Historically, business interest has generally been deductible for income tax purposes. There are limits on the deduction of personal interest and investment interest, but business interest was generally deductible. There was a narrow-earnings-stripping limitation that applied to corporations and denied a deduction for business interest to a related person who was not subject to U.S. tax on the corresponding interest income. But even that limitation applied only if the corporation had a debt-to-equity ratio greater than 1.5 to 1.
The TCJA eliminated the narrow-earnings-stripping limitation and introduced a new, much broader limitation on the deduction of business interest expense. Under this new rule, the deduction of business interest is limited to the sum of: (a) the taxpayer’s business interest income, (b) 30% of the taxpayer’s adjusted taxable income (but not less than zero), and (c) any floor plan financing interest paid by vehicle dealers.
This limitation applies at the taxpayer level: sole proprietor, single-member LLC, S corporation, C corporation (including a REIT) or any entity taxed as a partnership. For a taxpayer that isn’t a corporation or a partnership, such as a sole proprietorship or single-member LLC), the gross receipts test is applied as if the taxpayer were a corporation or partnership. For an affiliated group of corporations that files a consolidated return, the limitation applies at the consolidated tax return filing level.
Business interest expense on debt existing prior to the effective date of the TCJA is not grandfathered and therefore is not exempted from this new 30% limitation. In addition, this limitation applies after other interest disallowance, deferral, capitalization or other limitation provisions are first applied. Thus, the limitation does not apply to interest that is required to be capitalized under the construction period interest rules for self-constructed property. It also does not apply to accrued interest that is not currently deductible by an accrual basis taxpayer because it is payable to a related party that utilizes the cash method of accounting.
Adjusted taxable income is defined as taxable income computed without regard to:
- Any items of income, gain, deduction or loss that are not related to a trade or business. (For example, gain from the sale of an asset held for investment would be ignored, but Sec. 1231 gain from the sale of a business asset would be included.)
- Any business interest income or business interest expense.
- Any net operating loss.
- Any deduction under new Sec. 199A (the 20% pass-through deduction).
- The deduction of depreciation, depletion and amortization (but only for tax years beginning before January 1, 2022).
Any interest expense that is disallowed under this provision is carried forward indefinitely to subsequent tax years, when it will again be subject to the same 30% limitation.
- In the case of all entities other than partnerships, the disallowed interest carries forward at the taxpayer level (sole proprietor, single-member LLC, S corporation and C corporation). It appears that in the case of corporate ownership changes, any interest expense carryover would be subject to the Sec. 382 limits on the use of loss carryovers.
- In the case of an entity taxed as a partnership, the disallowed business interest from the partnership’s calculation is passed through to the partners and then carries forward at their level. Complicated rules then determine the partners’ ability to deduct that carryforward interest in subsequent years against excess taxable income allocated to the partners from the partnership that generated the excess business interest expense. The partners’ basis in their partnership interest is also required to be reduced by the amount of any disallowed interest that is passed through to them from the partnership, regardless of whether the partners can deduct that interest expense currently.
- If partners sell their partnership interest before they are able to deduct the excess interest passed through to them from the partnership, they are allowed to increase their tax basis in their partnership interest by the amount of that unused interest. While this ensures that the taxpayers receive at least some tax benefit from the excess interest, it has the effect of converting what would otherwise be an ordinary deduction for interest expense into a less valuable, reduced capital gain on the sale of the partnership interest. Needless to say, this provision clearly adds a whole new level of complexity to the already complex tax issues that apply to partnerships and partnership interests.