Business Interest Expense Deductions Become More Restrictive in 2022 by Heath Standorf, CPA
One of the few unfavorable provisions of the Tax Cuts and Jobs Act (TCJA) recently became even more detrimental to certain businesses. Effective Jan. 1, 2022, the amount of net business interest expense (BIE) businesses may deduct from taxable income is further reduced. The results have the potential to increase investment and borrowing costs, making it more expensive for many companies to conduct business. Here’s what you need to know and how you can prepare.
The TCJA introduced Section 163(j) to the tax code in 2018, calling for a cap on net interest expense as a share of earnings and bringing the U.S. in line with the standards the Organization of Economic Cooperation and Development (OECD) issued for its 38 member countries.
Effective for tax years beginning in 2018, deductions for business interest expense are limited to 30 percent of adjusted taxable income (ATI), calculated as earnings before deductions for interest, taxes, depreciation and amortization (EBITDA). Any interest expense not allowed as a deduction could be carried forward and treated as business interest paid or incurred in the following taxable year. With the pandemic and subsequent passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2021, this restriction was lifted temporarily, allowing businesses to deduct more BIE in tax years 2019 and 2020.
Now that the pandemic relief is behind us, we must revert to the original language of the TCJA, under which the limitation calculation becomes even more restrictive beginning in 2022. You can no longer add back depreciation and amortization expenses in the calculation of ATI. Therefore, this will result in a reduced ATI and an even smaller BIE deduction. For many capital-intensive companies with significant depreciation and amortization expenses, this change can have a significant impact on tax calculations.
The good news for many companies is that they may qualify for an exemption from the more restrictive business interest deduction limitation for tax years 2022 through 2027, or they may have an opportunity to elect out, depending on their trade or business activities.
The Small Business Exception
The TCJA carves out a small business exception from the 30 percent BIE deduction limitation for entities that have average gross receipts of $27 million or less for the three most recent tax years and are not “tax shelters,” defined as pass-through entities, such as S corporations and partnership, that allocate more than 35 percent of their annual losses to limited partners or entrepreneurs who do not actively participate in the management of those entities. To qualify for this exception and avoid treatment as a tax shelter, businesses should consider the amount of time they commit to the businesses’ activities and reconsider their provisions for allocating losses to partners.
To determine gross receipts for the purpose of qualifying for an exception from the BIE deduction limitation, businesses may be required to aggregate gross receipts for affiliated companies. For partnerships and S corporations, the deduction limitation is applied at the entity level. However, the disallowed amount for a partnership is allocated to their individual partners, whereas the excess business interest expense of an S corporation can be carried forward to the following taxable year.
For U.S.-based multinational businesses, the Section 163(j) interest expense limitation rules should be applied to their controlled foreign corporations (CFCs) and CFC Groups to calculate Subpart F income, GILTI tested income and income effectively connected with a U.S. trade or business (ECI).
Controlled foreign corporations (CFCs) with common ownership have the option to calculate interest expense deduction limitations on a CFC-by-CFC basis or by applying consolidated group rules to calculate a single limitation for all commonly owned CFCs. These regulations also address the determination of deduction limitations for partnerships and their partners, including specific guidance for tiered partnerships, and the allocation of interest expense in pass-through entities. Taxpayers may rely on these proposed rules until the IRS issues and publishes its final regulations in the federal register. Consequently, it is critical that taxpayers seek the counsel of experienced advisors.
Excepted Trades and Business
Under Section 163(j), certain trades or businesses may be excepted from the limitation on business interest expense deduction, including:
- Those providing services as an employee,
- Certain real property trades or businesses that elect to be excepted,
- Certain farming businesses that elect to be excepted, and
- Certain regulated utility trades or businesses.
Qualifying real estate and farming businesses that elect out of the interest expense limitation must recognize that it is a permanent, un-revokable decision that comes with other financial implications. While they may receive the benefit of a full deduction for business interest expense, they will also lose their ability to deduct bonus depreciation and are required to use the Alternative Deprecation System (ADS) for certain assets, resulting in longer depreciation periods and lower annual depreciation deductions.
The decision to elect out of the business interest expense limitation is one that should be made under the guidance of professional advisors and CPAs to ensure taxpayers consider all the implications of their actions, including the current and future financial and tax impact on the business entity and all its shareholders.
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: Heath Standorf, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he helps high-net-worth entrepreneurs and real estate developers structure their businesses and manage complex transactions for optimal tax efficiency. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or at email@example.com