Final business interest expense limitation regulations

| 8/6/2020
Final business interest expense limitation regulations

On July 28, the U.S. Department of the Treasury and the IRS released long-awaited final regulations regarding the limitation on deduction of business interest expense under IRC Section 163(j) as amended by the Tax Cuts and Jobs Act of 2017 and the Coronavirus Aid, Relief, and Economic Security Act.

The final regulations adopt the proposed regulations issued in 2018 with significant revisions in response to comments provided. In addition to other changes, the final regulations:

  • Allow cost of goods sold depreciation to be added back in calculating adjusted taxable income (ATI) for taxable years beginning before Jan. 1, 2022. Such depreciation is added back to ATI in the year capitalized to inventory even if some of the depreciation remains in ending inventory and has not been recovered through cost of goods sold.
  • Narrow the definition of “interest,” which is expected to translate to overall larger business interest expense deductions. Notably, the final regulations exclude items such as debt issuance costs, loan commitment fees, substitute interest payments, guaranteed payments for the use of capital, and hedging gains or losses that affect the yield of a debt instrument, unless the anti-avoidance rule applies.
  • Allow a pro rata basis increase upon disposing a partial interest in a partnership for any remaining excess business interest expense (EBIE) previously allocated to the partner. Under the proposed regulations, the basis increase only occurred upon disposing of all or substantially all of the partnership interest.
  • Provide that if a partner or an S-corporation shareholder is allocated business interest expense from a partnership or an S corporation that meets the small-business exemption for the taxable year, such business interest expense is not subject to a Section 163(j) limitation at the partner’s or shareholder’s level.
  • Clarify the anti-abuse rules for electing real property trades or businesses.
  • Clarify the definition of "real property trade or business," particularly with respect to management and operations of real property.
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Treasury and the IRS simultaneously issued additional proposed regulations under Section 163(j) that provide new guidance on various issues not addressed in the final regulations, including:

  • New rules for the treatment of interest expense under Section 163(j) from debt-financed distributions, similar to those provided under Notice 89-35.
  • A rule for treating EBIE in tiered partnerships using an entity approach that does not allocate EBIE through an upper-tier partnership to its partners.
  • A special rule for self-charged lending transactions involving a partner who lends money to a partnership and is allocated EBIE from the same partnership. This rule allows the partner to reclassify its corresponding interest income as excess business interest income to the extent of the partner’s EBIE allocated during the taxable year.
  • Reproposed rules regarding the application of Section 163(j) to U.S. shareholders of controlled foreign corporations, nonresident alien individuals, and foreign corporations with effectively connected income in the United States. These rules are sufficiently different from the previously issued proposed regulations.
  • Clarification that a syndicate (which is considered a tax shelter) includes an entity that is not a C corporation if more than 35% of the losses of such entity during the taxable year are allocated (rather than allocable) to limited partners or limited entrepreneurs.

Additionally, the IRS issued Notice 2020-59, which provides a safe harbor for a trade or business that manages or operates a qualified residential living facility to be treated as a real property trade or business for purposes of Section 163(j). The IRS also published frequently asked questions on its website providing an overview of the aggregation rules that apply for purposes of the gross receipts test, which is used to determine whether a taxpayer meets the small-business exemption under Section 163(j), among other provisions.

The final regulations generally are effective for taxable years beginning on or after 60 days after the regulations are published in the Federal Register, which is still pending as of the date of this article. The final regulations may be relied upon retroactively for tax years beginning after Dec. 31, 2017, and before the effective date, provided they are consistently applied by the taxpayer and its related parties. Alternatively, taxpayers may rely on the original proposed regulations before the final regulations become effective, provided they are applied consistently. Taxpayers also generally may rely on the new proposed regulations before they become final and effective, provided they are applied consistently.

Businesses should evaluate how the final regulations will affect their interest expense deductions and consider whether amendment of prior year returns to apply the final regulations might be advantageous.

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Andrew Eisinger
Howard Wagner - social
Howard Wagner
Partner, National Tax Services