The legislation commonly known as the Tax Cuts and Jobs Act replaced the “earnings stripping” rules with “new” Section 163(j), which generally limits deductions for net interest expense of a business. Former Section 163(j) was somewhat narrower. It generally limited interest deductions for certain related-party debt and applied to corporations with a debt-to-equity ratio greater than 1.5 to 1 and whose net interest expense exceeded 50% of the corporation’s adjusted taxable income in a taxable year. New Section 163(j) applies to all debt, whether between related parties or incurred by a corporation, and regardless of the taxpayer’s debt-to-equity ratio.
New Section 163(j) disallows deductions for business interest expense that exceeds an adjusted earnings-based threshold. In general, deductions are disallowed to the extent business interest expense is incurred in a taxable year in excess of (1) business interest income; (2) 30% of the taxpayer’s adjusted taxable income; and (3) floor plan financing interest. The limitation applies after other potential limitations on deductibility of interest expense are considered, including interest capitalization rules or other disallowance provisions. Disallowed interest expense may be carried forward indefinitely to succeeding taxable years.
“Business interest” includes interest allocable to a trade or business and excludes “investment interest” (as defined in Section 163(d), which contains a separate limitation applicable to investment interest expense of non-corporate taxpayers).
“Adjusted taxable income” is generally computed using a formula that mimics EBITDA through 2021, but starting in 2022, a harsher definition kicks in that mimics EBIT.
There are notable exclusions for specified trades or businesses: the performance of services as an employee, electing real estate businesses, electing farm businesses, and certain regulated public utilities. Once made, the elections for real estate and farming businesses are irrevocable and, as a trade-off, those businesses will be required to use longer depreciation methods. Businesses with average annual gross receipts over the prior three years of $25 million or less are also excluded.
Special Rules for Partnerships and S Corporations
The business interest limitation applies at the partnership, not the partner, level. Business interest deductions are taken into account at the entity level as items of non-separately stated partnership income and loss. Each partner computes its adjusted taxable income without regard to its distributive share of partnership income and loss. This prevents partners from using their allocable shares of partnership adjusted taxable income to generate larger interest deductions as the taxable income is passed through.
To the extent a partnership has excess capacity for interest deductions (i.e., it could have deducted more had it incurred more interest expense), a partner can use its proportionate share of the excess capacity to avail itself of greater deductions for other interest expense it incurred at the partner level. The rules accomplish this by permitting partners to add their allocable share of the partnership’s “excess taxable income” to their separate computation of adjusted taxable income for the business interest expense deduction calculation.
Rules for entity-level interest expense deductions and the ability of pass-through owners to use a portion of the entity’s excess capacity also apply to S corporations and their shareholders.
Special carryforward rules apply if a partnership has excess interest expense that is disallowed under the new limitation. The excess interest expense is allocated to partners based on their distributive shares of non-separately stated taxable income and loss of the partnership and will be treated as paid or accrued by the partners starting in the next taxable year in which the partners are allocated excess taxable income from the partnership. Thus, carryforwards of disallowed interest expense can only be used by partners against (and to the extent of) subsequent excess taxable income of the partnership.
A partner’s basis in its partnership interest is decreased (not below zero) at the time the excess interest expense is allocated to the partner, even though the carryover can only give rise to partner deductions in later years. The result is a timing mismatch between the deduction and the basis reduction, which limits the partner’s ability to receive tax-free actual or deemed cash distributions and other partnership loss deductions. However, if a partnership interest is disposed of in a taxable or non-recognition transaction before a deduction is taken, the partner’s basis in the interest is increased immediately before the disposition by the partner’s share of the excess interest expense allocated to, but not yet deducted by, it. The rules also prohibit a transferor and a transferee from taking a deduction for the excess interest expense that creates this basis increase.
These special carryforward and corresponding basis rules do not apply to S corporations and their shareholders.
Rules for Corporations
Carryovers of disallowed interest expense are treated as attributes that can be carried over in certain non-recognition transfers. However, carryovers of disallowed interest expense are treated as items of pre-change loss that are subject to limitation under Section 382 upon certain ownership changes.
An Evolving State of Affairs
The most remarkable aspects of the new interest expense limitation are probably what its final provisions leave out.
Earlier versions of the legislation would have also limited interest deductions for U.S. members of international groups based on certain worldwide proportionality ratios. These provisions were abandoned in the final law.
On whether the new Section 163(j) limitations should be applied at the consolidated group level, the text is silent, but the legislative history indicates that it should. During a recent public event, a Treasury official indicated that forthcoming guidance would confirm that new Section 163(j) applies at the consolidated group level (and not on an elective basis), but then a few weeks later another Treasury official at another public event indicated that this still remains under consideration at the IRS, including whether to apply the limitation on a single-entity, separate-entity, or hybrid basis for consolidated groups. It is unclear how this ultimately will be applied.
Perhaps attributable to the speed with which this monumental tax reform effort was translated into law, the provisions do not grant specific regulatory authority for additional guidance. Old Section 163(j) granted such authority in numerous places. Nevertheless, administrative guidance is needed to address several open issues, such as rules applicable to consolidated groups and to foreign taxpayers with income effectively connected to a U.S. trade or business, and the ability to use carryforwards beyond 2017 for disallowed interest expense under the old Section 163(j) earnings stripping rules.
Also unclear is whether and how any guidance in this area might dovetail with a recent focus by the Treasury on debt recharacterization rules under Section 385. Recent final and temporary regulations issued under Section 385 that purported to expand its reach have since been delayed. Shortly before the enactment of the Tax Cuts and Jobs Act, the Treasury issued a statement announcing its intent to revoke and/or substantially revise them. Perhaps those proposals are being reconsidered in light of new Section 163(j).