Computing the Limitation
Let’s start by defining adjusted taxable income, which is calculated as follows.
+ Business interest expense
+ Net operating losses
+ Depreciation, amortization, and depletion
+ Qualified business income deduction
- Business interest income
+/- Other gains or losses unrelated to the operations of the business
Adjusted Taxable Income
If business interest expense exceeds 30% of this adjusted taxable income, the excess is disallowed as an expense in the current year. However, the disallowed interest deduction can be carried forward indefinitely.
Depreciation, amortization, and depletion will not be added back in the calculation of adjusted taxable income, though, when that provision expires in 2021. For some companies with high annual depreciation, including those that take advantage of the new 100% bonus depreciation, they could see a significant decrease to their adjusted taxable income, which could potentially cause more interest expense to be not deductible in the current year.
We say that the “deduction… is generally disallowed…” because there are a few exemptions to the disallowance.
Small business exemption
An exemption to the deduction limitation is if the business’s gross receipts for the past 3 years average $25 million or less. This test is applied every year to see if a business qualifies for the exemption.
In order to prevent break up of a business into smaller businesses to avoid the interest deduction limitation, the gross receipts of related businesses must be combined for purposes of the $25 million test. A related business is either a parent-subsidiary controlled group (parent company owns at least 50% of the subsidiary) or a brother-sister controlled group (5 or fewer shareholders own at least 50% of the stock of each entity).
Electing real property business exemption
Real estate professionals in a development, construction, rental, management, leasing, or brokerage type business may elect out of the interest expense limitation. The election out of the limitation is irrevocable and comes with a catch. If you claim the exemption for this reason, you must switch to the Alternative Depreciation System (ADS) to depreciate nonresidential real property, residential real property, and qualified improvement property. The ADS does not allow for bonus depreciation on your qualified improvements. Also, under ADS, the depreciable lives of assets are generally longer, which reduces the annual depreciation deduction.
Taxpayers involved in a farming business may also elect out of the interest deduction limitation. This election is also irrevocable and requires the taxpayer to use ADS to depreciate any property used in the farming business with a life of 10 years or more.
Floor plan interest exception
An additional exemption is for motor vehicle dealerships that have floor plan financing indebtedness that was used to finance the purchase of motor vehicles held for sale and is secured by the inventory that was purchased. Motor vehicles include automobiles, trucks, recreational vehicles, motorcycles, boats, farm machinery or equipment, and construction machinery or equipment. Interest paid on such floor plans is fully deductible.
Calculation for Pass-Through Entities
The business interest limitation applies to pass-through entities (such as partnerships and S corporations) at the entity level. The calculation of adjusted taxable income and allowable interest deduction is calculated by each entity. All partners or owners in the pass-through entity disregard income from that pass through entity when making their own calculation of adjusted taxable income and deductible business interest to avoid double counting of adjusted taxable income.
For example, assume Company ABC is owned 50% by Partnership A and 50% by Individual B. Company ABC has $500 of revenue and $150 of interest expense as its only activity during the year. ABC’s deduction for interest is limited to 30% of its adjusted taxable income, or $500 x 30% = $150. ABC is allowed to deduct all of its $150 in interest expense, for net taxable income of $350. On Partnership A’s K-1 from ABC will be reported its 50% share of the $350 in taxable income of ABC, or $175.
If Partnership A’s only activity other than the income passed through to it by ABC, is $50 of interest expense, it will also need to calculate adjusted taxable income to determine how much of the $50 in interest expense can be deducted. If Partnership A has no other income besides what is passed through from ABC, it has $0 in adjusted taxable income, which means none of its interest expense is deductible. If the double counting rule did not exist, Partnership A would be allowed to deduct all of its $50 in interest expense ($175 x 30% = $52.50).
The term “disallowed” in the definition only means that the excess interest is disallowed in the current year but can be carried forward to years that the business has enough adjusted taxable income. For partnerships, the excess is carried forward by the each partner rather than the entity. For S corporations, the excess is carried forward by the entity until it has enough income to cover the interest.
This new tax law could impact any businesses with debt financing, even those with lower levels of debt, in low profitability years. Businesses may want to rethink their capital structure, as the after tax cost of debt could increase if this limitation applies. Additionally, taking accelerated depreciation through 2021 will not impact the interest deduction limitation, as this is added back to taxable income in calculating adjusted taxable income. However, taking accelerated depreciation in 2022 and later will reduce taxable income and adjusted taxable income and could limit the interest expense deduction in those years. Finally, real estate professionals and farmers will need to weigh the benefits of electing out or not electing out of the limitation.