The new tax law imposes a limit on deductions for business interest for taxable years beginning in 2018. The limit, like other aspects of the law, has raised some questions for taxpayers. In response, the IRS has issued temporary guidance in Notice 2018-28 that taxpayers can rely on until it releases regulations. While the guidance provides some valuable information, it also leaves some questions unanswered.
The prior-law limit rules
The prior rules were for the so-called “earnings stripping” rules. They were intended to prevent corporations from wiping out their taxable income by deducting interest payments on debt owed to certain parties.
Under prior law, corporations could not deduct disqualified interest expenses if the borrower’s debt equaled more than one and a half times its equity and if net interest expense exceeded 50% of its adjusted taxable income. Disqualified interest included interest paid or accrued to:
- Related parties when the interest was not subject to federal income tax;
- Unrelated parties in certain instances when a related party guaranteed the debt; or
- A real estate investment trust (REIT) by a REIT taxable subsidiary.
The new-law limit
For tax years beginning after 2017, the deduction for business interest incurred by both corporate and non-corporate taxpayers is limited to the sum of:
- Business interest income for the taxable year
- 30% of the taxpayer’s adjusted taxable income for the tax year; and/li>
- The taxpayer’s floor plan financing interest paid by vehicle dealers for the tax year.
The limit applies to all taxpayers, except those with average annual gross receipts of $25 million or less, as well as real estate or farming businesses that make an election subjecting certain assets to longer depreciation (as discussed below).
The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limitation.
Treatment of pre-2018 interest carryforwards
The IRS announced that future regulations will address interest carryforwards from the last taxable year under the old law to the first taxable year under the new law. The business interest that is carried forward will be subject to potential disallowance under amended Section 163(j) in the same manner as any other business interest otherwise paid or accrued under the new law.
The IRS also promised the regulations would address the treatment of pre-2018 business interest under the base erosion and anti-abuse tax (new Section 59A). The base erosion tax applies only to businesses with average annual gross receipts of at least $500 million.
C-corporation business interest income and expense
The new regulations will clarify that, for purposes of the new Section 163(j), all interest paid or accrued on a C-Corporation’s debt is business interest. Also, all interest on debt held by a C-Corporation and that is not included in its gross income is business interest income.
For interest paid, accrued or includable in gross income by a non-corporate entity (for example, a partnership) in which the C-Corporation holds an interest, the regulations will clarify that the interest expense limits will not affect the corporation’s earnings and profits.
Treatment of consolidated groups
For groups of affiliated corporations that file a consolidated tax return, the new regulations will apply the business interest deduction limit at the group level. The regulations also will address the allocation of the limit among group members, the treatment of carryforwards when a member leaves the group and the treatment of a new group member’s carryforwards.
The regulations are not expected to treat an affiliated group that does not file a consolidated tax return as a single taxpayer for purposes of the interest expense deduction limit.
Electing to be exempt from the interest expense deduction limit
As mentioned above, real estate and farm businesses can make an election out of the Section 163(j) interest expense limit in exchange for less favorable depreciation deductions.
The election requires use of the alternative depreciation system (ADS) for certain property (generally, real or farm property with a recovery period of ten years or more). ADS requires depreciation over longer periods. The impact on an asset’s depreciable life can be larger or smaller depending on the asset. A larger consideration may be that electing businesses cannot claim first-year bonus depreciation on property to which the election applies.
Businesses should weigh the advantage of avoiding the interest expense deduction limit by making the election against the detriment of slower depreciation deductions, if the election is made.
The IRS has requested comments on the rules outlined in its interim guidance. Acknowledging the many unanswered questions, it also requested comments on which issues should be addressed next. Comments are due by May 31, 2018.