The TCJA provides several exceptions to the new 30% limitation on business interest expense. Taxpayers meeting the definition of a “small taxpayer” are automatically exempt. Certain “utility companies” are automatically exempt as well. Finally, taxpayers that are “real property trades or businesses” or “farming businesses” can make an irrevocable election to be exempt, but the price of such election is a reduction in the electing taxpayer’s depreciation expense.
A small taxpayer with average annual gross receipts for the prior three tax years that do not exceed $25 million is automatically exempt from the 30% business interest limitation. If a business hasn’t been around for three tax years, the gross receipts test is based on the period it has been in existence. For the purpose of calculating a taxpayer’s average annual gross receipts, the gross receipts of certain related taxpayers (commonly controlled businesses or affiliated service groups) need to be aggregated to determine whether the $25 million threshold has been exceeded. This aggregation rule includes parent-subsidiary controlled groups, brother-sister controlled groups, and related parties as described in Sec. 414(m) for discrimination testing of employee benefits (which are too complex to discuss here). These aggregation rules ensure that taxpayers cannot avoid the limitation by simply separating a single business into several separate legal entities.
Gross receipts, for the purpose of this small taxpayer test, include:
- Total sales, not reduced by cost of goods sold.
- All amounts received for services.
- Income from investments, such as interest (including OID and tax-exempt interest), dividends, rents, royalties and annuities, regardless of whether the amounts are derived in the ordinary course of the taxpayer’s trade or investments.
- Sales proceeds from capital assets or depreciable business assets, reduced by the taxpayer’s adjusted basis in the property.
It is important to note that the small taxpayer exception above does not apply to a tax shelter. Be careful, however: The definition of tax shelter for this purpose is likely broader than you expect; a partnership or S corporation that allocates more than 35% of its losses for the year to limited partners or limited entrepreneurs is considered a tax shelter. See my earlier TCJA Update for a more detailed definition of a tax shelter.
The 30% interest limitation also does not apply to utility companies that furnish or sell electrical energy, water or sewage disposal services; gas or steam through a local distribution system; or the transportation of gas or steam by pipeline. To avoid the interest limitation, the rates for the furnishing or sale of these items must have been established or approved by a state or political subdivision, by a public service or public utility commission or another similar body of a state or political subdivision or by the rate-making body of an electric cooperative.
A real property trade or business that has average gross receipts exceeding $25 million may make an irrevocable election not to have this 30% interest expense limitation apply. A real property trade or business is any trade or business involving real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. However, if this irrevocable election is made, the taxpayer is then required to depreciate its real property (nonresidential real property, residential rental property and qualified improvement property) using the ADS depreciation method instead of the regular depreciation method. The ADS method of depreciation requires that the property be depreciated over longer tax lives, and bonus depreciation (which is now 100% under the TCJA) cannot be claimed. The ADS method must be used not only for assets acquired after the election is made, but for all previously acquired assets of the taxpayer that are still being depreciated. An electing real property trade or business could still use regular depreciation lives and bonus depreciation on its remaining assets, such as the personal property components of a building. Thus, even for a taxpayer that owns rental real estate and is making the election to not have the 30% limitation apply, a cost segregation study will still provide significant tax benefits.
A farming business that has average gross receipts exceeding $25 million may also make an irrevocable election not to have this 30% interest expense limitation apply. A farming business is any trade or business involving:
- Operating a nursery or sod farm.
- Raising or harvesting trees bearing fruits, nuts or other crops or ornamental trees.
- Manufacturing, producing, growing or extracting any agricultural or horticultural product.
- Marketing agricultural or horticultural products that its patrons have manufactured, produced, grown or extracted.
- Providing supplies, equipment or services to farmers or organizations described in the prior two bullet points.
As is the case with a real property trade or business that makes this election, a farming business that makes this election is then required to depreciate any asset with a life longer than 10 years, including land improvements, barns and other farm buildings, using the ADS method of depreciation instead of regular depreciation. The ADS method must be used not only for assets acquired after the election is made, but for all previously acquired assets of the taxpayer that are still being depreciated. An electing farming business could still use regular depreciation lives and bonus depreciation on its assets that have a tax life of 10 years or less.
There are numerous outstanding questions on the practical application of this new interest limitation and the corresponding exceptions. While we wait for the IRS to release further guidance, taxpayers should model their 2018 tax liability by taking into consideration the application of this limitation as well as the net tax impact of electing out of the limitation if they are a real estate or farming business. Once guidance is available, taxpayers that are subject to the interest limitation will need to determine their after-tax cost of debt financing and evaluate other alternatives such as preferred equity.