The IRS released proposed regulations in November 2018 to provide taxpayers with guidance on applying a key tax reform provision related to business interest expense deductions. The 2017 tax law, commonly known as the Tax Cuts and Jobs Act (TCJA), created new limits on the deductibility of business interest expense for all businesses. Taxpayers are required to apply the limitation in tax years beginning after Dec. 31, 2017, but the application of several provisions remained unclear in the months following the passage of the TCJA, including:
- The definition of interest for purposes of the limitation
- The mechanics of calculating the interest expense limitation
- How partnerships, S corporations, and their owners apply the limitation
- How the limitation applies to foreign corporations with U.S. partners or shareholders
The proposed regulations would clarify how taxpayers calculate and apply the limitation, though many questions remain unanswered. The IRS recently released Form 8990, Limitation on Business Interest Expense under Section 163(j), along with instructions to this form.
Refresher on the Business Interest Expense Limitation
The TCJA now limits deductions for business interest expense to an amount that is equal to interest income plus 30 percent of the taxpayer’s adjusted taxable income (essentially EBITDA through 2021, thereafter EBIT). Any business interest expense that exceeds the new Section 163(j) limit is carried forward indefinitely.
The modifications to Section 163(j) apply to all businesses except those that are specifically exempt. There are five categories of exempt businesses:
- (1)The trade or business of being an employee,
- (2)An electing real property trade or business,
- (3)An electing farming business,
- (4)Certain regulated utility businesses, and
- (5)Certain “small businesses.”
The final category includes taxpayers other than “tax shelters” with average annual gross receipts under $25 million for the prior three years. Aggregation rules apply for the gross receipts of multiple taxpayers under common control. Notably, the definition of “tax shelters” used for purposes of this provision is quite broad and includes, among others, any partnership if more than 35 percent of the losses of the entity during the tax year are allocated to limited partners or limited entrepreneurs.
Real property trades or businesses and farming businesses can elect out of the limitation provisions altogether, but must apply the alternative depreciation system (ADS) to certain categories of real property. Property subject to ADS depreciation must utilize longer depreciable lives over a straight-line method, and is not eligible for bonus depreciation.
In the proposed regulations, the IRS offers more precise definitions of certain key terms, including the definition of interest, the components of adjusted taxable income, and applicable trades or businesses.
The proposed regulations’ definition of interest is expansive and includes both items that are treated as interest under other federal income tax provisions, as well as items that are closely related to business interest and affect the economic yield or cost of funds of a transaction involving interest, including:
- Substitute interest payments
- Certain debt issuance costs
- Certain commitment fees
- Guaranteed payments for the use of capital
- Income, deductions, gains or losses from derivatives or transactions used to hedge an interest-bearing asset or liability
The regulations also include a far-reaching anti-avoidance rule that requires amounts incurred in a transaction that would otherwise be a deductible expense or loss to be re-characterized as interest expense. This special rule applies to any amount that is incurred in a transaction where the taxpayer secures the use of funds for a period of time, and the amount predominantly represents consideration for the time value of money.
The proposed regulations provide numerous mechanical rules for the limitation calculation. For example, the limitation applies only after the application of any other provisions that would disallow, defer, capitalize or otherwise limit business interest. The proposed regulations then provide specific rules for C corporations, C corporations that are partners in a pass-through entity, Real Estate Investments Trusts (REITs), tax-exempt corporations, consolidated groups, pass-through entities and their partners, and foreign corporations.
In calculating EBITDA, the proposed regulations provide a particularly harsh result for manufacturing businesses. Such businesses would not be eligible to increase their EBITDA calculation by depreciation expense that is included in cost of goods sold. Because higher EBITDA translates to a higher limitation (i.e., more deductible interest expense), manufacturers are penalized compared to other industries.
Partnerships first calculate and apply the limitation at the partnership level. If there is no limitation at the entity level, the interest does not need to be separately stated from the taxable income or loss of the partnership and the corresponding partners’ distributive shares. On the other hand, any disallowed interest is separately stated and then allocated to the partners, who maintain their respective carryforwards of disallowed interest at the partner level. The proposed regulations outline an 11-step process to allocate the partnership’s adjusted taxable income, deductible and excess partnership interest expense, and business interest income to its partners.
