The business interest expense deductibility limitation provisions of Sec. 163(j) have taken on a broader scope since the passage of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Under the TCJA, many businesses that rely on debt financing and historically received interest expense deductions associated with it must use a mechanical computation to determine the deductibility of their interest expense. For tax years beginning after 2021, the starting point for the computation, adjusted taxable income (ATI), was recently modified in a way that can make the business interest limitation more restrictive. After providing some background on the Sec. 163(j) business interest limitation, this item discusses how the rules for calculating ATI have changed for 2022 and beyond and how this affects the deductibility limit.
Prior to the TCJA, the provisions of Sec. 163(j) had a narrow application. The Code subsection was expanded by the TCJA to apply to all businesses, with certain exceptions described below. In addition, the maximum deduction allowed for business interest now became limited to the sum of:
- The taxpayer’s business interest income for the tax year;
- 30% of the taxpayer’s ATI for the tax year; and
- Floor plan financing interest expense.
Any interest disallowed can be carried forward, subject to the provisions of Sec. 163(j) in the succeeding tax year. The 30% ATI limitation was increased to 50% of ATI for the 2019 and 2020 tax years by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, then reverted back to the 30% limitation for the 2021 tax year.
Some types of taxpayers are exempt from Sec. 163(j)’s deductibility limit. An exemption is generally available for small businesses — defined as businesses whose average annual gross receipts for a three-year period do not exceed $27 million (the inflation-adjusted amount for tax years beginning in 2022; see Sec. 448(c) and Rev. Proc. 2021-45).
Other exceptions exist, too. Performing services as an employee, as well as engaging in trades or businesses furnishing or selling utilities, is not considered a trade or business for purposes of Sec. 163(j). An electing real property trade or business (as described in Sec. 469(c)(7)(C)) and an electing farming business (as defined in Sec. 263A(e)(4) or 199A(g)) are not considered to be a trade or business for purposes of Sec. 163(j). Making these specific elections requires the use of the alternative depreciation system (ADS) to depreciate nonresidential real property, residential rental property, qualified improvement property, and property used in a farming business with a recovery period of 10 years or more. Once made, the election is irrevocable.
Computing the deductibility limit
The starting point for computing the limitation on the business interest deduction is determining ATI. ATI is taxable income computed without regard to (1) any item of income, gain, loss, or deduction that is not allocable to a trade or business; (2) any business interest or business interest income; (3) the amount of any net operating loss deduction under Sec. 172; and (4) the amount of any deduction allowed under Sec. 199A.
For tax years beginning prior to Jan. 1, 2022, ATI was also computed without regard to any deduction allowable for depreciation, amortization, or depletion. That is, these items were added back in calculating ATI. This add-back rule no longer applies for tax years starting after 2021 (Sec. 163(j)(8)(A)(v)). The rule’s expiration could significantly reduce the interest expense deduction limit for highly leveraged businesses.
To illustrate the potential effect of this change, the following example compares a company’s interest limitation before and after the recent modification to the ATI calculation.
Example: Company X, a C corporation, has average annual gross receipts of $60 million over the three-year tax period ending Dec. 31, 2022. The company has no business interest income or floor plan financing during the year. Its earnings before interest, depreciation and amortization (EBIDA) are $1.5 million. Company X has $50 million in outstanding debt. Interest expense on the debt is approximately $3 million per year. During 2022 the company purchased $1 million of computer equipment and elected to take bonus depreciation under Sec. 168(k). For its 2022 tax year, Company X will be limited to an interest expense deduction of $150,000. See the table “Interest Expense Limitation for 2022,” below.
By way of comparison, the table “Interest Expense Limitation for 2021,” below illustrates what the interest expense limitation would be if the same facts and circumstances took place during the 2021 tax year, when depreciation, amortization, and depletion were not considered in the computation of ATI.
As can be seen, under the same facts and circumstances, the expiration of Sec. 168(j)(8)(A)(v) results in an increased federal tax liability of $63,000.
Because of the change in the ATI calculation, practitioners should consider if an eligible client could qualify to be an electing real property trade or business or an electing farming business. The practitioner must weigh the cost of adopting the ADS method of depreciation for tax purposes with the effect of the changes in the Sec. 163(j) rules. The change in the business interest limitation provisions should be addressed with clients in connection with other tax planning strategies.