Business interest limitation rules (section 163(j)) – Where do we stand?

The business interest expense deduction limitation — the infamous section 163(j) — was enacted as part of the Tax Cuts and Jobs Act (TCJA). In addition to being a major revenue-raiser, this provision is one of the most complicated sections of the tax reform law, but since the TCJA passed in late 2017, the Treasury Department and the IRS have been busy cranking out rules and guidance to help taxpayers implement the new law — and 2020 was no exception.

Here is where things stand as of early fall:

Coronavirus Aid, Relief, and Economic Security (CARES) Act changes

Prior to the CARES Act, the business interest expense deduction was limited to the sum of the taxpayer’s business interest income, plus 30% of adjusted taxable income (ATI), plus floor plan financing interest expense. The CARES Act added several special rules, which should be taken into account for 2020 tax planning, including:

• The Act retroactively increased the section 163(j) limitation to 50% of ATI (up from 30%) for 2019 and 2020, for taxpayers other than partnerships. Taxpayers have the option of electing out of this rule and using 30% instead of 50%.
• For partnerships, the increase to 50% only applies for 2020. Partners allocated excess business interest expense (EBIE) from 2019 can deduct 50% of that amount as an interest deduction in their 2020 tax year, without limitation.
• The Act also allows taxpayers to elect to use their 2019 ATI to calculate the 2020 section 163(j) limitation. This election will be helpful for taxpayers experiencing losses in 2020 due to current economic conditions.

Of course, no discussion of the CARES Act would be complete without mentioning qualified improvement property (QIP) and the interaction of the bonus depreciation rules with section 163(j). Taxpayers with real property trades or businesses can elect out of the business interest expense deduction limitation, but the trade-off is that they must use longer depreciation recovery periods for nonresidential real property, residential real property and QIP — and, under these rules, QIP would not be eligible for bonus depreciation. However, due to a drafting error in the TCJA, QIP was not eligible for bonus depreciation — this was known as the “retail glitch.” For many real estate taxpayers, since tenant improvements weren’t eligible for bonus anyway, this meant there was very little downside to making the election out of the interest limitation.

Fast forward to the CARES Act. More than two years after passage of the TCJA, Congress finally got around to fixing the retail glitch. Of course, many taxpayers may have made different decisions regarding the real property trade or business election if QIP had been eligible for bonus depreciation all along. Fortunately, in a series of revenue procedures released in April, Treasury and the IRS gave taxpayers the chance to revoke the real property trade or business election, make a late election and correct or catch up depreciation for QIP. The deadline for making these changes for 2018, 2019 and/or 2020 returns generally is Oct. 15, 2021.

Final regulations

As we discussed in our previous tax alert, the IRS issued final section 163(j) regulations in late July. In terms of year-end planning, here are some things to keep in mind:

• Take advantage of the cost of goods sold depreciation add-back. In computing the interest limitation, ATI is analogous to earnings before interest, taxes, depreciation and amortization (EBITDA). For 2020 and 2021, manufacturers and other taxpayers who are required to capitalize depreciation to inventory can add back those amounts when computing ATI. This is a taxpayer-favorable change in the final regulations, which will result in a larger interest deduction. However, starting in 2022, the ATI component must be calculated without the add-back for depreciation and amortization, meaning a lower limit and smaller interest deductions.
• Consider a “protective” real property trade or business election. Rental real estate activities that do not rise to the level of a trade or business, such as triple net lease arrangements, generally are not subject to the section 163(j) business interest expense limitation. Whether an activity rises to the level of a trade or business is based on all the facts and circumstances and, in some situations, it may not be immediately clear if rental real estate is a trade or business or not. Under the final regulations, taxpayers conducting rental real estate activities can make the real property trade or business election on a protective basis. This ensures any business interest expense incurred in the activity will be excepted from the limitation, if the IRS later determines the taxpayer was operating a trade or business.
• Watch out for the tax shelter rule. For 2020, taxpayers with average annual gross receipts of $26 million or less are exempt from the section 163(j) limitation. Under the final regulations, exempt partnerships and S corporations do not have to separately state business interest, and the interest expense is not subject to further testing at the partner or shareholder level. However, there’s a catch — this exemption does not apply to tax shelters, which are defined much more broadly than one would anticipate. A “tax shelter” for this purpose is an entity, other than a C corporation, if more than 35% of the losses during the taxable year are allocated to limited partners or limited entrepreneurs. A “limited entrepreneur” is a person who has an interest in an entity (other than a limited partnership interest) and who does not actively participate in the management of the entity. Whether a taxpayer actively participates in management is based on facts and circumstances. With losses in many sectors continuing to pile up due to the pandemic, taxpayers that were planning to rely on the section 163(j) exemption need to make sure they don’t fall into the tax shelter trap.
• Make sure you know what “interest” is. The 2018 proposed regulations defined interest broadly and included many items not traditionally viewed as interest in the eyes of borrowers. In response to comments, the IRS removed a number of items from the definition of interest, including loan commitment fees, debt issuance costs and certain hedging costs. For partnerships, the IRS acknowledged that guaranteed payments for the use of capital typically are a return on a partner’s investment, not interest expense. Under the final rules, guaranteed payments for the use of capital will only be treated as business interest expense in certain abusive situations.

For more information on this topic, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.