The Tax Cuts and Jobs Act (TCJA) added Sec. 163(j) to the tax code, imposing new limitations on deductions of business interest expense (BIE), effective for tax years beginning after 2017. The business interest expense deduction limitations provision, together with proposed regulations issued in late 2018, has significant tax implications for hedge funds and other investment partnerships. Specifically, they limit the ability of many funds and their partners to deduct BIE.
Two recent developments provide some relief from Sec. 163(j) business interest expense deduction limitations. In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily increased the limit on BIE deductions from 30% to 50% of adjusted taxable income (ATI). Then, on July 28, the Treasury Department issued final and proposed regulations providing guidance on computing the limit, including a welcome clarification regarding its application to investment partnerships classified as trader funds. However, taking advantage of the business interest expense deduction limitations relief creates new compliance challenges.
Recap on Limits
BIE is interest expense properly allocable to a trade or business. Likewise, business interest income is interest income properly allocable to a trade or business. Sec. 163(j) generally limits BIE deductions to the sum of a taxpayer’s business interest income and 30% of the taxpayer’s ATI. Vehicle dealers and other businesses that use floor plan financing may fully deduct their floor plan financing interest.
The business interest expense deduction limit applies to all taxpayers, except:
- “Small businesses,” or businesses (other than tax shelters) whose average annual gross receipts for the preceding three years are $25 million or less;
- Real estate or farming businesses that opt-out; and
- Certain regulated utilities.
ATI means taxable income. It’s calculated without regard to:
- Any item of income, gain, deduction, or loss that isn’t 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 Sec. 199A of the tax code; and
- For tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
Disallowed interest expense may be carried forward indefinitely and deducted in subsequent years, subject to Sec. 163(j) business interest expense deduction limitations in those years.
Impact on Investment Partnerships
Generally, the Sec. 163(j) business interest expense deduction limitation applies to “trader funds,” but not to “investor funds.” That’s because trader funds, whose trading activities are “frequent, regular, and continuous,” are considered to be engaged in a trade or business. Investor funds, which tend to buy and hold assets, aren’t.
The limitation is first applied at the partnership level. Any allowable BIE deductions are taken into account when determining the partnership’s non-separately stated taxable income or loss. Disallowed interest expense allocated to a partner may only be deducted by that partner in succeeding tax years to the extent the partner is allocated excess taxable income (ETI) from the same partnership. If a partner who is allocated disallowed interest expense also has ATI from other sources, the partner will not be able to deduct any of the disallowed interest expense to reduce its taxable income from other sources.
ETI occurs when the partnership’s BIE is less than its business interest expense deduction limitation under Sec. 163(j). A partner’s ATI includes the partner’s distributive share of the partnership’s excess taxable income, but to prevent double counting, it excludes the partner’s distributive share of income, gain, deduction, or loss.
Increased Business Interest Expense Deductions
The CARES Act increases the 163(j) business interest expense deduction limitation from 30% to 50% for tax years beginning in 2019 and 2020 — although taxpayers may elect not to apply the higher limitation. Taxpayers may also elect to use their 2019 ATI to calculate the limitation for the 2020 tax year, which could benefit those whose income declined in 2020.
Two special rules apply to partnerships:
- A partnership must use the 30% of ATI limitation for its 2019 tax year. For the 2020 tax year, however, the 50% limitation applies, unless the partnership opts out, and the partnership may elect to substitute 2019 ATI for 2020 ATI.
- Unless partners opt-out, they may treat 50% of any EBIE allocated to them in their 2019 tax year as automatically paid or accrued to them in their 2020 tax year. This means they can deduct that 50% regardless of their ATI. The remaining 50% is subject to normal limitations and can only be offset against allocations of excess taxable income in future years.
Note that the additional business interest expense may create a net operating loss situation, which can now be carried back five years to offset the taxable income from prior years.
Potential Relief for Trader Funds
Sec. 163(j) has had an unexpected impact on trader funds. Historically, interest expense allocated to limited partners who are passive investors has been treated as investment interest expense, which is deductible under Sec. 163(d) to the extent of the investor’s net investment income. But according to the preamble of the 2018 proposed regulations, this interest appears to be subject to two limitations: First, as BIE at the partnership level under Sec. 163(j) and again as investment interest expense at the partner level under Sec. 163(d).
Because this approach is inconsistent with Sec. 163(j), which specifies that BIE doesn’t include investment interest expense, the 2020 proposed regulations require trader funds to take a bifurcated approach. Funds will need to allocate interest expense (as well as other items of income, gain, loss, and deduction) between partners that materially participate in trading activities and those who are passive investors. Also, they will need to apply the Sec 163(j) business interest expense deduction limitation only to interest expense allocable to material participants. Interest expense allocable to passive investors will be subject to the Sec. 163(d) limitation at the partner level.
Distinguishing between passive investors and material participants can be challenging. The passive activity loss rules permit taxpayers to treat certain otherwise passive activities as nonpassive by grouping them with activities in which they materially participate. To relieve funds from the burden of determining whether partners have made such groupings, the proposed regulations provide that passive investments in trader funds may not be grouped with other activities.
Make the Most of Deductions
The changes described above are welcome news for trader funds subject to the 163(j) limitation. However, they also impose new compliance burdens. To make the most of business interest expense deductions, analysis should be performed to determine the best tax strategy and to ensure that proper documentation is in place to track interest expense and to allocate it between passive and nonpassive investors. Contact your Untracht Early advisor to learn more.