On Nov. 26, the IRS released the long-awaited proposed regulations on the new 30 percent interest expense limitation under Section 163(j) effective for tax years beginning on or after Jan. 1, 2018. Generally, the new Section 163(j) limits trade or business interest expense deductions to interest income plus 30 percent of adjusted taxable income (ATI). ATI is taxable income with the following additions through the 2021 tax year:
Farming and real estate trades or businesses can elect to give up bonus depreciation to avoid the application of the 163(j) limitation. Special rules apply to utilities, auto dealers with floor plan financing interest, regulated investment companies, and real estate investment trusts. The limitation generally applies to businesses with gross receipts in excess of $25 million. The gross receipts of commonly controlled businesses are generally aggregated for purposes of the $25 million gross receipts test.
- Items not properly allocable to a trade or business
- Business interest expense
- Business interest income
- Net operating loss deductions
- Deductions for qualified business income under Section 199A
- Depreciation, amortization, and depletion
Farming and real estate trades or businesses can elect to give up bonus depreciation to avoid the application of the 163(j) limitation. Special rules apply to utilities, auto dealers with floor plan financing interest, regulated investment companies, and real estate investment trusts. The limitation generally applies to businesses with gross receipts in excess of $25 million. The gross receipts of commonly controlled businesses are generally aggregated for purposes of the $25 million gross receipts test.
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The regulations broadly define interest as an amount paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument, contractual arrangement, or a series of transactions including, but not limited to:
- Qualified stated interest
- Original issue discount (OID)
- Acquisition discount
- OID on stripped bonds and coupons
- Market discount under Sections 1276(a) or 1278(b)
- Repurchase premiums to the extent deductible by the issuer
- Swaps with significant nonperiodic payments
- Amounts affecting a taxpayer’s effective cost of borrowing, including payments on notional principal contracts used to manage interest-rate exposures with respect to debt instruments
- Debt issuance costs amortized under Treasury Regulation 1.446-5, which are treated as interest expense of the issuer
- Any guaranteed payments for the use of capital under Section 707(c), which are treated as interest
- Factoring income
For C corporations:
- All interest received is trade or business interest income.
- All interest paid is trade or business interest expense.
- All items of income, gain, and deduction (other than interest income and expense) are properly allocable to a trade or business and a component of adjusted taxable income.
- Investment interest expense allocated to a C-corporation partner by a partnership is recharacterized as trade or business interest expense for the C-corporation partner.
- Interest paid or accrued reduces earnings and profits in the year paid or accrued, even if the deduction is deferred under Section 163(j).
- Consolidated groups are treated as a single taxpayer, and a methodology similar to the net operating loss rules of Treasury Regulation 1.1502-21 is used to allocate the excess limitation. Interest on intercompany obligations is ignored.
For partnerships:
- Key definitions:
- Excess business interest income is the amount by which a partnership’s or S corporation’s business interest income exceeds its business interest expense in a taxable year.
- Excess business interest expense is the amount of disallowed business interest expense of the partnership for a taxable year.
- Excess taxable income generally is the excess of ATI over the allowable interest deduction.
- The limitation is determined at the entity level for partnerships and S corporations.
- An 11-step process is required to determine the allocation of interest to the partners in a partnership.
- A partner’s ATI generally is determined without regard to the income of the pass-through entity, but it is increased by the excess taxable income from the partnership.
- Any excess business interest expense from a partnership is carryforward available to the partner, not the partnership, and can be used to offset excess taxable income or excess business interest income from that partnership in future years.
- A partner’s basis in the partnership is reduced, but not below zero, by excess business interest expense.
- If a partner disposes all or substantially all of a partnership interest (whether by sale, exchange, or redemption), the adjusted basis of the partnership interest is increased immediately before the disposition by the remaining excess business interest expense carryforward.
- Guidance on the treatment of excess business interest expense in tiered partnerships has been reserved.
For S corporations:
- Unlike a partnership, any interest in excess of the Section 163(j) limit is carried forward by the partnership, not the partner.
Electing real property and farming trades or businesses:
- The proposed regulations provide the mechanics for a real property or farming business to elect out of the application of the Section 163(j) rules. If this election is made, the trade or business is required to depreciate its property under the alternative depreciation system. The election must be made on a timely filed return.
- The regulation package also includes proposed regulations under Section 469, which modifies the definition of a real property trade or businesses.
