The Tax Cuts and Jobs Act (TCJA) imposes a new limit on business interest deductions for taxable years beginning in 2018. This article will focus on the new law’s application to partnerships and address its applicability to various types of investment partnerships.
The New Law Limit
For tax years beginning after 2017, the TCJA amended Section 163(j) of the Internal Revenue Code (IRC). Under the amended rules, the business interest deductions incurred by both corporate and noncorporate taxpayers is generally limited to the sum of:
- Business interest income for the taxable year, and
- 30% of the taxpayer’s adjusted taxable income for the tax year.
The limit applies to all taxpayers, except those with average annual gross receipts of $25 million or less, real estate or farming businesses that elect to exempt themselves, and certain regulated utilities.
The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limit. Excess limit, however, cannot be carried forward.
“Business interest” means any interest paid or accrued on indebtedness properly allocable to a trade or business. Any amount treated as interest under the IRC is interest for purposes of the business interest limitation. Business interest does not include investment interest within the meaning of IRC Sec. 163(d).
Business Interest Income
“Business interest income” means the amount of interest includible in the taxpayer’s gross income for the tax year that’s properly allocable to a trade or business. The term does not include investment income within the meaning of IRC Sec. 163(d).
Adjusted Taxable Income
“Adjusted taxable income” means the taxpayer’s taxable income computed without regard to:
- any item of income, gain, deduction, or loss that is not properly allocable to a trade or business;
- any business interest expense or business interest income;
- any net operating loss (NOL) deduction;
- any qualified business income deduction allowed under Code Sec. 199A; and
- (for tax years beginning before Jan. 1, 2022) any deduction allowable for depreciation, amortization, or depletion.
The business interest limitation applies to partnerships at the partnership level. Any business interest deductions are considered in determining the partnership’s nonseparately stated taxable income or loss.
Each partner’s adjusted taxable income is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss. This rule is intended to prevent double counting. Without such a rule, the same dollars of adjusted taxable income of a partnership could generate additional interest deductions as the income is passed through to the partners.
Each partner’s adjusted taxable income is increased by the partner’s distributive share of the partnership’s excess taxable income. A partnership’s “excess taxable income” is equal to a percentage of the entity’s adjusted taxable income for the year. The percentage is:
- the excess of 30% of the partnership’s adjusted taxable income over the amount (if any) by which the partnership’s business interest exceeds its business interest income, over
- 30% of the partnership’s adjusted taxable income.
This rule allows a partner to deduct additional interest expense the partner may have paid or incurred to the extent the partnership could have deducted more business interest. For this purpose, a partner’s distributive share of partnership excess taxable income is determined in the same manner as the partner’s distributive share of the partnership’s nonseparately stated taxable income or loss.
Business interest that is not deductible by a partnership for any tax year is not treated as business interest paid or accrued by the partnership in the next tax year. Rather, it is treated as excess business interest that is allocated to each partner in the same manner as the partnership’s nonseparately stated taxable income or loss.
Any excess business interest that is allocated to a partner from a partnership under this rule for any tax year is treated as business interest paid or accrued by the partner in the next succeeding tax year in which the partner is allocated excess taxable income from the partnership, but only to the extent of the excess taxable income.
Partner’s basis adjustments
A partner’s adjusted basis in a partnership interest is reduced (but not below zero) by the amount of excess business interest allocated to the partner, even though the carryforward does not give rise to a partner deduction in the year of the basis reduction. However, the partner’s deduction in a future year for interest carried forward does not reduce the partner’s basis in the partnership interest.
Application to Investment Partnerships
IRC Sec. 163(j) applies as trader funds are deemed to be engaged in a trade or business. However, limited partners who do not materially participate should not be impacted as their allocable share of any interest expense is investment interest under IRC Sec. 163(d).
The general partner’s (GP) allocable share of any interest expense would be subject to limitation under IRC Sec. 163(j) since the GP’s interest expense is viewed as trade or business interest expense due to material participation.
IRC Sec. 163(j) will not apply to investor funds as they are not deemed to be engaged in a trade or business. Thus, any interest expense is investment interest expense, and not business interest expense.
Loan origination funds
IRC Sec. 163(j) applies, as loan origination is considered a trade or business. However, such funds will presumably have sufficient interest income such that IRC Sec. 163(j) should not be impactful.
Private equity funds
IRC Sec. 163(j) should not apply, as private equity funds are generally not deemed to be engaged in a trade or business.
Real estate funds
If the fund is a trader fund, the GP can be impacted. If the fund is an investor fund, IRC 163(j) will not apply.
In Notice 2018-28, issued April 2, 2018, the Internal Revenue Service and Department of the Treasury announced their intent to issue proposed regulations under IRC Sec. 163(j). The proposed regulations are expected to include clarification and rules governing the calculation of the annual business interest deductions by a partner in a partnership.
If you have any questions regarding how the new limit impacts your business interest deductions, contact your Untracht Early advisor.