Traps for Manufacturers Under Interest Expense Proposed Regulations

| 1/31/2019
The proposed regulations on the new 30 percent interest expense limitation under IRC Section 163(j) contain an unwelcome surprise for manufacturers that are required to capitalize depreciation to cost of goods sold.

As a general rule, the deduction for interest expense is limited to interest income plus 30 percent of adjusted taxable income (ATI). ATI is computed in the following manner through 2021:

Taxable income with the following additions:
  • 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
Beginning in 2022, depreciation, amortization, and depletion no longer will be added back in computing ATI. However, the proposed regulations provide that once depreciation is capitalized to inventory under Section 263A, the capitalized amount ceases to be characterized as depreciation for purposes of ATI.

Consider the following example comparing a manufacturer that capitalizes depreciation to inventory and a service business that is not required to capitalize depreciation under Section 263A. In each case, taxable income before the application of Section 163(j) is $1 million, interest expense is $1 million, and depreciation is $3 million. The manufacturer is required to capitalize the entire $3 million of depreciation to inventory under Section 263A. The calculation of ATI and the 30 percent limit for each business is as follows:
As comments are received, significant opposition to the provision in the proposed regulations is expected. Until final regulations are issued, however, manufacturers and those required to capitalize depreciation to inventory should assume that depreciation capitalized to inventory will not be added back into the computation of ATI.

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David Strong
David Strong
Partner, Washington National Tax
Howard Wagner - social
Howard Wagner
Partner, Washington National Tax