Advisories August 1, 2018

Federal Tax Advisory: The Interest Deduction Limitation

Executive Summary
Minute Read

Our Federal Tax Group explains why Section 163(j)’s small business exception is useful, but may not be quite the exemption taxpayers think it should be.

  • “Small business” is a difficult definition
  • Thwarted by the aggregation rule
  • Can you apply the real estate exemption?

New Section 163(j) does not seem to have caused a ripple in corporate borrowing, which is said to be at all-time highs. If public companies don’t care, S corporations, partnerships, and individuals may be more likely to escape due to the Section 163(j)(3) exemption for “small business.” But as usual, “small business” is a difficult definition.

Section 163(j) will not apply to any taxpayer with average annual gross receipts not exceeding $25 million for the three-tax-year period ending with the tax year that precedes the tax year at issue. Gross receipts are gross sales, investment income, and all amounts received for services. The test applies to the taxpayer, not the trade or business.

Example. High-salaried individual Jim makes $5 million in taxable compensation and sells stock for $21 million. Jim will be subject to the limitation except for the three-year averaging rule. But if the $21 million gross receipts is recurring due to investments in private equity funds, he could fall out of the exception. Of course, only his business interest expense would be affected by the limit. But his limit of deduction to 30% of his adjusted taxable income might not be so high because it would not include salary and investment income.

Also, the regulation aggregates the receipts of all persons treated as a single employer by Section 52(a) or (b), or Section 414(m) or (o). High-salaried individuals might try putting their leveraged business into a partnership, but the aggregation rule can thwart that effort to avoid the limit.

Even if Jim avoids direct involvement with Section 163(j), he can’t avoid indirect involvement if he owns an interest in a partnership that incurs debt, and they all do. The partnership will include in Jim’s K-1 his allocated share of deductible business interest, any nondeductible business interest, and investment interest that may be limited at Jim’s level.

But Jim says he is not concerned because all of his activities are related to real estate, and real estate is exempt. Right? Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business can elect (irrevocably) to be excluded from Section 163(j). That definition is broad but does not cover everything touching real estate.

An election by the real estate business is required to use the real estate exemption. It carries the downside of requiring use of the alternative depreciation method. That may not be so bad, except that it means bonus depreciation cannot apply. But it would not apply anyway to most real estate; however, efforts are under way to remove that limit on bonus depreciation.

The point is that the small business exception is very useful, but it may not entirely exempt taxpayers that think they should be exempt from the interest deduction limit.

For more information, please contact Jack Cummings at 919.862.2302.

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