This article summarizes the key highlights of the CARES Act modifications and recent IRS regulations associated with the interest expense limitation rules under IRC Section 163(j). In general, the interest expense limitation rules under Section 163(j) were enacted as part of the Tax Cuts and Jobs Act, effective for tax years beginning after December 31, 2017. Subject to certain limitations (e.g., small business exception, electing real estate businesses, and public utilities), taxpayers are limited in claiming business interest expense deductions based on a percentage of “adjusted taxable income” as further discussed below:
CARES Act Modifications of Business Interest Expense
The Tax Cuts and Jobs Act imposed a limitation for business interest expense based on 30 percent of a taxpayer’s taxable income (with certain adjustments as discussed below). Interest expense that is limited by the 30 percent of adjusted taxable income is suspended and carries forward to subsequent tax years. The CARES Act (enacted into law on March 27, 2020) modified the percentage amount for tax years beginning in 2019 and 2020 by raising the percentage of adjusted taxable income from 30 percent to 50 percent. For partnerships, the percentage of adjusted taxable income remains at 30 percent for 2019 and increases to 50 percent for 2020. For 2019 interest expense limited at the partnership level, 50 percent is deductible in 2020 by the partners without limitation, and the remaining 50 percent is deductible under the applicable limitation rules, i.e., when the partnership allocates excess taxable income to the partners.
The CARES Act modifications allow taxpayers to elect to use their 2019 adjusted taxable income for purposes of calculating their 2020 interest expense limitation amount. Further, the CARES Act’s legislation made a technical correction concerning qualified improvement property (due to an error in the legislation in the Tax Cuts and Jobs Act, Congress erroneously failed to include qualified improvement property as being eligible for 15-year depreciation and most significantly, 100 percent bonus depreciation). The CARES ACT enacted the correction and therefore qualified improvement property may now qualify for bonus depreciation (pre-CARES Act correction resulted in qualified improvement property being treated as 39 year life property for depreciation, and ineligible for bonus depreciation). The correction for qualified improvement property impacts real estate business owners who previously elected out of Section 163(j) since the result of such election required the taxpayer to use alternative depreciation for nonresidential real property, residential real property, and qualified improvement property (under the alternative depreciation system of depreciation, assets have longer depreciation lives, e.g., nonresidential real property has a 40 year life, and is not eligible for bonus depreciation). Taxpayers may revisit their previous elections out of the interest expense limitation rules (the IRS issued Rev. Rul. 2020-22 with procedures for taxpayers to revoke elections out of Section 163(j)) and claim bonus depreciation for qualified improvement property as a result of the legislative correction in the CARES Act.
Highlights of Key Section 163(j) Final Regulations
Final IRS Regulations were issued in June 2020 and recently in January 2021 covering calculations of adjusted taxable income, definition of interest, limitation rules for partnerships and carryover of suspended deductions, and limitation rules for S corporations and C corporations. The highlights of the IRS’ regulations are discussed below:
Small Business Exemption and Rules for Syndicates
As mentioned above, taxpayers that meet the small business exemption (based on a $26 million average gross receipts test in accordance with Code Section 448(c)) may avoid the interest expense limitation rules under Section 163(j). However, Section 448(c) contains a special rule for tax shelters, including “syndicates”. The final regulations define the term syndicate as including any partnership or other entity (except C corporations) if more than 35 percent of the losses of such entity are allocated to limited partners or limited entrepreneurs. This rule could cause a potential tax trap for the unwary, and subject otherwise small business taxpayers operating as pass-through entities to the Section 163(j) rules.
Calculation of Adjusted Taxable Income
Taxpayers’ business interest expense is limited by the applicable percentage discussed above (increased from 30 percent to 50 percent by the CARES Act for 2019 and 2020, except partnerships still use 30 percent for 2019) multiplied by adjusted taxable income (“ATI”). The calculation of taxpayer’s ATI begins with tentative taxable income with additions for depreciation and amortization deductions (applicable for tax years beginning before January 1, 2022), net operating losses, Section 199A deductions, and capital loss carrybacks and carryforwards. Depreciation that is capitalized into ending inventory under IRC Section 263A is also added back in determining ATI. Key subtractions from tentative taxable income include depreciation and amortization deductions associated with property sold during the taxable year (for tax years beginning before January 1, 2022). Also, with respect to controlled foreign corporations (“CFCs”), deemed income inclusions such as subpart F income and GILTI income is subtracted from tentative taxable income (Section 163(j) is applied at the CFC level).
Definition of Interest Expense
The IRS’ final regulations provided a narrower definition of what constitutes interest expense that first provided in the IRS’ initial proposed regulations. In addition to a traditional definition of interest (i.e., compensation for the use or forbearance of money under the terms of an instrument treated as a debt instrument for purposes of federal income taxes), the regulations include time value of money principals, thus, original issue discount (“OID”) and amounts treated as interest associated with contingent payment obligations are included in the definition of interest for Section 163(j) purposes. Further, although the proposed regulations included partnership guaranteed payments for the use of capital payable to a partner in the definition of interest, the final regulations removed such payments in the definition of interest (however, an example in the regulations include such guaranteed payments if the arrangement was motivated as an attempt to reduce interest expense and was economically equivalent to interest).
Application of Interest Expense Limitation Rules
In general, the interest expense limitation rules are applied at the partnership level in determining the non-separately stated income or loss of the partnership. Suspended interest expense is allocated to the partners and carried forward at the partner level. Suspended interest expense is treated as a reduction in the partners’ adjusted tax basis in their partnership equity. Suspended interest expense, i.e., excess business interest expense is deductible in subsequent tax years when the partnership allocates excess taxable income to the partner. The term excess taxable income is defined in the regulations as the amount of ATI in excess of the amount of the minimum amount of ATI that is required to deduct interest expense under the limitation rules (i.e., ATI x 30 percent or 50 percent as modified by the CARES Act). In addition, the regulations provide for a special basis adjustment for a partner’s suspended interest upon the disposition (including partial dispositions) of their partnership equity.
Application of Section 163(j) For
C Corporations and S Corporations
S Corporations apply the Section 163(j) interest expense limitation rules at the S corporation or entity level. Suspended interest expense remains at the entity level and is not allocated to the shareholder level. In subsequent tax years, once ATI is greater than the amount required to claim current tax year deductions, any suspended interest expense carryforward is deducted at the entity level to the extent allowable based on the applicable amount of ATI.
For C corporations, interest expense is treated as business interest expense subject to Section 163(j)limitation rules. Further, C corporation partners in a partnership that receive allocations of interest income and expense must treat such interest as business related, even though the partnership’s activities are investment related. Interest expense that is limited at the corporation level is treated as suspended interest, subject to carryforward rules that require ATI in subsequent tax years to be of an amount that will free up suspended interest. For purposes of determining the corporation’s earnings and profits (“E&P”) for dividend status, interest expense is treated as a reduction of E&P, even though subject to limitation under Section 163(j). In addition, suspended interest expense carryforwards are treated as an applicable carryforward under IRC Section 381 (attribute carryover rules) in certain corporate reorganizations such as mergers of corporations and subject to change in ownership limitation rules under Section 382.