum of:
To calculate your annual interest expense deduction limitation, follow these five steps:
1. Calculate your firm's business interest income and business interest expense. (Floor plan financing interest expense should be calculated separately.)
2. Identify the adjustments to taxable income to calculate ATI for your business. The adjustments include:
3. Calculate ATI. Adjustments that would otherwise increase regular taxable income (such as business interest income) are subtracted in calculating ATI. Adjustments that would otherwise reduce regular taxable income (such as depreciation) are added back in calculating ATI. ATI can't be less than zero.
4. Multiply ATI by 30%.
5. Calculate the business interest expense limitation. It equals the sum of:
The amount of your disallowed interest expense equals the difference between the business's total business interest expense and the deductible amount calculated in Step 5. This amount is then carried forward to future tax years indefinitely and treated as business interest expense incurred in the carryforward year.
To show how these calculations work, let's suppose ABC Company is a C corporation. For 2018, ABC has $200,000 of business interest income, $2.5 million of business interest expense and $10 million of ATI. Assume the small business exception doesn't apply, and the company has no floor plan interest.
For 2018, ABC can deduct all $2.5 million of its business interest expense. Why? That amount is less than the deductible limit of $3.2 million. The limit equals the sum of:
For 2019, ABC has $200,000 of business interest income, $1.2 million of business interest expense, and only $1 million of ATI. The company can only deduct $500,000 of its business interest expense in 2019. Why? ABC's business interest expense for 2019 is limited to the sum of:
The $700,000 of disallowed interest expense for 2019 ($1.2 million – $500,000) will be carried forward to future tax years.
This example shows that the business interest expense limitation is more likely to affect a business when it is having a subpar year. The good news is that the disallowed interest is carried forward to future years, so it can potentially be deducted when things get better.
Transition Rule Adds Complexity
Under a transition rule, deductions for depreciation, amortization and depletion are added back when calculating ATI for tax years beginning before 2022. For tax years beginning in 2022 and beyond, deductions for depreciation, amortization and depletion won't be added back.
So, for tax years beginning before 2022, taking advantage of generous depreciation tax breaks — such as 100% first-year bonus depreciation and generous Section 179 deductions — won't reduce ATI. For tax years after 2022, taking advantage of such breaks will reduce ATI, which will increase the likelihood that the interest expense limitation will come into play. That can be especially problematic if you take on debt to purchase depreciable assets.
Special Rules for Partnerships and S Corporations
The interest expense deduction limitation rules get more complicated for businesses that are operated as partnerships, LLCs treated as partnerships for tax purposes and S corporations.
Basically, the limitation is calculated at both the entity level and at the owner level, and special rules prevent double counting of income when calculating an owner's ATI for purposes of applying the limitation at the owner level.
For example, Double B LLC is owned 50/50 by Bubbling Boggle Corp. (BBC) and Bill Brown. Double B is treated as a 50/50 partnership for tax purposes. For 2018, it has $2 million of ATI and $800,000 of business interest expense. It has no business interest income or floor plan interest.
So, Double B's business interest expense deduction is limited to $600,000 (30% of the $2 million of ATI). Double B deducts the $600,000 and reports net income of $1.4 million to its owners ($700,000 each). The $200,000 of disallowed business interest ($800,000 – $600,000) is carried forward to future years.
BBC has no net income, but it has $250,000 of business interest expense of its own. If BBC were allowed to count its $700,000 share of Double B's net income in calculating its ATI, BBC could deduct $210,000 of its business interest expense (30% x $700,000).
However, the no-double-counting rule stipulates that BBC's ATI can't include its $700,000 of net income from Double B, because that income was already taken into account in determining Double B's ATI for purposes of calculating Double B's business interest expense limitation. Therefore, BBC's ATI is zero, and it can't currently deduct any of its $250,000 of business interest expense. Instead, it would be completely disallowed in the current year and carried forward to future years.
What if Double B has only $400,000 of business interest expense? In that case, $200,000 of its $600,000 business interest expense limitation goes unused. Under this hypothetical situation, BBC's business interest expense limitation equals 30% of its ATI of zero plus 50% of the $200,000 unused limitation from Double B. So, BBC can deduct $100,000 of the unused limitation from BBC (50% x $200,000). The remaining $150,000 of BBC's business interest expense would be disallowed in the current year and carried forward to future years.
Important note: A partner's basis in the partnership interest or an LLC member's basis in the LLC interest (outside basis) is reduced (but not below zero) by any disallowed business interest that's allocated to the partner (member). Upon disposition of the partnership (LLC) interest, the partner (member) increases outside basis by the amount of any basis decreases that are attributable to disallowed business interest expense that still hasn't been deducted. Similar rules apply to business interest expense incurred by S corporations.
The IRS is expected is issue additional guidance on the business interest expense limitation rules in the coming months. Contact your tax advisor for the latest developments and for ways to minimize the adverse effects of the limitation on your business.