Sikich Series on Tax Reform: IRS Issues Proposed Regulations on New Limits for Deducting Business Interest Expense

Among the stated principles in last year’s tax reform legislation, the “Tax Cuts and Jobs Act” (TCJA) was to promote economic growth, create new jobs, and make U.S. companies more competitive with companies around the world. Some of the key tax cut provisions in the bill were to lower tax rates for businesses, expand deductions for Capex by raising the “bonus depreciation” from 50% to 100%; and provide an entire new regime for international taxation. There were several TCJA changes, however, they were not tax savings measures; rather they will result in lost deductions and higher taxes. One such change involves the new rules for the deduction of business interest expense.

Background

The TCJA adopts a new limitation on the deductibility of business interest expense. The new rule will limit the deductibility of business interest to 30% of “Adjusted Taxable Income” (“ATI”). ATI is like “EBITDA”, and is defined as the taxable income of the business, but it does not include: any business interest income of the company; any Net Operating Loss (NOL) of the business; any tax depreciation or amortization deductions of the company; and the deductible business interest expense. The 30% deduction limitation (sometimes identified by its tax code reference of “Section 163(j)”) begins in 2018 and applies to many businesses, including C Corporations, and there will be added complications with any consolidated corporate group. There are also complex rules for calculating this limitation for pass-through businesses and their owners. Further, there is no transition rule or any relief for grandfathered amounts of prior debt incurred by a business. Any disallowed interest expense under this new 30% limitation carries forward indefinitely. It should also be noted that this depreciation and amortization modification indicated above will be removed after 2022, and this will lower ATI and may then result in more interest expense being disallowed.

As with most parts of the tax law there are exceptions, and this is the case with the new interest provisions. First, there is a general exception to these new interest limitation provisions for a “small business” which is defined by the new law as a business with gross receipts of less than $25,000,000 (average of prior three years’ gross receipts). Thus, a small business does not need to be concerned with these new interest limitations. There are also exceptions to these new rules for real estate businesses and agri-businesses to elect out of these new interest limitations, however, this election comes with it the cost of not being able to claim bonus depreciation. Finally, auto dealers with floor plan financing also avoid these new limits.

Proposed Regulations 

As you might expect, this new interest limitation will apply to many trades or businesses regardless of entity selection and in all industries. Thus, many businesses and tax practitioners were predicting the new IRS rules for this would be complicated. The IRS did not disappoint with the level of complexity when it released the proposed regulations on November 26, 2018. The proposed regulations under Section 163(j) run nearly 440 pages, including the preamble to the regulations (please click here to view a copy of the proposed regulations).

The proposed regulations (defined in §1.163(j)) are organized into eleven sections, and provide for the following areas:

1. Common definitions used throughout the proposed regulations.
2. General rules relating to the computation of a taxpayer’s new limitation under Section 163(j).
3. Ordering and other rules regarding the relationship of the new interest limitation and other provisions of the tax code affecting interest.
4. Rules applicable to C Corporations (including REITs, RICs, and consolidated group members) and tax-exempt corporations.
5. Rules governing the disallowed business interest expense carryforwards under the new rules for C Corporations.
6. Special rules for applying the new interest limitation to partnerships and S Corporations.
7. Rules regarding the application of the interest limitation rules to foreign corporations and their shareholders.
8. Rules regarding the application of the new interest limitations to foreign persons with effectively connected income.
9. Rules regarding elections for excepted trades or businesses, as well as a safe harbor for certain REITs.
10. Rules to allocate expense and income between non-excepted trades or businesses and excepted trades or businesses.
11. Certain transition rules relating to the application of the new Section 163(j) limitation.

As noted above, these new interest expense regulations are comprehensive and complicated. We will provide a more thorough analysis of these at a later time. Finally, the IRS announced a new form to handle this new interest expense limitation. Form 8990 will be used to report and calculate this interest expense adjustment. A draft of the Form 8990 was recently issued by the IRS (please click here to see this draft of Form 8990).

Observations and Takeaway

This new interest limitation impacts companies that are highly leveraged, but also companies that have a “down year,” and thus this new limitation may prune their interest expense deduction. Many companies may revisit how they will finance their future business operations; whether through debt or equity, and the impact becomes more expensive as interest rates start edging up. Finally, pass-through businesses will need to address these new interest rules at both the entity level (Partnership/LLC and S Corporation) and owner level, and this will involve some complex reporting and calculation issues. Please contact your Sikich tax advisor with any questions on these new rules.