The TCJA Limit On Interest Expense Deductions
Does it affect your business?
The Tax Cuts and Jobs Act (TCJA) introduced a variety of tax benefits for businesses. Among other things, it slashed corporate income tax rates, temporarily reduced individual rates and established a new 20% deduction for certain pass-through income. At the same time, the Act placed limits on several tax breaks, including the amount of interest expense a business may deduct.
“Small” businesses are exempt
Before you worry about the mechanics of the business interest limit, you should determine whether you qualify for the small business exemption. Businesses whose average annual gross receipts for the preceding three years are $25 million or less are not subject to the limit and, with a few rare exceptions, may deduct all their business interest expense.
Keep in mind that some related businesses must combine their gross receipts for purposes of the $25 million test. So, you cannot avoid the limit by splitting a larger business into separate entities.
How it works
If your gross receipts exceed the $25 million threshold, then under the TCJA, your annual deduction for business interest expense is limited to the sum of:
- Your business interest income;
- 30% of your adjusted taxable income; and
- Your floor-plan financing interest (for dealers of some motor vehicles, boats and farm equipment).
Put another way, aside from floor-plan financing, your net interest expense — that is, interest expense less interest income — is deductible up to 30% of adjusted taxable income. Note: The limit does not apply to investment interest.
Your adjusted taxable income is your taxable income without regard to:
- Nonbusiness income;
- Business interest expense or income;
- The amount of any net operating loss deduction;
- The 20% pass-through deduction; and
- Depreciation, amortization or depletion.
The last adjustment expires at the end of 2021. In other words, beginning in 2022, adjusted taxable income will be reduced by the amount of depreciation, amortization and depletion, limiting business interest deductions even further.
Disallowed interest expense may be carried forward indefinitely and deducted in subsequent years, subject to the same limits.
Real property and farming businesses may opt out
Some real property businesses — including development, construction, management, leasing and brokerage — may elect not to apply the business interest limit. The trade-off is that these businesses must forgo 100% bonus depreciation and depreciate specific assets over longer periods.
Once made, the election is irrevocable. A similar election is available for farming businesses.
What about pass-through entities?
A complete discussion of the application of the business interest limit to pass-through entities is beyond the scope of this article. But, in general, the limit applies at the entity level.
For a partnership, any interest above the limit is passed through to the partners and carried forward until it can be offset against “excess taxable income” allocated to the partners. Excess taxable income is essentially partnership income in each year that is sufficient to support interest deductions beyond the partnership’s actual interest expense for that year.
For an S corporation, excess interest is carried over at the entity level until the corporation generates sufficient income to absorb it.
Next steps to take
If your average annual gross receipts exceed $25 million, estimate the impact of the business interest limit on your tax bill. If it is significant, consider strategies for softening the blow, such as shifting from debt to equity financing. If you have a real property or farming business, weigh the costs and benefits of opting out of the interest limit.
Excess Business Loss Rule May Be Unfavorable To You
Sole proprietorships and pass-through entity structures, which include partnerships, S corporations and certain limited liability companies (LLCs), provide owners with some valuable tax benefits, such as avoidance of double taxation and the potential ability to deduct losses from the business on their individual tax returns. However, the Tax Cuts and Jobs Act (TCJA) has placed some limitations on deducting business losses. Here is a look at the changes in the rules and how they might affect you.
The way it was
Before the TCJA, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they arose. That was the result unless the passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or the business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL).
Under prior law, you could carry back an NOL to the two preceding tax years. You also could carry it forward for up to 20 tax years.
The way it is now
Through 2025, the TCJA changes the rules for deducting an individual taxpayer’s business losses. Unfortunately, the changes are unfavorable to affected taxpayers.
Before we look at the changes, it is important to review how the PAL rules work. They may apply if your business is a rental operation or you do not actively participate in the business.
In general, the PAL rules allow you to deduct passive losses only to the extent you have passive income from other sources, such as positive income from other business or rental activities or gains from selling them. Passive losses that cannot be currently deducted are carried forward to future years until you either have sufficient passive income to absorb them or you sell the activity that produced the losses.
If you successfully cleared the hurdles imposed by the PAL rules, the TCJA places a new hurdle in front of you: For tax years beginning in 2018 through 2025, you cannot deduct an “excess business loss” in the current year. For 2019, an excess business loss is the excess of your aggregate business deductions for the tax year over the sum of $255,000 (or $510,000 if you are a married joint-filer) and your aggregate business income and gains for the tax year.
The excess business loss is carried forward to the following tax year and can be deducted under the rules for NOL carryforwards. For NOLs that arise in tax years ending after December 31, 2017, you generally cannot use an NOL carryforward to shelter more than 80% of your taxable income in the carryforward year (under prior law, you could usually shelter up to 100%).
In addition, NOLs that arise in tax years beginning after December 31, 2017, can’t be carried back to an earlier tax year. Instead, they can be carried forward indefinitely.
As noted, the new loss limitation rules apply after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, the loss limitation rules are irrelevant.
For business losses passed through to individuals from S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, the new loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.
The rationale underlying the new loss limitation rules is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental activities) to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that, if you have excess business losses for 2019, the requirement that such losses must be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.
If it looks like your business may generate a loss, contact us to help you determine the impact of the TCJA on your tax situation.