Dissecting the Business Interest Expense Limitation
The tax reform bill commonly referred to as the Tax Cuts and Jobs Act included many provisions that reduce the tax burden of businesses, including a corporate tax rate cut from 35 percent to 21 percent and a new 20 percent deduction on qualified business income, among others.
Congress offset part of the cost of the tax cuts by placing limits on the amount of interest that certain businesses can deduct. Let’s untangle how the deduction limitation works.
Computing the limitation
Prior to 2018, taxpayers could generally deduct business interest, subject to a few relatively uncommon exceptions. Effective for tax years starting in 2018, a taxpayer’s deduction for net business interest is limited to 30 percent of adjusted taxable income, which is taxable income without taking into account:
- Non-business income, like gains from the sale of assets held for investment
- Business interest expense or business interest income
- Net operating loss deductions
- The new 20 percent qualified business income deduction
- Depreciation, amortization, or depletion
The limitation does not apply to investment interest. The adjustment for depreciation, amortization, or depletion applies only through 2021, so the limitation will be much more restrictive for capital-intensive businesses for tax years starting in 2022.
The deduction for floor plan interest — which is interest on debt incurred to finance a dealer’s purchase of motor vehicle inventory for sale or lease — is not limited. However, most businesses that have floor plan financing will not be able to claim the new 100 percent bonus depreciation deduction with respect to any of their asset purchases.
Example: Abby Company is a C corporation and has the following items of income and expense during the 2018 tax year.
Gross receipts 100
Interest income 5
Cost of goods sold (70)
Interest expense (15)
Taxable income before
interest limitation 10
Abby Company’s interest expense deduction is computed as follows:
Taxable income before
interest limitation 10
Add back: net interest expense 10
Add back: depreciation 10
Adjusted taxable income
Multiply by 30% x30%
Business interest deduction
In this example, Abby Company’s deduction for net interest expense is limited to $9, resulting in disallowance of $1 of interest expense ($15 interest expense - $5 interest income = $10 net interest expense - $9 interest expense limitation = $1 disallowance).
The limitation applies to all business entity types and is generally applied at the entity level. Any interest that is not deductible as a result of the limitation is carried forward indefinitely until it can be absorbed.
Exceptions to the limitation
The limitation does not apply to small businesses, electing real property businesses, electing farming businesses, and certain utility companies. Each of these exceptions is discussed, in turn, below.
Small business exception
Businesses with average annual gross receipts over a trailing three-year period of $25 million or less are not subject to the limitation. The gross receipts of related businesses must be combined for purposes of the $25 million test, so taxpayers cannot avoid the limitation by breaking the business up into several separate legal entities.
Electing real property business
Taxpayers engaged in a real property business, including a real estate development, construction, rental, management, or brokerage business, among others, may elect to not have the interest limitation apply to their business. The election is irrevocable and carries a cost: electing taxpayers are required to use the alternative depreciation system for their nonresidential real property, residential rental property, and qualified improvement property. The following table summarizes the differences:
|Applying interest limitation||Electing out of interest limitation|
|Asset category||Depreciable life (years)||Eligible for bonus?||Depreciable life (years)||Eligible for bonus?|
|Nonresidential real property||39||No||40||No|
|Residential rental property||27.5||No||30||No|
|Qualified improvement property — under tax reform||39||No||40||No|
|Qualified improvement property — if Congress passes a technical corrections bill||15||Yes||20||No|
|Most other tangible property||5 to 15||Yes||5 to 15||Yes|
The table illustrates that the differences in depreciation with and without the election are relatively small if Congress does not pass a technical corrections bill. For example, the depreciable life for nonresidential real property is 39 years without the election and 40 years with the election.
The difference will become significantly more pronounced if Congress passes a technical corrections act since qualified improvement property would generally be eligible for 100 percent bonus depreciation without the election and would be depreciated over 20 years with the election.
Electing farming business
Taxpayers engaged in a farming business may elect out of the interest limitation. A farming business includes the traditional cultivation of land or the raising or harvesting of any agricultural or horticultural commodity. It also includes, but is not limited to, a business of operating a nursery or sod farm, raising or harvesting fruit, nut, or ornamental trees, or any trade or business of a specified agricultural or horticultural cooperative.
An electing farming business is required to use the alternative depreciation system — with its accompanying restriction on using bonus depreciation and longer depreciation lives — for any asset with a useful life of more than 10 years, including land improvements, barns, and other farm buildings.
A business is not subject to the business interest limitation if it furnishes or sells any of the following:
- Electrical energy, water, or sewage disposal services
- Gas or steam through a local distribution system
- Transportation of gas or steam by pipeline
Application to pass-through entities
Pass-through entities apply the interest limitation at the entity level. If 30 percent of the adjusted taxable income of the pass-through entity exceeds the interest incurred by the entity, the excess passes through to the owner as “excess taxable income” and can be taken into account in computing the amount of business interest that can be deducted by the owner.
If an S corporation has interest expense in excess of the limitation, the excess carries over at the entity level until the corporation generates enough income to absorb the interest. If a partnership has interest in excess of the limitation, the excess interest is allocated to the partners with the excess interest carried over at the partner level until the partner is allocated excess taxable income from that entity.
The result is that an S corporation shareholder does not reduce its basis in the S corporation stock until the interest is deducted, but a partner reduces its basis in the partnership when the interest is incurred even if not yet deductible.
Mitigating the limitation
The business interest limitation can have a significant effect on your tax liability and can apply even to conservatively financed businesses. For example, because the limitation is based on a percentage of adjusted taxable income, the limitation can apply in years of low profitability.
Take the following steps to understand and help mitigate the effects of the business interest limitation.
- Model your 2018 tax liability taking into account the business interest limitation.
- Model the costs and benefits of electing for the limitation to not apply to real estate or farming businesses (e.g., comparing the benefit of the interest expense deduction to the cost of longer depreciation lives and ineligibility for 100 percent bonus depreciation).
- Consider the potential effect of the limitation on your capital structure since the limitation will increase the after-tax cost of debt financing. Some businesses may decide to use preferred equity in lieu of subordinated debt if the interest deduction is limited.
The IRS is expected to release guidance to clarify the application of the rules, so stay tuned for more information. Contact your tax advisor with questions about how the rules affect your business.