New Tax Law Limits Business Interest Expense Deductions
Kenneth Tornheim, CPA, CFE
Under the Tax Cuts and Jobs Act (TCJA), starting with tax years beginning in 2018, manufacturers with more than $25 million average annual gross receipts will generally be able to deduct less interest expense than they could have deducted under prior law. Here are some details about this new limitation.
Nuts and bolts
In general, businesses can deduct “ordinary and necessary” expenses incurred in operating a business, including raw materials, labor and overhead expenses. However, under the TCJA, business interest expense deductions for tax years starting in 2018 and beyond will be limited to the sum of: 1) business interest income, 2) 30% of adjusted taxable income (ATI) and 3) interest on any floor-plan financing (for vehicle dealers).
Businesses with $25 million or less in average annual gross receipts for the preceding three tax years are exempt from the limitation. Farming and real estate ventures with average annual gross receipts in excess of $25 million can also elect out of the limitation in exchange for lower depreciation deductions, but the options to elect out generally do not apply to manufacturers.
The limitation on deducting business interest expense could have an adverse effect on larger, capital-intensive firms that borrow money to purchase equipment, machines, computers and other fixed assets.
Manufacturers do not usually earn much interest income or use floor-plan financing. Therefore, their interest expense deduction will generally be limited to 30% of ATI.
ATI starts with taxable income calculated without considering the business interest expense limitation. That amount is then adjusted by:
- Excluding any non-business income, gains, deductions or losses;
- Subtracting business interest income;
- Adding back business interest expense;
- Adding back any net operating loss (NOL) deduction;
- Adding back the new deduction for up to 20% of qualified business income (QBI) from a pass-through business entity (such as a sole proprietorship, partnership, limited liability company or S corporation); and
- Adding back deductions for depreciation, amortization and depletion for tax years beginning before 2022.
For tax years beginning in 2022 and beyond, depreciation, amortization and depletion deductions will no longer be added back in calculating ATI, which will reduce the interest expense deduction limit for companies with depreciation deductions.
What happens to the interest expense that is disallowed under the limitation rule? It is not forgone. Rather, it is carried forward indefinitely to future tax years. Then, it is treated as business interest expense incurred in the carryforward year.
The interest expense limitation could impact whether larger manufacturers decide to pay cash or take out loans for equipment purchases or lease these items. This decision also might be affected by rising interest rates and the new accounting standard for leases that goes into effect for public companies in 2019 and private companies a year later.
The new accounting standard requires companies to report leased assets on their balance sheets. Compared to the current accounting treatment, this could adversely affect a company’s debt ratios and loan covenants.
Digesting the new rules
The TCJA brings sweeping changes to the tax code, and not all the changes are positive for businesses and their owners. The new limitation on business interest expense deductions could be especially unfavorable to larger manufacturers with significant debt on their balance sheets. Contact your tax advisor to understand how the new limitation on deductible business interest is likely to affect your business.
Sidebar: Calculating deductible interest expense under the new limitation
Widgets Makers is a manufacturer with $35 million in average annual sales over the last three tax years. For 2018, Widgets has ATI of $4.5 million after adding back $2 million of business interest expense and $1 million of depreciation. Widgets is a C corporation, so it cannot take the qualified business income (QBI) deduction. How much interest expense can Widgets deduct in 2018?
The company’s interest expense deduction for 2018 is limited to $1.35 million (30% × $4.5 million of ATI). The $650,000 of disallowed interest expense ($2 million – $1.35 million) is carried forward to future tax years.
Now, let’s assume the same facts for 2022, when the add-back for depreciation, amortization and depletion deductions is no longer permitted. How much interest expense will Widgets be allowed to deduct in 2022?
For 2022, Widgets’ ATI will equal $3.5 million, because the $1 million of depreciation is not added back in calculating ATI. So, the company’s interest expense deduction for 2022 is limited to $1.05 million (30% × $3.5 million of ATI). The $950,000 of disallowed interest expense ($2 million – $1.05 million) is carried forward to future tax years.
For example, assume the same basic facts for 2023, except Widgets has only $900,000 of interest expense for 2023. The company’s ATI is $3.5 million (the same as for 2022). So, the company’s interest expense limitation for 2023 is $1.05 million (30% × $3.5 million of ATI).
In this case, the company can deduct all the interest incurred in 2023 ($900,000). Plus, it can deduct $150,000 of the disallowed interest expense carryforward from 2022. That results in a total allowable interest expense deduction of $1.05 million for 2023 ($900,000 + $150,000).
Got Operating Problems? Employees May Have Solutions
Adam Guldan, CPA, MST
Management does not have all the answers — and they may be aware of only a fraction of the issues. Employees of all levels can be used as resources to provide simple and effective solutions. However, in order to get this feedback, employees may need encouragement and incentives to speak up.
Learn from frontline workers
For example, assume that a company lost two key accounts last year. This created some turmoil at the company and left management looking for answers. The various departments looked to pass fault on each other. The sales manager blamed it on quality control. The plant manager blamed procurement for switching suppliers. Marketing thought prices were high compared to its competitors.
The owner decided to survey factory workers and customer service representatives to help improve customer retention. Instead of playing the blame game, these workers had practical solutions.
Based on employee suggestions, the owner realigned workflow on the production line. These improvements eliminated bottlenecks and sped up the manufacturing cycle time. Then negotiated a long-term contract with a low-cost vendor that was willing to supply raw materials on a just-in-time basis. This lowered inventory carrying costs by 4% and improved the gross margin by 6%.
The owner also received a a fraud tip that a disgruntled former salesperson had sold stolen customer lists to an unethical competitor. The owner spoke with their attorney about investigating the breach and implemented stronger controls to prevent such an occurrence in the future.
Because of these changes, the company’s profits are up in the second quarter, and no additional customers have been lost.
The key is to incentivize and motivate employees to communicate. Some companies implement a cash reward program for suggestions that add value. Consider these guidelines:
- Be Goal-Oriented
You do not want to be inundated with complaints. Make it clear that you are looking for ideas that promote the company goals and add long-term value.
- Provide a Measurable Benchmark
Tie rewards to financial results, such as cost savings or revenue growth. For example, if a suggestion saves the company $40,000, a 2% reward is $800.
- Acknowledge Contributions
Announce people who receive rewards at a company-wide meeting or award ceremony. This shows employees that the incentive program is important to your organization.
- Go Beyond Surveys
Solicit feedback from a variety of sources, including emails, bulletin boards, hotlines, newsletters and departmental meetings.
Listen and Implement Changes
Everyone wants to be heard, regardless of position or experience level at the company. When your employees have the courage and initiative to make suggestions, pay attention and acknowledge their input, even if you decide not to act. Doing so can broaden your management team’s perspective, empower workers and improve productivity. Most of all employees and management can take pride in the fact they are contributing to a successful future.