Recently, the IRS proposed regulations that provide new guidance on the limitation for business interest expense deductions. The limitation, found in Internal Revenue Code Section 163(j), was added by the Tax Cuts and Jobs Act (TCJA). Investment partnerships may find identifying and tracking business interest subject to the limit, as well as calculating the limitation itself, challenging.
Understanding the Section 163(j) Limitation
Section 163(j) limits a taxpayer’s business interest expense deduction to the sum of:
- The taxpayer’s business interest income,
- 30% of the taxpayer’s adjusted taxable income (ATI), and
- The taxpayer’s floor plan financing interest.
This last item is relevant only to motor vehicle dealers. Most taxpayers can deduct their net business interest expense (interest expense less interest income) up to 30% of ATI. Disallowed interest expense may be carried forward indefinitely and deducted in subsequent years, subject to 163(j) limitations. The business interest expense deduction limitation applies only to business interest and not to investment interest.
To determine ATI, a taxpayer adjusts taxable income by eliminating the following items from the calculation:
- Income, gain, deduction, or loss items that aren’t properly allocable to a trade or business,
- Business interest expense and income,
- Net operating loss deductions,
- The 20% “pass-through” deduction under Section 199A, and
- For tax years beginning before January 1, 2022, deductions for depreciation, amortization, or depletion. (For tax years beginning on or after January 1, 2022, these deductions will be subtracted when computing ATI. Such subtractions reduce business interest deductions for many taxpayers.)
Certain taxpayers, such as real estate and farming businesses that elect to opt out of the new rules, are excluded from the business interest expense deduction limitation. However, businesses that make the election, which is irrevocable, must forgo certain accelerated depreciation benefits.
Also, the limitation doesn’t apply to taxpayers (other than “tax shelters”) with average annual gross receipts of $25 million or less for the preceding three years. Some related businesses must aggregate their gross receipts for purposes of this exception. Tax shelters include partnerships in which more than 35% of losses are allocable to limited partners, which will disqualify many investment partnerships from claiming the exception.
Know Key Terms and Rules
The proposed regulations explain several key terms and rules for calculating the business interest expense deduction limitation for various types of business entities. These are:
Interest. Interest is defined broadly to encompass not only amounts traditionally treated as interest under the tax code, but also amounts that are “closely related to interest and that affect the economic yield or cost of funds of a transaction involving interest, but that may not be compensation for the use or forbearance of money on a stand-alone basis.” This includes income, deduction, gain, or loss from a transaction used to hedge an interest-bearing asset or liability; substitute interest payments; commitment fees; debt issuance costs; and guaranteed payments by partnerships for the use of capital.
Keep in mind that the proposed regulations include an anti-avoidance rule. This rule requires taxpayers to treat certain expenses or losses as interest if they’re “predominantly incurred in consideration of the time value of money” in a transaction or series of integrated or related transactions.
Application to partnerships. The business interest expense deduction limitation is first applied at the partnership level. Any allowable business interest deduction expense is taken into account when determining the partnership’s nonseparately-stated taxable income or loss. A partner’s ATI includes the partner’s distributive share of the partnership’s “excess taxable income”, the excess of the partnership’s business interest expense limitation over its actual business interest expense. However, to prevent double-counting, a partner’s ATI doesn’t include the partner’s distributive share of income, gain, deduction, or loss.
If a portion of a partnership’s business interest expense is disallowed under the Section 163(j) limitation, the “excess business interest expense” isn’t carried forward by the partnership. Instead, it’s allocated to the partners, who may offset it in subsequent years against any excess taxable income allocated to them from the same partnership.
The proposed regulations outline a complex, 11-step procedure for calculating a partner’s share of the partnership’s ATI, excess business interest expense, excess taxable income, and other items. They also set forth rules on how to adjust a partner’s basis and treat disallowed business interest expense carryforwards.
Investor vs. trader funds. In general, the Section 163(j) limitation doesn’t apply to “investor funds” that buy and hold assets. These funds are not considered to be engaged in a trade or business, so their interest expense is considered investment interest rather than business interest. Also, a noncorporate taxpayer’s investment interest expense deductions are usually limited to the taxpayer’s net investment income for the year. On the other hand, “trader funds,” those that make frequent trades of securities or commodities, are typically considered to be engaged in a trade or business. Therefore, they are subject to the limitation.
A Word of Caution for Trader Fund Partners
One surprising result of the proposed regulations is their potential impact on a trader fund’s limited partners. Generally, business interest expense allocated to a trader fund’s noncorporate limited partners who don’t materially participate in the fund’s activities is considered investment interest. However, according to the preamble to the proposed regulations, this interest may be subject to two limitations:
- Section 163(j) limitation, which would apply at the partnership level, and
- Section 163(d) limitation, which would apply at the partner level to the same interest expense.
If your investment partnership uses leverage or otherwise generates business interest expense, review the proposed regulations then evaluate how they’ll affect your tax bill. Be sure to touch base with your Untracht Early advisor for news on the latest developments, as changes to the final regulations could affect your analysis.