The Tax Cuts and Jobs Act (TCJA) is generally viewed as providing opportunities to reduce Federal income taxes paid with respect to business activities. For the most part, that is true. Regular corporations now have a fixed tax rate of 21 percent. S corporations and other pass-through businesses, with some exceptions, now receive a 20 percent deduction that can effectively reduce the top marginal tax rate on such income to 29.6 percent.
However, there are some potentially negative components of the TCJA. One involves an important cost for many businesses – interest expense.
Under new provisions found in Internal Revenue Code section 163(j), the amount of business interest expense which can be deducted in the current taxable year is limited to the sum of:
- The taxpayer’s business interest income,
- 30 percent of the taxpayer’s adjusted taxable income, and
- If applicable, the taxpayer’s floor plan financing interest expense.
As with a number of new provisions under TCJA, there are exceptions, which include:
- Businesses with average gross receipts of less than $25 million which are not characterized as tax shelters,
- Businesses that are providing personal services as an employee, and
- Electing small real property, farming, and certain regulated utility businesses.
Should a portion of interest expense not be currently deductible, the amount can be carried forward indefinitely.
The breadth of implications of these new rules is becoming more apparent as the current cycle of tax return preparation is being carried out. Presumably, there will be some surprises in the application of these rules and, at a minimum, questions will arise as to how to handle the associated tax reporting.
One important starting point in gaining a grasp of the impact lies in the calculation of “adjusted taxable income,” which begins with taxable income that is adjusted for the following items:
- Any income items not properly allocable to a trade or business,
- Business interest income and expense,
- A net operating loss deduction, if applicable,
- The new 20 percent deduction for qualifying business income,
- Depreciation, amortization, or depletion deductions (but only for years through 2022) and subject to important restrictions for companies subject to “uniform capitalization” provisions of the tax code, and
- Depreciation recapture upon the sale of business property, if applicable.
While the underlying complexities of the new IRC 163(j) provisions are beyond the scope of this article, a few takeaways are worthy of note.
Small Business Exception
The $25 million exception is not measured on a stand-alone basis for each business but rather by including all businesses treated as under common control. Where such grouping results in a potential failure to meet the $25 million limit, there may be opportunities to modify ownership to exclude one or more entities. Or, there may be opportunities to bunch revenues in particular tax periods to provide some temporary relief. Care should also be taken with respect to the definition of a “tax shelter,” which may have broader application than one may think.
Electing Out for a Real Property Trade or Business
If the $25 million exception is not met, a real property trade or business may still be eligible to elect out of the IRC 163(j) provisions by switching to the Alternative Depreciation System in connection with depreciation deductions. A real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, or conversion business activity in addition to rental, leasing, property management, or real property brokerage business. This is a broad scope of potential candidates for election out. Both the immediate as well as longer-term implications of the stretching out of depreciation deductions should be compared with the current and longer-term benefits of eliminating an interest expense limitation.
While proposed regulations and revenue procedure that have been issued by the IRS provide a basic outline relating to many issues arising under the new IRC 163(j) provisions, further technical pronouncements will be required and ultimately the courts will have opportunities to weigh in. Owners of businesses potentially impacted by the new provisions should be discussing current operating activities involving debt financing as well as plans for the future as a response to the new rules.
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