Businesses Face Complex Rules for New Interest Expense Deduction in 2018 by Andreea Cioara Schinas, CPA
Posted on October 25, 2018 by Andreea Cioara Schinas
Despite the generous tax breaks that the Tax Cuts and Jobs Act (TCJA) delivers to most businesses, the new law also introduces a few unfavorable provisions, including a significant limit on the deductions that certain businesses can claim as business interest expense.
Changes to Regulations
Prior to the TCJA, most businesses generally could deduct 100 percent of the interest accrued and paid on loans, credit cards and other types of business-related debt instruments they entered into to finance their operations. The primary restrictions to the deduction applied to loan interest associated with a taxpayer’s passive activities and those items of interest U.S. corporations paid to their foreign affiliates that did not have exposure to U.S. federal income taxes or were located in countries with a lower tax rate than the U.S. To prevent U.S. businesses from abusing the deduction to strip earnings out of the U.S. to lower tax jurisdictions, the tax code disallowed the deduction when an entity’s net interest expense exceeded 50 percent of its adjusted taxable income, and when the borrower’s debt equaled more than one-and-a-half times its equity.
This changes in 2018 with the passage of the TCJA, which eliminates the full deduction of business interest expense for those entities whose average annual gross receipts from all related businesses exceeds $25 million during the three years prior to the year in which the taxpayer is claiming the deduction. Rather than completely repealing the deduction, however, Congress limits the amount that large businesses may write off for business interest expense to the sum of:
- Business interest income,
- 30 percent of adjusted taxable income (ATI) before interest taxes, depreciation and amortization (EBITDA) for tax years 2018 through 2020, and
- Floor-plan financing interest on debt that taxpayers extend to customers to finance the purchase or lease of motor vehicles, boats or self-propelled farm machinery or equipment.
In 2022, the deduction will be limited further to 30 percent of ATI before interest taxes (EBIT) depreciation. Any remaining business interest expense disallowed as a deduction under the new 30 percent ATI limit may be carried forward indefinitely and applied to future tax years unless the limitation amount is more than taxpayer’s net business interest expense for the year.
Who is Not Subject to the 30 Percent Limitation Rules?
The TCJA specifically exempts from the 30 percent deduction limitation those businesses whose aggregate gross receipts for the three most recent tax years are $25 million or less. According to the IRS, this exemption will exclude most all small and midsize U.S. businesses from the limitation rules.
It is important for taxpayers with affiliated corporations that file consolidated returns to recognize that they must apply the gross receipts test at the single-entity group level for all of their related companies. However, taxpayers may exclude intercompany debt from this gross receipts calculation. Taxpayers also should note that their calculation of average annual gross receipts will vary from year to year based on how their businesses performed over the most recent three years. For example, a business filing taxes for 2018 will be subject to the business interest expense deduction limitation when average gross receipts totaled $30 million for 2015, 2016 and 2017. However, if the company has a bad year in 2018 and average gross receipts for 2016, 2017 and 2018 total $20 million, it will be exempt from the limitation rules and be able to deduct the full amount of business interest expense on its 2019 tax returns.
The law also provides a special exemption for certain real estate and farming businesses. Specifically, businesses that develop/redevelop, construct/reconstruct, acquire, operate, manage, rent/lease or broker real property may elect out of the business interest expense limitation. However, doing so will require them to use the Alternative Depreciation System (ADS) to more slowly depreciate nonresidential property, residential rental property and qualified improvement property. Making this decision requires taxpayers to plan ahead and rely on their accountants to determine whether electing out of the rules and applying lower depreciation deductions would provide them with enough of a tax benefit.
Considerations for Electing Out of Business Interest Estate Rules
Real estate businesses that make an election to opt out of the interest expense deduction limit rules must recognize that doing so is a permanent decision they cannot revoke. Therefore, special consideration should be given to not only the potential advantages of making an election to be exempt from the new rules and claiming a full deduction for business interest expense, but also the reduced annual depreciation deductions and loss of first-year bonus depreciation that comes with electing out.
Making these decision is even more complicated today, while we await further guidance from the IRS on how businesses, including partnerships and pass-through entities, should interpret the law and apply it to their specific and unique circumstances.
The advisors and accountants with Berkowitz Pollack Brant work with businesses in all industries and across international borders to help them understand complex and evolving tax laws and develop sound strategies for complying with the law while maximizing tax-saving opportunities.
About the Author: Andreea Cioara Schinas, CPA, is a director with Berkowitz Pollack Brant’s Tax Services practice, where she provides corporate tax planning for clients through all phases of business operations, including formation, debt restructuring, succession planning and business sales and acquisitions. She can be reached in the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000, or via email at email@example.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.