Additionally, the proposed regulations clarify that Section 734(b) adjustments to partnership property are included in the calculation of the partnership’s adjusted taxable income. Partner-specific basis adjustments, such as Section 743(b) adjustments and remedial allocations under Section 704(c)(1), however, are instead considered in the calculation of a partner’s adjusted taxable income.
As previously stated, partners separately maintain carryforwards of disallowed partnership interest, or “excess business interest” (EBI). Partners take deductions for EBI carryforwards in succeeding years to the extent the partners are allocated “excess taxable income” (ETI) from the same partnership in a succeeding year. ETI essentially is the partnership’s taxable income in excess of the level needed to fully deduct the partnership’s business interest for a given year. Partners may not utilize taxable income from sources other than the same partnership to claim deductions for EBI carryforwards from the given partnership. However, ETI from a partnership can be used to determine a partner’s interest expense limitation with respect to other interest from non-partnership sources.
Partnerships with C corporations Partners
The proposed regulations confirm prior administrative guidance released in April 2018 and provide that a C corporation’s interest income and expense will be deemed to be business interest subject to the limitation (unless specifically excepted). For instance, this applies to investment interest income and expense allocated by a partnership to a C corporation partner.
Application to Corporations
Although pass-through entities must determine whether interest expense, interest income, and other items (income, gain, deduction, or loss) are allocable to a trade or business, a C corporation’s items generally are treated as allocable to a trade or business (unless the C corporation engages in an excepted trade or business). Also, the proposed regulations specify that a corporation’s deduction for current-year business interest expense is considered first, followed by any disallowed business interest expense carryforwards from a prior taxable year. Disallowed carryforwards are deducted in the order of the taxable year in which they arose, beginning with the earliest taxable year. Consolidated groups and S corporations are subject to similar rules. These ordering rules are important because a corporation’s disallowed carryforwards may be subject to Section 382 (net operating loss) limitations as a result of an ownership change.
The proposed regulations further discuss the impact of disallowed business interest expense on the earnings and profits (E&P) of a C corporation. They provide that the disallowance and carryforward of business interest expense has no bearing on the corporation’s E&P. E&P is meant to reflect a corporation’s economic ability to make dividend distributions to its shareholders, and the rule in the proposed regulations furthers this principle.
The proposed regulations provide that Section 163(j) applies to controlled foreign corporations (CFCs) and the partnerships they own. Thus, CFCs with business interest expense must apply the rules of Section 163(j) to Subpart F income computations, tested income for GILTI purposes, and income that is effectively connected with the conduct of a U.S. trade or business. Detailed examples that illustrate the application of the business interest expense limitation to CFCs are included in the proposed regulations as well.
The proposed regulations will take effect prospectively, starting in the tax year that ends after the date the regulations are published in the Federal Register. Taxpayers can choose to rely on the proposed regulations in tax years beginning after Dec. 31, 2017, provided that they and their related parties apply these regulations consistently.
Key Takeaways and Remaining Uncertainty
While the proposed regulations provide much needed clarity on a variety of issues that arose following the enactment of the new business interest expense limitation, there remain many ambiguities and unanswered questions. In particular, the treatment of excess business interest expense in tiered partnerships, in partnership mergers and divisions, and in lending transactions between a partner and a partnership have all been reserved for future proposed regulations.
Investment partnerships, most real estate partnerships, and other partnership businesses need to carefully consider the application of the small business exemption to their structures, and whether they may be considered tax shelters under the proposed rules.
Some taxpayers might choose not to rely on the proposed regulations, particularly if certain requirements of the proposed regulations (e.g., broad scope of interest expense, or the depreciation rule for manufacturers) provides for unfavorable results that might be avoided.
The inherent complexity of the proposed 11-step process to calculate the business interest expense limitation at the partner level requires partnerships to make extensive disclosures to their partners.
For more information on the clarifications to business interests, please contact us.
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Published on February 19, 2019